Classification of Financial Markets

Markets can be classified into different categories depending on the characteristic of the market or instrument used to create categories. Securities created by institutions in the markets normally pay an interest on the nominal amount (the amount shown on the certificate or contract). The interest-bearing securities market is split into the money market and the capital market, based on the term to maturity (the term left to redemption of the debt) of the securities.

 - The capital market is the market for the issue and trade of long-term securities.

 - The money market is that of short-term securities.

When goods such as financial instruments are traded in a market, there are certain differences between transactions done in these markets. The differences in transactions in the financial markets can be categorised in different categories, two of which are the following:

 - The timing difference between the closing of the transaction and the delivering of the goods or     settlement of the transaction
 - The difference in certainty that the other party will honour the transaction.

In the spot market, the closing of the transaction and the delivery of the goods take place simultaneously or within a short-term time span prescribed by the specific market. Uncertainty about delivery from the other party is very limited, otherwise no transaction would take place.

The forward market is the market where a transaction is closed in the present, and the settlement of the transaction and the delivery of goods are in the future. The delivery date and the price are determined at the closing of the transaction. Because of the time lapse between the closing and the settlement of the transaction, the risk that one of the parties might not be able to deliver at the settlement date is higher than in the spot market.

The futures market is similar to the forward market, except that in the futures market, the risks of settlement and quality of the product are addressed. The same transaction as in the forward market would be closed, with the addition of the standardisation of the amount of goods, the quality of the goods and guarantee (by an exchange) of the payment of the price and delivery of goods or cash settlement of the difference.


  Risks of Financial Transactions .


Borrowing and lending of money create certain risks, namely

 - That the borrower will not be able to repay the money

 - That the lender is receiving a fixed rate on his investment while market rates fluctuate in such     a way that the yield on his initial investment is now below current market related rates

 - That the value of the capital invested could decrease due to movements in the market.

To lower the risk of a financial transaction, the risk can be sold to people or institutions that are willing to take on that risk without immediately taking over the effects of the transaction. The institution willing to buy the risk associated with the transaction would have to be compensated for taking on the risk. In monetary terms, the compensation for taking on the risk would, however, be less than the possible maximum loss associated with the risk. The trading of these risks associated with financial instruments resulted in the development of derivative products.

To hedge a position means to reduce the risk associated with a financial transaction or position, by selling the risk or by taking an opposite financial position, with the effect that a market movement would not result in substantial financial loss. A financial position which is not hedged, is called an open position.

The trading of risks created a market for the hedging of risks involved in financial transactions, which is a market derived from the original financial transaction. Contracts are drawn up for these kinds of transactions and because these contracts are derived from the original financial transaction, they are called derivatives. In a publication by Paul Eloff of the South African Futures Exchange, the following description of derivatives is given:

“Derivatives such as future contracts and options, are instruments whereby price risks are reallocated from those not willing to accept the risk and placed with those who are willing to accept the risk.”