Topic 3: Financial Markets and Instruments

Introduction to Financial Markets

Financial markets are platforms or systems where financial securities, such as stocks,
bonds, and derivatives, are bought and sold. These markets enable businesses,
governments, and individuals to raise capital, invest, and manage financial risks.
Understanding the structure, functions, and classifications of financial markets is
essential for analyzing how funds are allocated within an economy.

Types of Financial Markets

1. Capital Markets
o Equity Market (Stock Market):
§ A market where shares of companies are issued and traded, either
through exchanges or over-the-counter markets. Companies use
equity markets to raise capital by oFering ownership shares.
§ Primary Market: Involves the issuance of new securities directly
from companies to investors (e.g., Initial Public OFerings - IPOs).
§ Secondary Market: Involves trading previously issued securities
between investors.
§ Example in Kenya: Nairobi Securities Exchange (NSE), where
companies like Safaricom trade their shares.
o Debt Market (Bond Market):
§ A market where debt securities such as bonds are issued and
traded. Bonds represent loans made by investors to borrowers
(typically companies or governments).
§ Corporate Bonds: Issued by companies to raise funds.
§ Government Bonds: Issued by governments to finance public
spending.
§ Example in Kenya: Treasury bonds issued by the Kenyan
government through the Central Bank of Kenya (CBK).
2. Money Markets
o Short-term debt securities are traded in money markets, usually with
maturities of less than one year. They provide liquidity to businesses and
governments.
o Examples of Instruments: Treasury Bills (T-Bills), Commercial Paper,
Certificates of Deposit.
o Example in Kenya: The Central Bank of Kenya (CBK) auctions T-Bills to
finance short-term government debt.
3. Derivative Markets
 o Derivatives derive their value from underlying assets like stocks, bonds,
currencies, or commodities. They are used for hedging risks or
speculation.
o Types of Derivatives:
§ Futures: Contracts to buy or sell an asset at a future date at a
predetermined price.
§ Options: Contracts that give the holder the right, but not the
obligation, to buy or sell an asset at a specific price before a certain
date.
§ Swaps: Contracts to exchange cash flows between two parties,
often used to manage interest rate risks.
4. Foreign Exchange Markets (Forex)
o A decentralized market where currencies are traded. It's the largest
financial market in the world, facilitating international trade and
investment by allowing the conversion of one currency to another.
o Example in Kenya: The exchange of Kenyan Shillings (KES) with other
currencies like the US Dollar (USD) or Euro (EUR).

Financial Instruments

1. Equity Securities (Stocks)

o Common Stock: Represents ownership in a company and entitles holders
to vote on corporate matters and receive dividends.
o Preferred Stock: OFers fixed dividends and has priority over common
stockholders in the event of liquidation but usually lacks voting rights.
2. Debt Securities (Bonds)
o Government Bonds: Issued by the government, these are considered low-
risk securities.
o Corporate Bonds: Issued by corporations, they typically oFer higher
returns than government bonds but come with higher risk.
o Convertible Bonds: Bonds that can be converted into a predetermined
number of shares in the issuing company.
3. Money Market Instruments
o Treasury Bills (T-Bills): Short-term government debt instruments.
o Commercial Paper: Unsecured, short-term debt issued by companies to
finance short-term liabilities.
o Certificate of Deposit (CD): A savings certificate with a fixed maturity date
and interest rate, oFered by banks.
4. Derivatives
o Futures Contracts: Standardized contracts to buy or sell assets at a future
date at a price determined today.
 o Options Contracts: Give the buyer the right to buy or sell an asset at a
specific price within a certain period.
o Swaps: Used to exchange diFerent financial instruments between two
parties, typically involving cash flows like interest rates.

Regulation of Financial Markets

1. Regulatory Bodies:
o Capital Markets Authority (CMA): Regulates capital markets in Kenya,
ensuring market integrity and investor protection.
o Central Bank of Kenya (CBK): Responsible for regulating and overseeing
money markets, forex markets, and issuing government securities.
o Nairobi Securities Exchange (NSE): The primary stock exchange in Kenya,
where shares and bonds are traded.
2. Regulatory Objectives:
o Market Integrity: Ensuring transparency and fairness in the market to
protect investors.
o Investor Protection: Providing safeguards against fraud, manipulation,
and malpractice.
o Systemic Stability: Preventing risks that could lead to a breakdown in the
financial system.
o Examples of Regulations:
§ Know Your Customer (KYC): Anti-money laundering measures that
ensure financial institutions know the identity of their clients.
§ Market Surveillance: Monitoring trading activity to detect and
prevent illegal practices like insider trading.

Functions of Financial Markets

1. Facilitating Price Discovery:
o Financial markets help in determining the price of securities based on
supply and demand factors. For example, the stock price of Safaricom on
the NSE is determined by the willingness of buyers and sellers to trade at
specific prices.
2. Providing Liquidity:
o Markets provide liquidity, allowing investors to quickly buy or sell securities
without significantly aFecting their price. In liquid markets like the NSE,
investors can easily convert their shares into cash.
3. Risk Management:
o Through derivative markets, investors can hedge against price fluctuations,
interest rate changes, and foreign exchange risks. For example, Kenyan
exporters might use currency futures to hedge against currency
fluctuations when trading internationally.
 4. Raising Capital:
o Companies and governments raise funds through the issuance of equity,
debt, or other financial instruments. For example, Kenyan companies issue
IPOs on the NSE to fund expansion projects.
5. Facilitating International Trade:
o The Forex market enables businesses to convert currencies, facilitating
cross-border trade and investment. For example, a Kenyan importer can
convert KES to USD to pay for goods sourced from the U.S.

Key Participants in Financial Markets

1. Investors:
o Individual or institutional participants who buy and sell securities to
generate returns. Institutional investors include pension funds, mutual
funds, and insurance companies.
o Retail Investors: Individuals who invest in financial markets, typically
through stock exchanges like the NSE.
o Institutional Investors: Large entities such as pension funds or mutual
funds, which manage large portfolios of stocks and bonds.
2. Issuers:
o Entities that raise capital through the issuance of securities, such as
companies (through IPOs) or governments (through bond oFerings).
o Example in Kenya: The government issues Treasury bonds to finance
national infrastructure projects.
3. Intermediaries:
o Institutions that facilitate the trading of securities, including brokers,
dealers, and investment banks. They provide liquidity, execute trades, and
oFer advice to clients.
o Brokerage Firms: Help individuals and institutions trade securities. For
example, a firm like Faida Investment Bank in Kenya acts as a brokerage for
trading stocks on the NSE.
4. Regulators:
o Regulatory authorities oversee financial markets to ensure transparency,
fairness, and compliance with the law. In Kenya, the Capital Markets
Authority (CMA) and the Central Bank of Kenya (CBK) play crucial roles in
regulating market activities.

Factors ASecting Financial Markets

• Economic Indicators: GDP, inflation, interest rates, unemployment.
• Government Policies: Monetary policy, fiscal policy, regulations.
• Global Events: Political instability, natural disasters, trade wars.
Market ESiciency:
• The EFicient Market Hypothesis (EMH) posits that stock prices accurately reflect
all available public information. This means that it's impossible to consistently
outperform the market by using publicly available information.
There are three forms of market eFiciency:
1. Weak-form eSiciency: Stock prices reflect all past price and volume data.
Technical analysis, which attempts to predict future prices based on past price
patterns, is unlikely to be profitable in a weak-form eFicient market.
2. Semi-strong-form eSiciency: Stock prices reflect all publicly available
information, including financial statements, analyst reports, and news
announcements. Fundamental analysis, which involves analyzing a company's
financial performance and prospects, may not provide an advantage in a semi-
strong-form eFicient market.
3. Strong-form eSiciency: Stock prices reflect all information, both public and
private. Even insider information would not provide an advantage in a strong-form
eFicient market.
• While the EMH is a widely accepted theory, there is ongoing debate about its
validity. Some studies suggest that markets may not be fully eFicient, particularly
in the short term. However, the consensus is that markets tend to be reasonably
eFicient, making it challenging to consistently outperform the market over the
long term.

Conclusion
Financial markets are critical to the functioning of a modern economy. They provide
platforms for raising capital, managing risk, and facilitating international trade, while also
serving as vehicles for investment. A well-functioning and regulated financial market
enhances economic growth by ensuring eFicient allocation of resources. Understanding
the diFerent types of financial markets, the instruments traded within them, and the role
of regulatory bodies is essential for any business professional looking to engage in
financial decision-making.