HOW DO FINANCIAL MARKETS OPERATE ?

Financial markets operate because people have different needs and requirements and these requirements need to be matched together. Where this occurs on a large scale, markets develop. Market forces can thus be described as the supply of an item or service where there is a demand for that item or service. Trading therefore creates a price mechanism; the price is based on the value to the traders (buyers and sellers) which heavily depends on certain market forces.

The consequence of people having needs creates Supply and Demand; this is one of the core underlying factors as to how and why markets operate and Alfred Marshall (1842-1924) demonstrated this in the Demand/Supply cross. It shows that the forces of supply and demand simultaneously determine price as shown.

In order to facilitate the various forms of activities undertaken by participants financial markets operate six basic functions. These functions are briefly listed below:

Borrowing and Lending

Financial markets permit the transfer of funds (purchasing power) from one agent to another for either investment or consumption purposes.

Price Determination

Financial markets provide vehicles by which prices are set both for newly issued financial assets and for the existing stock of financial assets.

Information Aggregation and Coordination

Financial markets act as collectors and aggregators of information about financial asset values and the flow of funds from lenders to borrowers.

Risk Sharing

Financial markets allow a transfer of risk from those who undertake investments to those who provide funds for those investments.

Liquidity

Financial markets provide the holders of financial assets with a chance to resell or liquidate these assets.Efficiency

Financial markets reduce transaction costs and information costs.

There are four kinds of operators in the Financial Markets. These are:

• Investors
• Companies
• Financial Institutions
• Governments

Financial market operations play an important role in the well-being of everyone. Markets interact and will influence worldwide issues such as wealth, inflation, and stability in a country or region.

The U.S then started to trade similar contracts between the 1830’s & 1840’s due to Mid-west problems with grain supply and demand. Futures were supposed to give buyers choice and certainty in grain arrivals and shipments, although as quality, delivery and payments were not guaranteed, this created problems during resale. This led to the birth of the Chicago Board Of Trade (CBOT) in 1848 and sometime in 1851 the earliest “forward” contract is recorded for 3000 bushels of corn. The CBOT then formalized grain trading by developing standardized agreements called “futures contracts”. Speculators were drawn into the markets in 1877 due to futures trading becoming more formalized.

In the late 1890’s the Chicago Mercantile Exchange (CME) was also formed in the U.S, trading agricultural products. By the 1970’s trading in futures and other derivatives had exploded in volume. Fischer Black and Myron Scholes developed pricing models which allowed investors and speculators to rapidly price futures and options on futures. This demand led to a substantial growth of major exchanges that expanded across the globe. Also in the 1970’s there was an emergence of major currency futures on the CME which has since helped make it the largest futures exchange in the U.S.