A capital market is an organization where securities like debt and equity are traded to raise long-term funds in the economy. The capital market is fragmented into the stock market which trades equity securities and the bond market which trades debt securities.
Various financial instruments like equity, insurance, derivative instruments, and so on are traded in the capital market to enhance liquidity.
Features of capital market are as follows:
• Tax asymmetries: Most economies have varieties of taxes and tax incentives that cause tax asymmetries. These make security transactions more beneficial to someones. A number of financial transactions may create additional wealth because of tax differences.
• Information asymmetries: Most financial information is published and therefore, is publicly available. But sometimes, certain persons may have superior information than others. These persons may earn an abnormal return sometimes.
• Transaction costs: These costs do not affect the prices. But, they can cause one transaction to be more profitable than the other. Transaction costs of two similar financial transactions may be different. Similarly, the transaction costs of two persons to a particular transaction may be different.
In practice, capital markets have imperfections. Efficient markets may not be perfect. For developing frameworks for analyzing financial decisions, a good starting point is to assume that capital markets are perfect. Once a framework developed, the practical implications of market imperfections can be analyzed.
• No entry barriers: Anyone can participate in the market. Thus the suppliers or users of funds can enter the market and deal with each other.
• Large number of buyers and sellers: Perfect competition in the market is ensured by the presence of a large number of buyers and sellers of securities.
• Divisibility of financial assets: Financial assets are divisible and therefore, affordable investments are made by all participants.
• Absence of transaction cost: There are no transaction costs. Participants can buy and sell securities with ease and without any costs.
• No tax differences: Ideally, there are no taxes. There should not be any tax distortions. One set of investors should not be favored over others.
• Free trading: Anyone is free to trade in securities in the capital market. There should not be government restrictions on trading.
Foreign exchange markets
Foreign Exchange market (forex market) refers to the purchase and sale of foreign currencies. The bulk of the forex market is “over the counter” (OTC) which means the two parties’ trades are performed on the telephone, telex, or fax, through electronic dealing systems, or through the intermediation of brokers and not on the floor of an exchange.
The financial market makers such as financial institutions (banks) act as intermediaries and perform the currency transactions by quoting purchase and selling prices.
Types of foreign exchange markets
1. Spot and forward market – The spot market involves trading foreign exchange currencies for immediate delivery. Delivery and payment take place on the following second day of business and the rate quoted is called “spot rate” the date of settlement is known as the “value date” and the transactions are called “spot transactions”.
The forward markets involve contracts for delivery or receipt of foreign exchange at a specified future date and the transaction is called a “forward transaction”.
2. Unified and dual markets – Unified markets include greater liquidity, increased price discovery, lower short-run exchange rate volatility, and reliable access to foreign exchange. Dual markets are found in countries with multiple exchange markets.
3. Offshore and onshore markets – During the earlier stages of financial development, the forex market operates onshore with respect to the domestic jurisdiction of the country. There were limitations in imports and exports of domestic banknotes due to limited currency convertibility and; regulations that prohibited trading domestic currency, and holdings of currency accounts abroad.
Participants in foreign exchange markets
• Corporates – They mainly include business houses, international investors, and multinational corporations. They operate in the market by buying or selling currencies within the framework of exchange control regulations.
• Commercial banks – They play an important role in the forex market. They operate in the market by trading currencies for their clients. The large volume of transactions consists of banks dealing directly among themselves and smaller transactions usually consist of intermediary foreign exchange brokers.
• Central bank – Central banks get involved in the forex market to regain the price stability of the exchange rate, protect certain levels of price in the exchange rate, and support economic goals like inflation and growth.
• Exchange brokers – They ensure the most favorable quotations between the banks at a low cost in terms of time and money. Banks provide opportunities to brokers in order to increase or decrease the rate of buying or selling foreign currencies.
The risks relating to foreign exchange
There are following types of risks we face relating to foreign exchange explained below:
1. Transaction risk: Transaction risk is the in-built risk in foreign exchange transactions. It consists of a number of trading items such as foreign currency, invoiced trade receivables, and payables along with capital items such as foreign currency dividends and loan payments.
2. Position risk: Bank transactions, both on-spot and forward-based, result in positions being created in the currencies in which these transactions are denominated. A position risk arises when a dealer in a bank is having an overbought (long) or an oversold (short) position. Dealers enter into these positions in expectation of a positive movement.
3. Settlement of credit risk: Settlement risk is the risk of a counterparty failing to meet the obligations in a financial deal after the bank has fulfilled the obligations on the date of settlement of the contract. Settlement risk exposure possibly exists in foreign exchange or in local currency money market business.
4. Mismatch or liquidity risk: In the foreign exchange business, it is not possible to be in an ideal position always, where sales and purchases are according to maturity and there are no mismatched circumstances. Some mismatching of maturities is inevitable, as a result of which the bank may lose or gain.
5. Operational risk: Operational risks do not have any relation with the dealer. Operational risk is affected by the manner in which transactions are settled or handled operationally. Some of the operational risks are as follows:
• Dealing and settlement
• Pipeline transaction
• Overdue bills and forward contracts
6. Sovereign risk: One more kind of risk which banks and other agencies that deal in foreign exchange face is sovereign risk. Sovereign risk is based on the government of a country. Although an importer in the country agrees to pay for his imports, the central bank of the country may not allow the importer to do so.
7. Cross-country risk: Cross-country risk occurs due to the possession of large exposures in any one country. A bank that has such large exposures could suffer huge losses in the country’s troubled conditions. This occurred in Japan when several Japanese banks suffered enormous losses when the Indonesian rupiah collapsed in 1997 as did organizations in Hong Kong and the United States.