Question

FINANCIAL MARKETS SHOULD PROVIDE THE CAPACITY TO AVOIDING RISK. THEREFORE, ONE OF THE BASIC FUNCTION FOR FINANCIAL MARKET IS RISK AVOIDING FUNCTION.

-Explain the function and explain the state of function in USA?

Answer 1

There are a variety of Risks associated with financial instruments such as:

1. Credit risk - a risk that the counterparty will not pay off their credit

2. Market risk - risk associated with events that impact an entire section or whole of the financial market

3. Liquidity risk - risk associated with unavailability of counterparty

4. Foreign exchange risk - risk associated with unexpected movements in the foreign exchange rates

etc.

An efficient financial market should provide the investors with options to avoid/hedge their risks. This can be ensured by the offering a diverse range of products and market participation by a large number of participants (i.e. investors, issuers of financial instruments such as companies). For example, USA has the largest financial market in the world. the volume of transactions are always high, i.e. most instruments are always liquid. Hence, the USA financial market (stock market) has largely eliminated liquidity risk for investors by allowing a large number of market participants. However, certain small cap stocks may be illiquid due to idiosyncratic reasons.

The stock exchanges such as NYSE and NASDAQ eliminate the counterparty risk or settlement risk by taking on the role of clearing houses. They become the counterparty to both sides of a trade, i.e. become buyer to the entity selling on the exchange and vice-versa.   

National Securities Clearing Corporation (NSCC) is the subsidiary of the Depositary Trust Clearing Corporation (DTCC) in USA. It provides central counterparty services, clearing, risk management, settlement and also guarantees the completion of transactions for various financial instruments.