What are financial markets?
Financial markets largely refer to any market in which securities trading takes place, including the stock market, the bond market, the foreign exchange market and the derivatives market, among others. The financial markets are essential for the proper functioning of capitalist economies.
Understanding the financial markets
Financial markets play a vital role in facilitating the proper functioning of capitalist economies by allocating resources and creating liquidity for businesses and entrepreneurs. Markets allow buyers and sellers to easily trade their financial assets. The financial markets create securities products that provide a return to those who have excess funds (investors / lenders) and make these funds available to those who need additional money (borrowers).
The stock market is just one type of financial market. Financial markets are created by buying and selling many types of financial instruments, including stocks, bonds, currency and derivatives. Financial markets rely heavily on transparency of information to ensure that markets set effective and appropriate prices. Market prices of securities may not be representative of their intrinsic value due to macroeconomic forces such as taxes.
Some financial markets are small and inactive, while others, such as the New York Stock Exchange (NYSE), trade billions of dollars in securities daily. The stock market is a financial market that allows investors to buy and sell stocks of listed companies. The primary stock market is where new stock issues, called initial public offerings (IPOs), are sold. All subsequent share trading occurs in the secondary market, where investors buy and sell securities they already own.
The prices of securities traded on the financial markets do not necessarily reflect their true intrinsic value.
Types of financial markets
An over-the-counter (OTC) market is a decentralized market – meaning that it has no physical location and that trading takes place electronically – in which market participants trade securities directly between two parties without broker. An over-the-counter market manages the exchange of publicly traded stocks that are not listed on the NYSE, Nasdaq or the American Stock Exchange. In general, the firms that trade in the over-the-counter markets are smaller than the firms that trade in the primary markets, because the over-the-counter markets require less regulation and are less expensive to use.
A bond is a security in which an investor lends money for a defined period at a predetermined interest rate. You can think of a bond as an agreement between the lender and the borrower that contains the details of the loan and its payments. Bonds are issued by companies as well as by municipalities, states and sovereign governments to finance projects and operations. The bond market sells securities such as notes and bills issued by the US Treasury, for example. The bond market is also called the debt, credit or fixed income market.
Generally, money markets trade in very liquid short-term maturities (less than a year) and are characterized by a high degree of security and a relatively low return on interest. At the wholesale level, the money markets involve large-volume exchanges between institutions and traders. At the retail level, they include money market mutual funds purchased by individual investors and money market accounts opened by bank customers. Individuals can also invest in money markets by purchasing short-term certificates of deposit (CD), city notes or US treasury bills, among other examples.
A derivative is a contract between two or more parties whose value is based on an agreed underlying financial asset (such as a security) or a set of assets (such as an index). Derivatives are secondary securities whose value is only derived from the value of the primary security to which they are linked. In itself, a derivative is worthless. Rather than trading stocks directly, a derivatives market trades futures and options and other advanced financial products, which derive their value from underlying instruments such as bonds, commodities, currencies, interest rates, market indices and stocks.
The foreign exchange market is the market in which participants can buy, sell, trade and speculate on currencies. As such, the foreign exchange market is the most liquid market in the world, because cash is the most liquid asset. The currency market handles more than $ 5 trillion in daily transactions, which is more than the futures and equity markets combined. As with the OTC markets, the foreign exchange market is also decentralized and consists of a global network of computers and brokers from around the world. The foreign exchange market is made up of banks, trading companies, central banks, investment management companies, hedge funds, brokers and retail forex investors.
Key points to remember
- The financial markets largely refer to any market in which securities trading takes place.
- There are many types of financial markets, including (but not limited to) the foreign exchange, money, stocks and bonds markets.
- The financial markets trade in all types of securities and are essential to the proper functioning of a capitalist society.