What exactly are financial markets?
A financial market is any market where securities such as stocks, bonds, foreign exchange, or derivatives are traded. Financial markets are essential to the functioning of capitalist economies.
Financial Market Understanding
Capitalist economies rely on financial markets to allocate resources and provide liquidity for firms and entrepreneurs. Buyers and sellers can easily swap financial assets in marketplaces. Financial markets generate securities products to reward investors and lenders and supply funds to borrowers.
The stock market is one type of financial market. Individuals engaging in trading stocks, bonds, currencies, and derivatives give rise to the formation of financial markets. The transparency of information is essential to the functioning of efficient and accurate pricing in the financial markets.
The New York Stock Exchange (NYSE), which conducts daily deals totaling one trillion dollars in securities, is on the world’s financial markets’ smaller end of the spectrum. Investors can buy and sell shares in publicly traded companies through the stock market. The primary stock market is responsible for the sale of newly issued shares. Investors will swap their equity holdings with one another on the secondary market.
Financial market prices may not represent inherent worth.
Financial Market Types
Different marketplaces exist, and each emphasizes its instrument courses.
Stock markets
Stock markets are perhaps the most common financial markets. Traders and investors exchange company shares on these platforms. Companies raise funds, and investors seek rewards in stock markets.
Stocks can be exchanged on exchanges like the NYSE, Nasdaq, or OTC. Most stock trading is done on regulated exchanges, which helps the economy by circulating money.
Stock markets often involve individual and institutional investors, traders, market makers, and experts who maintain liquidity and offer two-sided markets. Brokers are third parties who arrange trades between buyers and sellers without taking a stock stake.
OTC (Over-the-Counter) Markets
An over-the-counter (OTC) market is a decentralized electronic trading environment where players exchange securities directly without a broker. Most stock trading is done on exchanges; however, OTC markets may trade smaller or riskier businesses that don’t fulfill exchange listing requirements. Certain derivatives markets are completely OTC, making them vital to financial markets. OTC markets and transactions are generally less regulated, liquid, and opaque.
Bond Markets
Bonds allow investors to lend at a fixed interest rate for a specific term. Consider a bond as an agreement between a lender and borrower, detailing loan specifics and payments. Corporations, towns, states, and sovereign governments issue bonds to finance projects and operations. For instance, the bond market offers U.S. Treasury notes and banknotes. The bond market is sometimes termed debt, credit, or fixed-income.
Monetary markets
Money markets often trade extremely liquid short-term products (less than one year) with high safety and low-interest rates.
The wholesale money markets are characterized by high levels of trade volume conducted between various institutions and dealers. The definition incorporates retail money market mutual funds as well as bank accounts. When investing in the money market, individuals can purchase certificates of deposit (CDs), municipal notes, or U.S. Treasury bills.
Markets for derivatives
Derivatives are contracts between parties based on an agreed-upon financial asset, such as a share or index. Derivatives markets trade futures, options, and other financial products based on underlying assets such as bonds, commodities, currencies, interest rates, market indexes, and stocks instead of directly trading equities.
Futures markets list and trade contracts. Unlike OTC forwards, futures markets are well-regulated, employ defined contract specifications, and settle and confirm trades using clearinghouses. Options exchanges like CBOe list and regulate options contracts. Exchanges for futures and options can list agreements on equities, fixed-income instruments, commodities, etc.
The Forex Market
Participants in the forex market can purchase, trade, hedge, and speculate on exchange rates between currency pairings. The FX market is the most liquid since cash is the most liquid asset. Currency markets trade around $7.5 trillion daily, more than futures and equities combined.
Like OTC markets, the FX market is decentralized and has a global network of computers and brokers. The forex market includes banks, commercial companies, central banks, investment management organizations, hedge funds, retail brokers, and investors.
Markets for commodities
Producers and consumers exchange physical commodities like agricultural products, energy products, precious metals, and “soft” commodities like cotton, coffee, and sugar at commodities markets. These are spot commodity marketplaces, where tangible things are traded for money.
Most of these commodities are traded on derivatives markets that use spot commodities. Commodity forwards, futures, and options are traded on OTC and listed exchanges worldwide, including CME and ICE.
Markets for cryptocurrencies
More than a thousand cryptocurrency tokens are traded internationally on various internet marketplaces. These exchanges offer digital wallets for trading cryptocurrencies or fiat currencies like dollars or euros.
Most crypto exchanges are centralized, so consumers are vulnerable to hacking and fraud. Decentralized exchanges function without a central authority. These exchanges enable P2P trading without an exchange authority. Major cryptocurrencies provide futures and options.
Financial Market Examples
The previous sections demonstrate that “financial markets” are vast. Stock markets let companies go public, and the OTC derivatives market contributed to the 2008–09 financial crisis.
Stocks and IPOs
As it grows, a firm requires more money. It often needs more cash than it can acquire via operations, bank loans, or venture and angel investment. To obtain cash, firms might sell shares to the public through an initial public offering (IPO). This transitions the company from a “private” enterprise with limited shareholders to a public company with public investors holding shares.
Early investors can cash out part of their ownership in the firm at the IPO, frequently earning large profits. Underwriters decide the IPO price during pre-marketing.
After a company’s shares are listed on a stock market, and trading begins, their price will vary as investors and traders evaluate their inherent value, supply, and demand.
OTC Derivatives and 2008 Financial Crisis: MBS and CDOs
Among other things, the mortgage-backed securities industry exacerbated the financial crisis of 2008–2009. These OTC derivatives package, slice, and sell mortgage cash flows to investors. A series of events, each with its trigger, led to the banking system’s near collapse. Some claim that the crisis began in the 1970s with the Community Development Act, which loosened credit rules for low-income clients, leading to subprime mortgages.
When the Federal Reserve Board lowered interest rates to prevent a recession in the early 2000s, subprime mortgage debt that Freddie Mac and Fannie Mae insured increased. The combination of low credit criteria and cheap money led to a housing boom, causing speculation and a real estate bubble. After the dotcom crash and the 2001 recession, investment banks built collateralized debt obligations (CDOs) from secondary market mortgages to generate easy profits.
Investors couldn’t grasp subprime mortgage risks since they were packaged with prime mortgages. As the CDO market heated up, the long-standing housing bubble exploded. As house values collapsed, subprime borrowers defaulted on debts worth more than their homes, compounding the fall.
When investors recognized MBS and CDOs were worthless owing to toxic debt, they tried to sell them. No market existed for CDOs. The bankruptcy of subprime lenders caused a liquidity contagion that spread to the top of the financial sector. Lehman Brothers and Bear Stearns imploded under subprime debt, and over 450 banks failed during the next five years. A taxpayer-funded bailout saved many large banks from collapse.
What are the different types of financial markets?
Stock, bonds, FX, commodities, and real estate markets are examples of financial markets and their responsibilities. Financial markets are divided into capital, money, primary, secondary, and listed/OTC.
How do financial markets work?
Despite having diverse asset classifications, institutions, and laws, all financial markets bring buyers and sellers of an asset or contract together to trade. This is often done through an auction or price-discovery method.
What are financial markets’ main functions?
Financial markets primarily aim to effectively distribute monetary resources and assets within monetary economies. By facilitating a free market for capital, financial obligations, and money, financial markets help the economy become more efficient and allow investors to profit from capital gains.
Bottom Line
Economic development and stability require liquidity, money, and engagement from financial markets. Without financial markets, capital allocation would be inefficient, reducing trade, investments, and growth.
Many businesses raise funds from investors in stock and bond markets, making markets vital to the economy. Speculators use different asset classes to predict future prices. While hedgers utilize derivatives to reduce risks, arbitrators use market mispricings. Brokers typically mediate between buyers and sellers for a commission.
Conclusion
- Any securities trading market is a financial market.
- Forex, money, stock, and bond markets are examples of financial markets.
- These markets may contain OTC or regulated exchange-listed assets or securities.
- Financial markets exchange all forms of securities and are essential to capitalism.
- Financial market failures can cause recessions and unemployment.
