Written by Brenda Nakalema

Introduction to Financial Markets

What are Financial Markets? Financial Markets is a term used to refer to any marketplace where trading- buying and selling- …

What are Financial Markets?

Financial Markets is a term used to refer to any marketplace where trading- buying and selling- of securities takes place. It includes the stock market, bond market, forex market and derivatives market, among others. Financial markets could be are akin to fuel in a car; they keep capitalist economies running smoothly.

Understanding Financial Markets

Financial markets play a pivotal role in the smooth running of capitalist economies by enabling the allocation of resources and creating liquidity for businesses and entrepreneurs. The markets create an avenue through which buyers and sellers can trade their financial assets. Financial markets create securities products that enable those with excess funds to secure a return on their investments by channelling funds from the have’s (investors/ traders) to the have-not’s (borrowers).

The stock market represents just one type of Financial Market. Financial Markets are created by buying and selling of different types of financial instruments like equities, bonds, currencies, and derivatives. A core value upheld by financial markets is informational transparency. This is to ensure that the markets set prices that are both efficient and appropriate. Although prices are set and adhered to, the market prices are not always true representations of the securities’ underlying value because of larger factors such as taxes.

Some financial markets are relatively small, with minimal activity, and others, such as the New York Stock Exchange (NYSE), trades trillions of dollars of securities on a daily basis. The equities (stock) market is a financial market which enables investors to buy and sell shares in publicly-traded companies. The primary stock market is the one where new issues of stocks (for companies that are listing for the first time), also called Initial Public Offering (IPOs), are sold. All other stock trading occurs in the secondary market, where investors buy and sell shares that are already publicly owned.

Functions of Financial Markets

The forces of demand and supply of an asset in a financial market help to determine the price of the asset. The interaction between investors and companies causes price fluctuations that allow for market participants to determine whether the asset is under or overvalued.

For capitalist economies, money must be kept in constant circulation in order for it to be utilized to achieve various goals. Financial markets facilitate the flow of capital from those that have it in excess to those that can put it to good use.

Financial markets ensure that there’s liquidity within the economy. Buyers need to be assured that their assets will be easy to sell at the right time and price, and sellers must be assured that there will always be buyers. Financial markets facilitate the easy overloading of assets.

Financial markets serve as the primary meeting place for buyers and sellers of financial securities and instruments. Because of financial markets, it is easier for buyers and sellers to fulfil each other’s needs quickly and efficiently.

Types of Financial Markets

The most commonly known financial market is the stock market. The stock market is where companies list their shares to be bought and sold by traders and investors. Stock or Equity markets are utilized when companies want to raise capital using an Initial Public Offering (IPO). Within the secondary market, shares of already publicly owned companies are traded.

Stocks may be traded on listed stock exchanges such as the New York Stock Exchange (NYSE), the Nasdaq, or they might be traded over-the-counter (OTC). The bulk of stock trading is done via regulated exchanges, which play a vital role in the economy both by acting as a gauge of the overall health in the economy, as well as an avenue for acquiring capital gains and dividend income for investors; including those with retirement accounts like IRAs and 401(k) plans.

The stock market is open to all; however, the usual participants include (both retail and institutional) investors and traders, plus market makers (MMs) and specialists that maintain liquidity and facilitate two-sided markets. Brokers are often times third parties who don’t personally own the stocks but enable trades between buyers and sellers.

Over-the-counter Markets

This is a market with no physical locations, and trading is conducted electronically, also called a decentralized market. Trades are effected electronically, with buyers and sellers trading directly without a broker. While OTC might handle trading in certain stocks, e.g. smaller or riskier companies that could not meet the requirements to list on the bigger exchanges, most stock trading is done through exchanges. However, there are a few derivatives markets that are strictly OTC and therefore are part of a vital segment of the financial markets. Generally, OTC markets and their trades are less regulated, less liquid, and their authenticity is harder to verify.

Bond Markets

A bond is a financial security in which an investor loans a certain sum of money for a specified period of time at a pre-established rate. It’s basically an agreement between the lender and borrower that defines the details of the loan and its payment. Bonds can be issued by corporations, municipalities, states and independent governments as a source of finance for projects and operations. The bond market enables the sale of securities such as notes. The bond market is also known as debt, credit or fixed-income market.

Money Markets

This is where trade in products that are highly liquid with short term maturities (less than a year) and are considered to have high safety matched with a low return in interest are traded. When dealing at the wholesale level, money markets typically involve large volume trades between institutions and traders. At the smaller retail level, transactions include money market mutual funds purchased by individual investors and money market accounts opened by bank customers. Money markets can also be invested in by buying short-term certificates of deposit (CDs), municipal notes, or Treasury bills.

Derivatives Markets

A Derivative is defined as a contract between two or more parties whose value is determined by an agreed-upon underlying financial asset (such as a security) or set of assets (such as an index). Derivatives are commonly referred to as secondary securities because their value is solely derived from the value of the underlying asset to which they are linked. Without the value of the underlying asset taken into account, a derivative is worthless and cannot be traded for anything. Instead of directly trading stocks, a derivatives market trades in futures and options contracts, as well as other more advanced financial products which similarly derive their value from underlying instruments like commodities, bonds, currencies, interest rates, market indexes and stocks.

Futures markets refer to financial markets where contracts are listed and traded. Unlike forwards, which trade OTC, futures markets make use of standardized contract specifications, are well- regulated and utilize clearing houses to confirm and settle trades. Options markets, for example, the Chicago Board Options Exchange (CBOE), similarly list and regulate options contracts. Both futures and options exchanges may opt to list contracts on different asset classes such as equities, fixed-income securities, commodities and others.

Forex Market

The Foreign Exchange Market (Forex) is a market that allows participants to buy and sell foreign currency and make gains off the fluctuations that occur in the market. The forex market is the most liquid globally, owing to the fact that cash is the most liquid asset there is. The currency market handles daily transactions surpassing $5 trillion, which is greater than both the futures and equity markets combined. Just like the OTC markets, the forex market is decentralized, and therefore trades are conducted through technology from different parts of the world. The forex is comprised of banks, commercial companies, central banks, investment management firms, hedge firms, and retail forex brokers and investors.

Commodities Markets

Through commodities markets, producers and consumers are provided with a platform to meet and exchange commodities such as agricultural products (corn, livestock, soybeans, maize, coffee), energy products (oil, gas, carbon credits), precious metals (gold, silver, platinum) and others. Spot Commodity markets are the ones where physical goods are exchanged for money.

The majority of trading takes place on derivatives markets that make use of spot commodities as underlying assets. Forwards, futures and options on commodities are traded both OTC and on listed exchanges globally, such as Chicago Mercantile Exchange (CME) and the Intercontinental Exchange (ICE).

Cryptocurrency Markets

Cryptocurrencies recently took on a popularity like never seen before, with even the most conservative investors trying their hand at trading these volatile assets. Cryptocurrencies such as Bitcoin, Ethereum and others are decentralized digital assets that are based on blockchain technology. Currently, cryptocurrency tokens are available in large numbers and are traded globally across a vast network of independent online crypto exchanges. These exchanges provide traders with digital wallets that they can utilize to swap one currency for another or for fiat money like dollars and pounds.

Since most crypto exchanges are centralized, users are susceptible to hacks or fraud. However, there are also decentralized exchanges that carry out their operations without adhering to a central authority. These enable the direct trading of digital currencies without the necessity of an exchange authority to facilitate transactions.