Have you ever wondered why financial markets are so crucial to our economy? What makes them so important? Financial markets play a crucial role in the functioning of our economy and have a significant impact on our daily lives.
Financial markets are where buyers and sellers trade financial securities, such as stocks, bonds, and commodities. They provide a platform for companies to raise capital and for individuals to invest their savings. The stock market, for example, allows companies to raise funds by selling shares of their business to investors. This, in turn, allows companies to expand and create jobs, which contributes to economic growth.
In this article, we will explore the importance of financial markets, how they impact our economy, and why it is crucial for individuals to understand how they work. We will also discuss the various types of financial markets and their functions in our economy.
Financial markets are platforms where financial instruments are bought and sold, including stocks, bonds, currencies, and commodities.
What Are Financial Markets?
Financial markets are where the trading of securities takes place, encompassing the stock market, bond market, forex market, derivatives market, and others. These markets are crucial for the proper functioning of capitalist economies.
Bonds are financial instruments that allow governments or large companies to raise money. Essentially, bonds are a future ‘IOU’ that can be bought and sold in the financial markets. Government bonds, also known as ‘gilts’, are a form of government debt.
The foreign exchange markets allow people to exchange one currency for another.
Understanding the Financial Markets
Financial markets are essential to the functioning of capitalist economies, as they allocate resources and create liquidity for businesses and entrepreneurs. These markets enable buyers and sellers to trade their financial holdings and create securities that provide returns for investors with excess funds while making funds available to those who need additional money.
The stock market is just one type of financial market, which encompasses equities, bonds, currencies, and derivatives. Informational transparency is crucial for financial markets to set efficient and appropriate prices, although macroeconomic forces like taxes can impact these prices.
Some financial markets trade trillions of dollars daily, while others are smaller with less activity. The equities market allows investors to buy and sell shares of publicly traded companies, with new issues of stocks sold in the primary market and subsequent trading occurring in the secondary market.
It’s important to note that market prices of securities may not always reflect their intrinsic value. Overall, understanding financial markets is essential for anyone interested in investing or financing their business.
Types of Financial Markets
Stock markets are a type of financial market that allows companies to list their shares for trading by investors and traders. It is one of the most well-known financial markets. Companies use stock markets to raise capital through an initial public offering (IPO) and then shares are bought and sold in the secondary market. The secondary market is where various buyers and sellers participate in trading shares.
Stocks can be traded on listed exchanges, such as the New York Stock Exchange (NYSE) or Nasdaq, or over-the-counter (OTC). Regulated exchanges play an essential role in the economy as they provide capital gains and dividend income to investors, including those with retirement accounts such as IRAs and 401(k) plans.
Participants in a stock market include retail and institutional investors and traders, market makers (MMs), and specialists who maintain liquidity and provide two-sided markets. Brokers facilitate trades between buyers and sellers, but they do not take an actual position in a stock.
An over-the-counter (OTC) market is a decentralized market, which means that it does not have physical locations and trading is conducted electronically. Market participants trade securities directly between two parties without a broker. While OTC markets may handle trading in certain stocks (e.g., smaller or riskier companies that do not meet the listing criteria of exchanges), most stock trading is done via exchanges.
Certain derivatives markets are exclusively OTC, and so they make up an important segment of the financial markets. Transactions in OTC markets are characterized by their informality and flexibility, which allows for customized products to be created to meet the specific needs of market participants. However, broadly speaking, OTC markets and the transactions that occur in them are far less regulated, less liquid, and more opaque than exchanges.
OTC markets present a higher level of counterparty risk, as there is no central clearinghouse or exchange to guarantee the performance of contracts. This means that buyers and sellers are more exposed to the credit risk of their counterparties, which is why OTC transactions are often done between institutions with a pre-existing relationship or based on collateral.
Despite these risks, OTC markets are still a valuable source of funding for some companies and are used to trade a range of financial instruments such as bonds, currencies, and derivatives.
Bond markets are a critical component of the financial markets, as they allow corporations and governments to raise funds by issuing debt securities. A bond is essentially an agreement between the borrower and the lender, whereby the lender loans money to the borrower for a defined period at a pre-established interest rate. Bonds are issued by a wide range of entities, including corporations, municipalities, states, and sovereign governments, to finance projects and operations.
The bond market is also known as the debt, credit, or fixed-income market. One of the largest bond markets is the United States Treasury market, where securities such as notes and bills are issued by the United States Treasury to finance government operations. Bonds are typically sold to investors in large denominations, such as $1,000 or $10,000, and pay interest at regular intervals until they mature.
Bonds are generally viewed as a lower-risk investment than stocks, as they provide a steady stream of income and are backed by the issuer’s ability to pay the interest and principal. However, as with any investment, there are risks associated with investing in bonds, such as the risk of default by the issuer or changes in interest rates that can affect the value of the bond. To mitigate these risks, investors may diversify their bond portfolios by investing in bonds from different issuers and with different maturities.
Money markets are a subcategory of fixed-income markets that trade in products with highly liquid short-term maturities of less than one year. These markets are characterized by a high degree of safety and a relatively low return on interest. They are used by banks and other financial institutions to manage short-term liquidity needs and by corporations as a source of short-term funding.
The money markets trade in a variety of financial instruments, including certificates of deposit (CDs), repurchase agreements, commercial paper, and Treasury bills. At the wholesale level, large-volume trades take place between institutions and traders. At the retail level, individual investors can participate through money market mutual funds or money market accounts opened with banks.
Money market mutual funds are popular with individual investors who seek to earn a slightly higher return on their cash holdings than traditional savings accounts. These funds invest in highly liquid and low-risk short-term debt securities such as Treasury bills and commercial paper. Money market accounts, on the other hand, are offered by banks and provide a way for customers to earn interest on their deposits while maintaining easy access to their funds.
Overall, the money markets play a critical role in the financial system by providing short-term liquidity to participants and helping to stabilize the broader financial markets.
A derivative is a financial agreement involving two or multiple parties. The basis of it is a financial asset or a group of assets. The value of derivatives is based on the primary securities with which they are associated.
These items do not possess inherent value. The derivatives market involves trading in futures, options contracts, and other complex financial products as opposed to direct stock trading. The value of these products is based on underlying instruments such as bonds, commodities, currencies, interest rates, and stocks.
Futures markets are the platforms where futures contracts are listed and traded. Futures markets differ from forwards as they use standardized contract specifications, are regulated, and rely on clearinghouses for trade settlement and confirmation.
Options markets, such as the Chicago Board Options Exchange (CBOE), list and regulate options contracts similarly.
Futures and options exchanges offer contracts on different asset classes, including equities, fixed-income securities, and commodities.
The forex (foreign exchange) market is the market in which participants can buy, sell, hedge, and speculate on the exchange rates between currency pairs. The forex market is the most liquid in the world, as cash is the most liquid of assets. The currency market handles more than $6.6 trillion in daily transactions, which is more than the futures and equity markets combined.
The forex market is decentralized and consists of a global network of computers and brokers from around the world. It is open 24 hours a day, five days a week, and operates across all time zones. Trading is conducted electronically, with transactions taking place directly between market participants.
The forex market is made up of various participants, including banks, commercial companies, central banks, investment management firms, hedge funds, and retail forex brokers and investors. Among the most active traders in the forex market are large banks, such as Citibank, Deutsche Bank, and JPMorgan Chase, which trade currencies on behalf of their clients and their accounts.
Retail investors can also participate in the forex market through forex brokers, who offer access to the market via electronic trading platforms.
Due to its decentralized nature, the forex market lacks a central exchange. Instead, trading is conducted through a network of interconnected banks and other financial institutions, with prices quoted by individual market makers. This can lead to some price discrepancies between different brokers and markets, and investors need to be aware of the potential risks associated with trading in the forex market.
Nonetheless, the forex market remains an important part of the global financial system, providing a means for international trade and investment, as well as opportunities for profit for traders and investors.
Commodities markets facilitate the exchange of physical commodities such as agricultural products (e.g., corn, livestock, soybeans), energy products (oil, gas, carbon credits), precious metals (gold, silver, platinum), and “soft” commodities (such as cotton, coffee, and sugar). This exchange is done through spot commodity markets where physical goods are traded for money between producers and consumers.
The majority of trading in commodities occurs on derivatives markets that utilize spot commodities as underlying assets. These commodities, including forwards, futures, and options, are exchanged both over-the-counter and on listed exchanges worldwide, such as the Chicago Mercantile Exchange (CME) and the Intercontinental Exchange (ICE).
Commodities markets are affected by a variety of factors, including weather patterns, geopolitical events, and supply and demand. For example, a drought or a natural disaster that damages crops can cause the price of agricultural commodities to rise. The demand for energy commodities such as oil and gas can be affected by changes in economic activity and shifts towards renewable energy sources. Political instability in a major producer country can disrupt the supply of commodities and cause price volatility.
Commodities markets play an important role in the global economy, as they provide a way for producers to sell their goods and for consumers to secure the resources they need. They also provide investors with a means of diversifying their portfolios and hedging against inflation and other risks. However, they can also be subject to manipulation and speculation, which can lead to price distortions and market disruptions.
In recent years, cryptocurrencies like Bitcoin and Ethereum have emerged and grown in popularity. They are decentralized digital assets that rely on blockchain technology. Numerous cryptocurrency tokens are now available and traded worldwide on various independent online crypto exchanges. These exchanges provide traders with digital wallets to exchange cryptocurrencies or fiat currencies like dollars or euros.
Most crypto exchanges are centralized, which makes users vulnerable to hacking and fraud. However, there are decentralized exchanges that operate without a central authority. These exchanges allow direct peer-to-peer P2P trading of digital currencies. Futures and options trading is also available for major cryptocurrencies.
These financial products allow traders to speculate on the future price of a cryptocurrency and provide risk management tools for businesses and investors who use cryptocurrencies in their operations. Moreover, cryptocurrency exchanges have expanded their offerings to include other financial instruments, such as lending and borrowing services, margin trading, and staking, which provide additional ways to invest in and earn returns on cryptocurrencies.
Examples of Financial Markets
The financial markets are vast and varied, as the previous sections have illustrated. To provide more tangible examples, we can examine the function of stock markets in taking a company public and the role of the over-the-counter (OTC) derivatives market in the global financial crisis of 2008-2009.
Stock Markets and IPOs
The process of raising capital through stock markets involves an initial public offering (IPO), in which a private company sells shares to the public. As a company grows, it often needs larger amounts of capital than it can obtain through ongoing operations or traditional bank loans.
Going public through an IPO can provide the necessary funds by allowing the company to raise capital through the sale of shares to a larger pool of investors.
During an IPO, the company changes its status from a private to a publicly-traded company. Early investors in the company can cash out part of their stake in the process, often making significant profits. Underwriters set the IPO price during the pre-marketing process.
After the company’s shares are listed on a stock exchange, the price of those shares will fluctuate as investors and traders assess their intrinsic value and the supply and demand for them.
Factors such as economic conditions, company performance, and investor sentiment can all influence stock prices. Stock prices can rise or fall rapidly in response to changes in these factors, which makes stock markets an attractive but risky investment option.
OTC Derivatives and the 2008 Financial Crisis: MBS and CDOs
The 2008-09 financial crisis was caused by several factors, and one of the widely identified ones is the market for mortgage-backed securities (MBS). These are over-the-counter (OTC) derivatives where cash flows from individual mortgages are bundled, sliced up, and sold to investors. The crisis resulted from a sequence of events, each with its trigger and culminating in the near collapse of the banking system.
The seeds of the crisis were sown as far back as the 1970s with the Community Development Act, which required banks to loosen their credit requirements for lower-income consumers, creating a market for subprime mortgages. The amount of subprime mortgage debt, which was guaranteed by Freddie Mac and Fannie Mae, continued to expand into the early 2000s when the Federal Reserve Board began to cut interest rates drastically to avoid a recession.
The combination of loose credit requirements and cheap money spurred a housing boom, which drove speculation, pushing up housing prices and creating a real estate bubble. In the meantime, investment banks, looking for easy profits in the wake of the dot-com bust and the 2001 recession, created a type of MBS called collateralized debt obligations (CDOs) from the mortgages purchased on the secondary market.
However, because subprime mortgages were bundled with prime mortgages, there was no way for investors to understand the risks associated with the product. When the market for CDOs began to heat, the housing bubble that had been building for several years had finally burst. As housing prices fell, subprime borrowers began to default on loans that were worth more than their homes, accelerating the decline in prices.
When investors realized the MBS and CDOs were worthless due to the toxic debt they represented, they attempted to unload the obligations. However, there was no market for the CDOs. The subsequent cascade of subprime lender failures created liquidity contagion that reached the upper tiers of the banking system.
Two major investment banks, Lehman Brothers and Bear Stearns, collapsed under the weight of their exposure to subprime debt, and more than 450 banks failed over the next five years. Several of the major banks were on the brink of failure and were rescued by a taxpayer-funded bailout.
How Do Financial Markets Work?
Despite covering many different asset classes and having various structures and regulations, all financial markets work essentially by bringing together buyers and sellers in some asset or contract and allowing them to trade with one another. This is often done through an auction or price-discovery mechanism.
What Are the Main Functions of Financial Markets?
Financial markets serve multiple functions in the economy, but their primary purpose is to facilitate the efficient allocation of capital and assets. In a financial economy, capital is constantly in motion, flowing from investors and savers to borrowers and spenders.
Financial markets provide a platform for this flow of capital, enabling investors to purchase financial assets such as stocks, bonds, and derivatives, and allowing borrowers to raise funds by issuing these same assets.
Here are several important functions of financial markets:
1. Puts savings into more productive use
Financial markets play a crucial role in the economy by putting savings to more productive use. Instead of allowing money to sit idle in a savings account, financial markets such as banks provide opportunities for individuals and companies to access loans for various purposes such as home loans, student loans, and business loans. By channelling savings towards investments and productive activities, financial markets facilitate economic growth and development.
Banks and other financial institutions use the money deposited by savers to lend to borrowers who need capital to start or grow their businesses, invest in new projects, or make large purchases. This intermediation process helps to match savers with borrowers, thereby providing a means for individuals and businesses to access the capital they might not otherwise have. As a result, financial markets promote investment, entrepreneurship, and innovation, which are critical drivers of economic growth and job creation.
2. Determines the price of securities
Financial markets play a crucial role in determining the price of securities. Unlike goods and services whose price is determined by the law of supply and demand, the prices of securities are determined by financial markets.
Investors aim to make profits from their securities, and the prices of securities in the financial markets reflect the current and expected future performance of the companies and economies that issue them.
In other words, the price of a security reflects the value that the market places on it. This value is influenced by a wide range of factors, including the performance of the issuing company, the economic conditions in the country or region, and global events that can affect the overall market sentiment.
By providing a platform for buyers and sellers to interact, financial markets allow for the efficient determination of the prices of securities.
This, in turn, enables investors to make informed decisions about buying, selling, or holding securities in their portfolio.
3. Makes financial assets liquid
Financial markets also provide liquidity to financial assets, allowing investors to easily buy and sell securities as needed. This helps to ensure that buyers and sellers can find each other and trade assets quickly and at a fair price, increasing the efficiency of the market.
The presence of liquid markets also reduces the risk associated with holding an asset, as investors can sell it quickly if they need to raise cash or adjust their portfolio.
Overall, the ability to easily buy and sell financial assets through financial markets promotes market efficiency and stability.
4. Lowers the cost of transactions
Financial markets have made it possible for investors to acquire various types of information about securities without the need to spend money. This includes information about market trends, financial statements, and company news, among others.
This information is readily available in financial newspapers, online platforms, and other sources.
Moreover, financial markets have also facilitated the automation of trading activities, which has lowered the cost of transactions. This has made it possible for investors to buy and sell securities at a lower cost than what was possible in the past.
The use of technology in financial markets has further increased efficiency, reduced errors, and increased transparency.
Who Are the Main Participants in Financial Markets?
Financial markets have a wide range of participants, each with different objectives and roles. These participants play a crucial role in the functioning of financial markets.
One of the main participants in financial markets is firms that use stock and bond markets to raise capital from investors. These firms may issue stocks or bonds to raise money for various purposes, such as funding new projects or expanding their business. In exchange for their investment, investors receive ownership in the company or the promise of future repayment with interest.
Another important participant is speculators who look to various asset classes to make directional bets on future prices. They seek to profit from market movements by buying or selling securities based on their predictions of future trends. Speculators may include individual investors, hedge funds, and other investment firms.
Hedgers are also essential participants in financial markets. They use derivatives markets to mitigate various risks, such as price fluctuations, interest rate movements, or currency fluctuations. Hedging involves taking an offsetting position in security to protect against adverse price movements.
For example, a company that exports goods may hedge against currency risk by buying a futures contract that locks in a favourable exchange rate.
Arbitrageurs are another key participant in financial markets. They seek to take advantage of mispricings or anomalies observed across various markets. Arbitrageurs profit by simultaneously buying and selling securities or assets in different markets to capture the price difference. This activity helps to ensure that prices in different markets remain in line with each other, leading to efficient pricing across the financial system.
Brokers act as intermediaries between buyers and sellers in financial markets. They bring buyers and sellers together, earning a commission or fee for their services. Brokers may provide research and advice to clients, help execute trades, and facilitate the settlement of transactions.