Note on Financial Markets
By
ADAM HAYES
Reviewed by
CIERRA MURRY
Fact checked by KIRSTEN ROHRS SCHMITT
What Are Financial Markets?
Financial markets refer broadly to any marketplace where securities trading
occurs, including the stock market, bond market, forex market, and derivatives
market. Financial markets are vital to the smooth operation of capitalist
economies.
Understanding the Financial Markets
Financial markets play a vital role in facilitating the smooth operation of capitalist
economies by allocating resources and creating liquidity for businesses and
entrepreneurs. The markets make it easy for buyers and sellers to trade their
financial holdings. Financial markets create securities products that provide a
return for those with excess funds (investors/lenders) and make these funds
available to those needing additional money (borrowers).
The stock market is just one type of financial market. Financial markets are
created when people buy and sell financial instruments, including equities, bonds,
currencies, and derivatives. Financial markets rely heavily on informational
transparency to ensure that the markets set prices that are efficient and
appropriate.
Some financial markets are small with little activity, and others, like the New
York Stock Exchange (NYSE), trade trillions of dollars in securities daily. The
equities (stock) market is a financial market that enables investors to buy and sell
shares of publicly traded companies. The primary stock market is where new
issues of stocks are sold. Any subsequent trading of stocks occurs in the secondary
market, where investors buy and sell securities they already own.
Types of Financial Markets
There are several different types of markets. Each one focuses on the types and
classes of instruments available on it.
Stock Markets
Perhaps the most ubiquitous of financial markets are stock markets. These are
venues where companies list their shares, which are bought and sold by traders
and investors. Stock markets, or equities markets, are used by companies to raise
capital and by investors to search for returns.
Stocks may be traded on listed exchanges, such as the New York Stock Exchange
(NYSE), Nasdaq, or the over-the-counter (OTC) market. Most stock trading is
done via regulated exchanges, which plays an important economic role because it
is another way for money to flow through the economy.
Typical participants in a stock market include (both retail and institutional)
investors, traders, market makers (MMs), and specialists who maintain liquidity
and provide two-sided markets. Brokers are third parties that facilitate trades
between buyers and sellers but who do not take an actual position in a stock.
Over-the-Counter Markets
An over-the-counter (OTC) market is a decentralized market—meaning it does
not have physical locations, and trading is conducted electronically—in which
market participants trade securities directly (meaning 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, however, are exclusively OTC,
making up an essential segment of the financial markets. Broadly speaking, OTC
markets and the transactions that occur in them are far less regulated, less liquid,
and more opaque.
Bond Markets
A bond is a security in which an investor loans money for a defined period at a
pre-established interest rate. You may think of a bond as an agreement between
the lender and borrower containing the loan's details and its payments. Bonds are
issued by corporations as well as by municipalities, states, and sovereign
governments to finance projects and operations. For example, the bond market
sells securities such as notes and bills issued by the United States Treasury. The
bond market is also called the debt, credit, or fixed-income market.
Money Markets
Typically, the money markets trade in products with highly liquid short-term
maturities (less than one year) and are characterized by a high degree of safety and
a relatively lower interest return than other markets.
At the wholesale level, the money markets involve large-volume trades between
institutions and traders. At the retail level, they include money market mutual
funds bought by individual investors and money market accounts opened by bank
customers. Individuals may also invest in the money markets by purchasing short-
term certificates of deposit (CDs), municipal notes, or U.S. Treasury bills, among
other examples.
Derivatives Markets
A derivative is a contract between two or more parties whose value is based on an
agreed-upon underlying financial asset (like a security) or set of assets (like an
index). Rather than trading stocks directly, a derivatives market trades in futures
and options contracts and other advanced financial products that derive their value
from underlying instruments like bonds, commodities, currencies, interest rates,
market indexes, and stocks.
Futures markets are where futures contracts are listed and traded. Unlike forwards,
which trade OTC, futures markets utilize standardized contract specifications, are
well-regulated, and use clearinghouses to settle and confirm trades. Options
markets, such as the Chicago Board Options Exchange (Cboe), similarly list and
regulate options contracts. Both futures and options exchanges may list contracts
on various asset classes, such as equities, fixed-income securities, commodities,
and so on.
Forex Market
The forex (foreign exchange) market is where participants can buy, sell, hedge,
and speculate on the exchange rates between currency pairs. The forex market is
the most liquid market in the world, as cash is the most liquid of assets. The
currency market handles more than $7.5 trillion in daily transactions, more than
the futures and equity markets combined.1
As with the OTC markets, the forex market is also decentralized and consists of a
global network of computers and brokers worldwide. The forex market is made up
of banks, commercial companies, central banks, investment
management firms, hedge funds, and retail forex brokers and investors.
Commodities Markets
Commodities markets are venues where producers and consumers meet to
exchange physical commodities such as agricultural products (e.g., corn,
livestock, soybeans), energy products (oil, gas, carbon credits), precious metals
(gold, silver, platinum), or "soft" commodities (such as cotton, coffee, and sugar).
These are known as spot commodity markets, where physical goods are
exchanged for money.
However, the bulk of trading in these commodities takes place on derivatives
markets that utilize spot commodities as the underlying assets. Forwards, futures,
and options on commodities are exchanged both OTC and on
listed exchanges around the world, such as the Chicago Mercantile Exchange
(CME) and the Intercontinental Exchange (ICE).
Cryptocurrency Markets
Thousands of cryptocurrency tokens are available and traded globally across a
patchwork of independent online crypto exchanges. These exchanges host digital
wallets for traders to swap one cryptocurrency for another or for fiat monies such
as dollars or euros.
Because most crypto exchanges are centralized platforms, users are susceptible to
hacks or fraudulent activity. Decentralized exchanges are also available that
operate without any central authority. These exchanges allow direct peer-to-peer
(P2P) trading without an actual exchange authority to facilitate the transactions.
Futures and options trading are also available on major cryptocurrencies.
Examples of Financial Markets
The above sections make clear that the "financial markets" are broad in scope and
scale. To give two more concrete examples, we will consider the role of stock
markets in bringing a company to IPO and the role of the OTC derivatives market
in the 2008-09 financial crisis.
Stock Markets and IPOs
As a company establishes itself over time and grows, it needs access to additional
capital. It will often find itself in need of much larger amounts of capital than it
can get from ongoing operations, traditional bank loans, or venture and angel
funding. Firms can raise the amount of capital they need by selling shares of itself
to the public through an initial public offering (IPO). This changes the company's
status from a "private" firm whose shares are held by a few shareholders to
a publicly traded company whose shares will be subsequently held by public
investors.
The IPO also offers early investors in the company an opportunity to cash out part
of their stake, often reaping very handsome rewards in the process. Initially, the
underwriters usually set the IPO price through their pre-marketing process.
Once the company's shares are listed on a stock exchange, and trading
commences, the price of these shares will fluctuate as investors and traders assess
and reassess their intrinsic value and the supply and demand for those shares at
any given moment.
What Are the Different Types of Financial Markets?
Some examples of financial markets and their roles include the stock market, the
bond market, forex, commodities, and the real estate market, among others.
Financial markets can also be broken down into capital markets, money markets,
primary vs. secondary markets, and listed vs. OTC markets.
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 exist for several reasons, but the most fundamental function is
to allow for the efficient allocation of capital and assets in a financial economy.
By allowing a free market for the flow of capital, financial obligations, and
money, the financial markets make the global economy run more smoothly while
allowing investors to participate in capital gains over time.
The Bottom Line
Financial markets provide liquidity, capital, and participation that are essential for
economic growth and stability. Without financial markets, capital could not be
allocated efficiently, and economic activity such as commerce and trade,
investments, and growth opportunities would be greatly diminished.
Many players make markets an essential part of the economy—firms use stock
and bond markets to raise capital from investors. Speculators look to various asset
classes to make directional bets on future prices. At the same time, hedgers use
derivatives markets to mitigate various risks, and arbitrageurs seek to take
advantage of mispricings or anomalies observed across various markets. Brokers
often act as mediators that bring buyers and sellers together, earning a commission
or fee for their services.
