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Definition and Types of Financial Markets

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by Oluwapelumi Adejumo · 7 min read
Definition and Types of Financial Markets
Photo: Depositphotos

The role the financial markets play in the success and strength of an economy cannot be quantified. Here you will find out what are the financial markets and get deeper into their types.

Financial markets are a collection of marketplaces where the trading of securities, stocks, bonds, and derivatives takes place. Financial markets are critical to the smooth running of every capitalist economy. This is achieved by allocating resources as well as creating liquidity for entrepreneurs and businesses.

Financial markets make it convenient for buyers and sellers to trade their financial holdings. They also create securities products that provide a profit for individuals who have excess funds (investors) and make this fund available to those who require additional money (commonly called borrowers).

Key Characteristics of a Financial Market

A financial market has the following characteristics:

  • Functions as a link. A financial market is able to connect borrowers to potential investors and also bridge the gap between the two in order to facilitate mutual benefits.
  • Easy accessibility. Financial markets are easily accessible anytime for investors as well as borrowers.
  • Possesses marketable and non-marketable trading options. Participants of a financial market are able to initiate the purchase or sale of marketable commodities. Examples of these include shares, bonds, and debentures with non-marketable securities like post office deposits, bank deposits, and loans.
  • Government regulations. The operations and activities of a financial market are controlled and regulated by the government. Every country is putting in place its own rules and guidelines.
  • Deals in short and long-term investment. A financial market has the capacity to provide investors with the opportunity to put their money into different schemes or securities for short or long-term benefits.
  • Involves financial third parties. A financial market needs the service of financial intermediaries such as banks, stock exchanges, non-banking financial companies, mutual fund companies, brokers, insurance companies, etc.

Types of Financial Markets

There are different types of financial markets and each exists to serve a specific function. They also depend on each other to strengthen confidence in the minds of investors. They include:

  • The Stock Market

The stock market is a series of exchanges where successful corporations turn to in order to raise huge amounts of money for the purpose of expansion. Stocks refer to the shares of ownership of a public corporation that are sold to investors via an intermediary called broker-dealers. Investors are able to make profits when there is an increase in the company’s earnings. This in turn keeps the US economy running. Although buying stocks is easy, it takes a lot of knowledge to know which stock to buy and from which company. There is such an option as mutual funds. They provide you the liberty to buy a lot of stock at once. This makes it an easier tool to invest in compared to individual stocks.

  • The Bond Market

The bond market is for organizations that require very large loans. An increase in the price of stock leads to a decrease in the price of bonds. Examples of bonds that exist include treasury bonds, municipal bonds, and corporate bonds. With bonds, there is also an assurance of liquidity that contributes to the smooth running of the US economy. Treasury bonds and treasury bond yield function in a way that a drop in the value of a treasury bond will lead to an increase in treasury bond yields in order for there to be compensation. The rise in treasury bond yields will also lead to a rise in mortgage interest rates. When there is a decline in treasury value, the value of the US Dollars also drops. This leads to a rise in the price of importation and can as well lead to inflation.

  • The Commodities Market

A commodity market is a place for companies to offset their future risks when purchasing or selling natural resources. Companies are able to lock down a recognizable price owing to the fluctuating nature of the prices of commodities such as gold, corn, and oil. Many investors have the opportunity to trade for profit as a result of the public nature of the exchanges.

  • Derivatives Market

Derivatives are complicated financial products whose values depend on underlying assets. Hedge funds and sophisticated investors use derivatives to amplify their potential gains. Hedge funds became widely popular in 2007 owing to their assumed higher returns for high-end investors. Many are of the opinion that since hedge funds invest heavily in futures, they decrease the volatility of the stock market and the US economy as well. The 2008 global financial crisis was due to hedge fund investments in subprime mortgages and other derivatives.

  • Foreign Exchange Market

Forex trading is a decentralized global market that facilitates the buying and selling of currencies. In April 2019, about $6.6 trillion were traded daily and about 88 percent involved the US Dollars. Almost one-fourth of the trade is executed by banks on behalf of their customers in order to reduce the volatility of doing business abroad. Hedge funds account for another 11 percent and some are speculative. Foreign exchange markets influence exchange rates and also the value of the dollar and other currencies.

Functions of Financial Markets

The role the financial markets play in the success and strength of an economy cannot be quantified.

Firstly, financial markets make productive usage of savings. Financial markets such as banks open savings account up for individuals and companies that need loans such as student loans, business loans, house loans, etc.

Secondly, financial markets determine the price of securities. Financial markets, unlike goods and services whose prices are influenced by the law of demand and supply, determine the prices of securities thus helping investors to make profits from their securities.

Thirdly, financial markets liquidate financial assets. Buyers and sellers are able to leverage the financial markets to sell their securities or make investments as they desire. This would allow buyers and sellers the liberty to trade securities anytime they desire.

Finally, financial markets reduce the cost of transactions. With the financial markets, participants are able to acquire certain information about securities at no cost.

Pros and Cons of Financial Markets

The merits of financial markets include the following:

  • The provision of a platform for corporations to raise money in the short and long term.
  • With the financial markets, companies are able to raise capital at a lower value compared to taking loans from banks and at better interest rates. Financial markets are also able to give out a large number of loans, something banks don’t do.
  • Companies are provided with the flexibility on the financial markets to raise capital from the market from time to time till it exhausts its authorized share capital.
  • Intermediaries in financial markets provide financial strategic practices to firms and investors. The intermediaries also supply guidance, data, and skilled services which may be unavailable otherwise.
  • It provides a platform for international, inter-currency money lending and borrowing.

However, there are several cons to consider. Firstly, there are too many formalities with the aid of regulatory bodies that can make the whole system time-consuming and inconvenient. Then, in the financial markets, investors can lose their money as a result of the non-availability of data or due to lack of awareness. Besides, sometimes corporations can’t afford to enter into the financial markets as a result of stringent policies and regulations. Corporations are all unable to establish resources that require continuous monitoring and compliance check procedure.

Conclusion

Financial markets rely heavily on informational transparency in order to ensure that the markets set prices that are not only efficient but also appropriate. The market prices of securities may not be indicative of their underlying worth or value because of macroeconomic forces such as taxes. Some financial markets like the New York Stock Exchange (NYSE) trade trillions of dollars worth of securities on a daily basis.

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FAQ

What are financial markets?

Financial markets are a collection of marketplaces where the trading of securities, stocks, bonds, and derivatives takes place. Financial markets are critical to the smooth running of every capitalist economy. This is achieved by allocating resources as well as creating liquidity for entrepreneurs and businesses.

What are the different types of financial markets?

The different types of financial markets include stock market, bond market, commodities market, derivatives market, foreign exchange market.

What are the main functions of financial markets?

Financial markets liquidate financial assets, lower the cost of transactions, put savings into more productive use, and determine the prices of securities. 

Who are the main participants of financial markets?

The main participants of financial markets are the banks, governments, corporations, government-sponsored enterprises, money market mutual funds, futures market exchanges, brokers and dealers, as well as the Federal Reserve. 

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