What is a financial market?
What is financial market? It’s a location or facility for the trading of financial instruments such as shares, currencies, bonds or commodities. A market may have a physical trading floor or it may exist only in cyber-space, but in both cases there will be rules of conduct that traders must observe.
- Financial markets are places where buyers and sellers come together to trade financial instruments such as stocks, bonds, currencies, and commodities.
- The primary function of financial markets is to provide a platform for businesses and governments to raise capital by issuing securities to investors.
- Financial markets can be divided into two broad categories: primary markets and secondary markets.
- In primary markets, new securities are issued and sold to investors for the first time, while in secondary markets, existing securities are traded between investors.
Where have you heard about financial markets?
If you are an investor, you will be familiar with financial markets providing the chance to buy, sell and check the price of your assets. Financial markets are rarely out of the news, be that because prices are rising or falling.
What you need to know about financial markets
Financial markets vary greatly in size, liquidity and the adoption of technology. But they tend to share common features. The assets that they trade are standardised: one dollar, one General Electric share, one barrel of Brent crude is the same as the next. A diamond exchange is not really a financial market because all stones are different.
There are usually trading hours and periods within which bargains must be settled. Trades are cleared either by the market itself or under its rules. The most reputable markets will stand behind each trade, guaranteeing to make good any loss suffered by a counter-party should a trader default.
Primary and secondary markets
The word ‘market’ tends to be used as a general term to denote both the primary and secondary markets. But the two are very distinct concepts – the primary market is the market where securities are created, and the secondary market is where they’re traded among investors.
Firms float new stocks and bonds to the public for the first time in the primary market. It’s also the place where governments or public sector institutions raise money through bond offerings. The key thing to bear in mind about the primary market is that securities are purchased directly from an issuing company.
The secondary market is generally referred to as the stock market – examples being the New York Stock Exchange, Nasdaq and FTSE. In the secondary market, investors trade among themselves without the involvement of the issuing companies. So, if you’re buying Omnicorp stock, you only deal with another investor who owns shares in Omnicorp – not with Omnicorp itself.
Different types of financial market
As well as the generic terms primary and secondary market, there are all different kinds of financial market. Here’s a quick rundown of what is the stock market, what is the bond market, what is the forex market, and what is the derivatives market:
- What is the stock market? It’s the collection of markets and exchanges where the issuing and trading of equities, bonds and other types of securities takes place. The stock market is one of the most important elements of a free-market economy, as it gives companies access to capital in exchange for granting investors a slice of ownership.
- What is the bond market? It’s a financial market where participants can issue new debt, or buy and sell debt securities. This is generally in the form of bonds, but can also include bills, notes and so on. Its main aim is to provide long-term funding for public and private expenditures.
- What is the money market? It’s a component of the financial markets for assets involved in short-term borrowing, lending, buying and selling with original maturities of a year or less. Trading in money markets is done over the counter and is wholesale.
- What is the forex market? It’s a global decentralised or over-the-counter market for the trading of currencies. This involves all aspects of buying, selling and exchanging currencies at current or determined prices.
- What is the derivatives market? It’s the financial market for derivatives – financial instruments like futures contracts or options, which are derived from other types of assets.
Who’s involved in financial markets?
Financial markets have all sorts of participants – let’s start with the investor. An investor is someone who allocates capital in the expectation of future financial return. They might invest in equity, debt securities, real estate, currency, commodities or derivatives, among others. And there are two main types of investor: retail investors (individuals, trusts acting on behalf of individuals, and umbrella companies pooling investment funds); and institutional investors (these can be venture capital and private equity funds, businesses that make investments, investment trusts, mutual funds, hedge funds and other funds).
Next, investment banks. Executing transactions such as the sale of stocks and bonds requires special expertise, from pricing financial instruments to dealing with regulatory stipulations. That’s where an investment bank comes in. Investment banks function like a bridge between big enterprises and investors. They advise businesses and governments on financial challenges, and help them to secure financing from bond issues, derivatives or share offerings. A broker is the individual who arranges transactions between a buyer and a seller for a commission when the deal is done.
An investment policy statement (IPS) is a document drawn up between a portfolio manager and a client, setting out general rules for the manager. The statement outlines the client’s main investment aims and objectives, and lists the strategies the manager should employ to achieve these goals. An IPS also includes information on issues like asset allocation, risk tolerance and liquidity requirements.
Market liquidity and volatility
Two more terms you’ll often hear in discussions about financial markets are market liquidity and volatility:
Market liquidity is a market's ability to buy or sell an asset without causing a dramatic change in the asset's price. An asset's market liquidity is a measure of the asset's ability to sell quickly without having to lower its price significantly. In a relatively illiquid market, a quick sale will require the asset’s price to be cut by a fair amount. Liquidity is measured either by trade volume relative to shares outstanding, or based on the bid-ask spread or transactions costs of trading.
Volatility is a measure of the dispersion of returns for a security or market index, and can be measured using the standard deviation between returns from the security or market index. The higher the volatility, the riskier the security tends to be. Higher volatility means that a security's value can potentially be spread over a larger range of values. Lower volatility means that a security's value doesn’t fluctuate massively, but changes in value at a steady rate. This tends to make the security less risky.
Find out more about financial markets
We’ve told you what is the stock market,what is the bond market,what is the forex market, and what is the derivatives market. You can see that financial markets are a huge subject area – and our comprehensive glossary has definitions for dozens more related terms, including investor, financial instrument, liquidity and volatility. Take a look at some of them to deepen your understanding of how markets work.
There’s always lots going on in the realms of financial market regulation and technology – so here are a few interesting articles on the subject:
The Daily Telegraph said in October 2017 that new financial regulations could be about to trigger the biggest shake-up in the City in three decades.
Lexology has an introduction to Distributed Ledger Technology in financial markets. The piece sets out the conclusions of the Project Stella report, a European Central Bank and Bank of Japan joint venture which looked at how distributed ledger technology could be applied to financial market infrastructure. Read more here.
Finally, Business Insider has an interesting article on misconduct in financial markets, which it says comes in 25-year cycles and in 26 different forms. The publication speaks to Gerry Harvey and Mark Yallop, of the FICC Markets Standards Board and Bank of England's Prudential Regulation Committee, about the age-old issue of market malpractice. Read more here.
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