What are the financial markets?

What are the financial markets?

Financial markets
Photo by @FreedomTumZ

It’s a virtual or physical environment in which the trading of financial products takes place.  

Financial markets definition

Today, the term “financial markets” (often shortened to FX) typically relates to electronic trading exchanges, some of which may have physical locations. In practice, the markets are organisations that facilitate trade in these financial products. 

Why are financial markets useful?

Benefit 1: Raise funds

Firstly, they help to raise funds for businesses who may want to expand by investing for the future in physical or human resources. 

Firms will do this by going to a financial market to sell a proportion of their shares. By doing this, they are handing over ownership of a part of their business to individuals or institutions who become shareholders. These shareholders are then able to influence how the business is run.

Benefit 2: Facilitate International trade

Secondly, the financial market allows banks to exchange currencies on behalf of their clients who trade internationally. The globalised nature of today’s’ economies, with supply chains stretching from China to Europe to the Americas, relies on foreign currency exchange to lubricate international trade.

Here the risk is in the change in the exchange rate. If the Euro falls against the Yen before delivery of the goods, the German company will lose money. So what to do? Answer: Ask the bank or broker to buy Yen in a financial market at the price it is today and make the exchange on delivery. This ensures that the German company doesn’t lose money on the transaction if the euro falls in value close to the delivery date. 

Benefit 3: Pensions and investments

Thirdly, for those of us with pensions or private investments, we rely on market growth to make returns on our investment. Pension fund managers will invest in a broad range of assets to try and make our pension grow. They’ll do this mainly through investing in shares and bonds. Ideally, they will try to find a balance between making profits and taking risks in order to balance our portfolios (and theirs).

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How many types of financial markets are there?

The key financial markets are: 

  • Money markets 
  • Bond markets
  • Capital markets 
  • Derivatives markets 
  • Commodity markets 
  • Foreign exchange markets 
  • Spot markets 

Increasingly, insurance is also regarded as a financial market. Many people take out insurance on loans to cover payments on that loan in the event that you lose your job. Businesses can do this too to protect against investment losses.

Money Market

This is the exchange of very short-term loans, normally a year or less. Sometimes the loans can be for a matter of hours. The main players in this market are the banks and financial institutions and unless you work for, or own a financial institution, you are unlikely to get involved in this market.

Participants pay interest on their loans and repay them when agreed.

Why are money markets useful?

The two main reasons we need money markets are:

  • To provide liquidity for the global financial system
  • To help industries secure short-term loans to meet capital requirements

What is actually traded in the money markets?

Typically traded financial instruments are certificates of deposits, treasury bills, and commercial paper. These markets are not regulated because the majority of participants are professional investors.

Capital Market

This is where public equity and public debt is traded. Public equity (say shares) are traded on the stock market and public debt is bought and sold in the debt market.  

An important difference between the capital market and the money market we’ve just discussed is timescale:

  • Money market = short term loans
  • Capital market = long term loans

Within the capital market is a primary and a secondary market. 

Primary market

You have participated in the primary capital market if you invested in a company by buying shares or if you have taken out a mortgage.

Secondary market

The secondary market is where existing securities (like shares) already created on the primary market get traded among investors or traders. You might, for instance, want to sell your shares to another investor. In many ways, the existence of these secondary markets increases confidence among investors in the primary capital markets and here it is easy to withdraw your investment quickly (or cash out) if you want to.

Photo by @andreyyalansky19

 

Foreign Exchange Market

The “FX”, “forex”, or “currency market”  are all names for the Foreign Exchange Market which is where exchange rates are determined. These days it is extremely decentralised and covers the entire globe. It’s regarded as an over-the-counter (OTC) market where currencies are bought, sold, exchanged at current or future prices.

The FX market is the largest market in the world with estimates suggesting that in 2019 FX turnover was approximately $5.2 trillion per day. 

Who trades the foreign exchange market?

Roughly 95% of trading on the FX market is carried out by the large international and multinational banks, companies and institutions. Retail private traders like you take up the remaining 5% of the trading volume.

Typically this market operates through financial institutions with banks using financial firms known as “dealers”, to trade large quantities of foreign exchange. Because most of the foreign exchange dealers are banks, this market is often referred to as the “interbank market”.

Other types of foreign exchange market participants

Also participating in the FX market are:

Speculators – who take bets on the value of different currencies relative to each other. Anyone who believes they can predict the future price movement of any currency pair can do this if they understand the risks involved.

International traders – who need to convert currencies from one to another in order to do business across international borders. As an example, a business in Europe can import goods from the USA and elect to pay in dollars, even though their primary income is in euros.

Is the foreign exchange market regulated?

Because there are so many sovereign jurisdictions involved it is extremely difficult to regulate the Foreign Exchange Market so it is classed as unregulated.

Derivatives Market

Derivatives are financial instruments that are derived from other products. If you buy a cash stock, you are buying the underlying asset and you become the owner of that stock. But if you buy a stock derivative, you don’t own that stock and its underlying asset but you can still profit on the price movement of the stock.

Not surprisingly, the derivatives market follows the underlying market prices. Both can be traded but one is the stock and the other is a contract relating to the stock.  

There are four major derivative contracts and you may have heard of some of them: options, futures, forwards, and swaps. There are also four main participants operating in derivatives markets – Hedgers, Arbitrageurs, Margin traders and Speculators (traders).

Estimates suggest that in 2019 the European derivatives market had a notional value of €775 trillion in 2019. That is the combined value of all the assets traded in the derivatives market in that year. It’s a huge market.

There are derivatives markets in many financial markets. If you decide that you don’t want to own any underlying assets then you can decide to trade the derivatives market. You can easily get exposure to forex, commodities, stocks, indices and even cryptocurrencies.

There are two kinds of products in the derivatives market; exchange-traded and over-the-counter. 

Exchange-Traded Derivatives

Exchange-traded derivatives are standard financial contracts. They require payment of a deposit before they are then traded on futures exchanges, guaranteed and settled through a clearinghouse.

The clearinghouse is the middle-man between the buyer and the seller and they serve as guarantors to ensure that the exchange is correct. In this way, they reduce the risk of the exchange.

Exchanges, such as the Chicago Board Options Exchange (CBOE) or New York Mercantile Exchange (NYMEX) list Exchange-traded derivatives. Pricing has been standardised and a process has been developed which clearly shows the expiry month and strike price of exchanges using unique letter codes. Regulators, such as the SEC (Securities and Exchange Commission) will oversee the process.

Over The Counter Derivatives

Over-the-counter (OTC) derivative trading does not need the supervision of an exchange. Instead, two parties can trade directly and prices are not always publicly disclosed.

Insurance Market

As its name implies, the insurance market is where the buying and selling of insurance take place. All sorts of people, companies or groups can buy insurance to cover specific risks. And the financial sector is no different. Here, insurance can be bought and sold to cover, for instance, the risks associated with the purchase of financial products. 

Part of the underlying reason for the 2008 financial crash was the fact that the insurance industry had insured bad financial products. Check out the ‘The Big Short’, where you might hear about ‘collateralized debt obligations’ (CDOs). These were the financial products that banks insured. When they defaulted, the banks tried to claim on their insurance but in this instance, the insurers couldn’t payout. You might remember stories of huge insurance bailouts.

 

Financial market - Insurance
Photo by @Tereza

 

Commodity Market

This is any kind of market that trades physical assets like livestock, fruit, sugar, oil and gas rather than manufactured products such as steel. They are divided into hard commodities such as silver, gold, oil and gas and soft commodities such as sugar, wheat and fruit.

Commodities such as these are foundations of our global economy and essential for economic growth. Commodity markets can be both physical and virtual.

How are commodity markets traded

For years futures contracts have been the usual method of investing and trading in commodities. Farmers, for instance, may take a partial payment for their agriculture products which in turn helps to set future prices. Factors such as the weather are used as an indication of the quality of an upcoming harvest and also affect pricing.

Today commodity markets include both physical trading and derivatives trading and use methods such as spot prices, futures, and options.

What affects the commodity markets

Because they are physical products, the commodity market is affected by factors like the weather, war, supply and demand, politics, economic issues and the U.S. dollar. The U.S. dollar is important because most contracts for commodities are priced in dollars in international markets. Commodity prices are known to fluctuate substantially.

Examples of commodity markets

Examples of commodity markets include:

  • the London Metal Exchange for non-precious metals, 
  • The Chicago Mercantile Exchange for energy and metals,
  • the ICE Futures US for agricultural products, 
  • The Chicago Board of Trade for agricultural products.

Commodities are usually traded as futures contracts which are simple agreements to buy or sell assets at agreed prices and dates in the future. This means that commodity contracts can be owned and exchanged without the need to own the underlying asset.

Financial Markets Conclusion

All forms of trading take place in financial markets. They can be used to raise capital, to trade currencies or commodities or simply for speculation purposes. They provide opportunities to trade using a range of financial instruments and if you are going to trade in them, you need to understand carefully how each one works.

OK so far? If you are up for learning a little more, our next lesson will talk in more detail about the market participants. 

 

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