Types of Financial Markets
This lesson will cover the following:
- Nature and functions of financial markets
- Types of financial markets in terms of instruments maturity
- Main divisions of financial markets
A financial market is a market in which people and entities can trade financial securities, commodities and other fungible assets at prices that are determined by pure supply and demand principles. Markets work by placing the two counterparts, buyers and sellers, at one place so they can find each other easily, thus facilitating the deal between them.
Financial markets may be viewed as channels through which flow loanable funds directed from a supplier who has an excess of assets toward a demander who experiences a deficit of funds.
There are different types of financial markets and their characterization depends on the properties of the financial claims being traded and the needs of the different market participants. We recognize several types of markets, which vary based on the type of the instruments traded and their maturity. A common breakdown is the following:
The capital market aids raising of capital on a long-term basis, generally over 1 year. It consists of a primary and a secondary market and can be divided into two main subgroups – Bond market and Stock market.
- The Bond market provides financing by accumulating debt through bond issuance and bond trading
- The Stock market provides financing by sharing the ownership of a company through stocks issuing and trading
A primary market, or the so-called “new issue market”, is where securities such as shares and bonds are being created and traded for the first time without using any intermediary such as an exchange in the process. When a private company decides to become a publicly-traded entity, it issues and sells its stocks at a so-called Initial Public Offering. IPOs are a strictly regulated process which is facilitated by investment banks or finance syndicates of securities dealers that set a starting price range and then oversee its sale directly to the investors.
A secondary market, or the so-called “aftermarket” is the place where investors purchase previously issued securities such as stocks, bonds, futures and options from other investors, rather from issuing companies themselves. The secondary market is where the bulk of exchange trading occurs and it is what people are talking about when they refer to the “stock market”. It includes the NYSE, Nasdaq and all other major exchanges.
Some previously issued stocks however are not listed on an exchange, rather traded directly between dealers over the telephone or by computer. These are the so-called over-the-counter traded stocks, or “unlisted stocks”. In general, companies which are traded this way usually dont meet the requirements for listing on an exchange. Such shares are traded on the Over the Counter Bulletin Board or on the pink sheets and are either offered by companies with a poor credit rating or are penny stocks.
The money market enables economic units to manage their liquidity positions through lending and borrowing short-term loans, generally under 1 year. It facilitates the interaction between individuals and institutions with temporary surpluses of funds and their counterparts who are experiencing a temporary shortage of funds.
One can borrow money within a quite short period of time via a standard instrument, the so-called “call money”. These are funds borrowed for one day, from 12:00 PM today until 12:00 PM on the next day, after which the loan becomes “on call” and is callable at any time. In some cases, “call money” can be borrowed for a period of up to one week.
Apart from the “call money” market, banks and other financial institutions use the so-called “Interbank market” to borrow funds within a longer period of time, from overnight to several weeks and up to one year. Retail investors and smaller trading parties do not participate on the Interbank market. While some of the trading is performed by banks on account of their clients, most transactions occur in case a bank experiences extra liquidity, a surplus of funds, while another has a shortage of liquidity.
Such loans are made at the Interbank rate, which is the rate of interest, charged on short-term loans between banks. An intermediary between the counterparts, called a dealer, announces a bid and an offer rate with the difference between the two representing a spread, or the dealers income. The Interbank interest in London is known as LIBOR (London Interbank Offered Rate) and LIBID (London Interbank Bid Rate). Respectively in Paris we have PIBOR, in Frankfurt – FIBOR, in Amsterdam – AIBOR, and Madrid – MIBOR.
Foreign exchange market
The foreign exchange market abets the foreign exchange trading. Its the largest, most liquid market in the world with an average traded value of more than $5 trillion per day. It includes all of the currencies in the world and any individual, company or country can participate in it.
The commodity market manages the trading in primary products which takes place in about 50 major commodity markets where entirely financial transactions increasingly outstrip physical purchases which are to be delivered. Commodities are commonly classified in two subgroups.
- Hard commodities are raw materials typically mined, such as gold, oil, rubber, iron ore etc.
- Soft commodities are typically grown agricultural primary products such as wheat, cotton, coffee, sugar etc.
It facilitates the trading in financial instruments such as futures contracts and options used to help control financial risk. The instruments derive their value mostly from the value of an underlying asset that can come in many forms – stocks, bonds, commodities, currencies or mortgages. The derivatives market is split into two parts which are of completely different legal nature and means to be traded.
These are standardized contracts traded on an organized futures exchange. They include futures, call options and put options. Trading in such uniformed instruments requires from investors a payment of an initial deposit which is settled through a clearing house and aims at removing the risk for any of the two counterparts not to cover their obligations.
Those contracts that are privately negotiated and traded directly between the two counterparts, without using the services of an intermediary like an exchange. Securities such as forwards, swaps, forward rate agreements, credit derivatives, exotic options and other exotic derivatives are almost always traded this way. These are tailor-made contracts that remain largely unregulated and provide the buyer and the seller with more flexibility in meeting their needs.
It helps in relocating various risks. Insurance is used to transfer the risk of a loss from one entity to another in exchange for a payment. The insurance market is a place where two peers, an insurer and the insured, or the so-called policyholder, meet in order to strike a deal primarily used by the client to hedge against the risk of an uncertain loss.