What is the financial market?
It is a market place where various financial assets, for example, stocks, bonds, commodities, derivatives, etc, are traded. It is basically found in each country, and the growth of the financial market helps in the development of the economy of any country. The size of the market varies from one country to another like some countries have a small financial market while some have large ones, for example, Nasdaq in the U.S.
Main functions of the Financial market
- This market acts as an intermediary between lenders and borrowers as in business sector money flows from investors or lenders to business or borrowers for the purpose of production or sales of goods and services. It becomes a transmission mechanism through which the transfer of funds is facilitated. It helps investors to invest in various businesses to earn profit in the long or short run. Therefore, it helps both investors and businesses to grow and raise money.
- Demand and supply of an asset in a financial market helps to determine their price. The financial market provides pricing information result from the interaction between buyers and sellers in the market when they trade the financial asset.
- The financial market provides liquidity of assets which are being traded in the market which means an investor can easily sell their assets and convert them into cash whenever they want.
- It provides transparency and security while dealing in financial assets.
- A financial market handles many transactions. It can reduce the cost of the transaction by exploiting the economies of scale.
The financial market can be classified on the basis of various factors and therefore it is divided into four categories.
1. On the basis of nature of the claim – It is based on the type of claim investors have on their invested assets, and therefore it is further divided into two parts:-
- Debt market – It is a market where investments are made in debt instruments like bonds, loans, etc. Debt instruments are tools which are used by government organizations or businesses to raise capital for the better functioning of their corporations. These instruments have fixed interest rate, therefore, called fixed claims, which means claims on the assets are restricted to a certain amount for a fixed period of time and investors earn this interest income in return.
- Equity market – It is a market where investments are made on the stocks which mean share of ownership in the company. This market provides more profit to the investor in comparison to debt market through dividends, growth of stock price etc, but it can also make investor lose money if the stock price reverses to the downside, therefore it is also riskier than debt market. Overall it refers to owners capital in the business, thus it is a residual claim which means whatever is left in the business after paying off to fixed liabilities belong to shareholders.
2. On the basis of maturity of claim – Business units have to raise short and long term funds to meet their working and fixed capital requirements from time to time. Therefore this category is divided into two parts, the money market which deals in short term credit and capital market which handles the medium and long term credit.
- Money market – It is a market of short term funds which deals in the financial assets whose period of maturity is up to one year. This market deals in credit instruments such as a bill of exchange, treasury bills, etc. It is a less risky market and pays a reasonable rate of return to investors, generally in the form of interest income.
- Capital market – It is a market where instruments with medium to long term maturity are traded. It is mainly concerned with raising capital by dealing in stocks, bonds, and other long term investments. It is further divided into two segments: Primary market – It is a market where the company lists security for the first time or where the already listed company issues fresh security. It directly involves the company and the shareholder to transact with each other and the amount paid by the shareholder for the primary issue is received by the company. Secondary market – Once the security gets listed it becomes available for trading over the exchange between the investors. The market which facilitates this trading is called the secondary market. Company is not directly involved in this market as a transaction doesn’t impact the cash flow position of the company. Payments in such exchange are settled among investors.
3. On the basis of nature of assets – It is further divided into five parts:-
- Stock market – It is also called a secondary market where listed securities of companies are available for trading over the exchange between investors. Stocks are shares of ownership in the public or private companies where investors earn a profit when their respective companies grow and the prices of their stocks increases.
- Bond market – It is also called the debt market or credit market where investors can invest in government and cooperative issued debt securities. These bonds are issued to raise capital for business expansion, projects, maintaining ongoing operations, etc; in return, investors earn profit in the form of fixed interest income.
- Commodity market – It is a market where primary products and natural resources are being traded. It is divided into two parts, hard commodities, which consist of natural resources which are to be mined and extracted such as gold, oil, etc and soft commodities are primary or agricultural products such as wheat, sugar, soya bean, etc.
- Forex market – It is a global market where various currencies around the world are traded. It includes various banks, commercial companies, hedge funds, central banks, investors, etc. It is a highly liquid market and also considered as the largest one.
- Derivative market – It is a market where derivative instruments like futures, options contracts are traded. They are a bit complicated as their value is derived from other forms of assets. Derivatives are used to hedge a position or speculate on the movements of stocks. Many investors and hedge funds use them to enhance their potential gains.
4. On the basis of organizational structure – It is divided into two parts:-
- Exchange-traded market – It is a centralized and organized market. Certain intermediaries are involved in the settlement of transaction between buyer and sellers. All companies are subject to certain rules and regulations imposed by exchange authorities. Counterparty risks is not an issue in exchange as all trades are closely monitored by exchange authorities.
- Over the counter market – It is a non-centralized market where trades are done directly between the two parties without any involvement of an intermediary. Rules and regulations are very few here as dealers themselves work as market makers by quoting price at which they will buy and sell securities or other financial products. A trade can be executed between two parties in the over the counter market without others being aware of the price at which transaction was completed. Counterparty risk is very high in this market.