“Have you checked the markets today?” “How are the financial markets going?” “Do you invest in markets?”
We hear the words ‘market’ and ‘financial markets’ get used a lot. But what exactly is a financial market?
Financial Markets, Explained
The first thing you should know about financial markets is that there isn’t just one. As you’ll learn below, there are several types of financial markets. However, they exist for the same reason: To bring together buyers and sellers of securities. (Security is just another word for a tradable financial asset.)
Virtually all developed countries have their own financial markets. In general, when a country’s financial markets are widely used and properly regulated, its economy is able to operate more smoothly.
At the pillar of all financial markets are exchanges. The Australian Securities Exchange (ASX) and the New York Stock Exchange (NYSE) are some exchanges that you may have heard of.
The ASX is Australia’s main securities exchange (Source: Shutterstock)
Who uses financial markets?
Because there are various types of financial markets, you won’t be surprised to learn that there are a variety of market participants. (‘Market participant’ is a blanket term that’s widely used by people who talk about financial markets.)
You may use financial markets to invest some of your savings. Companies and governments may use financial markets to get access to more money.
Role Of Financial Markets
Financial markets play a pivotal role in the operation of a capitalist economy. The term ‘capital’ refers to ownership of money or other assets such as shares and real estate.
Capitalism is an economic system in which private individuals and businesses own capital, instead of the government or another central authority. Examples of capitalist economies include Australia, the U.S., Hong Kong, Canada, and the UK.
If financial markets didn’t exist, it’d be a lot harder for private individuals and businesses to buy and sell capital. That wouldn’t be good because access to capital is essential to drive economic growth.
Types Of Financial Markets
The most common types of financial markets are bond markets, stock markets, commodities markets, derivatives markets, foreign exchange (forex) markets, and cryptocurrency markets. On the global stage, the forex market is by far the largest of all financial markets.
Think of bonds as IOUs. When you buy a bond, you’re lending your money to an entity. That entity is called the bond issuer.
When you hold the bond, you’re entitled to a special type of regular interest payment known as coupon payments. Every bond has an expiry date, which is typically multiple years from the time of issuance. If you hold the bond when it expires, the bond issuer will return the amount that was borrowed.
Almost always, governments and companies are the only two types of entities that issue bonds. They do this as a way to access more money.
Basically anyone can be a bond holder. Because bonds are viewed as low-risk and they provide a steady income stream, they are popular among retirees. In general, the types of institutional investors that would have a proportionately greater bond allocation include life insurance companies, pension funds, endowment funds, and superannuation funds.
READ: What Is Economics?
The stock market is the financial market you’ve likely heard the most about. Some of the world’s most well-known companies are listed on stock markets. For example, Amazon is listed on a U.S. stock exchange called the Nasdaq.
On a stock market, you can buy and sell shares of stock. When you own shares in a company, you own part of that company. (The word ‘equity’ describes the shareholders’ stake in a company.)
Stock markets allow companies to access more money. This is possible thanks to a process known as issuing stock. There are many reasons why a company would issue stock. A lot of the time, it’s to help fund the cost of expanding.
What a lot of people don’t realise is that you can buy and sell shares in international stock exchanges. Over the past decade or two, this has become a lot easier and cheaper.
Compared to bonds, stock investing is riskier and the potential return is greater. (When it comes to investing, risk and reward are fundamentally linked.)
A commodity market is where raw materials are bought and sold. Examples of commodities include oil, gold, beef, natural gas, cocoa, corn, and silver. The commodity market is generally broken up into three categories: energy; precious and industrial metals; and agriculture.
If you’ve bought or sold commodities in the past, chances are that it was in the ‘precious and industrial metals’ category. That’s because this category includes precious metals like gold and silver.
One of the main reasons people buy gold and silver is to protect their wealth against inflation. An investor may choose to invest in a commodity such as gold, to protect themselves against inflation. (Inflation is a rise in prices across an economy.) In simple terms, when an economy is experiencing high inflation, your money “doesn’t go as far.”
The global derivatives market is enormous. It dwarfs the size of the bond market, stock market, and commodities market.
The derivatives market is literally the financial market for derivatives. A derivative is a security with a price that depends on the price of one or more underlying assets. In other words, derivatives derive their value from others assets.
Derivatives are particularly big in the commodities industry and market. For many centuries, derivatives have helped commodities such as rice and grain be shipped all over the world.
In recent decades, due to technological innovations, derivatives have soared. Nowadays, there are derivatives for all sorts of things including stocks, commodities, bonds, mortgages, interest rates, and cryptocurrencies. There are even derivatives that are based on other derivatives.
The most common types of derivatives are futures, forwards, options, and swaps.
Foreign exchange (forex) market
You may be surprised to learn that the foreign exchange market—commonly abbreviated as the ‘forex market’—is comfortably the largest financial market in the world. Every day, several trillions worth of dollars worth of currencies are bought and sold.
There are many reasons why currencies are bought and sold, such as if a person or business is investing or borrowing overseas. Another reason is for speculation purposes. That is, you speculate on possible exchange rate movements with a view of making a profit.
The value of a country’s currency is constantly going up and down if it is a so-called ‘floating currency’. Most of the world’s currencies—such as the Australian dollar, the U.S. dollar, and the Japanese yen—are floating currencies. (The Australian government floated the Australian dollar in October 1983.)
When a currency is floating, its value is determined by market forces—that is, demand and supply. That said, many countries’ central banks are able to influence exchange rates.
Value of the Australian dollar against other major currencies (Source: Reserve Bank of Australia)
The cryptocurrency market is unique in the sense that it trades on a 24/7 basis. Like any financial market, crypto exchanges and brokers are at the heart of the cryptocurrency market.
For many years, all cryptocurrencies on exchanges were traded through spot markets. Nowadays, you can also buy and sell cryptocurrency derivatives. For example, CME Group—the world’s largest financial derivatives exchange—lets you buy and sell bitcoin futures contracts.