What is Financial Market: Types and Importance

Financial market is a place where various financial instruments, such as stocks, bonds, currencies, and derivatives, are traded. These allow investors to manage their financial risk and thus generate profits. Financial markets are governed by regulatory bodies like the Securities and Exchange Commission (SEC) in the United States and SEBI in India. These organizations protect investors, maintain fair and transparent trading practices.

In this article, we will be discussing what is financial market. Financial markets have a crucial role in the economy, enabling businesses to access funding, investors to earn investment returns, and governments to manage their finances. Let us learn more about this market.

Table of Contents

• What is financial market?
• Importance of financial markets
• Types of financial markets
  • Stock market
  • Bond market
  • Foreign exchange market
  • Commodity market
  • Derivative market
  • Futures market
  • Over-the-counter (OTC) Market
• Functions of Financial Markets
• Classification of Financial Markets
• Regulations in Financial Markets
• Financial Markets: At a Glance

What is Financial Market?

A financial market is a marketplace where buyers and sellers trade financial instruments, such as stocks, bonds, currencies, and derivatives. Investors, companies, and governments raise capital, manage risks, and transfer assets over here. These markets can be further classified into primary market and secondary market. In the primary market, trades between financial institutions and traders take place. Here, new securities such as Initial Public Offerings (IPOs), are traded.

Secondary market deals with previously issued securities, such as certificates of deposits. Some of the largest financial markets in the world are including the New York Stock Exchange NYSE, the London Stock Exchange, Nasdaq, and the Tokyo Stock Exchange. These markets operate in different time zones and are interconnected through electronic trading platforms, allowing investors in financial markets to trade around the clock.

Importance of Financial Market

Financial markets is a marketplace to trade financial instruments. These markets provide finance for companies to help them in investing and thus grow. They also facilitate the smooth operation by allocating resources and creating liquidity. Overall it satisfies the needs of lending and borrowing for individual, government and corporations.

Financial markets serve as indicators of economic performance, reflecting changes in the demand and supply of financial assets, as well as broader economic conditions. The following points summarize the importance of financial markets:

• Capital Formation: Businesses and governments raise capital to fund their operations and investments through financial markets. By issuing stocks, bonds, and treasury bills, businesses gain the capital for investing in research and development.
• Risk Management: This market helps in risk management. Investors can manage risks by diversifying their investments across different asset classes, such as stocks, bonds, and commodities. Derivatives, such as futures and options contracts, provide investors with additional tools for hedging against potential losses.
• Price Discovery: Financial markets provide a platform for buyers and sellers to come together to determine the prices of financial assets. This price discovery process ensures that financial assets are priced efficiently based on the supply and demand for them.
• Liquidity: Financial markets provide investors with the ability to buy and sell financial assets quickly and easily. This liquidity makes it possible for investors to exit positions and access their capital when needed, which is critical for managing cash flow and minimizing risk.
• Economic Growth: Financial markets promote economic growth by providing the capital and liquidity that businesses need to invest in new products, services, and technologies. This investment helps to drive innovation, create jobs, and boost productivity.

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Types of Financial Markets

The following are different types of financial markets:

1. Stock Market

Stock market refers to a financial market where publicly traded companies issue and trade shares. This marketplace allows buyers and sellers to trade ownership in companies. When companies issue shares, they basically sell ownership to investors who can trade these shares on stock market. The price is predetermined on the basis of supply and demand of buyers and sellers. 

Stock market allows access to the capital and this allows investors to get a share in profit and growth of companies. When the stock market is performing well, it signals that investors have confidence in the economy and businesses are thriving. Investors can invest in different types of stocks such as growth stocks and value stocks, based on their requirements.

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2. Bond market

Also known as debt market, bond market is a financial market where bonds are both issued and traded. It is a debt security where an investor loans money to the government or any corporation in lieu of an interest payment. Here the principal is returned at a future date. The government and other entities issue bonds to raise money. Bond issuers need to pay interest to bondholders mostly on a semi-annual basis. 

The rate is determined by various factors including issuer’s creditworthiness and prevailing rate of interest in the market. The financial securities in this market are rated by independent credit rating agencies that indicate the creditworthiness of the issuer. To gain exposure in the bond market, they need to invest through the bond mutual funds and ETFs. These funds invest in the diversified bonds portfolio, which provides investors with exposure to a range of maturities and issuers.

3. Foreign Exchange Markets

Also known as Forex or FX market, in this financial market, currencies are traded. This is one of the most liquid financial markets in the world. Trading in Forex takes place 24 hours a day, 5 days a week. Here, trading sessions in major financial centres around the world, including New York, London, Tokyo, and Sydney. 

Forex market is decentralized so it has no central exchange or clearinghouse. Instead, forex trading takes place through a network of banks, brokers, and other financial institutions. In addition to traditional forex trading, investors can also gain exposure to currency movements through currency ETFs and currency mutual funds. These investment vehicles provide investors with exposure to currencies instead of just one or two currencies.

4. Commodity markets

Commodity markets are the trading markets for raw materials and primary products. Through this market, the exchange of these goods between producers, traders, and end-users is facilitated. Factors including weather patterns, geographical events, economic growth as well as supply and demand influence the prices in this market. 

Such a market can be physical, where buyers and sellers trade physical goods. Commodity markets can also be virtual, including Intercontinental Exchange and the Chicago Mercantile Exchange. Such markets have a significant role in global trade. These are crucial for producers, consumers of commodities and investors who want to diversify their portfolios.

5. Derivative Market

The derivative market is a financial market where investors can buy and sell financial instruments. The financial instruments include futures contracts, options contracts, and swaps. Value of these instruments is derived from the underlying asset. 

The underlying asset could be either a stock, commodity, currency, or even an index. Derivatives allow investors to manage risk by hedging against the price movements in underlying asset or to speculate on future price movements. Alternatively, options may be used for speculating the potential increase or decrease in the price of the underlying asset. 

It is more complex and sophisticated than other financial markets, and requires a higher level of expertise and risk management. Some of the largest derivative markets include Chicago Board Options Exchange, and New York Mercantile Exchange.

6. Futures Market

Futures market is a type of financial market where investors can trade futures contracts. These are the agreements for buying and selling underlying assets such as commodities, currencies, or financial instruments, at a specified price and time in the future. Futures markets are highly regulated and operate through centralized exchanges, such as the Chicago Mercantile Exchange and the Intercontinental Exchange. 

These exchanges provide a platform for buyers and sellers to trade futures contracts, ensuring transparency and efficiency in the trading process. By trading futures contracts, investors can manage exposure to price movements in the underlying asset, as well as take advantage of potential price changes in the future.

Futures markets are also important for price discovery, as the price of a futures contract reflects the market’s expectation of the future price of the underlying asset. This information can be used by investors, producers, and consumers to make informed decisions about buying, selling, and producing the underlying asset.

7. Over-the-counter (OTC) Market

Over-the-counter (OTC) or off-exchange trading is performed directly between two parties, without any exchange supervision. OTC trading occurs with commodities, financial instruments and derivatives of such products.

In the OTC market, parties may agree on an unusual quantity. In OTC, market contracts are bilateral, thus, the contract is between two parties only. Each party may have credit risk concerns related to the other party. The OTC market is significant in asset classes including interest rate, foreign exchange, stocks, and commodities.

An over-the-counter is a bilateral contract where two parties agree on how a trade or agreement will be settled in future. It is from an investment bank directly to its clients. Forward contracts and swaps are examples of such contracts. It is usually done either online or on the telephone.

Functions of Financial Markets

The following are the functions of financial markets:

1. Companies and governments use financial markets to raise money by selling stocks and bonds.
2. Financial markets help determine the prices of stocks, bonds, and other assets based on supply and demand.
3. These markets make it easy to buy and sell assets quickly, turning investments into cash when needed.
4. Investors can diversify their investment portfolios to reduce financial risk. Financial markets offer various options to help manage this risk.
5. Financial markets provide valuable information about the health of companies and the economy, helping investors make informed decisions.
6. They direct money to businesses and projects that show the most promise, ensuring that resources are used efficiently.
7. Governments can raise money to fund public projects by selling bonds in financial markets.
8. Financial markets offer a range of investment options, allowing people to choose based on their goals and risk tolerance.
9. Central banks use financial markets to manage interest rates and control the money supply, influencing the economy.
10. By offering various investment options, financial markets encourage people to save and invest their money, which helps the economy grow.

Classification of Financial Markets

Financial markets are classified in the following manner:

Regulations in Financial Markets

These are highly regulated to ensure transparency, fairness, and stability in trading. The regulations governing financial markets vary by country and region, but generally fall into the following categories:

1. Securities and Exchange Commission (SEC): This regulatory body in the US oversees the securities industry, including the stock and bond market. It enforces laws requiring companies to disclose financial information to the public, and regulates trading of securities to ensure transparency.
2. Commodity Futures Trading Commission (CFTC): This regulatory body in the US oversees the futures market, including futures contracts on commodities, currencies, and financial instruments. The CFTC enforces laws that require fair trading practices and prevent fraud and manipulation in the futures market.
3. European Securities and Markets Authority (ESMA): This regulatory body in the European Union oversees financial markets, including the stock market and bond market. It enforces laws to promote transparency and protect investors. ESMA also coordinates the regulation of financial markets across the EU.
4. Financial Conduct Authority (FCA): This regulatory body in the UK oversees financial markets, including the stock and forex markets. FCA enforces laws that promote fair competition and protect consumers while maintaining the integrity of financial markets.
5. International Organization of Securities Commissions (IOSCO): This global association of regulatory bodies oversees financial markets around the world. It sets standards for the regulation of financial markets, promotes international cooperation, and works to ensure the stability of global financial markets.

Types of Financial Markets at a Glance

1. Stock markets: These are markets where publicly traded companies issue and trade shares of their stock. It allows investors to buy and sell these shares in the hope of profiting from the company’s growth.
2. Bond markets: These are the type of financial markets where governments, corporations, and other entities issue and trade bonds, which are essentially loans that investors can buy and receive interest payments on.
3. Foreign exchange markets: These are markets where currencies are bought and sold. They are used by businesses and investors to hedge against currency fluctuations and to speculate on the movements of different currencies.
4. Commodity markets: These are markets where commodities such as gold, silver, oil, and agricultural products are traded. They are used by producers, consumers, and investors to manage the risks associated with commodity price fluctuations.
5. Derivatives markets: These are markets where financial instruments such as options, futures, and swaps are traded. Derivative markets are used by investors and businesses to manage risk, speculate on market movements, and hedge against changes in interest rates, exchange rates, and commodity prices.
6. Futures market: It is a financial market where contracts for the future delivery of a specific asset, such as commodities, currencies, or financial instruments, are traded. Futures contracts refer to the agreement between a buyer and a seller to exchange an asset at a specific price and date in future.