Boundless: "Types of Financial Markets"

Read this section to learn about capital and financial markets, including topics like capital, technological change, and financial capital.

Financial markets are of many types, including general and specialized; capital and money; and primary and secondary.

Learning Objective

  • Describe different types of financial markets


Key Points

    • A financial market is an aggregate of possible buyers and sellers of financial securities, commodities, and other fungible items, as well as the transactions between them.
    • The term "financial markets" is often used to refer solely to the markets that are used to raise finance: for long-term finance, capital markets are used; for short-term finance (maturity up to one year), money markets are used.
    • Stock markets and bond markets are two types of capital markets that provide financing through the issuing of shares of stock or the issuing of bonds, respectively. A key division within the capital markets is between the primary markets and secondary markets.
    • While capital markets and money markets constitute the narrower definition of financial markets, other markets, such as derivatives and currency markets, are often included in the more general sense of the word.

Terms

  • Derivative: A financial instrument whose value depends on the valuation of an underlying asset; such as a warrant, an option, etc.
  • Maturity: Date when payment is due.
  • Capital: Money and wealth. The means to acquire goods and services, especially in a non-barter system.
  • Fungible: Able to be substituted for something of equal value or utility; interchangeable, exchangeable, replaceable

A financial market is an aggregate of possible buyers and sellers of financial securities, commodities, and other fungible items, as well as the transactions between them. Examples of financial markets include capital markets, derivative markets, money markets, and currency markets. There are many different ways to divide and classify financial markets: for example, into general markets and specialized markets, capital markets and money markets, and primary and secondary markets.

Within the financial sector, the term "financial markets" is often used to refer solely to the markets that are used to raise finance:

  • for long-term finance, capital markets are used
  • for short-term finance (maturity up to one year), money markets are used.

Stock markets and bond markets are two types of capital markets that provide financing through the issuing of shares of stock and the issuing of bonds, respectively. A key division within the capital markets is between the primary markets and secondary markets. Newly formed (issued) securities are bought or sold in primary markets, such as during initial public offerings. Secondary markets are for the secondary trade of securities, providing a continuous and regular market for the buying and selling of securities.

While capital markets and money markets constitute the narrower definition of financial markets, other markets are often included in the more general sense of the word. The derivatives market is the financial market for derivatives—financial instruments like futures contracts or options—which are derived from other forms of assets. Currency markets, enabled by foreign exchange (or forex) markets enable currency conversion and determine the relative value of world currencies.

Role of Financial Markets in Capital Allocation

One of the main functions of financial markets is to allocate capital, matching those who have capital to those who need it.

A financial market is an aggregate of possible buyers and sellers of financial securities, commodities, and other fungible items and the transactions between them. Within the financial sector, the term “financial markets” is often used to refer just to the markets that are used to raise finance: the capital markets for long-term finance and the money markets for short-term finance (maturity up to one year).

Allocating Capital

One of the main functions of financial markets is to allocate capital. Capital markets especially facilitate the raising of capital while money markets facilitate the transfer of liquidity, matching those who have capital to those who need it. Financial markets attract funds from investors and channel them to enterprises that use that capital to finance their operations and achieve growth, from start-up phases to expansion–even much later in the firm’s life. Money markets allow firms to borrow funds on a short-term basis, while capital markets allow corporations to gain long-term funding to support expansion.

Funds borrowed from the money markets are typically used for general operating expenses, to cover brief periods of illiquidity. When a company borrows from the primary capital markets, often the purpose is to invest in additional physical capital goods, which will be used to help increase its income. Financial capital is money used by entrepreneurs and businesses to buy what they need to make their products or provide their services. It can take many months or years before the investment generates sufficient return to pay back its cost, and hence the finance is long-term. Long-term capital can come in the form of shared capital, mortgage loans, and venture capital, among other types.

Without financial markets, borrowers would have difficulty finding lenders themselves. Intermediaries such as banks help in this process. Banks take deposits from those who have money to save. Many individuals are not aware that they are lenders providing capital, but many do lend money at least indirectly, for example when they put money in a savings account or contribute to a pension. Intermediaries like banks can then lend money from this pool of deposited money in the form of loans to those who seek to borrow. More complex transactions than a simple bank deposit require markets where lenders and their agents can meet borrowers and their agents, and where existing borrowing or lending commitments can be sold on to other parties. One example is the stock exchange, where a company can raise money by selling ownership shares to investors and its existing shares can be bought or sold.

Role of Financial Markets in Providing Feedback to Management

Financial markets can provide feedback to management by showing signals of the demand to supply funds to that enterprise.

Management often has imperfect information about its own business, especially its business’ value in the outside world. One way in which managers try to gain feedback on their business is by conducting market research to discover what people want, need, or believe. Once that research is completed, it can be used to determine how to market various products.

Financial markets can also provide feedback, demonstrating how potential shareholders view the financial value of one company as compared to its competitors. For example, investors who hold shares in multiple firms in a sector may have more information about the prospects in that sector than the manager of one firm in that sector. In economics and contract theory, information asymmetry deals with the study of decisions in transactions where one party has more or better information than the other, creating an imbalance of power. Financial economists have applied information asymmetry in studies of differentially informed financial market participants (insiders, stock analysts, investors, among others).

These various audiences can provide feedback to management, such as when the stock price rises or declines. That said, the stock market is an example of a system prone to oscillation. It is governed by positive and negative feedback resulting from the cognitive and emotional factors among market participants. This may be the result of data-based fundamental analysis or more sentiment-based analysis, meaning that the feedback from the stock market can vary in its usefulness for mangers making short-term and long-term decisions.

Source: Boundless. “Types of Financial Markets.” Boundless Finance. Boundless, July 21, 2015. Retrieved Oct. 26, 2015

Last modified: Tuesday, May 7, 2019, 2:15 PM