An Introduction to the Financial Markets

Make Financial Markets Work for You

a couple that understands financial markets
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What are the financial markets? It can be confusing because they go by many terms. They include capital markets, Wall Street, and even simply "the markets.” Whatever you call them, financial markets are where traders buy and sell assets. These include stocks, bonds, derivatives, foreign exchange, and commodities. The markets are where businesses go to raise cash to grow. It’s where companies reduce risks and investors make money.

  • Financial markets create liquidity that allows businesses to grow and entrepreneurs to raise money for their ventures. 
  • They reduce risk by having information publicly available to investors and traders. 
  • These markets calm the economy by instilling confidence in investors. 
  • Investor confidence stabilizes the economy.

Types of Financial Markets

Most people think about the stock market when talking about financial markets. They don't realize there are many kinds that accomplish different goals. Markets exchange a variety of products to help raise liquidity. Each market relies on each other to create confidence in investors. The interconnectedness of these markets means that when one suffers, other markets will react accordingly.

The Stock Market

This market is a series of exchanges where successful corporations go to raise large amounts of cash to expand. Stocks are forms of ownership of a public corporation that are sold to investors through broker-dealers. The investors profit when companies increase their earnings. This keeps the U.S. economy growing. It's easy to buy stocks, but it takes a lot of knowledge to buy stocks in the right company.

To a lot of people, the Dow is the stock market. The Dow is the nickname for the Dow Jones Industrial Average, which is just one way of tracking the performance of a particular group of stocks. There are also the Dow Jones Transportation Average and the Dow Jones Utilities Average. Many investors ignore the Dow and instead focus on the Standard & Poor's 500 index or other indices to track the progress of the stock market. The stocks that make up these averages are traded on the world's stock exchanges, two of which are the New York Stock Exchange (NYSE) and the Nasdaq.

The market depends on the perceptions, actions, and decisions of both buyers and sellers concerning the profitability of the companies being traded.

Mutual funds give you the ability to buy a lot of stocks at once. In a way, this makes them an easier tool to invest in than individual stocks. By reducing stock market volatility, they have also had a calming effect on the U.S. economy. Despite their benefits, you still need to learn how to select a good mutual fund.

The Bond Market

When organizations need to obtain very large loans, they go to the bond market. When stock prices go up, bond prices tend to go down. There are many different types of bonds, including Treasury Bonds, corporate bonds, and municipal bonds. Bonds also provide some of the liquidity that keeps the U.S. economy functioning smoothly.

It's important to understand the relationship between Treasury bonds and Treasury bond yields. When Treasury bond values go down, the yields go up to compensate. When Treasury yields rise, so do mortgage interest rates. Even worse, when Treasury values decline, so does the value of the dollar. That makes import prices rise, which can trigger inflation.

Treasury yields can also predict the future. For example, an inverted yield curve heralds a recession.

The Commodities Market

A commodity market is where companies offset their futures risks when buying or selling natural resources. Since the prices of things like oil, corn, and gold are so volatile, companies can lock in a known price today. Since these exchanges are public, many investors also trade in commodities for profit only. For example, most investors have no intention of taking shipments of large quantities of pork bellies.

Oil is the most important commodity in the U.S. economy. It is used for transportation, industrial products, plastics, heating, and electricity generation. When oil prices rise, you'll see the effect in gas prices about a week later. If oil and gas prices stay high, you'll see the impact on food prices in about six weeks. The commodities futures market determines the price of oil.

Futures are a way to pay for something today that is delivered tomorrow. They increase a trader's leverage by allowing him or her to borrow the money to purchase the commodity.

The futures market removes some of the volatility in the U.S. economy. It allows businesses to control the future costs of the critical commodities they use every day.

Leverage can create outsize gains if traders guess right. It also magnifies the losses if traders guess wrong. If enough traders guess wrong, it can have a huge impact on the U.S. economy, actually increasing overall volatility. 

Another important commodity is gold. It's bought as a hedge against inflation. Gold prices also go up when there is a lot of economic uncertainty in the world. In the past, every dollar could be traded in for its value in gold. When the U.S. went off the gold standard, it lost this relationship to money. Still, many people look at gold as a safer alternative to cash or currency.

Derivatives 

Derivatives are complicated financial products that base their value on underlying assets. Sophisticated investors and hedge funds use them to magnify their potential gains. In 2007, hedge funds increased in popularity due to their supposed higher returns for high-end investors. Since hedge funds invest heavily in futures, some argued they decreased the volatility of the stock market and, therefore, the U.S. economy. The hedge fund investments in subprime mortgages and other derivatives caused the 2008 global financial crisis.

Even before this, hedge funds had demonstrated their risky nature. In 1997, the world's largest hedge fund at the time, Long Term Capital Management, practically brought down the U.S. economy.

Forex Trading

Forex trading is a decentralized global market in which currencies are bought and sold. About $6.6 trillion were traded per day in April 2019, and 88% involved the U.S. dollar. Almost one-fourth of the trades are done by banks for their customers to reduce the volatility of doing business overseas. Hedge funds are responsible for another 11%, and some of it is speculative.

This market affects exchange rates and, thus, the value of the dollar and other currencies. Exchange rates work on the basis of demand and supply of a nation’s currency, as well as of that nation’s economic and financial stability.

Functions of Financial Markets

Financial markets create an open and regulated system for companies to acquire large amounts of capital. This is done through the stock and bond markets. Markets also allow these businesses to offset risk. They do this with commodities, foreign exchange futures contracts, and other derivatives.

Since the markets are public, they provide an open and transparent way to set prices on everything traded. They reflect all available knowledge about everything traded, reducing the cost of obtaining information because it's already incorporated into the price.

The sheer size of the financial markets provides liquidity. In other words, sellers can unload assets whenever they need to raise cash. The size also reduces the cost of doing business. Companies don't have to go far to find a buyer or someone willing to sell.

Frequently Asked Questions (FAQs)

When does inside information have the least value in a financial market?

The efficient market hypothesis (EMH) is an economic theory stating that the stock market efficiently finds the correct price for securities based on all available information. There are variations on this theory, and strong-form EMH holds that even insider information is considered "available information" in terms of market pricing. That means it doesn't have financial value to insiders—the information has already been priced into the stock.

What kind of financial assets are sold on secondary markets?

Except for the forex market, all of the markets listed above are secondary markets. A secondary market is simply an exchange where securities and other assets are sold after their original issue. For example, after a bond auction, bondholders can go to the secondary market and sell the bonds they bought at auction.

Article Sources

  1. Office of Investor Education and Advocacy. "Bonds." Accessed Jan. 26, 2022.

  2. Securities and Exchange Commission. "Interest Rate Risk: When Interest Rates Go Up, Prices of Fixed-rate Bonds Fall." Accessed Jan. 26, 2022.

  3. Office of Investor Education and Advocacy. "Commodities." Accessed Jan. 26, 2022.

  4. Federal Reserve Bank of St. Louis. "Do Rises in Oil Prices Mean Rises in Food Prices?" Accessed Jan. 26, 2022.

  5. Office of Investor Education and Advocacy. "Derivatives." Accessed Jan. 26, 2022.

  6. BIS. "Turnover of OTC Foreign Exchange Instruments." Accessed Jan. 26, 2022.

  7. Iowa State University. "Introductory Notes on Financial Markets." Accessed Jan. 26, 2022.

  8. New York University Stern School of Business. "Foundations of Finance: Market Efficiency," Pages 3-7. Accessed Jan. 26, 2022.