An Introduction to the Financial Markets

Definition, Types and Function

a couple that understands financial markets
You can make financial markets work for you with a solid understanding. Photo: Blend Images/Moxie Productions

What are the financial markets? That's a good question, because financial markets 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.

Types of Financial Markets

The Stock Market is a series of exchanges where successful corporations go to raise large amounts of cash to expand. Stocks are shares of ownership of a public corporation that are sold to investors through broker dealers. The investors profit when the companies increase their earnings, which keeps the U.S. economy growing. It's easy to buy stocks, but 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, which is the nickname for the Dow Jones Industrial Average, is just one way of tracking the performance of a group of stocks. There is also the Dow Jones Transportation Average and the Dow Jones Utilities Average. Many investors ignore the Dow, and instead focus on the S&P 500 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 include the New York Stock Exchange and the NASDAQ.

Find out more about How the Stock Market Works.

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 is where organizations go to obtain very large loans. Generally, when stock prices go up, bond prices go down. There are many different types of bonds, including Treasury Bondscorporate 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. This 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 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. They have no intention of purchasing large quantities of pork bellies, for example.

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. What are futures? They are a way to pay for something today that is delivered tomorrow. This removes some of the volatility in the U.S. economy. It allows businesses to control future costs of the critical commodities they use every day.

Futures also increase a trader's leverage by allowing him or her to borrow the money to purchase the commodity. This 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.

 Commodities trading was responsible for record-high oil prices in 2008 and 2011, which resulted in food riots and even the Arab Spring.

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. However, once the U.S. went off the gold standard, it lost this relationship to money. Nevertheless, this history means that many people still look at gold as safer alternative to cash or currency.

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 is when currencies are bought and sold. More than $5.3 trillion are traded per day, and 87 percent involves 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 percent and some of it is speculative. This market affects exchange rates and therefore the value of the dollar and other currencies. For more, see How Do Exchange Rates Work?

Functions of Financial Markets

Financial markets create an open and regulated system for companies to get 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. This reduces the cost of getting information, because it's already incorporated into the price.

The sheer size of the financial markets provide liquidity. In other words, sellers can unload assets whenever they need to raise cash. The size also reduces the cost of doing business, since companies don't have to go far to find a buyer, or someone willing to sell. (Source: “Six Basic Functions of Financial Markets”, Iowa State University, March 5, 2012.)