Financial market

A Financial market is a market in which financial assets, instruments, and claims are issued, bought, sold, or otherwise traded. Financial markets facilitate the transfer of funds between entities with available capital and entities seeking financing.

A simplified representation is:

$\text{Financial Market}\to \text{Capital Allocation}+\text{Trading}+\text{Price Discovery}$

Financial markets form an important component of the Financial system and can facilitate Financial intermediation, risk transfer, investment, and the movement of capital across time and geographic locations.

Functions

Financial markets perform several interconnected functions, including:

• facilitating the issuance of financial assets;
• enabling the trading of existing financial assets;
• allocating capital among competing uses;
• facilitating price discovery;
• providing liquidity;
• enabling the transfer and management of financial risk;
• providing information about market prices and expected returns.

A simplified representation is:

$\text{Capital Providers}\to \text{Financial Market}\to \text{Capital Users}$

Primary market

The primary market is the market in which newly issued financial securities are sold to investors.

A simplified relationship is:

$\text{Issuer}\to \text{New Securities}\to \text{Investors}\to \text{Capital to Issuer}$

Examples include:

• initial public offerings;
• new share issues;
• corporate bond issues;
• government securities auctions;
• other new security offerings.

The proceeds from a primary-market transaction generally flow to the issuer, subject to the structure of the transaction.

Secondary market

The secondary market is the market in which previously issued financial assets are traded among investors.

A simplified relationship is:

$\text{Investor A}\leftrightarrow \text{Financial Asset}\leftrightarrow \text{Investor B}$

In a secondary-market transaction, the issuer generally does not receive the purchase proceeds directly from the transaction.

Secondary markets can provide liquidity and facilitate price discovery.

Types of financial markets

Financial markets can be classified according to the types of instruments traded and their economic functions.

Major categories include:

• capital markets;
• money markets;
• equity markets;
• bond markets;
• foreign exchange markets;
• commodity markets;
• derivatives markets.

The categories can overlap because a particular financial instrument may be associated with more than one classification.

Capital markets

Capital markets facilitate the raising and investment of relatively longer-term capital.

They commonly include:

• equity markets;
• bond markets;
• other longer-term debt markets.

A simplified relationship is:

$\text{Long-Term Capital}\leftrightarrow \text{Capital Markets}$

Companies and governments can use capital markets to obtain financing, while investors can use them to invest capital in financial assets.

Money markets

The money market facilitates borrowing and lending involving relatively short-term financial instruments.

Examples can include:

• Treasury bills;
• commercial paper;
• certificates of deposit;
• repurchase agreements;
• other short-term instruments.

A simplified relationship is:

$\text{Short-Term Funds}\leftrightarrow \text{Money Market}\leftrightarrow \text{Short-Term Borrowers}$

Money markets can assist financial institutions, governments, corporations, and other participants in managing short-term funding and liquidity requirements.

Equity markets

Equity markets facilitate the issuance and trading of ownership interests in companies.

A simplified representation is:

$\text{Equity Investor}\to \text{Capital}\to \text{Company}$

In exchange, investors receive an ownership interest represented by shares.

Returns to equity investors can arise from:

$\text{Equity Return}=\text{Capital Gain}+\text{Dividend Income}$

Actual returns can be positive or negative and depend on changes in the market value of the investment and distributions received.

Bond markets

Bond markets facilitate the issuance and trading of debt securities.

A simplified relationship is:

$\text{Investor}\to \text{Capital}\to \text{Bond Issuer}$

The issuer generally agrees to make specified interest and principal payments according to the terms of the bond.

A simplified bond cash-flow structure is:

$\text{Bond Return}=\text{Interest Income}+\text{Change in Market Value}$

The market value of a bond can change as interest rates, credit conditions, and other market variables change.

Foreign exchange market

The Foreign exchange market facilitates the exchange of one currency for another.

A simplified relationship is:

$\text{Currency A}\leftrightarrow \text{Foreign Exchange Market}\leftrightarrow \text{Currency B}$

Foreign exchange markets are used for international trade, investment, payments, hedging, and other financial transactions.

Derivatives markets

The Derivatives market facilitates trading in financial contracts whose value is derived from an underlying asset, rate, index, or other variable.

Examples include:

• options;
• forward contracts;
• futures contracts;
• swaps.

A simplified relationship is:

$\text{Derivative Value}=f(\text{Underlying Variable})$

where $f$ represents a relationship between the derivative's value and the relevant underlying variable.

Derivatives can be used for hedging, risk transfer, speculation, and price discovery.

Market participants

Financial markets involve a wide range of participants.

These can include:

• individual investors;
• institutional investors;
• banks;
• insurance companies;
• pension funds;
• mutual funds;
• governments;
• corporations;
• central banks;
• market makers;
• brokers and dealers;
• other financial intermediaries.

A simplified market structure is:

$\text{Buyers}\leftrightarrow \text{Financial Market}\leftrightarrow \text{Sellers}$

Different participants can have different objectives, including investment, financing, liquidity management, hedging, or speculation.

Liquidity

Liquidity refers to the ability to buy or sell an asset without causing a substantial change in its price.

A simplified relationship is:

$\text{Higher Market Liquidity}\to \text{Lower Transaction Friction}\to \text{Greater Ease of Trading}$

Highly liquid markets generally have substantial trading activity and a relatively large number of willing buyers and sellers.

Liquidity can vary significantly across financial instruments and can decline during periods of market stress.

Price discovery

Financial markets facilitate price discovery through interactions between buyers and sellers.

A simplified relationship is:

$\text{Supply}+\text{Demand}+\text{Available Information}\to \text{Market Price}$

Market prices can incorporate information about expected future cash flows, risk, liquidity, interest rates, economic conditions, and investor expectations.

Risk and return

Financial markets allow investors to choose among assets with different expected returns and levels of risk.

A simplified relationship is:

$\text{Expected Return}=f(\text{Risk},\text{Cash Flows},\text{Market Conditions})$

Financial economics provides models for relating expected returns to systematic and other sources of risk, including the capital asset pricing model and various factor models.

Market efficiency

The concept of market efficiency concerns the extent to which available information is reflected in market prices.

A simplified representation is:

$\text{Available Information}\to \text{Market Participants}\to \text{Asset Prices}$

Different forms of the efficient-market hypothesis make different assumptions about the information incorporated into prices.

Regulation

Financial markets are subject to regulatory and supervisory frameworks intended to promote market integrity, investor protection, transparency, and financial stability.

Regulatory mechanisms can include:

• disclosure requirements;
• trading rules;
• market-abuse restrictions;
• licensing requirements;
• clearing and settlement requirements;
• capital and margin requirements;
• reporting obligations.

A simplified relationship is:

$\text{Financial Market Regulation}\to \text{Market Integrity}+\text{Investor Protection}+\text{Financial Stability}$

The specific regulatory framework varies by jurisdiction and type of financial market.

Clearing and settlement

Financial-market transactions generally require mechanisms for clearing and settlement.

A simplified sequence is:

$\text{Trade Execution}\to \text{Clearing}\to \text{Settlement}$

Clearing involves determining the obligations arising from transactions, while settlement involves the transfer of the relevant financial assets and funds.

Central counterparties can participate in the clearing of certain transactions and may reduce bilateral counterparty exposure through standardized clearing arrangements.

Financial markets and the financial system

Financial markets are one component of the broader Financial system.

A simplified representation is:

$\text{Financial System}=\{\begin{array}{c}\text{Financial Institutions}\\ \text{Financial Markets}\\ \text{Financial Infrastructure}\\ \text{Regulatory Framework}\end{array}$

Financial markets interact with banks, financial institutions, payment systems, regulators, and other components of the financial system.

See also

• Financial system
• Financial institution
• Financial intermediation
• Capital market
• Money market
• Stock market
• Bond market
• Foreign exchange market
• Derivatives market
• Primary market
• Secondary market
• Price discovery
• Liquidity
• Market efficiency
• Financial regulation
• Systemic risk