Understanding Financial Markets

Understanding Financial Markets

In this lesson, you’re expected to:
– understand what a financial market is
– discover the different types of financial markets
– learn about the loanable funds theory

Purpose of Financial Markets

Event though they may appear complicated, financial markets serve a very basic purpose:

To connect the people who have money with the people who want money.

What is a Financial Market?

A financial market is a broad term describing any marketplace where buyers and sellers participate in the trade of assets such as stocks, bonds, derivatives, foreign exchange and commodities.

They are typically defined by having transparent pricing, basic regulations on trading, costs and fees, and market forces determining the prices of securities that trade.

These markets are where businesses go to raise cash to grow, and investors make money.

Financial markets can be found in nearly every nation in the world.

Some are very small, with only a few participants, while others – like the New York Stock Exchange (NYSE) and the forex markets – trade trillions of dollars daily.

Importance of Financial Markets

Financial markets create an open and regulated system for companies to obtain large amounts of financial capital to grow their businesses. This is done through the stock and bond markets. Markets also allow these businesses to offset risk with commodities and foreign exchange futures contracts, as well as other derivatives.

Since the markets are public, they provide an open and transparent way to set prices on everything traded. These prices assume that all available knowledge about everything traded is taken into consideration. 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 easily 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.

Functions of Financial Markets

Financial markets serve six basic functions:

1) Borrowing and Lending: financial markets permit the transfer of funds (purchasing power) from one agent to another for either investment or consumption purposes.

2) Price Determination: they provide vehicles by which prices are set both for newly issued financial assets and for the existing stock of financial assets.

3) Information Aggregation and Coordination: financial markets act as collectors and aggregators of information about financial asset values and the flow of funds from lenders to borrowers.

4) Risk Sharing: they allow a transfer of risk from those who undertake investments to those who provide funds for those investments.

5) Liquidity: they provide the holders of financial assets with a chance to resell or liquidate these assets.

6) Efficiency: they reduce transaction costs and information costs.

[Optional] How Does the Stock Market Work?
2) Bond Market

The Bond Market is where organizations go to obtain very large loans. Generally, when stock prices go up, bond prices go down.

This market is alternatively referred to as the debt, credit or fixed-income market.

It is much larger in nominal terms that the world’s stock markets. Bonds can be bought and sold by investors on credit markets around the world.

What is a Bond?

A bond is a debt investment in which an investor loans money to an entity (corporate or governmental), which borrows the funds for a defined period of time at a fixed interest rate.

Bonds are used by companies, municipalities, states and foreign governments to finance a variety of projects and activities.

There are many different types of bonds, including treasury bonds, corporate bonds, and municipal bonds. Bonds also provide some of the liquidity that keeps an economy functioning smoothly.

Bonds can be bought and sold by investors on credit markets around the world.

The main categories of bonds are corporate bonds, municipal bonds, and Treasury bonds, notes and bills, which are collectively referred to as simply “Treasuries.”

4) Derivatives Market

What are Derivatives?
A derivative is a complicated financial contract that derives its value from an underlying asset. The buyer and seller agree on how much the asset price will change over a specific period.

Examples of common derivatives are forwards, futures, options, swaps and contracts-for-difference (CFDs).

[Optional] How big is the derivatives market?
5) Forex (Foreign Exchange) Market

The foreign exchange market is a global online network where traders buy and sell currencies. It has no physical location and operates 24 hours a day, seven days a week.

It is one of the largest, most liquid markets in the world with an average traded value that exceeds $5 trillion per day and includes all of the currencies in the world.

The forex market is the largest market in the world in terms of the total cash value traded, and any person, firm or country may participate in this market.

Enlarged version: http://bit.ly/2mhRKOH
[Optional] Foreign Exchange Market
Financial Instruments – Key Concepts

• Treasury bonds, notes, and bills are promissory notes issued by the federal government when it borrows money.

• Corporate bonds are promissory notes issued by corporations when they borrow money.

• Shares of stock are financial instruments that give to the holder a share in a firm’s ownership and therefore the right to share in the firm’s profits.

• Dividends are the portion of a corporation’s profits that the firm pays out each period to its shareholders.

[Optional] What Are Mutual Funds? Pros, Cons, and Types
What is the Loanable Funds Theory?

Economists offer a simple model for understanding financial markets and how the real interest rate* is determined.

The loanable funds market is a hypothetical market that exists to bring together savers and borrowers. Savers supply and borrowers demand.

The real interest rate occurs at the point where the amount saved equals the amount borrowed.

Real Interest Rate: the rate of interest an investor, saver or lender receives (or expects to receive) after allowing for inflation.
In the loanable funds market, the price is the real interest rate.

Savers, the producers of loanable funds, respond to the price by offering more funds as the rate increases and less as the rate decreases. Borrowers act as consumers of loanable funds – their behavior is explained by the law of demand.

When the interest rate is high, they are less willing and able to borrow, and when the interest rates are low, they are more willing and able to borrow.

Savers and borrowers are both represented by households, businesses, government, and the foreign sector.

Importance of Loanable Funds Market

Changes in the saving and borrowing behavior of the various sectors of the economy result in a change in the real interest rate and change in the quantity of loanable funds exchanged.

The loanable funds theory of interest rate determination is useful for understanding changes in long-term interest rates.

[Optional] The big events that shook financial markets in 2016
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