What is the role of financial markets?
FOREX.com May 7, 2021 10:00 AM
Financial markets have a crucial role in our economic system; they allow global commerce to transact smoothly and continuously, with no breaks, while reducing price shocks. Discover everything you need to know about financial markets.
We’re going to discuss many roles of financial markets here, including:
- Capital markets
- Stock markets
- Money markets
- Forex market
- Bond market
- Commodities market
- Derivatives market
Clicking on a subject listed above will take you directly to the relevant section.
Financial markets overview
Whether it’s tech entrepreneurs raising billions or pensioners enjoying comfortable retirements, the benefits of a highly functioning financial market ecosystem should be equitable.
Financial markets have a significant impact on our daily lives in many ways; it’s not just about how we directly engage with markets as traders and investors.
You might question the function and value of financial markets: you just witness stock markets rise and fall, and hear mentions of closing market prices on radio and television news programmes but often feel detached from the activity.
You might even believe financial markets don’t affect you but they do have a vital role to play in more ways than you’d think.
- Have a pension? If it’s invested in stocks and bonds, you need growth from stock and capital markets
- Have savings? The interest paid is linked to the central bank interest rate, which relates to bond market prices
- Going on holiday? The $6 trillion a day turnover FX market dictates your rate. You get fewer euros for your pounds if sterling is down
- House purchase? The lender will probably secure the mortgage from the capital markets
- Want a personal loan? The lender will access capital and money markets to borrow at one rate and lends to you at another
- Want to see your local or central government invest in capital expenditure? They’ll access the capital markets by selling bonds
- Are prices of day-to-day goods rising? Inflation is on the rise, maybe because your domestic currency is falling in value, meaning your pay needs to stretch further
The main financial markets and their specific roles
There are three principal financial markets we’ll refer to, money markets, capital markets and forex markets. All three underpin most financial markets’ roles. We’ll then get more granular as we spotlight the bond, commodities, and derivatives markets.
- Money markets provide short term loan finance for businesses and households, including inter-bank lending; commercial banks providing liquidity to each other
- Capital markets are where securities like shares and bonds are issued to raise medium to long-term finance for businesses and governments
- Foreign exchange markets are where currencies get exchanged and traded to allow the smooth transaction of international commerce
These three markets are interlinked, and how their efficiency helps support the global economic ecosystem is a fascinating subject.
- Financial markets create liquidity allowing businesses to grow and entrepreneurs to raise money for their ventures
- They reduce risk by having information readily available to investors and traders
- Financial markets smooth economies by creating investor confidence
- Investor confidence helps to stabilise economies
A capital market is either a primary or secondary market. Primary markets issue or sell new bonds or equities to investors. The secondary market is where existing securities get bought and sold between investors or traders on an exchange, over-the-counter (OTC) or elsewhere. Secondary markets increase investor confidence in primary markets. Investors know they can liquidate their investments quickly.
The parties who typically buy the bonds and stock include individuals, investment banks, pension funds, hedge funds, sovereign wealth funds.
Governments (local or national) and companies are one of the principal entities that access capital markets. Governments issue bonds via capital markets to raise money for their fiscal spending commitments, for example, let’s say the US government wants to finance a $2 trillion, ten-year infrastructure repair and rebuild programme. They’d sell bonds (called treasuries) to investors who’ll buy the bonds knowing that the US government will always pay.
Without this function of the capital market, governments (central, local, or municipal) would struggle to raise funds to invest, repair and rebuild.
Stock markets are exchanges where corporations try to raise ample cash to expand. Investors receive shares (stock) in public corporations sold through broker-dealers. Investors profit if the listed companies increase their earnings. Examples of equity markets include the NYSE and NASDAQ.
Equity indices are a basket of stocks quoted on stock markets. The Dow is the nickname for one of the most famous stock market indices, the Dow Jones Industrial Average.
The DJIA tracks the performance of a select group of thirty stocks measured by their market capitalisation size. Standard & Poor’s 500 index is another popular index, as is the DAX 30 in Germany.
Stock market prices depend on sentiment, underpinned by the perceptions, decisions and actions of both buyers and sellers as they consider the profitability of the companies traded.
Microsoft is just one example of how firms access capital/equity markets to flourish, how interconnected financial markets are and how the trickle down of wealth should occur.
On March 13, 1986, Microsoft (founded over a decade earlier) executed an IPO (initial public stock offering) and raised $61 million. The firm paid its first dividend in 2003 at the cost of $870m. The billions of US dollars paid out since then illustrates the interconnectivity of our markets. Pension-fund holders, employees, and individual shareholders will have benefitted from this outstanding share of wealth. The firm Mr Gates founded currently employs 163,000 people.
A market is described as a money market if it’s composed of liquid, short-term assets - positions on these assets can be opened and closed quickly. Money market funds will typically invest in highly liquid, low-risk securities, such as government securities, certificates of deposit, and the commercial paper of companies.
The money market is part of the foundations of the global financial system. The money market typically deals in debt of less than one year. It’s used mainly by governments and corporations to keep their cash flow steady and for investors to make a modest profit.
It facilitates overnight swaps of vast amounts of money. Most money market transactions are wholesale transactions between financial institutions and companies.
Institutions that participate include banks that lend to each other and companies that raise money by selling commercial paper into the market, which other companies or funds can buy.
Some wholesale transactions reach consumers as components of money market mutual funds and other investments.
The foreign exchange (FX) market is a global decentralised or over-the-counter market for trading currencies. The forex market establishes the foreign exchange rates for every currency. All the aspects of buying, selling, and exchanging currencies at the current or future determined prices occur on forex markets.
With an estimated $6 trillion turnover per trading day, it is the largest market globally, followed closely by the credit market. Close to 88% of FX trade involves the US dollar, and banks account for approximately 25% of the trades, helping clients reduce the volatility risk of doing business overseas. Hedge funds are responsible for another 11%, and retail trade 10%.
The FX market affects the exchange rates value of the euro, US dollar and other currencies. FX exchange rates are arguably the perfect example of the efficient market hypothesis; a currency price gets generated by the supply and demand of a nation’s money, and the sentiment relating to a nation’s economic and financial stability.
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When organisations need to obtain substantial loans, they approach the bond market. As a rule of thumb, if stock prices go up, bond prices go down.
There are several types of bonds, Treasury bonds, corporate bonds, and municipal bonds. Bonds can provide some liquidity that allows the US economy to function smoothly.
The relationship between Treasury bonds and Treasury bond yields are crucial. When Treasury bond values go down, the bond yields rise to compensate. If Treasury yields rise, so do mortgage interest rates.
When Treasury values decline, the value of the dollar falls versus many of its peers. Inflation can creep up as import prices rise.
A commodity market is where companies offset their future risks when they’re buying or selling natural resources.
Companies look to secure prices of volatile commodities like oil, gas, and agricultural products to insure themselves versus unexpected future costs.
Because commodities exchanges are public, investors trade commodities for profit only; most investors don’t want to sign for the delivery of pork bellies.
Oil is the most critical commodity for the US economy. Manufacturing, transportation, industrial production, heating, and electricity generation all rely on oil. Therefore, the price of oil is crucial to many aspects of the smooth running of the economy.
The commodities market dictates the price of oil. If oil prices rise, then you might see a knock-on effect a week or so later when you fill put petrol in your car. If oil and gas prices remain high, food prices can begin to rise.
Many commodities traders also use the futures market. With futures you for something today that gets delivered in the future. Futures contracts allow traders to use leverage to borrow money to buy commodities.
The futures market removes some of the volatility in economies. Businesses can control the future costs of critical commodities used every day.
Derivatives are complex financial products, and their value is derived based on the price of underlying assets. Sophisticated investors and hedge funds might include derivatives as part of their trading strategies to magnify their potential gains.
The derivatives market is a financial market for financial instruments like futures contracts, CFDs and options.
The derivatives market gets divided into two specific parts: exchange-traded derivatives and over the counter (OTC) derivatives. The legal nature of these products and how they get traded is different, for example the OTC market is where most retail traders access derivatives through their broker. In contrast they’d trade directly with exchange traded derivatives. The derivatives market in Europe has a notional amount of over €700 trillion.
The essential functions of financial markets in summary
Financial markets provide open and regulated systems for companies to raise substantial amounts of capital. This process occurs through stock and bond markets.
Markets also allow businesses to offset risk through access to commodities, foreign exchange futures, and other derivative markets.
Because financial markets are public, open, and transparent, exchanges set prices on everything traded. Financial markets should also reflect all the available knowledge about the assets and securities bought and sold.
The size of financial markets provides liquidity. Sellers can dispose of assets whenever they need to raise cash. The size should reduce the cost of doing business; companies and investors don’t struggle to find buyers or sellers.
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