What Are Financial Markets, and Why They Are Important
Talking about stocks, currencies, bonds, cryptocurrencies, we don't think that all of these assets relate to particular financial markets. What is a financial market? For newbies, the term financial market may sound scary. It may sound like something related to big money, lots of complicated operations that are understandable only for people with professional education.
Even if you think this way, you do interact with financial markets, if not daily, then very often. Would you like to understand how the markets work? If yes, keep reading.
Financial Markets: Definition
Let’s start with the meaning of the financial market. Financial markets are a marketplace where assets, such as currencies, derivatives, bonds, and stocks, are traded. The financial market serves as a place where traders can purchase and sell securities and speculate on prices. Also, financial markets provide money for organizations.
The financial markets are a marketplace where assets such as currencies, derivatives, bonds, stocks are traded. Additionally, they provide money for companies.
The financial market includes the well-known word “market”, representing the place where products can be bought or sold. The only difference between the goods market is the products you purchase or sell. Securities serve as products on financial markets.
Why You Need to Understand Financial Markets
You may think: why should I understand how the financial markets work if I am interested only in currency trading? We would like to assure you that it's vital to have a full overview of this term.
- Potential profit. Financial markets serve not only to create liquidity for huge businesses and enterprises but to benefit those who want to trade assets. If you understand how the markets work, you will easily find the market for online trading.
- New opportunities. Have you ever thought you might lose your job because of the company's bankruptcy, a bad CEO, or a financial crisis? Would you like to prevent this from happening and feel more confident? Financial markets allow you to change your standard office job into something more attractive. Also, financial markets can't operate without people. Thus, they create additional job opportunities.
- Capital. You should know about financial markets not only if you are a trader, but if you own or represent a company or serve for a government organization. All of these are participants in the financial markets that receive access to capital.
History of Financial Markets
It's challenging to present a history of financial markets as the term includes many markets. As the stock market is the most significant, let's talk primarily about its history.
It's widely accepted that the stock market started operating in the 17th century. Amsterdam Stock Exchange was the first stock exchange established in 1602. The exchange managed the Dutch East India Company's assets, the first company that placed corporate stocks and bonds. It was a prototype of modern financial markets.
Types of Financial Markets
If you have noticed, we say financial markets in the plural form. This means there are many types. Let's consider how they differ, their benefits, and their drawbacks.
Over-the-Counter Market (OTC)
OTC is a decentralized market that doesn't have a physical location. Trades are provided digitally. The over-the-counter market doesn't require a broker so the trades are made only between two parties. Such a market presents stocks of smaller enterprises that can't enter such big markets as Nasdaq or the New York Stock Exchange. It happens because OTC markets have lower requirements. It doesn't mean that these stocks are bad. Still, if you need more reliable securities, you should enter global stock markets.
Fast. The process of trading is faster as it doesn't require a third party (a broker).
Less reliable stocks. The OTC market has low requirements for firms to place their stocks. That's why such stocks may be less reliable assets.
Safety. The lack of a broker creates risks for your financial safety.
A bond or fixed income market is the financial market where companies issue bonds and investors buy them. Bonds are a kind of loan investors provide to firms. Companies place bonds to attract funds for different purposes. Buying bonds, investors get a percentage of their funds. Payments are made on determined dates.
Low risk. This is the primary advantage of the bond market. Bonds are one of the most reliable securities. The only reason why you can't get your payments is the bankruptcy of the company. However, companies rarely close their business.
Lower gains. If you consider long-term investments with limited risks, you should be ready. Only high risks can bring substantial results.
Guaranteed payments. Guaranteed payments are also favorable for investors who want to receive a stable income.
Forex is one of the biggest financial markets with a significant annual turnover. Online brokers made this market even more attractive for traders as it takes just several minutes to place a buy or sell order. The main idea of Forex trading is that it combines buyers and sellers of a specific currency worldwide. That's why it takes several seconds to place an order and find a buyer/seller for your asset.
Fast potential profit. It takes several minutes to see results on the FX market as it allows trading on different timeframes starting from 1-minute.
High risks. High risks are the primary limitation of the forex market.
Easy market. Although you need to have knowledge and skills to place orders on the forex market, currency trading is much easier than a stock or bond market. Everyone has a chance to do well.
Stock, share, or an equity market is a marketplace where companies issue stocks to attract additional funds, and investors purchase them to own company shares. The main difference with the bond market is that by holding stocks, you own a company's share; while buying bonds, you only provide a loan to a firm that will be paid back later. As soon as you get your money back with a percentage, you can no longer require additional payments. Holding the company’s stocks, you receive income until you sell your shares or the company goes bankrupt.
Long-term investment. Stocks are long-term investments that allow you to get income for at least several years.
High risks. The stock market is one of the most volatile. Compared to the bond market, your income can be canceled easier.
High potential profit. The equity market provides high rewards, as investors should be paid for an increased risk.
A derivative is an agreement between at least two parties. The value of the derivative is based on the chosen asset or assets if we talk about indices.
Trading on the derivatives market, you don't deal with real assets such as stocks, commodities, bonds, or currencies; you trade financial products that get their value directly from the chosen asset. Futures, options, and CFD are examples of the derivative market’s instruments.
CFD is one of the most famous financial products that is provided by many forex brokers. CFD stands for contract for difference and allows you to trade not real assets such as oil, gold, or stocks, but to speculate on the price difference.
Low risks. The derivative market is considered one of the least risky.
Risks of loss. Although every market includes risks of loss, derivatives have a higher degree of risk probability.
Easiness. This market doesn't require specific knowledge and allows you to trade without particular research.
A commodity market is a marketplace where investors can place buy/sell orders on commodities or natural resources. For example, oil, metals, and corn. This market is mostly presented by CFDs that allow you to utilize the price speculations without owning real securities. What will you do with barrels of oil? It’s better to take advantage of a correct price prediction.
Stability. Most of the commodities serve as safe-haven assets that are used by traders in times of uncertainty.
Difficult to predict. Commodities have a limited range of fundamental factors that affect their price and can be foreseen.
The money market's main feature is that securities have high liquidity but short-term maturity (not more than a year). Such securities provide safety but low interest. The most famous examples of the money market are US Treasury bills, municipal bonds, and certificates of deposit with a short maturity.
Low risks. Instruments of the money market include low risks.
Short-term investments. If you are looking for investments that will bring you income in the long-term future, this market is not for you.
Low income. Low risks lead to lower potential profit.
There is another financial market classification; it's an organization of the process.
Before, we talked about the financial markets in general. However, big stock exchanges can also be called financial markets. Let's mention three of them. NYSE (New York Stock Exchange), NASDAQ, and Nasdaq small-cap. These exchanges provide many financial operations; that's why they are called financial markets.
Above, we mentioned this type of market. But here, we need to do some clarification. Two big banks can organize a deal without entering a stock exchange if both parties agree on the conditions. Still, sometimes, they have to get a quote from the stock exchange if the security wasn't traded before. In this case, parties place orders at a pre-agreed price. In a minute, a reverse trade occurs. There is no change in the portfolios, but the stock gets a stock exchange quote.
How Financial Markets Work
As there are many financial markets, their structure and operations differ, but we will mention essential points.
Most of the financial markets have a physical location. They include numerous participants. It's not only two parties who entered the market to buy or sell assets; every market has a regulator that controls operations' fairness. For instance, new stock issues must be registered with the SEC (US Securities and Exchange Commission).
Talking about the stock market, after a buyer places an order to purchase a security, the operation is done via a broker. The broker places the trades on the stock exchange. The trade is executed as soon as there is a seller. A buyer receives a certificate that can be transferred from one investor to another. Bonds can also be transferred between investors.
Bonds and stocks appear on the markets as soon as companies decide to gain additional funds. At the same time, forex, options, and futures markets operate based only on the supply and demand factor.
The financial markets include many participants. Usually, they have a physical location. Parties come to the markets to either buy or sell securities.
If we talk about the forex market, it includes governments, commercial banks, central banks, traders, investment funds, and corporations. All the trades are made via a broker that enters the interbank market to execute its clients' trades. Brokers are regulated by institutions that differ regarding the area where the broker operates. For example, CySEC regulates brokers, which operate in Europe.
Futures and options trades are provided via brokers as well. Buyers of futures get protection against price increases, while sellers protect their funds from a price decline.
As all operations are mostly done via brokers or financial managers, they get a commission for their operations, while traders get either a profit or loss.
Giant banks are another critical participant in the financial markets. They operate huge funds either themselves or on behalf of their clients.
The Role of Financial Markets
Financial markets have plenty of roles. Let's consider them.
- Smooth operations. A financial market helps distribute resources and create liquidity for businesses and entrepreneurs.
- A financial market is a marketplace for trading operations. It becomes much easier to find a buyer or a seller of the securities you have/need.
- A financial market creates products. These products provide a return for investors or lenders who have funds. Simultaneously, it helps to provide the money for borrowers (those who require additional funds).
- Make money work. What is the benefit of keeping money on your account or at home when you can simply increase your income?
- Security price. A financial market is a place where traders buy and sell securities. But what is the fair price of an asset? The financial markets are used to define the reasonable cost of financial products.
- Provide liquidity. The financial market provides liquidity of assets. The more market participants are interested in an asset, the higher degree of liquidity it has.
- A financial market is a marketplace that arranges the effective work of market participants and creates specific rules that make the working process more effective.
What Affects Financial Markets?
Financial markets don't operate in isolation. There are factors that either lead to an increase or fall in the financial markets.
- The first factor is the supply-demand issue. It makes financial products rise and fall according to the interest of market participants.
- Politics. The markets are highly dependent on political events. Politics and economics are interconnected. Wars, elections, sanctions cause increased market fluctuations.
- Market sentiment. Investor expectations make assets move. The fair price is based on the supply/demand factor, which is formed based on market expectations.
- Government. Interest rates, taxes, and trade policy affect the price of financial assets.
- Economy. Economic indicators determine the strength of the economy, thus affecting assets that are correlated with the country's economy.
Financial Crisis and Financial Markets: Interconnection
Even if you didn't know what financial markets were before you read this article, you have heard about financial crises. Financial crises affect financial markets dramatically. Usually, the first market that reacts to the crisis is the stock market. Later, regarding the strength of the crisis, it can affect other marketplaces.
The Wall Street Crash of 1929
The Wall Street Crash of 1929, also known as the Great Crash, occurred in the autumn of 1929 and was highlighted by the New York Stock Exchange's collapse. This crisis had the most considerable effect in US history. It was a signal of the Great Depression.
There were many reasons for the crisis. One of them was the overproduction of agriculture, which caused financial despair among farmers. Also, it's worth mentioning the impact of the greed of investors. The collapse happened in September, but the first market falls were in March and May. The market managed to recover fast, and investors believed stocks would continue rising forever. Just between June and September, the Dow Jones increased by over 20%.
The market crash and the Great Depression caused the most massive crisis of the 20th century for the US.
The 21st century has already faced many financial crises. We will mention the most outstanding ones.
One of the dramatic global crises occurred in 2007-2008. The crisis was highlighted by the collapse of the banking system and the US housing bubble. Home mortgage debt to GDP, which was at 46% during the 1990s, rose to 73% in 2008.
One of the crucial factors that led to the market crash was that lots of financial institutions had securities whose value was based on home mortgages. For example, mortgage-backed securities or credit derivatives. These assets decreased in value significantly.
The crisis began in the US but later covered the whole world as the US economy is one of the world's leading economies. It determines the global trend.
2020 is notable for a series of financial collapses caused by the pandemic. The stock market crisis happened on February 20th and finished only on April 7th. It was the worst market crash since 1929. The international stock indices plunged fast. The largest plummet happened on March 16th and was called Black Monday. The global markets lost around 13%.
However, before that, the market suffered two falls. On March 9th, there was the first Black Monday when the Dow Jones Index lost around 8%. On March 12th, the crash was called Black Thursday, when the DJI plummetted by around 10%.
This crisis not only led to the plunge of stocks but significant volatility on the commodity market. The oil conflict between Russia and Saudi Arabia caused a decline in oil prices. WTI oil had a negative price for the first time in history.
Many companies, especially from the oil industry, filed for bankruptcy protection, which caused bond defaults.
Although the market recovered in April, fears of the second wave led to the repeat of the falls.
Should You Be Afraid of a Financial Crisis?
Many traders, in particular newbies, are afraid of crises. They believe that they will lose all their funds, and the crisis is the worst time for their trading activities. We are going to convince you that it's absolutely not like that.
A financial crisis leads to a depreciation of risky assets and a rise of safe-haven ones. If you don't own any assets, it's time to buy them at a low price. The market is cyclical, so every fall is followed by a rise.
Stable assets continue rising even in a crisis.Thus, you can invest in them, knowing that their value will keep growing despite challenging market conditions.
Although the number of funds on the markets may decrease in times of crisis, enterprises and individuals will continue to buy and sell assets to either get additional income or hedge their risks. It means that markets keep working even in times of crisis.
To conclude, it doesn't matter if you are a professional investor or a trader, you should know how financial markets work. It opens a wide range of financial instruments for new opportunities.
Before you start dealing with such complicated assets as stocks and bonds, you can start with the forex market. Libertex provides a convenient trading platform full of technical tools that will allow you to build an effective strategy. The broker offers a wide range of securities; thus, the situation can work out for you even in times of crisis. CFD trading with leverage and long-term investments are our competitive advantage.
Why to trade with Libertex?
- access to a demo account free of charge
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- no commissions for extractions in Latin America
Let’s round up our guide about the financial markets.
What Do You Mean by the Financial Market?
A financial market is a marketplace where businesses and individuals buy and sell assets to gain money or hedge risks.
What Are the Different Types of Financial Markets?
There are two main classifications of financial markets. These are types of traded securities and the process. There are forex, stock, bond, derivatives, commodities, and money markets. There are also stock and over-the-counter markets.
What Is the Main Function of Financial Markets?
There are plenty of functions of the financial markets. One of the most significant is operation smoothing. So, the market helps distribute resources and creates liquidity for businesses and entrepreneurs.
How Do Financial Markets Work?
Each market has its own operation process. Still, it's worth knowing that almost all markets have a physical location. Also, there are plenty of participants. A broker has one of the critical roles.
What Are the Objectives of the Financial Market?
The financial markets serve to organize the process of asset trading. They regulate the process and set a fair security price.
What Are the 6 Functions of Financial Markets?
Financial markets distribute resources between market participants, create financial products, serve as a place for trading operations, make money work, define the fair price of securities, and provide liquidity of financial products.