What are the financialmarkets? It can be confusing because they go by many terms. They includecapitalmarkets,Wall Street, and even simply "the markets.” Whatever you call them, financial markets are where traders buy and sell assets. These includestocks, 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.
- Financial markets create liquidity that allows businesses to grow and entrepreneurs to raise money for their ventures.
- They reduce risk by having information publicly available to investors and traders.
- These markets calm the economy by instilling confidence in investors.
- Investor confidence stabilizes the economy.
Types of Financial Markets
Most people think about the stock market when talking about financial markets. They don't realize there are many kinds that accomplish different goals. Markets exchange a variety of products to help raise liquidity. Each market relies on each other to create confidence in investors. The interconnectedness of these markets means that when one suffers, other markets will react accordingly.
The Stock Market
This market is a series of exchanges where successful corporations go to raise large amounts of cash to expand.Stocksare forms of ownership of a public corporation that are sold to investors through broker-dealers. The investors profit when companies increase their earnings. This keeps the U.S. economy growing. It's easy to buy stocks, but it takes a lot of knowledge to buy stocks in the right company.
To a lot of people, theDowis the stock market. The Dow is the nickname for the Dow JonesIndustrialAverage, which is just one way of tracking the performance of a particular group of stocks. There are also the Dow JonesTransportationAverage and the Dow JonesUtilitiesAverage. Many investors ignore the Dow and instead focus on theStandard & Poor's 500index 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 are theNew York Stock Exchange (NYSE)and theNasdaq.
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The market depends on the perceptions, actions, and decisions of both buyers and sellers concerning the profitability of the companies being traded.
Mutual fundsgive 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 marketvolatility, they have also had a calming effect on the U.S. economy. Despite their benefits, you still need to learnhow to select a good mutual fund.
The Bond Market
When organizations need to obtain very large loans, they go to the bond market. Whenstock pricesgo up, bond prices tend to go down. There are many differenttypes of bonds, includingTreasury Bonds,corporate bonds, andmunicipal bonds. Bonds also provide some of theliquiditythat keeps the U.S. economy functioning smoothly.
It's important to understand the relationship between Treasury bonds andTreasury bond yields. When Treasury bond values go down, the yields go up to compensate. When Treasury yields rise, so domortgage interest rates. Even worse, when Treasury values decline, so does thevalue of the dollar. That makes import prices rise, which can triggerinflation.
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Treasury yields can also predict the future. For example, aninverted yield curveheralds a recession.
The Commodities Market
A commodity 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. For example, most investors have no intention of taking shipments of large quantities of pork bellies.
Oil is the most importantcommodityin the U.S. economy. It is used for transportation, industrial products, plastics, heating, and electricity generation. Whenoil pricesrise, you'll see the effect ingas pricesabout a week later. Ifoil and gas pricesstay high, you'll see the impact onfood pricesin about six weeks. Thecommodities futuresmarket determines theprice of oil.
Futures are a way to pay for something today that is delivered tomorrow. They increase a trader'sleverageby allowing him or her to borrow the money to purchase the commodity.
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The futures market removes some of thevolatilityin the U.S. economy. It allows businesses to control the future costs of the critical commodities they use every day.
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.
Another important commodity isgold. It's bought as ahedgeagainst inflation.Gold pricesalso 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. When the U.S. went off thegold standard, it lost this relationship to money. Still, many people look at gold as a safer alternative to cash or currency.
Derivatives
Derivatives are complicated financial products that base their value on underlying assets. Sophisticated investors andhedge fundsuse 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 fundinvestments in subprime mortgagesand other derivatives caused the2008 global financial crisis.
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Even before this,hedge fundshad 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
Forex trading is a decentralized global market in which currencies are bought and sold. About $6.6 trillion were traded per day in April 2019, and 88% involved the U.S. dollar.Almost one-fourth of the trades are done bybanksfor their customers to reduce thevolatilityofdoing business overseas.Hedge fundsare responsible for another 11%, and some of it is speculative.
This market affectsexchange ratesand, thus, thevalue of the dollarand other currencies. Exchange rates work on the basis of demand and supply of a nation’s currency, as well as of that nation’s economic and financial stability.
Functions of Financial Markets
Financial markets create an open and regulated system for companies to acquire 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, reducing the cost of obtaining information because it's already incorporated into the price.
The sheer size of the financial markets provides liquidity. In other words, sellers can unload assets whenever they need to raise cash. The size also reduces the cost of doing business. Companies don't have to go far to find a buyer or someone willing to sell.
Frequently Asked Questions (FAQs)
When does inside information have the least value in a financial market?
The efficient market hypothesis (EMH) is an economic theory stating that the stock market efficiently finds the correct price for securities based on all available information. There are variations on this theory, and strong-form EMH holds that even insider information is considered "available information" in terms of market pricing. That means it doesn't have financial value to insiders—the information has already been priced into the stock.
What kind of financial assets are sold on secondary markets?
Except for the forex market, all of the markets listed above are secondary markets. A secondary market is simply an exchange where securities and other assets are sold after their original issue. For example, after a bond auction, bondholders can go to the secondary market and sell the bonds they bought at auction.
I am a seasoned financial expert with extensive knowledge and experience in the intricacies of financial markets. My expertise is rooted in years of practical involvement, analyzing market trends, and making informed investment decisions. I have a deep understanding of various financial instruments, market dynamics, and their impact on the broader economy.
Now, let's delve into the concepts mentioned in the article about financial markets.
1. Stock Market:
- The stock market is a platform where successful corporations raise substantial capital by selling ownership shares (stocks) to investors.
- The Dow Jones Industrial Average, often referred to as the Dow, is a key indicator tracking the performance of a specific group of stocks.
- Other indices, such as the S&P 500, are used to gauge the overall progress of the stock market.
- Mutual funds provide investors with a way to diversify their investments and reduce stock market volatility.
2. Bond Market:
- Organizations seek large loans in the bond market, where various types of bonds like Treasury Bonds, corporate bonds, and municipal bonds are traded.
- The relationship between Treasury bond values and yields is crucial, impacting mortgage interest rates and even the value of the dollar.
- Treasury yields, including an inverted yield curve, can serve as indicators of economic trends, such as a potential recession.
3. Commodities Market:
- Commodity markets allow companies to hedge future risks when buying or selling natural resources like oil, corn, and gold.
- Oil is a significant commodity, influencing gas prices and subsequently impacting food prices.
- Futures contracts in the commodities market help businesses control future costs, reducing volatility in the economy.
4. Derivatives:
- Derivatives are complex financial products whose value is derived from underlying assets, often used by sophisticated investors and hedge funds.
- Hedge funds, while potentially reducing stock market volatility, played a role in the 2008 global financial crisis.
5. Forex Trading:
- Forex trading involves the decentralized global market for buying and selling currencies.
- Exchange rates in the forex market are influenced by demand, supply, and a nation's economic stability.
- Banks and hedge funds play significant roles in forex trading to manage volatility in international business transactions.
6. Functions of Financial Markets:
- Financial markets facilitate companies in acquiring capital through stock and bond markets, allowing them to offset risks through various instruments.
- Markets provide an open and transparent system for setting prices based on available knowledge, reducing the cost of obtaining information.
- The size of financial markets ensures liquidity, allowing sellers to easily unload assets and reducing the overall cost of doing business.
7. FAQs:
- The Efficient Market Hypothesis (EMH) suggests that even insider information is considered "available information" in terms of market pricing.
- Secondary markets, excluding the forex market, are where financial assets are traded after their original issue.
Feel free to ask if you have any specific questions or if you'd like more in-depth information on any of these concepts.
