A beginner’s guide to financial markets and their importance from CEO and FC expert Mankash Jain
The backbone of capitalist economies, financial markets are any marketplace that facilitates securities trading. Therefore, financial markets include everything from the bond market, stock market and forex market to derivatives and many more.
Financial markets can include securities or assets that trade OTC (over the counter) or by being listed on regulated exchanges. All of this is why so much economic disruption arises from the collapse of financial markets, leading to hyper inflation, recession and unemployment.
If you’ve ever travelled to another country and exchanged currencies, if you’ve ever bought insurance or if you’ve ever borrowed money for a mortgage then you’ve made a transaction that is only possible due to the existence of financial markets.
How do financial markets work?
Financial markets create liquidity and allocate resources for businesses and entrepreneurs to trade. In other words, financial markets match up sellers with buyers in order to set a price for different financial assets.
These financial assets include the following:
If you have a share in a company, you own the equivalent part of the company. The reason companies create shares in the first place is to raise funds so that they can grow and invest.
Companies of a certain size (and Governments) can issue bonds to raise money. These can be thought of as a kind of ‘IOU’ that can then be traded (bought and sold) across financial markets. You may come across Government bonds referred to as ‘gilts’. These are basically a kind of Government debt.
The Foreign Exchange markets allow people to exchange currencies.
Financial markets offer everyone investment opportunities
Anyone can invest in shares (these are sometimes known as equities) to make money. For those who are successful, investing in shares/equities ends up providing better returns than sticking with a traditional savings account with a bank.
However, while savings accounts are risk-free, investing in shares brings some risk. Any investment value can fall as well as rise and just because returns have always been good in the past doesn’t mean they always will be in future.
Insurance companies also use financial markets to ensure payouts for people who have taken out their policies. Other uses include for financial lenders, such as banks, which loan out sums of money to people for different uses.
Financial markets in the UK and around the world
Financial markets allow businesses (and Governments) to raise funds and the investor (those who actually buy financial assets) to earn interest. In the UK, there are lots of internationally important financial markets, including the British International Investment and European Bank for Reconstruction and Development.
However, there are also lots of smaller financial markets too,. Wherever financial markets operate, they work along the same lines:
- Underpin and facilitate savings
Financial markets allow people to save money by choosing savings accounts or investing in shares and bonds to earn future interest.
- Provide loans
Businesses or Governments issue bonds and loans in exchange for public money.
- Allocate capital to be used productively
Rather than leaving their idle money in a bank account, people can invest it into a function and make interest.
- Facilitate forward markets
Forward markets allow people to buy a product at a pre-agreed price but sometime in the future. This means they avoid the risks of price volatility.
- Allow transactions to happen
Financial markets facilitate a method for buyers and sellers to exchange funds as part of their transactions.
- Provide an equity market
This is a share market where a company shares to the public in exchange for capital that they use to grow and expand. The person investing can (but doesn’t always) earn a return on their investment. This generally comes as a dividend, which is paid when the business is performing well.
What happens when a financial market fails?
When the financial market doesn’t work properly or efficiently for whatever reason, it’s a financial market failure. This then results in a loss of economic output. Just like all other market types, the financial market depends on the price mechanism.
This is the basic system where the price of goods are determined by the ratio of supply and demand. Should the price of a financial asset stray too far from its actual value, then the market will fail.
We can group financial market failures into the following:
- A financial crisis
This occurs when the price of the asset falls sharply meaning businesses and consumers can no longer service their debts. Financial institutions and banks may then experience shortages of liquidity. This kind of crisis can be set off by human behaviours, systemic failures or Government regulatory failures.
2. A bubble
A market bubble happens when the financial asset was overvalued and predictions for its future value were overstated. The price then drops dramatically. You will have heard of these throughout history, with the Dot.com Bubble a famous example. This was when a massive investment in technology in the 1990s led to an extremely overvalued market that just couldn’t sustain it. When the market peaked and then crashed, investors panicked and the stock market plummeted.
3. Market rigging
This is when a business either fixes prices or falsely raises them in order to get more profit for themselves.
Financial markets – a summary to take away
- Financial markets allow for financial assets to be traded.
- There are three types: FOREX (Foreign Exchange) markets, capital markets and money markets.
- Money markets issue financial assets with short dates, such as commercial bills and treasury bills.
- Financial markets issue undated or longer term financial assets, including shares and bonds.
- FOREX markets allow for the exchange of currencies.
- There are six major functions for financial markets:
- Facilitating savings.
- Providing loans.
- Facilitating transactions.
- Allocating capital to more productive use.
- Providing an equity market.
- Providing forward markets
- Financial market failures occur when it fails to operate properly or efficient and economic output is lost.
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