A financial market is a marketplace where people trade financial securities and derivatives at low transaction costs. It includes money markets and capital markets, which are the primary places to trade stocks and bonds.
Robust financial markets help direct savings to households, businesses and governments that need them most by connecting those who want to borrow funds with those who value them highest. They are critical to the functioning of a capitalist economy.
The stock market enables companies to raise money often referred to as capital by selling shares to investors. This gives the investors fractional ownership in the company and allows them to profit from it in two ways – through dividends and capital appreciation.
The market is a network of exchanges where people trade shares and other financial assets. It also includes over-the-counter (OTC) marketplaces that allow for private trading between qualified investors.
Investors can purchase shares from the market by placing a buy or sell order with a broker. The price of a share is determined by supply and demand, with the market moving based on a number of factors including news, earnings reports, political events and economic data.
The market is regulated by organisations such as the Securities and Exchange Commission and FINRA (Financial Industry Regulatory Authority). This ensures that there are enough buyers and sellers for everyone to get a fair deal. There are a variety of order types available to investors which are executed instantly at the current bid or ask prices.
The bond market, which includes domestic and foreign government and corporate debt securities, offers investors a different way to diversify their portfolios. Unlike stocks, bonds offer a fixed return on investment with regular interest payments and a promise to repay the original amount at maturity.
Local governments — such as cities and states — borrow in the bond market to finance projects such as schools, roads and bridges. The bond market for these local investments is known as the municipal bond market in the U.S. and as the local government bond market in other developed countries.
Private companies and financial institutions issue corporate bonds to raise money to invest in growth and expansion, but the market for these is much smaller than the market for government bonds. Investors buy bonds for several reasons: capital preservation, income, diversification and as a hedge against inflation. Like stocks, bonds can rise or fall in price. But their values are more closely linked to changes in the economy and perceptions of future interest rates.
The derivatives market offers investors the chance to gain exposure to a wide variety of financial assets without actually owning them. These contracts are based on the values of underlying assets that can include stocks, bonds, commodities, currencies, interest rates and market indexes. Derivatives can be used to hedge existing positions or for pure speculation.
Businesses can use derivatives to reduce their exposure to unexpected tremors in the prices of key goods and costs. Hershey’s, for example, can use a derivative to lock in cocoa prices or Southwest Airlines can ensure that rising jet fuel costs won’t ground profits.
These instruments can be complex and are often traded over-the-counter or on centralized exchanges. Their value is derived from the value of an underlying asset and as such, their prices can fluctuate significantly. They can also expose investors to counterparty risk, which is the possibility that the other party in a contract will default. This was at the root of the credit crisis that led to the collapse of venerable firms like Lehman Brothers and Bear Stearns.
Foreign Exchange Market
The foreign exchange market offers investors an opportunity to make investments in the currencies of countries throughout the world. It is the largest and most liquid market in the world, trading 24 hours a day, five days a week.
Its participants include central banks, commercial banks, multinational corporations that must pay for goods and services in different currencies, and traders and speculators. Central banks typically set the exchange rate for their country’s currency to maintain stability and protect the economy.
Most transactions are made in the spot market, where buyers and sellers trade currencies at their current price. The forward market is a little different, where participants agree to trade one currency for another at a future date and at a price that is determined today. This market is important because it allows firms to hedge against currency risk. It also helps companies with international operations to make their transactions as cost-effective as possible.