What is Financial Market?

Financial markets facilitate the raising of financial capital by government agencies and corporations. Government agencies can issue or sell bonds to finance the construction of roads and bridges or to provide additional services to the population.

Corporations can issue debt and sell stock to raise funds to invest and grow their businesses. Financial markets also facilitate the transfer of previously issued debt and equity from existing to new investors.

Money and Capital Markets

Money markets issue and trade debt securities with maturities of one year or less. These markets are usually characterized by high liquidity, so that money market securities can be easily sold or traded without losing value.

These short-lived securities generally have low yields and low risk. In the capital markets, debt or securities with a maturity of more than one year and corporate stocks or equity securities are issued and traded.

Capital market securities are typically issued to finance the purchase of homes by individuals, buildings and equipment by corporations, and the provision of infrastructure (roads, bridges, buildings, etc.) by governments.

Corporations and governments issue long-term debt, called bonds, to finance their assets and operations. Mortgages are issued to finance homes and buildings. Corporations also issue stock to meet their financing needs.

Primary and Secondary Markets

There are primary and secondary markets for debt instruments (bonds and mortgages) and stocks. The initial issue of debt instruments and equities takes place on a primary market.

Proceeds from the sale of new securities, after deducting issuance costs, go to the issuing company or government issuer. The primary market is the only “market” where the issuer of securities directly profits (receives funds) from the sale of its securities. Mortgage loans are used to finance the purchase of houses and other real estates.

Secondary markets are physical locations or electronic forums where debt securities (bonds and mortgages) and stocks are traded. Secondary markets for securities facilitate the transfer of previously issued securities from existing investors to new investors.

Securities transactions or transfers generally take place on organized securities exchanges or on the over-the-counter electronic market. Individuals and other investors may actively buy and sell existing securities in the secondary market.

While these investors may make profits or losses on their securities investments in the secondary market, the issuer of the securities does not profit (or lose) from these activities. The secondary market for securities is generally divided into short-term (money market) and long-term (capital market) categories.

Major Types of Financial Markets

There are four main types of financial markets – debt securities markets, equity markets, derivative securities markets, and foreign exchange markets. Debt securities are obligations to repay borrowed funds.

Debt securities markets are markets in which money market securities, bonds (issued by corporations, financial institutions, and governments), and mortgages are originated and traded. Debt securities with longer-term maturities are issued and traded in bond markets.

Government agencies (federal, state, and local), financial institutions, and corporations may issue bonds.

Shares, also called common stock, are ownership interests in companies. Stock markets are markets where ownership interests in companies are initially sold and traded.

Companies may raise capital either through a private placement, in which new shares of common stock are issued directly to specific investors or through a public offering, in which new shares of common stock are sold to the general public. Financial institutions may also raise equity through the sale of their companies’ common stock.

In addition to money and capital markets, there are also markets for derivative securities, i.e., markets for financial contracts or instruments that derive their value from underlying debt and equity values.

One well-known form of derivative security is the ability to buy or sell a company’s stock at a specified price and within a specified time period.

Derivative securities may be used to speculate on the future price performance of the underlying financial assets or to reduce the price risk associated with holding the underlying financial assets. Organized exchanges settle standardized derivative securities contracts, while negotiated contracts are traded on electronic markets, often involving commercial banks or other financial institutions.

Foreign exchange markets (also called FOREX ) are electronic markets where banks and institutional traders buy and sell various currencies on behalf of businesses and other customers. In the global economy, consumers may wish to purchase goods manufactured or services provided in other countries.

Similarly, an investor residing in one country may wish to hold securities issued in another country. For example, a U.S. consumer may want to purchase a product in another country. If the product is priced in the country’s currency, it may be necessary to exchange U.S. dollars for foreign currency to complete the transaction.

Companies that sell their products abroad generally receive payment in foreign currencies. However, because the relative values of currencies can change, companies often use foreign exchange markets to reduce the risk of holding too much of certain currencies.

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