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Financial markets

In economics, a financial market is a mechanism that allows people to buy and sell (trade) financial securities (such as stocks and bonds), commodities (such as precious metals or agricultural goods), and other fungible items of value at low transaction costs and at prices that reflect the efficient-market hypothesis.

Financial markets have evolved significantly over several hundred years and are undergoing constant innovation to improve liquidity.

Both general markets (where many commodities are traded) and specialized markets (where only one commodity is traded) exist. Markets work by placing many interested buyers and sellers in one "place", thus making it easier for them to find each other. An economy which relies primarily on interactions between buyers and sellers to allocate resources is known as a market economy.

In finance, financial markets are used to match those who want capital to those who have it and facilitate:

  • The raising of capital (in the capital markets);

  • The transfer of risk (in the derivatives markets);

  • International trade (in the currency markets).

A capital market is a market for securities (debt or equity), where business enterprises (companies) and governments can raise long-term funds. It is defined as a market in which money is provided for periods longer than a year[1], as the raising of short-term funds takes place on other markets (e.g., the money market). The capital market includes the stock market (equity securities) and the bond market. Financial regulators, such as the UK's Financial Services Authority (FSA) or the U.S. Securities and Exchange Commission (SEC), oversee the capital markets in their designated jurisdictions to ensure that investors are protected against fraud, among other duties.

Capital markets may be classified as primary markets and secondary markets. In primary markets, new stock or bond issues are sold to investors via a mechanism known as underwriting. In the secondary markets, existing securities are sold and bought among investors or traders, usually on a securities exchange, over the counter, or elsewhere.

The derivatives markets are the financial markets for derivatives. The market can be divided into two that for exchange traded derivatives and that for over-the-counter derivatives. The legal nature of these products is very different as well as the way they are traded, though many market participants are active in both.

International trade is exchange of capital, goods, and services across international borders or territories. It refers to exports of goods and services by a firm to a foreign-based buyer (importer).

In most countries, it represents a significant share of gross domestic product (GDP). While international trade has been present throughout much of history (see Silk Road, Amber Road), it’s economic, social, and political importance has been on the rise in recent centuries.

Industrialization, advanced transportation, globalization, multinational corporations, and outsourcing are all having a major impact on the international trade system. Increasing international trade is crucial to the continuance of globalization. International trade is a major source of economic revenue for any nation that is considered a world power. Without international trade, nations would be limited to the goods and services produced within their own borders.

International trade is in principle not different from domestic trade as the motivation and the behavior of parties involved in a trade do not change fundamentally regardless of whether trade is across a border or not. The main difference is that international trade is typically more costly than domestic trade. The reason is that a border typically imposes additional costs such as tariffs, time costs.

Another difference between domestic and international trade is that factors of production such as capital and labor are typically more mobile within a country than across countries. Thus international trade is mostly restricted to trade in goods and services, and only to a lesser extent to trade in capital, labor or other factors of production.

Then trade in goods and services can serve as a substitute for trade in factors of production. Instead of importing a factor of production, a country can import goods that make intensive use of the factor of production and are thus embodying the respective factor. An example is the import of labor-intensive goods by the United States from China. Instead of importing Chinese labor the United States is importing goods from China that were produced with Chinese labor.

International trade is also a branch of economics, which, together with international finance, forms the larger branch of international economics.

The foreign exchange market is the largest and most liquid financial market in the world. Traders include large banks, central banks, currency speculators, corporations, governments, and other financial institutions. The average daily volume in the global foreign exchange and related markets is continuously growing.

Typically a borrower issues a receipt to the lender promising to pay back the capital. These receipts are securities which may be freely bought or sold. In return for lending money to the borrower, the lender will expect some compensation in the form of interest or dividends.

Dividends are payments made by a corporation to its shareholder members. It is the portion of corporate profits paid out to stockholders. When a corporation earns a profit, that money can be put to two uses: it can either be re-invested in the business (called retained earnings), or it can be paid to the shareholders as a dividend. Many corporations retain a portion of their earnings and pay the remainder as a dividend.

For a joint stock company, a dividend is allocated as a fixed amount per share. Therefore, a shareholder receives a dividend in proportion to their shareholding. For the joint stock company, paying dividends is not an expense; rather, it is the division of an asset among shareholders. Public companies usually pay dividends on a fixed schedule, but may declare a dividend at any time, sometimes called a special dividend to distinguish it from a regular one.

Cooperatives, on the other hand, allocate dividends according to members' activity, so their dividends are often considered to be a pre-tax expense.

Dividends are usually settled on a cash basis, as a payment from the company to the shareholder. They can take other forms, such as store credits (common among retail consumers' cooperatives) and shares in the company (either newly-created shares or existing shares bought in the market.) Further, many public companies offer dividend reinvestment plans, which automatically use the cash dividend to purchase additional shares for the shareholder.

In economics, typically, the term market means the aggregate of possible buyers and sellers of a thing and the transactions between them.

The term "market" is sometimes used for what are more strictly exchanges, organizations that facilitate the trade in financial securities, e.g., a stock exchange or commodity exchange. This may be a physical location (like the NYSE) or an electronic system (like NASDAQ). Financial markets can be domestic or they can be international.

Financial market participants

There are two basic financial market participant categories, Investor vs. Speculator and Institutional vs. Retail. Action in financial markets by central banks is usually regarded as intervention rather than participation.

A market participant may either be coming from the Supply Side, hence supplying excess money (in the form of investments) in favor of the demand side; or coming from the Demand Side, hence demanding excess money (in the form of borrowed equity) in favor of the Demand Side. This equation originated from Keynesian Advocates. The theory explains that a given market may have excess cash; hence the supplier of funds may lend it; and those in need of cash may borrow the funds as supplied. Hence, the equation: aggregate savings equals aggregate investments.

The demand side consists of: those in need of cash flows (daily operational needs); those in need of interim financing (bridge financing); those in need of long-term funds for special projects (capital funds for venture financing).

The supply side consists of: those who have aggregate savings (pension funds, insurance funds) that can be used in favor of demand side. The origin of the savings can be local savings or foreign savings.

An investor is any party that makes an Investment. However, the term has taken on a specific meaning in finance to describe the particular types of people and companies that regularly purchase equity or debt securities for financial gain in exchange for funding an expanding company. Less frequently the term is applied to parties who purchase real estate, currency, personal property, or other assets.

Speculation, in the narrow sense of financial speculation, involves the buying, holding, selling, and short-selling of stocks, bonds, commodities, currencies, collectibles, real estate, derivatives or any valuable financial instrument to profit from fluctuations in its price as opposed to buying it for use or for income via methods such as dividends or interest. Speculation or agiotage represents one of three market roles in western financial markets, distinct from hedging, long term investing and arbitrage. Speculators in an asset may have no intention to have long term exposure to that asset.

An institutional investor is an investor, such as a bank, insurance company, retirement fund, hedge fund, or mutual fund, that is makes large investments, often held in very large portfolios of investments. Because of their sophistication, institutional investors may often participate in private placements of securities, in which certain aspects of the securities laws may be inapplicable.

A retail investor is an individual investor possessing shares of a given security. Retail investors can be further divided into two categories of share ownership.

1. A Beneficial Shareholder is a retail investor who holds shares of their securities in the account of a bank or broker, also known as “in Street Name.” The broker is in possession of the securities on behalf of the underlying shareholder.

2. A Registered Shareholder is a retail investor who holds shares of their securities directly through the issuer or its transfer agent. Many registered shareholders have copies of their stock certificates.

Types of financial markets

The financial markets can be divided into different subtypes:

  • Capital markets which consist of:

  • Stock markets, which provide financing through the issuance of shares or common stock, and enable the subsequent trading thereof.

  • Bond markets, which provide financing through the issuance of bonds, and enable the subsequent trading thereof.

  • Commodity markets, which facilitate the trading of commodities.

  • Money markets, which provide short term debt financing and investment.

  • Derivatives markets, which provide instruments for the management of financial risk.

  • Futures markets, which provide standardized forward contracts for trading products at some future date; see also forward market.

  • Insurance markets, which facilitate the redistribution of various risks.

  • Foreign exchange markets, which facilitate the trading of foreign exchange.

  1. Capital market

A capital market is a market where both government and companies raise long term funds to trade securities on the bond and the stock market. It consists of both the primary market where new issues are distributed among investors, and the secondary markets where already existent securities are traded.

In the capital market, mortgages, bonds, equities and other such investment funds are traded. The capital market also facilitates the procedure whereby investors with excess funds can channel them to investors in deficit.

The capital market provides both overnight and long term funds and uses financial instruments with long maturity periods.

The primary role of the capital market is to raise long-term funds for governments, banks, and corporations while providing a platform for the trading of securities.

This fundraising is regulated by the performance of the stock and bond markets within the capital market. The member organizations of the capital market may issue stocks and bonds in order to raise funds. Investors can then invest in the capital market by purchasing those stocks and bonds.

The capital market, however, is not without risk. It is important for investors to understand market trends before fully investing in the capital market. To that end, there are various market indices available to investors that reflect the present performance of the market.

The capital markets consist of primary markets and secondary markets.

The primary market is that part of the capital markets that deals with the issuance of new securities. Companies, governments or public sector institutions can obtain funding through the sale of a new stock or bond issue. This is typically done through a syndicate of securities dealers.

The process of selling new issues to investors is called underwriting. In the case of a new stock issue, this sale is an initial public offering (IPO). Dealers earn a commission that is built into the price of the security offering, though it can be found in the prospectus.

Features of primary markets are:

This is the market for new long term equity capital. The primary market is the market where the securities are sold for the first time. Therefore it is also called the new issue market (NIM).

In a primary issue, the securities are issued by the company directly to investors. The company receives the money and issues new security certificates to the investors. Primary issues are used by companies for the purpose of setting up new business or for expanding or modernizing the existing business.

The primary market performs the crucial function of facilitating capital formation in the economy.

The new issue market does not include certain other sources of new long term external finance, such as loans from financial institutions. Borrowers in the new issue market may be raising capital for converting private capital into public capital; this is known as "going public."

The financial assets sold can only be redeemed by the original holder.

Methods of issuing securities in the primary market are:

  • Initial public offering;

  • Rights issue (for existing companies);

  • Preferential issue.

The secondary market is the financial market where previously issued securities and financial instruments such as stock, bonds, options, and futures are bought and sold. The term "secondary market" is also used to refer to the market for any used goods or assets, or an alternative use for an existing product or asset where the customer base is the second market (for example, corn has been traditionally used primarily for food production and feedstock, but a second- or third- market has developed for use in ethanol production).

With primary issuances of securities or financial instruments, or the primary market, investors purchase these securities directly from issuers such as corporations issuing shares in an IPO or private placement, or directly from the federal government in the case of treasuries. After the initial issuance, investors can purchase from other investors in the secondary market.

The secondary market for a variety of assets can vary from loans to stocks, from fragmented to centralized, and from illiquid to very liquid. The major stock exchanges are the most visible example of liquid secondary markets - in this case, for stocks of publicly traded companies.

Exchanges such as the New York Stock Exchange, Nasdaq and the American Stock Exchange provide a centralized, liquid secondary market for the investors who own stocks that trade on those exchanges. Most bonds and structured products trade “over the counter,” or by phoning of one’s broker-dealer. Loans sometimes trade online using a Loan Exchange.

Secondary marketing is vital to an efficient and modern capital market. In the secondary market, securities are sold by and transferred from one investor or speculator to another. It is therefore important that the secondary market be highly liquid (originally, the only way to create this liquidity was for investors and speculators to meet at a fixed place regularly; this is how stock exchanges originated, see History of the Stock Exchange). As a general rule, the greater the number of investors that participate in a given marketplace, and the greater the centralization of that marketplace, the more liquid the market.

Accurate share price allocates scarce capital more efficiently when new projects are financed through a new primary market offering, but accuracy may also matters in the secondary market because:

1) price accuracy can reduce the agency costs of management, and make hostile takeover a less risky proposition and thus move capital into the hands of better managers,

2) accurate share price aids the efficient allocation of debt finance whether debt offerings or institutional borrowing.

Newly formed (issued) securities are bought or sold in primary markets. Secondary markets allow investors to sell securities that they hold or buy existing securities.

The secondary market is a market for used goods. Here one investor can buy a security from other investors instead of the issuer. All the securities are first created in the primary market and then, they enter into the secondary market. In the New York Stock Exchange, all the stocks belong to the secondary market.

Secondary Market is the market where, unlike the primary market, an investor can buy a security directly from another investor in lieu of the issuer. It is also referred as "after market". The securities initially are issued in the primary market, then they enter into the secondary market.

In other words, secondary market is a place where any type of used goods are available. So, the secondary market should be liquid.

In the secondary markets, existing securities are sold and bought among investors or traders, usually on a securities exchange, over the counter, or elsewhere which consist of:

  • Stock markets, which provide financing through the issuance of shares or common stock, and enable the subsequent trading thereof.

  • Bond markets, which provide financing through the issuance of bonds, and enable the subsequent trading thereof.

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