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In financial markets, buyers and sellers trade financial assets or securities. Examples are the capital market and the money market. The futures, derivatives, commodities, and foreign exchange markets are other examples.
For example, the money market deals in short-term financial instruments such as commercial paper and certificates of deposit. Meanwhile, the capital market trades long-term financial instruments such as bonds and stocks.
Financial markets exist to help determine market prices. They are similar to goods markets, where supply and demand determine fair prices. But different from the goods market, the trade does not involve goods but financial assets.
The financial market is also a place for us to accumulate wealth. We move our money from the present to the future by investing. For example, we buy bonds to get coupons and capital gains. Or, we buy stocks to earn dividends and capital gains. Long story short, through financial markets, we can build wealth in the future.
Financial markets in the economy
In economics, you may encounter three types of markets. Financial markets are the first. The other two are product markets and factor markets.
Factor markets trade inputs to the production process, such as labor. In this market, households become suppliers while businesses are buyers.
Meanwhile, the product market trades goods and services. They are the output produced by the business. Thus, businesses act as sellers/suppliers in this market, and households act as buyers.
Finally, financial markets unite those who need funds and those who have excess funds. Transactions involve not goods or services but financial assets/securities such as stocks and bonds.
Unlike goods markets, buyers in financial markets come from households, businesses, or other institutions such as governments, central banks, hedge funds, etc. Often, we refer to them as (retail and institutional) investors. Meanwhile, offers come from companies, governments, or other institutions like the world bank.
Where are the financial markets located?
Financial markets can be in a physical location, such as a stock exchange, or virtual over a network, such as a forex market. Their transactions can be centralized or decentralized. For example, stock exchanges centralize transactions by bringing investors together to trade shares in one place.
Decentralized transactions in financial markets involve direct negotiations between buyers and sellers. They are known to us as the over-the-counter (OTC) market.
Trading on the OTC market is not subject to exchange rules. Contracts are made and agreed upon between the transacting parties. Unlike stock exchanges, contracts on the OTC market may be non-standardized, and their prices are generally not available to the broad public.
What are the functions of financial markets?
Effectively functioning financial markets are vital to the economy. The three basic functions are:
- Facilitating monetary funds/capital to be allocated to its highest use
- Determining fair prices for financial assets
- Provides liquidity for tradable assets
Financial markets facilitate the economy in mobilizing money. The market brings together those needing funds (e.g., companies and governments) and those with excess funds (e.g., households).
For example, on the one hand, companies need funds for their productive activities, investing in capital goods. They then raise funds by selling shares to the public or issuing bonds.
On the other hand, households, say you, have excess funds. Your income is more than enough to meet consumption. You then invest it by buying corporate bonds.
Investing in bonds is more productive than keeping your money under the pillow. It allows you to earn coupons and capital gains in return. Finally, your money increases by investing.
Mechanisms in financial markets work through supply and demand to determine fair prices (price discovery). Fair prices are essential for reducing information asymmetry and determining the best price for buyers and sellers.
Imagine if a stock does not have a fair price available in the market. You may have bought the stock too expensive. Or, companies may undersell their shares, leading them to raise less funds than they otherwise would.
Effective financial markets provide liquidity. Thus, buyers easily find sellers. Conversely, sellers can also easily find buyers when selling their assets. Finally, liquidity reduces transaction costs.
Liquidity makes it easier for you to convert financial assets into cash. Additionally, it reduces the risks associated with selling at a low price.
For example, when the market is illiquid, you may have difficulty finding buyers willing to accept your price. So, you may be forced to lower your price to entice them to buy. If true, you are losing because you have to sell at a lower price than you are willing to accept.
How do financial markets work?
Financial markets work to find fair prices. The mechanism is similar to a product market where buyers and sellers meet to determine equilibrium through supply and demand. We call this process price discovery.
Changes in supply and demand determine prices. If market demand is stable, increasing market supply decreases prices and vice versa. If the market supply is stable, increasing demand increases the market price and vice versa.
Liquidity, which is when participants are actively trading, is an important aspect as it ensures participants can easily buy and sell financial instruments without losing value.
However, unlike product markets, pricing can be complex because it involves various financial assets. For example, we use the discounted cash flow (DCF) method or the Gordon growth model to evaluate stocks and determine their fair price. Meanwhile, we determine the yield in the corporate bond market by adding a premium to the yield benchmark (government bonds). Apart from the tenor, the premium considers several risks, such as default risk, changes in interest rates, and liquidity.
What is the financial market infrastructure?
Financial market infrastructure facilitates transactions and their settlement. It engages financial institutions and system operators to provide clearing, settlement, and record-keeping services for monetary and other financial transactions.
The financial market infrastructure involves a multilateral system for the following functions:
- Payment System (PS) to facilitate payment transactions
- Central Securities Depositories (CSD) to manage equity and bond transactions safely and efficiently
- Securities Settlement System (SSS ) to provide additional clearing and settlement functions, such as confirmation of trade instructions and settlement.
- Central Counterparty (CCP) to reduce counterparty risk by providing over-the-counter (OTC) derivative clearing and settlement services.
- Trade Repository (TR) to maintain centralized electronic records of transaction data.
Who performs these functions can vary from country to country. The institution may involve:
- Stock exchange
- Securities and futures clearing house
- Custodian
These institutions form what we call Self Regulatory Organizations (SRO). SRO has the authority to make regulations related to activities in the financial market, are binding, and must be followed by its members.
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