What are Financial Markets?

Financial markets are like a shopping mall…

At just about any mall in America, there are dozens, maybe even hundreds, of retail stores all under one roof. If you wanted to, you could spend hours walking around and window shopping. There are stores for clothes, shoes, video games, food, and all sorts of other things. Just like the mall is the broad term that refers to all of the stores inside, the financial market refers to all kinds of places to buy and sell financial instruments.

Just like a farmer’s market is where people buy and sell farm products, the financial market is where people buy and sell financial products. Basically, if it has to do with trading money rather than products, it’s part of the financial market. It includes trading business ownership, foreign currency, contracts, loans, and many others.

A market is anywhere that buyers and sellers come together to trade. There are quite a few markets that fall into the financial market category. Here are a few:

The primary characteristics of the money market are that it’s short-term and low-risk. It’s mostly for trading U.S. Treasury bills (short-term federal government debt instruments) and short-term municipal bonds (local government debt instruments). But it also includes certificates of deposit (CDs — financial instruments created by banks) of less than a year and even some high-quality business loans. Overnight loans between banks also fall into the money market sector of the financial market. Lenders in the money market are typically individuals looking for stability and liquidity. They usually invest in money market accounts (savings accounts that invest in the money market).

When corporations or governments need to raise capital, they usually go to the capital market. They may issue long-term financial instruments to investors to raise the money they need. Those instruments are capital assets for the investor, who can resell them to other investors. There are two primary ways to raise funds in the capital market — selling equity or issuing debt.

The stock market is the place companies sell equity (ownership rights to part of the company) to raise cash. Corporations issue shares of stock (a certificate of equity ownership) during an initial public offering (IPO). The stock market is also the place that investors sell those stocks to one another. In the United States, the New York Stock Exchange (NYSE) and the NASDAQ make up the stock market.

The bond market is the place companies, and governments, sell debt instruments called bonds. A bond is a promise to pay a certain amount of money to the owner of the bond on a specific maturity date. It may or may not include periodic interest payments during the life of the bond. Bondholders can sell these debt instruments to other investors on the bond market, rather than waiting for the bond to mature.

The capital market can also be divided into the primary and secondary markets:

• The primary market refers to the initial creation of a financial instrument in the capital market. It includes the IPO process of issuing shares of stock in a company and the initial sale of a bond. In the primary market, the money goes from an investor to the issuing entity.
• The secondary market refers to the resale market for these capital assets. It’s where investors buy and sell those stocks and bonds to other investors. Stock exchanges are a significant part of the secondary capital market.

Loans are also financial instruments that investors buy and sell on the debt market. Buyers of these debts sometimes repackage them into something called a collateralized debt obligation (CDO). These CDOs use the payments from the underlying debts to pay investors. A CDO can include anything from credit card debts to student loans — and everything in between.

The buying and selling of currency is part of the financial market. There are two general forms of currency markets:

The foreign exchange (Forex) market is where people exchange one country’s money for another. While some people do this in preparation for a trip overseas, others do this as an investment strategy. Because most currencies are free-floating (the exchange rate changes based on supply and demand for each currency), changes in the value of a currency can represent a potential profit. Just like investors might buy a stock that they think is on the way up, they might buy a currency for the same reason.

The cryptocurrency market is a newer part of the financial market. Cryptocurrencies are virtual coins that aren’t recognized as legal tender by any government. However, people can accept a bitcoin as payment just as well as they could agree to take a dozen eggs. Because people are willing to use cryptocurrencies as a form of payment or as an alternative investment, there's a supply and demand for them. So, there's a cryptocurrency market in which people trade dollars for cryptocurrencies, hoping the value goes higher.

The futures market is the place investors buy and sell futures contracts, which are contracts for the future delivery of something at a predetermined price. Futures contracts can be for physical delivery of a commodity, like 1,000 barrels of oil, or the cash value of something, like S&P 500 futures. Some of the buyers and sellers in the futures market are trying to lock in a price to avoid volatility. Others are speculating on which direction the price will change, trying to earn a profit from being right. Buying and selling futures contracts as an investment makes it part of the financial market.

An option gives its buyer the right, but not the obligation, to buy or sell something at a future date for a predetermined price. Once an option contract gets created, the owners can sell their position to other investors. Options contracts can be for individual stocks, market indices (like the S&P 500 or the Dow Jones Industrial Average), or even futures contracts. A call option gives its owner the right to buy something at a fixed strike price, while a put option gives its owner the right to sell something at a fixed strike price.

A derivative is a sophisticated financial instrument that derives its value from something else. The most common types of derivatives are futures and options contracts. Each of these instrument’s value is derived in part from the value of the underlying commodity, currency, or security. For example, the value of an option to buy 100 shares of a blue chip stock is mostly based on how much the stock is worth. Another form of a derivative is an asset-backed security (ABS). These financial assets are tied to underlying assets, like business loans or mortgages. Several of these financial assets get repackaged into an ABS, which investors can buy and sell on the financial market. One other notable derivative is a credit default swap, which is similar to insurance policies that pay the holder if the underlying security defaults. All of these financial assets are rooted in some other financial asset’s performance. In other words, they mostly derive their value from the supply and demand of other assets.

The financial market works the same way other markets do, based on the laws of supply and demand. The law of supply says that people will become more willing to sell something as the price rises. The law of demand states that people will become more willing to buy something as the price falls. At some point in the middle, there is a price and quantity combination — called the market equilibrium — that balances the forces of supply and demand.

When companies issue debt contracts, such as loans or bonds, they create financial assets. Investors buy and sell those assets on the secondary market. In this case, the owners of assets are suppliers and investors looking to purchase them are buyers. Again, the laws of supply and demand work to balance the market by finding an equilibrium price.

In addition to the buying and selling of financial assets, there are some meaningful relationships between non-depository institutions and the financial market. A depository institution is an account that allows an account holder to deposit and withdraw money. A non-depository institution holds money long-term, often by selling shares or policies.

Financial markets serve many functions in a market economy. The following are some of the more critical ones:

Capital access: The financial market allows businesses to grow. Without investing money into equipment, buildings, inventory, and other factors, businesses couldn’t operate. And without access to the money to make investments, they wouldn’t happen. In this way, the financial market allows businesses to offer products and hire people, which is how the economy functions at all.

Liquidity: If investors had to hold their stake in a company forever, it'd be hard to commit the money in the first place. Similarly, it'd be hard to buy a 30-year bond if that money was off-limits for 30-years. The financial market allows investors to get out of their investment at any point along the way. They just need to sell their position to another investor. This ability to quickly convert a financial asset into cash is called liquidity.

Price determination: After you buy something, it can be challenging to keep a handle on what it’s worth. After a few months or years, you know it’s probably not worth the same amount you paid for it. The financial market provides the service of keeping tabs on the value of those assets. Since there are typically hundreds of identical assets changing hands every day, you always know precisely what your assets are worth.

Leading indicator: The financial markets move quickly. When news breaks and policies change, the financial markets react in real time. Sometimes, the stock market reveals information about a slowing economy before any of the official statistics do. In this way, the financial markets can act as an advanced warning about where things are heading.

The financial market is a critical component of a functioning economy. It's where people with ideas can go for funding. It’s also the place where people saving for the future often put their money to grow it for retirement. Financial markets connect people that want to save for the future and people that want to spend in the present. It helps entrepreneurs open businesses and individuals own homes and cars. Without the financial markets, people could need to save money for a lifetime, without earning interest, just to open a small business. So, the financial market enables economic growth. It also allows people to own expensive assets they’d never be able to afford otherwise.

Keep in mind, options trading has significant risk and isn’t appropriate for all investors — and certain complex options strategies carry even additional risk. To learn more about the risks associated with options trading, please review the options disclosure document entitled Characteristics and Risks of Standardized Options, available here or through https://www.theocc.com. Investors should absolutely consider their investment objectives and risks carefully before trading options. Supporting documentation for any claims, if applicable, will be furnished upon request.