A financial market is a platform for trading assets and securities. There are various types of financial markets. The most popular are stock markets, forex markets, commodities markets, derivatives markets, bond markets, money markets, and cryptocurrency markets.
What are Capital Markets?
The capital market, a crucial part of the financial markets, is a platform that facilitates the trading of financial instruments such as stocks, debt instruments, bonds, exchange-traded funds, etc. It is a source for raising funds for individuals, firms, and governments. Financial markets play a critical role in facilitating the seamless operation of economies through resource allocation and liquidity creation for corporations and entrepreneurs.
The failure of financial markets can have far-reaching repercussions on the economy resulting in recession and unemployment. The dot-com bubble and the sub-prime crisis are two prominent examples of such occurrences that have rattled the financial market in this millennium.
Financial markets offer various instruments, including equities, bonds, currencies, and derivatives. These markets also depend heavily on information flow to ensure efficient and appropriate pricing. So the leading types of financial markets are stock markets, bond markets, commodities markets, cryptocurrency markets, foreign exchange markets, money markets, and derivatives markets.
The stock market is a platform to trade shares of public companies. These shares or equities denote fractional ownership in a corporation. Each share comes at a price, and investors earn money when the stock prices appreciate due to several macroeconomic or business-specific factors. Stock Markets play an essential role in the economy as a gauge of its overall health and provide an opportunity for investors to earn capital gains and dividend income.
While it is simple for investors to purchase stocks, the real challenge is selecting the right stocks that will profit. The investor can earn a profit when stocks are purchased at a lower price and are sold at a higher price.
Companies use the stock markets, or equities markets, to raise capital through the primary market or an initial public offering (IPO). After the listing, many buyers and sellers can trade in these shares, known as a secondary market.
Several indices, such as the Dow Jones Industrial Average (DJIA) and the S&P 500, act as the barometer for market performance. Most trading in stocks happens on regulated exchanges like the New York Stock Exchange or NASDAQ. Most countries have one stock exchange. However, there can also be more than one stock exchange in a country.
The participants in a stock market include traders, investors, retail, and institutional. Several mobile applications cater and market makers for maintaining liquidity in the markets. Intermediaries such as brokers facilitate trades but do not assume any position in a stock.
Interestingly, the stock exchanges functioned even centuries back when no technology was involved. In the developed world, the biggest stock markets in the world officially emerged in the 19th and 20th centuries.
Today, technology has transformed stock market functioning. Investors can buy or sell stocks with just a click. Several mobile applications cater to the retail investors’ needs from market research, actual trading, and overall portfolio performance. In times to come, Artificial Intelligence, Data Science, and Blockchain technology will govern various aspects of stock market trading.
Investors buy bonds from a company, government, or municipality, which returns the amount within an agreed period plus interest. These entities issue bonds to seek financing for projects and operations. Even small towns issue bonds to finance capital expenditures for public projects like schools, fire stations, and roads.
The most significant advantage of bond market investing is security. Bonds carry less risk than stocks. It is also one of the reasons why bonds pay lower returns on investments than stocks. Government-backed bonds are relatively safer than corporate bonds. However, corporate bonds usually pay higher interest rates.
In worst-case scenarios like bankruptcy, corporate bondholders may recover a portion of their investments. They have privilege over shareholders when a corporation does the final payout.
We can consider a bond as an agreement between the lender and borrower containing the details of the loan and its payments. The bond market also is called the debt, credit, or fixed-income market.
The bond market trading is typically done in the primary market — wherein the investors purchase the debt securities from sellers, who are also the borrowers. Whereas in the secondary market, investors trade securities that were issued previously. Bond trading is mainly done over the counter or OTC.
The volume of capital traded in the bond markets is much more than in the stock markets. There is also private placement in the bond market, wherein bonds are issued privately instead of in public markets. Usually, institutional investors like insurance companies, endowments, and pension funds participate in the private placement of bonds. The main feature that renders bonds unattractive to a few investors is their slow growth compared to the potentially higher returns of stocks.
Commodities markets are a marketplace for producers and consumers to trade physical commodities. These commodities include agricultural products like corn, livestock, and soybeans or energy products such as oil, gas, and carbon credits. The commodities market can also cater to precious metals such as gold, silver, platinum, or “soft” commodities such as cotton, coffee, and sugar.
Commodities markets are as old as human civilization. From serving as simple futures markets in the past to currently operating as exchanges backed by advanced analytics and sophisticated products, commodities markets have seen an incredible journey.
There are two kinds of commodities market: Spot and Future. In the spot commodity markets, physical goods are exchanged for money. Then there is also a future commodity market wherein the price of the items that are supposed to be delivered at the predetermined date is already fixed.
Most of the trading of these commodities happens on derivatives markets that utilize spot commodities as the underlying assets. On the OTC and listed exchanges, forwards, futures, and options on commodities are exchanged. Chicago Mercantile Exchange (CME) and the Intercontinental Exchange (ICE) are two such globally renowned exchanges.
An organized commodity market can coordinate the trading of agricultural products more efficiently and effectively. The market offers a guaranteed mechanism for selling agricultural products, which is extremely useful for small and unorganized farmers. The commodity market provides a centralized and liquid marketplace for producers and consumers. These market participants can also leverage commodities derivatives to hedge future consumption or production. Investors, Speculatorsand arbitrageurs play a critical role in commodity markets.
Over the past couple of years, virtual currencies have emerged as an attractive asset class, in which blockchain technology has played a pivotal role. The global cryptocurrency markets have grown by leaps and bounds. Cryptocurrencies like Bitcoin, Ethereum, and other decentralized digital assets are based on blockchain. There are several cryptocurrency tokens available today trading across the globe through various independent online crypto exchanges. These exchanges offer digital wallets where traders can exchange crypto coins or use conventional currencies.
As most crypto exchanges are centralized platforms, users are exposed to hacks or fraud. Decentralized exchanges operating without any central authority are gaining momentum in the crypto market. These exchanges enable direct peer-to-peer (P2P) trading of digital currencies without an actual authority for intermediaries to facilitate these transactions.
The crypto market has expanded phenomenally over the past decade, and it just crossed the $2 trillion mark. While the crypto markets show immense potential, the regulatory landscape is far from certain. Different countries have different regulations regarding the cryptocurrency market. Many regulators or governments view cryptocurrency as a danger rather than an innovative technology. This is because much of the technology is still being developed and yet to be applied to scenarios in the real world.
Many countries have recognized the hidden power of blockchain technology and are fast adopting cryptocurrencies to tap into the future benefits. Today, crypto trading is not restricted to high net worth or just a few institutional investors. Retail traders, especially millennials, are particularly excited about crypto trading.
A foreign exchange market allows participants to capitalize on the exchange rates movement of various currency pairs through trading, speculation, and hedging. The foreign exchange market participants include retail investors, banks, corporations, fund houses, and investment management companies for hedging and speculative purposes. The forex market operates 24 hours, five days a week. Forex Markets are centuries old and date back to the Mesopotamian period. Today the forex market comprises 170 different currencies.
The forex market is the largest financial market in the world. It handles over $5 trillion in daily transactions, more significant than the combined value of derivatives and the equities market. The forex market is decentralized, consisting of an expansive network of computers and intermediaries worldwide.
Unlike the stock markets, a single exchange doesn’t dominate the forex markets. Forex brokers can also act as market makers and might quote bids and ask prices that differ from the competitive bids of the currency pairs in the market.
There are two levels of the forex market—the interbank market and the over-the-counter (OTC) market. Large banks trade currencies for balance sheet adjustments, client transactions, or hedging in the interbank market. At the same time, retail investors trading through brokers and online platforms are a part of the OTC market.
The money market comprises trades in short-term debt investments, typically debt of less than one year. Governments and corporations participate in money markets to attain consistent cash flow, while investors take to money markets to earn a decent profit. Several types of securities in the money market include short-term Treasuries (T-bills), commercial paper, repurchase agreements (repos), certificates of deposit (CDs), and money market funds investing in these instruments. Typically, the money market funds invest in shares priced at $1.
The money market sees voluminous trades between institutions, companies, and traders at the wholesale level. On the other hand, the retail level includes individual funds buying money market mutual funds and bank customers getting started with money market accounts.
The money market sees the purchase and sales of massive volumes of very short-term debt products, such as overnight reserves or commercial paper.
As they are practically risk-free, money market investments offer a very low-interest rate, just the risk-free rate of return. They don’t provide significant investment returns compared to their riskier counterparts like stocks or bonds. The money market is an integral part of the global financial system. It allows savers to lend money to those requiring short-term loans and employs capital for productive use. These quick loans benefit governments, corporations, and banks to meet their short-term obligations or regulatory requirements. Investors with extra cash in hand also invest in money markets to earn interest.
The derivatives market refers to a platform for trading financial instruments like futures contracts or options. These financial contracts derive their value from an underlying asset or group of assets like common stocks, bonds, currencies, commodities, and market indices. Derivatives are also called secondary securities for the same reason.
The value of the underlying assets is subject to change according to market conditions. Investors enter into derivative contracts to earn profits by speculating on the underlying asset’s value in the future. While a derivative’s value is based on investment, owning a derivative doesn’t imply that the investor owns the asset. The most commonly used derivatives are futures, forward, swaps, options, and warrants.
Derivatives can be used to hedge or mitigate risk and for speculation, implying investors assume risk with an expectation of rewards. Derivatives are typically considered advanced investing.
There are two primary classes of derivative products: “lock” and “option.” Swaps, futures, and forwards fall under the category of Lock products. These contracts bind the respective parties by predetermined terms from the beginning throughout the contract’s life.
Futures and forward contracts are agreements to buy or sell an asset at a specific price at a pre-decided date. A forward contract is traded over-the-counter, and it is a private and bespoke agreement. On the other hand, a futures contract has standardized terms and is exchange-traded. The prices are settled daily until the end of the contract. The futures and the forward market were established for agricultural commodities. But later, it expanded to other asset classes such as equities, foreign exchange, interest rates, energy, and precious metals.
A swap works as an agreement between two parties to exchange cash flows for a set period. Swaps are not standardized exchange-traded instruments. They are customized contracts traded over-the-counter (OTC) between private parties. Large corporations and financial institutions are the leading players in the swaps market. Retail investors hardly participate in the swap markets.
On the other hand, options products offer the holder the right, but not the obligation, to buy or sell the underlying asset or security at a specific price on or before the option’s expiration date. Options have become a pivotal element for reducing risks and enhancing the portfolio’s profitability. Initially, only institutional investors had access to the options markets, while the mainstream investors stayed away due to the requirement of heavy capital.
However, with the internet-based trading and automated electronic trading system taking over, options trading is now accessible to one and all.
Like all of the assets discussed above, the options markets have a long and storied history starting in 350 BC.