Financial markets provide a way for people, companies, institutions, and even governments to get the money necessary to pay for a variety of purchases for goods, services, and large capital projects. The financial markets provide a mechanism for people to buy and sell financial instruments such as stocks, bonds, commodities, and other securities. In earlier times the financial marketplace was physical, but with the advent of computers it has become “virtual” as well.
Modern financial markets evolved from older trading markets. The modern markets are more efficient because they have been able to assemble a much larger number of investors than in earlier times; they are also able to offer a much wider array of securities for trading. Financial markets have undergone many changes in the last 300 years. Many of these changes are designed to protect capital, to increase fungibles, to increase liquidity, and to provide for trading at low transaction costs. Access to financial markets has also grown enormously with the advent of computers.
Students of financial markets have developed the efficient-market hypothesis (EMH). Developed by Eugene Fama of the University of Chicago, the hypothesis claims that financial markets are “information ally efficient.” In effect this proposes that information on stocks, bonds, commodities, property, and other traded assets is well enough understood that the prices of the traded items result from full knowledge. The EMH is similar to assumptions of classical economics that said that an economy had perfect mobility of labor, capital, information, and other market affecting factors. These assumptions were rather gratuitous and not completely realistic.
Another assumption of the EMH is that it is impossible to outperform the market with knowledge that the market already has. News affects financial prices. It is unknowable and acting without it is like acting with the expectation that luck will provide the answers. The rise of news sources in the 1700s accompanied the development of the Industrial Revolution. News of ships affected insurance rates; news of weather, wars, and world problems affected prices. The individual who possessed advanced knowledge could beat the market in some instances. The case of Nathan Rothschild trading on news of the outcome of the Battle of Waterloo is a classic case of trading on knowledge before others get the news.
Markets may be general or specialized. Trading in general markets includes all manner of securities. Trading in specialized markets is limited to only one or a few commodities or securities. When markets are made they create a “space” for people to engage in exchange. The market may have only a few traders or a great many bidding for the values being traded. Free markets allow individuals to trade with few or no restrictions. Command economies seek to dictate the course of the trading or its outcome. Many of the financial markets today are the product of mixed economies. That is, they are free markets that are regulated and in many instances directed. In such cases the market, instead of being the aggregate of possible buyers and sellers who are trading something, includes government directions for political, moral, or social purposes, which, however nobly justified, distort the market.
If financial markets did not exist it would be very difficult for many projects to be financed. If the project is a school or something that is of social importance but will not directly generate income it still takes money to pay for the school or project. Financing a project on a “pay-as-you-go” basis can be seen in some countries where even short-term loans are rare, so people save, build, save some more and then build some more rather than using a financial market to pay for a project.
Banks are key institutions in the financial markets. They use the deposits of their depositors when pooled together as capital for lending. The loans, mortgages, and other financing activities performed by banks are the basis of the modern financial system. However, financing often requires more assets than a single bank has to lend. The use of a stock exchange or syndicated borrowing allows banks to participate but to not have excessive exposure to default risks because they are able to syndicate the financing.
There are a variety of borrowers that enter into the financial markets. They include individuals, corporations, governments, publicly traded joint-stock companies, and other private institutions. Individuals seek loans from banks for short-term financing. Sometimes the loan may be for capital consumer goods such as a refrigerator. Or it may be for much larger financing in order to buy an automobile or a mortgage for a house or a farm.
Companies are constantly seeking capital for both short term financing or for longer term projects. For instance the financing of automobiles means that the dealer has to have an inventory and then has to see that the automobile is paid for through borrowing if the purchaser does not have the cash to make the purchase. If credit is easy then financing is readily available, even at subprime rates. However, if corporations cannot finance their inventories or sales until payment arrives then it is difficult to do business except with older methods of cash on delivery. For example, college textbook stores buy millions of dollars worth of books every year. They usually pay the textbook company after the arrival of the books. Sometimes payment is made after the income is generated from the sale of the books; without financing business would be slower and at a much lower volume.
Governments are borrowers of huge sums of money. In many countries spending by the government exceeds the revenue from taxes, fees, and other sources. Budget deficit borrowing is a nearly universal practice. The collateral for the loans is in theory the entire country. However, collecting by a lender would be difficult unless another government were to become its collector. In the 19th century this was a frequent practice. Public corporations may be government-owned enterprises such as post offices, railroads, or utilities such as the Tennessee Valley Authority. These types of institutions also engage in significant financing. They often borrow through the use of international agencies that facilitate lending through the foreign exchange markets.
Financial markets are either domestic or international. With the rise of computers and global trading the world’s assets have become available for lending. Consequently financial markets may be domestic but with foreign assets that are hard to distinguish. Or trading or borrowing may be international for domestic purposes by a government or for a local project. Much of the debt of the United States is owed to foreigners; on the other hand billions of dollars have been invested in foreign countries through the World Bank or foreign aid.
Markets that handle billions of dollars in exchanges have to be organized to facilitate the volume in trades and values. So “market” often refers to the exchanges where board of trade or other kinds of organizations facilitate transactions. These are stock exchanges, bond exchanges, commodity exchanges, or other exchanges for the trading of values. They may have a physical location such as the New York Stock Exchange, or the Chicago Mercantile Exchange. Or with the emergence of the internet they have an electronic system of exchange such as that of the NASDAQ. With electronic trading between institutions through computer programs the exchanges are executed in huge volumes and values. Globally the move is to electronic exchanges that can handle volume in the billions of dollars per hour or more.
Financial markets do more than provide places of exchange. Capital markets enable businesses and others to raise capital for business operations, investments, projects, or other activities. They also allow the use of derivatives for the transfer of risk. In the case of currency markets they provide a mechanism of international trade.
Capital markets may be primary markets or secondary markets. In primary markets money is raised by the issuance of new securities. Funding sought by governments, businesses, or other institutions can be raised by sale of new stock or new bonds. Capital marketing is usually done by a syndicate of securities dealers who act as underwriters. The process of underwriting a new issue of a security, called an initial public offering (IPO), usually produces cash for the borrowers, investments for the lenders, and fees for the securities dealers. The details of the IPO have to be stated clearly in the investment prospectus. In the United States a prospectus that is deceptive in some way can put those responsible into serious legal jeopardy. Many other countries also have stringent requirements for capital investment prospectuses.
Financial markets that are secondary capital markets are used for the exchange of securities that have been on the market for some time. For example, shares of General Electric that were issued 25 years ago would be in the secondary market and probably traded as part of the liquidation of an estate or for other reasons that made it practical for the investor to sell them. Secondary markets can exist in any type of good. Flea markets are a basic example of a popular secondary market. In financial markets the “aftermarket” is the market that exists just after the issuance of a new IPO. It is in effect the beginning of the trading in that market. Mutual funds are a way to invest in a basket of stocks, but with the aid of mangers who can supervise the investments.
There are a number of ways to array the types of financial markets as a variety of submarkets. The capital markets include the stock markets and the bond markets. Stock markets provide mechanisms for trading that finances corporations through the introduction of new public offerings of shares of a new company or of additional shares of an established company. For a new business such as a computer or stem cell company, shares purchased from it by investors offer the company a way to get capital and share with purchasers a way to invest in the growth potential of the company. Sometimes the investment may be a speculative play, but so is trying a new variety of seeds or a new crop for which a market has to be developed. In both instances the speculation is a gamble but it is based upon, or should be, much more rational calculations than games of chance at a casino.
Bond markets are mechanisms for financing all manner of projects. Borrowing from banks or other sources of capital and using the money for schools, hospitals, roads, dams, or other infrastructure projects that generate long-term cash flows of interest and the return of principal have been traditionally practiced for decades. Laws in the United States exempt interest paid to states or localities from federal taxation in order to encourage this type of financing. It lowers the cost of the borrowing for the states or localities by making the investment easier to repay at a lower cost and by allowing investors to go untaxed.
Commodity markets are centers for the exchange of livestock, grains, or other agricultural products or the exchange of metals or other non-agricultural items. Diamond exchanges in the diamond centers are commodity markets, as are local cattle sale barns. High volume sales are those through exchanges such as the Chicago exchange.
Money markets allow businesses or other institutions to engage in short-term borrowing of large sums of money. For many institutions the “petty cash” of their huge number of investors is a large sum that can be profitably loaned without concern that all investors will want all of their petty cash at one time.
The market in derivatives is relatively new. It provides a mechanism for exchanging instruments that carry a higher risk of default and loss because the underlying values may include subprime loans. Using derivatives allows for the management of risk.
Futures are contracts for the future delivery of something, usually a commodity such as sugar to a bakery, or cotton to a spinning mill. The futures contract locks in a price for the producer who is in effect a commodity consumer at the time of delivery and use. By hedging on the price, which for the industrial user is a form of cost averaging, the futures market creates futures contracts that permit speculators to maintain and stimulate the market.
Forwarding contracts are sold in forward markets. They are a form of financial market securities. Forward contracts are agreements between buyers and sellers to buy something at a future time for a set price. For a grower of the hops used in making beer the spring forwarding contract locks in a price guarantee. The brewer is also guaranteed a product at a known price at a future time that will allow for the continued brewing of the beer. However, if the brewer were to sell the forward contract in a forward market the brewer would collect the price of the hops before they were delivered. The forward price is different from the spot price, which is the price for immediate delivery.
Insurance markets are centers of exchange for distributing risks. In the days of the sailing ships the risks of sea voyages were high. As it was known that a few of those ships would be lost, the selling of shares in voyages of many ships was a way of spreading the risk. Today all manner of risks are insured against, from ships at sea to sexual misconduct by clergy. The insurance markets provide a way for engaging in risk management as a hedge against losses. The losses are contingent upon some act of nature, or in more recent times some kind of malfeasance. Without insurance markets many forms of activity would be viewed as too risky. On the other hand some critics have charged that insurance may make the insured less risk-averse than they should be.
Foreign exchange markets are centers for currency changing. Doing any kind of business other than bargaining requires some type of medium of exchange. Currencies are the most efficient media of exchange. Some currencies such as the dollar, the euro, the yen, or the Swiss franc are in much higher demand than are the currencies of countries that are war torn, economically depressed, or not heavily engaged in the global economy. Currency exchanges, through computers, now more than ever permit global trade to take place at much higher levels and at much higher rates than ever before. The retail currency trading market is global. It is called the “retail forex” meaning the retail foreign exchange (or retail FX) market. It has become the center of huge payment transfers. Retail currency trading allows currency speculations and currency exchanges to set the price of currencies based on supply and demand for those currencies as they are needed to pay for goods and services in the global market.
The foreign currency exchange rates (“forex”) market is a subset of the larger foreign exchange market. Its prices are set by market forces. The participants in the markets are individuals and companies. At the present time many companies offer off-exchange foreign currency futures as well as option contracts.
The FX market had perhaps $90 trillion available around the world for investments until the credit crisis of 2008. However, it still is the center for the exchange of currencies between large banks, currency speculators, governments, and others. As goods are traded, and tourists collectively spend billions in dollars or other currencies, the daily volume in currency exchanges as currencies seek repatriation is huge. The Bank for International Settlements supervises and coordinates the regulations that promote stable international currency exchanges.
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