The Financial Environment

Financial Markets

Overview of Financial Markets

There are a variety of specific financial markets that trade derivatives and securities. Some of these markets include the stock market, the capital market, the equity security market, primary markets, the bond market, the money market, the derivative security market, the debt security market, and the foreign exchange market.

Generally the term financial market refers to a marketplace where investors trade derivatives and securities, such as stocks and bonds. Derivatives are contracts with value that are determined by the value of an underlying asset. Securities are any interest in an enterprise where the investor expects a financial return that will result mainly from others' efforts. There are a number of specific financial markets to consider. The most well-known is the stock market, where company shares are bought and sold. The capital market is part of the financial system, which allows borrowers and lenders to exchange funds through loans. The capital market is primarily concerned with raising funds by dealing in shares, bonds, and other long-term investments. This is where stocks for publicly traded companies are sold to investors. The equity security market is a marketplace where ownership rights in organizations can be listed in equity markets to be bought and sold or privately traded. An equity security traded on the equity security market is ownership interest held by a stakeholder in a business entity and realized in the form of proprietorship. The primary market issues new securities on the exchange to investors as either stocks or bonds, a process handled by underwriting groups and investment banks. Any subsequent trading of those shares will occur in the secondary market. The secondary market is a marketplace where previously issued securities are sold and bought by investors. For example, Lindsey's Athletic Apparel Boutique wants to issue stock in its company. The company first offers an initial public offering (IPO) on the stock market. An IPO is a public offering where company shares are sold to institutional investors, as well as sometimes retail investors. Shares in Lindsey's Athletic Apparel Boutique would then be sold on an equity security market and realized as equity securities.

Another financial market is the bond market, a capital marketplace where participants issue new debt or buy and sell debt securities. The bonds that are primarily sold in these markets are corporate, municipal, and U.S. Treasury bonds. If Lindsey's Athletic Apparel Boutique wants to offer bonds to potential customers, the company goes to the bond market and sells debt securities that will allow customers to return the bonds with interest.

Another financial market is the money market, where financial instruments with high liquidity and very short maturities are traded. Liquidity is the degree to which an asset can easily be bought or sold without a change in price. This market can be used for borrowing and lending in the short term, for periods from one day to one year. Money markets allow companies to acquire the cash and cash equivalents that they need in a short amount of time. Customers in the money market are able to make a safe investment.

Another financial market is the cash or spot market, where goods are sold for cash and are delivered immediately; this is not a market for inexperienced investors. Another complex market is the derivative security market. The derivative security market is the marketplace where financial instruments such as futures contracts and options derived from another asset can be bought and sold. Some common derivatives securities are forwards, futures, options, swaps, and contracts for difference. An option, which is the most commonly used derivative security, gives the owner the choice of buying or selling a particular good at a specified price on or before a specified time. In contrast, futures, another popular derivative security, require the owner to purchase or sell the underlying asset at a specified price on a specified future day. Some popular derivatives assets, such as corn, gas, and other material items, fluctuate based on inflation and supply and demand.

The debt security market is a marketplace where short- and long-term debt securities are bought and sold. A debt security is a financial instrument that establishes a creditor-debtor relationship or that represents investment in the form of debt.

The last major market is the interbank market and the foreign exchange market. The foreign exchange market (Forex) is a currency marketplace that is expressly used for trading currencies, or more specifically, where traders exchange currency to meet their clients' hedging needs or to profit from currency price movements. The interbank market and Forex deal with financial institutions and banks and do not include retail investors and smaller trading partners.

Each of these markets carries its own level and form of risk, which is a fundamental consideration for any investor. The markets are also part of an overarching economy. Each of these markets lends to and is affected by global economic movements such as inflation, resource depletion, and governmental policy.

Financial Market Structure

The various financial markets are structured into markets that deal with specific types of securities and derivatives.

How Financial Markets Interconnect

Financial markets are interconnected, influence each other, and must function to create one larger global economy.

Financial markets and the financial environment are interconnected. The financial environment is the part of an economy where financial firms, investors, and markets make decisions on the allocation of resources. For the market to be successful, each entity, such as individual investors, financial institutions, and the financial markets, must be able to cooperate and fulfill its function. Initially, a corporation or a firm will issue securities to earn capital for its business in order to invest in new buildings, employees, or projects. The securities the company issues are traded on the primary market. After the securities are initially sold, new investors can invest in the company in the secondary market, where previously issued securities are traded. When stockholders get shares of stock within the company, they are able to receive dividends, the distribution of a corporation's earnings in the form of cash, stock or property. When the investors sell the stock, they will make a profit or incur a loss based on the company's stock price at the time the shares are sold.

Financial institutions, on both a global and local level, are entities such as banks that conduct financial transactions, including investments, loans, and deposits. When a customer needs a personal loan, they go to a bank and apply for financing. If the individual is approved, the bank issues a loan with interest. The bank may sell this loan to other customers in the form of certificates of deposit (CDs), bonds, or mutual funds. CDs are negotiable instruments that promise to pay a sum of money at a future date, and a bond is a long-term investment instrument that requires a corporation to return the amount of the initial investment with interest. Those who invest in these kinds of debt instruments provide the backing for loans. In return, investors get their money back with interest. Municipalities and corporations may similarly issue bonds when attempting to finance a project.

The markets rely on each other but also on individual investors, whose behavior, beliefs, and actions have significant effects on the market. For example, the government may increase interest rates as a way to slow inflation. As a result, people cannot afford to buy houses, so the real estate market declines. Stocks in real estate funds drop, bringing down the overall market. If the individual investors do not have confidence in the market, they will sell stock, causing volatility. If a company is doing well, it may repurchase its stock and issue bonds. Repurchasing the supply that the company generated increases the prices of stock since there is less stock available. All of these factors interconnect to create one larger global economy.

Interconnected Financial Markets

Stock and loans that have been issued can then be sold on specific financial markets.