Many people do not realise how important a financial market is. A financial market can be defined as any marketplace where people trade assets such as currencies, commodities, stocks and bonds. A financial market can be domestic or international.
The diagram below depicts the simplified function of a financial market. Building societies or banks such as NYSE, Commonwealth Bank, HSBC, ANZ and IMB bring two parties of people together. On the left, we have investors or lenders. These are the people who are willing to lend their money for a promised rate of return. On the other side, there are the borrowers. These are companies and government bodies who are looking for money to fund their projects to operate and grow. A financial market enables the flow of funds between the borrowers and lenders to the buyers and sellers.
There are always costs for borrowers such as dividends or interest which are given to the lenders. As for the bank or building society, they will simply make profit from the transaction fees. Some of the banks charge commissions from both parties. A financial market facilitates the trading of different securities. Some of the common financial markets are the money market, capital market, foreign exchange market (Forex market) and commodities market.
Money Market
The money markets are where the short-term, high-quality debt securities less than a year old maturity are traded. We can see this as low the risk investment but the return is low at the same time. Examples of money markets are treasury bills, commercial paper and certificates of deposit.
Capital Market
Capital markets are where the long term securities are traded. We can find stocks and long-term debt securities such as bonds in capital markets. Equity markets are where companies sell their shares to raise funds. Companies can also choose to raise debts in the form of bonds. Unlike the money market, capital markets have a higher return, but also have a higher risk.
Foreign Exchange Market (Forex Market)
Forex is an international market where currencies are traded. The market opens 24 hours a day, 5 days a week. It is the largest market in the world with more than $1.9 trillion worth of trading transactions each day. The dynamic and high liquidity nature of Forex attracts many traders from around the world. Forex trading involves buying one currency while selling another to make a profit. The transactions are speculative where there are no real money notes involved.
Commodity Market
One of the popular ways to invest in the commodities market is through futures contracts. Each commodity is bought and sold in particular unit size. There are two types of commodities – hard and soft. Examples of hard commodities are metals, oils, natural gasoline, gold and silver. Examples of soft commodities are livestock or agriculture, including beef, pork, coffee and wheat.
In conclusion, a financial market is a structure which enables the flow of funds. Financial markets play an important role in facilitating the raising of capital, connecting businesses and the investors who hold the funds.
Financial markets also provide the service for risk transferring in derivative markets. Financial markets are where the investors liquidate their investments and turn their equities into cash. Forex markets make trading among different nations possible.
The health of an economy can be affected by the financial market as there is a strong connection between the financial market development and economic growth. Without a well-developed financial market, it may cost more to raise capital and lower the return of saving. In our next article, we will discuss details of the stock market.
