What are financial markets? Definitions, functions, and types of financial markets

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Financial markets are the beating heart of global economies, and surely you've seen an image or two of Nasdaq's bright light showing different numbers in green or red. (And if you haven't, that's OK too!) But what does the term “financial market” actually mean? We're here to give you all the definitions, functions, and types of financial markets. This way, you'll be able to understand the different pathways for investing, wealth creation, and risk management — whether you’re an experienced investor or just starting your investment journey. 

Let's start with the basics: What are financial markets?

A financial market is a platform or system where buyers and sellers come together to trade stocks, bonds, commodities, currencies, or other financial assets. These buyers and sellers can be individual investors, financial institutions, or governments.

Financial markets can exist physically, such as stock exchanges, or virtually through electronic trading systems, and they’re vital pillars of the global economy, influencing economic policies and shaping the financial landscape worldwide. 

Keep reading to learn more about the different types of financial markets and what they represent.

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Financial markets are diverse ecosystems with specific segments. They’re divided into several types of assets — the stock market deals in equities, for example — and each type has its own characteristics, functions, and economic impact. 

Knowing the difference between each financial market type can give you a better understanding of the opportunities and risks that come along with investing. And that, in turn, can help inform how and where you choose to invest. 

Stock markets are a platform for investors to buy and sell shares of public companies. Multinational corporations like Apple, Microsoft, and Coca-Cola, among many others, are publicly traded. This means they’ve issued stocks or bonds that are available to the public. The buying and selling of stocks and bonds allow investors to own pieces of these companies. 

The primary function of stock markets is to make stock trading easier. Investors can buy stocks through initial public offerings (IPOs) or stock exchange markets like Nasdaq or the London Stock Exchange. 

But why do companies sell stock? And moreover, why do investors buy them? First, owning stocks grants shareholders ownership in a company, giving them voting rights in major corporate decisions. Second, investors can profit if a company is doing well. That means its stock price will go up, and investors can sell their shares at a higher price than what they paid.

However, investing in stocks requires an understanding of market trends and company performance, financial analysis, and serious risk assessment. 

Over-the-counter (OTC) markets refer to decentralized platforms or networks without the supervision of an exchange. In these markets, stocks, bonds, commodities, and other financial assets are bought and sold directly between buyers and sellers.

Unlike stock exchanges with centralized locations and specific trading hours, OTC markets operate electronically and facilitate trading 24/7 across various locations. While OTC markets are regulated, they aren't as strict as formal stock markets, which could potentially mean higher risks and less transparency.

Bond markets deal with debt securities from governments and companies. Governments, for example, might issue bonds to raise funds for public projects or to cover budget deficits, while companies use them to fund operations, expansions, or other financial needs.

When you buy a bond, you're actually lending your money to that group. In return, investors get a specified amount of interest over a predetermined period, and the group eventually repays the principal amount (the bond's face value) at maturity. 

Bonds vary in risk levels and returns. Government bonds are often considered safer, while corporate bonds may offer higher interest but come with higher risks, depending on the company's creditworthiness.

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The money market is a financial market focused on borrowing and lending funds. Unlike a bond market, it's focused on the short-term, usually under a year. Instead of stocks, investors get money instruments, Treasury bills, certificates of deposit (CDs), commercial paper, repurchase agreements (repos), or short-term government and corporate bonds that show how much money is being borrowed or lent. 

By facilitating short-term funding, the money market helps maintain economic stability. It ensures banks, governments, and companies have access to funds to manage their short-term needs and maintain a stable cash flow. 

A derivative is a financial contract between two or more parties. Instead of trading financial assets directly, the derivatives market involves trading futures, options contracts, and other complex financial products. These instruments derive their worth from underlying assets such as bonds, commodities, currencies, interest rates, market indexes, and stocks.

Basically, the derivatives markets allow individuals and institutions to improve risk management. For example, a company can use futures contracts to lock in the price of raw materials, protecting against potential price increases. At the same time, investors can use derivatives to speculate on the future price movements of assets without owning them, buying options to bet on the rise or fall of a stock's price, for example. 

With future and option contracts, the derivatives market amplifies potential gains but also magnifies potential losses.

If you've ever travelled to a country where the local currency was worth more than your money at home, you'll quickly understand the foreign exchange market. That's because it's a market where currencies are traded globally. It's the largest and most liquid financial market, allowing investors, governments, and companies to buy and sell currencies in the hope of making a profit. 

Participants in the forex market use currency pairs to trade. For instance, the EUR/USD pair represents the euro against the American dollar. The price of one currency against another fluctuates, and traders attempt to profit from these fluctuations by buying and selling currency pairs.

See? It’s just like that cousin trying to sell you dollars above the market price (if you know, you know).

Commodities trading involves the buying and selling of raw materials like agricultural products (wheat, corn, coffee), metals (gold, silver, copper), energy resources (crude oil, natural gas), and other natural resources. 

In the spot commodity market, investors trade these physical products for money. However, most trading that involves these commodities occurs on derivatives markets, with spot commodities as the underlying assets. 

Cryptocurrency markets serve as digital platforms to trade cryptocurrencies like Bitcoin and Ethereum. Decentralized and operating 24/7, these markets facilitate global transactions through online exchanges. 

Investors and traders engage in these markets to capitalize on price fluctuations.  Understanding the cryptocurrency market involves navigating blockchain intricacies, analyzing various digital currencies, and managing the inherent risks amid evolving regulations. You'll also want to learn how to read crypto charts!

Now that you know what types of financial markets are out there, remember that all of them have unique benefits and risks. Learning more about each market type and understanding these risks is crucial to making informed decisions — all so that you can benefit from the advantages that financial markets can offer.

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