a financial market is a mechanism that allows people to
easily buy and sell (trade) financial securities
(such as stocks and bonds), commodities (such as precious
metals or agricultural goods), and other fungible items of value
at low transaction costs and at prices that reflect the efficient market hypothesis.
markets have evolved significantly over several hundred years
and are undergoing constant innovation to improve liquidity.
markets (where many commodities are traded) and specialized markets
(where only one commodity is traded) exist. Markets work by placing
many interested sellers in one "place", thus making them easier
to find for prospective buyers. An economy which relies primarily
on interactions between buyers and sellers to allocate resources
is known as a market economy in contrast either to a command economy
or to a non-market economy that is based, such as a gift economy.
Financial markets facilitate:
- The raising
of capital (in the capital markets);
- The transfer
of risk (in the derivatives markets);
trade (in the currency markets).
They are used
to match those who want capital to those who have
a borrower issues a receipt to the lender promising to pay back
the capital. These receipts are securities which may be
freely bought or sold. In return for lending money to the borrower,
the lender will expect some compensation in the form of interest
The term Financial
markets can be a cause of much confusion.
markets could mean:
that facilitate the trade in financial products. i.e. Stock
exchanges facilitate the trade in stocks,
bonds and warrants.
2. the coming
together of buyers and sellers to trade financial products. i.e.
stocks and shares are traded between buyers and sellers in
a number of ways including: the use of stock exchanges; directly
between buyers and sellers etc.
students of finance will use both meanings but students of economics
will only use the second meaning.
markets can be domestic or they can be international.
of financial markets
markets can be divided into different subtypes:
markets which consist of:
markets, which provide financing through the issuance of
shares or common stock, and enable the subsequent trading
markets, which provide financing through the issuance of
Bonds, and enable the subsequent trading thereof.
markets, which facilitate the trading of commodities.
markets, which provide short term debt financing and investment.
markets, which provide instruments for the management of
markets, which provide standardized forward contracts
for trading products at some future date; see also forward
markets, which facilitate the redistribution of various risks.
exchange markets, which facilitate the trading of foreign exchange.
markets consist of primary markets and secondary markets. Newly
formed (issued) securities are bought or sold in primary markets.
Secondary markets allow investors to sell securities that they
hold or buy existing securities.
financial markets, let us look at what they are used for, i.e.
what is their purpose?
markets, borrowers would have difficulty finding lenders themselves.
Intermediaries such as banks help in this process. Banks take
deposits from those who have money to save. They can then lend
money from this pool of deposited money to those who seek to borrow.
Banks popularly lend money in the form of loans and mortgages.
transactions than a simple bank deposit require markets where
lenders and their agents can meet borrowers and their agents,
and where existing borrowing or lending commitments can be sold
on to other parties. A good example of a financial market is a
stock exchange. A company can raise money by selling shares to
investors and its existing shares can be bought or sold.
table illustrates where financial markets fit in the relationship
between lenders and borrowers:
|Relationship between lenders and borrowers
are not aware that they are lenders, but almost everybody does
lend money in many ways. A person lends money when he or she:
- puts money
in a savings account at a bank;
to a pension plan;
- pays premiums
to an insurance company;
in government bonds; or
in company shares.
tend to be borrowers of capital. When companies have surplus cash
that is not needed for a short period of time, they may seek to
make money from their cash surplus by lending it via short term
markets called money markets.
a few companies that have very strong cash flows. These companies
tend to be lenders rather than borrowers. Such companies may decide
to return cash to lenders (e.g. via a share buyback.) Alternatively,
they may seek to make more money on their cash by lending it (e.g.
investing in bonds and stocks.)
borrow money via bankers' loans for short term needs or longer
term mortgages to help finance a house purchase.
borrow money to aid short term or long term cash flows. They also
borrow to fund modernisation or future business expansion.
often find their spending requirements exceed their tax revenues.
To make up this difference, they need to borrow. Governments also
borrow on behalf of nationalised industries, municipalities, local
authorities and other public sector bodies. In the UK, the total
borrowing requirement is often referred to as the public sector
borrowing requirement (PSBR).
borrow by issuing bonds. In the UK, the government also borrows
from individuals by offering bank accounts and Premium Bonds.
Government debt seems to be permanent. Indeed the debt seemingly
expands rather than being paid off. One strategy used by governments
to reduce the value of the debt is to influence inflation.
and local authorities may borrow in their own name as well
as receiving funding from national governments. In the UK, this
would cover an authority like Hampshire County Council.
Corporations typically include nationalised industries. These
may include the postal services, railway companies and utility
have difficulty raising money locally. They need to borrow internationally
with the aid of Foreign exchange markets.
1980s and 1990s, a major growth sector in financial markets is
the trade in so called derivative products, or derivatives for short.
In the financial
markets, stock prices, bond prices, currency rates, interest rates
and dividends go up and down, creating risk. Derivative
products are financial products which are used to control
risk or paradoxically exploit risk. It is also called financial
the most obvious buyers and sellers of foreign exchange are importers/exporters.
While this may have been true in the distant past, whereby importers/exporters
created the initial demand for currency markets, importers and
exporters now represent only 1/32 of foreign exchange dealing,
according to BIS.
of foreign currency transactions today shows:
- Banks and
spending (for example, military bases abroad)
has gone into the study of financial markets and how prices vary
with time. Charles Dow, one of the founders of Dow Jones &
Company and The Wall Street Journal, enunciated a set of ideas
on the subject which are now called Dow Theory. This is the basis
of the so-called technical
analysis method of attempting to predict future changes. One
of the tenets of "technical analysis" is that market trends give
an indication of the future, at least in the short term. The claims
of the technical analysts are disputed by many academics, who
claim that the evidence points rather to the random
walk hypothesis, which states that the next change is not
correlated to the last change.
of changes in price over some unit of time is called the volatility.
It was discovered by Benoit Mandelbrot that changes in prices
do not follow a Gaussian distribution, but are rather modeled
better by Levy stable distributions. The scale of change, or volatiliy,
depends on the length of the time unit to a power a bit more than
1/2. Large changes up or down are more likely than what one would
calculate using a Gaussian distribution with an estimated standard
markets in popular culture
Gekko is a famous caricature of a rogue financial markets operator,
famous for saying "greed ... is good".
stories about financial markets tend to make the news. The general
perception, for those not involved in the world of financial markets
is of a place full of crooks and con artists. Big stories like
the Enron scandal serve to enhance this view.
make the headlines involve the incompetent, the lucky and the
downright skillful. The Barings scandal is a classic story of
incompetence mixed with greed leading to dire consequences. Another
story of note is that of Black Wednesday, when sterling came under
attack from hedge fund speculators. This led to major problems
for the United Kingdom and had a serious impact on its course
in Europe. A commonly recurring event is the stock market bubble,
whereby market prices rise to dizzying heights in a so called
exaggerated bull market. This is not a new phenomenon; indeed
the story of Tulip mania in the Netherlands in the 17th century
illustrates an early recorded example.
markets are merely tools. Like all tools they have both beneficial
and harmful uses. Overall, financial markets are used by
honest people. Otherwise, people would turn away from them en
masse. As in other walks of life, the financial markets have
their fair share of rogue elements.
FinancialMathematics.com provides in depth technical treatment
of financial markets and modeling
Valdez, An Introduction To Global Financial Markets
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M.J. Gruber, S.J. Brown, W.N. Goetzmann (2003): Modern Portfolio
Theory and Investment Analysis, John Wiley & Sons, New York
- E.F. Fama
(1976): Foundations of Finance, Basic Books Inc., New York
- R.C. Merton
(1992): Continuous-Time Finance, Blackwell Publishers Inc.
Valdez, An Introduction To Global Financial Markets, Macmillan