Financial Markets: Types and Functions

Posted on Mar 12, 2025 in Economy

Financial Markets

Any marketplace where the trading of securities occurs. They are made by buying and selling numerous types of financial instruments including equities, bonds, currencies, and derivatives.

What happens when financial markets fail? Economic disruption, recession, and unemployment.

Objective: To channel the savings of families and companies to investment and create security products that provide a return for those who have access to funds and make funds available for those who need it.

Governed by: Supply and demand law

They allocate resources and create liquidity for businesses and entrepreneurs.

Functions

  • Brokers who connect people who need financing.
  • Set an appropriate price on any asset.
  • Provide liquidity to assets.
  • Reduce time and cost of intermediation.
  • Collect and spread information about securities.

Characteristics

  • Range: Number of financial securities traded on a financial market.
  • Transparency: Ability to obtain information about the market easily.
  • Freedom: Determined by the non-existence of barriers to buy and sell, or barriers to entry or exit.
  • Depth: It’s deeper the higher the number of buy/sell orders.
  • Flexibility: Ease of rapid action of agents before the appearance of a desire to buy or sell. Ability to change prices in an economy.

Features raised at max = Perfect market

A perfect market is structured to have no anomalies that would otherwise interfere with the best prices obtained. If it exists, we have:

  • Homogeneous products
  • Large numbers of buyers and sellers
  • No artificial restrictions
  • No transportation cost
  • Information available for everyone
  • All are price takers

Stock Market

1. What is the stock market?

An institution that offers stock trading, offering regulated stock trading.

2. What are the activities of the stock market?

Physical, virtual, or both. Institutionalized Formal Exchange (Physical or electronic) and OTC.

3. Some characteristics of the stock market

  • Government regulation and oversight
  • Risk and rewards for investors
  • Episodes of volatility
  • Bull market and bear market

4. Benefits of the stock market

Investors can convert their investment into cash whenever they want.

5. Some functions of the stock market

Pricing of securities: The stock market helps to value the securities on the basis of demand and supply. Investors can value their investments.

6. Stock market players:

  • Investors
  • Listed companies
  • Credit rating agencies

7. What is the Securities Exchange Commission (SEC)?

The organization that controls the fairness of prices and other regulations that can affect market participants. In Mexico, the equivalent is the Comisión Nacional del Mercado de Valores.

8. Example of an electronic exchange

Nasdaq stock exchange, where electronic stock exchanges can buy and sell on an automatic computer network.

9. Electronic Communication Networks (ECN) function:

Directly connects buyers and sellers.

10. What are the types of stock markets that exist?

  • Auction exchange
  • Electronic exchange
  • Electronic communication network
  • Over-the-counter exchanges

Money Market

Money market: Invests in debt instruments, mainly in time deposits, notes, and bonds of both domestic and foreign issuers.

Advantages of the Money Market: Taking advantage of the interest offered for placing money in the account and releasing it at the maturity date.

Money market funds seek stability and security with the goal of never losing money and keeping net asset value (NAV) at $1. (YES)

Types of Money market instruments

  • Money market funds
  • Money market accounts
  • Certificates of Deposit (CDs)
  • Commercial Paper
  • Banker’s Acceptances
  • Eurodollars
  • Repos

How many types of money markets are there? Five (money market funds, commercial paper, banker’s acceptances, Eurodollars, and repos).

Objective of the money market? The objective of this market is to unite money suppliers and demanders and to reconcile the needs of savers with those of private companies, state-owned enterprises, the Federal Government, and State Governments.

What is exchanged in the money market? Money or other financial assets with short-term maturity and high liquidity are exchanged; that is, they are easily converted into money. Examples are interbank deposits, commercial paper, and treasury bills.

Equity Market

1. True or false. The equity market is a hub in which shares of companies are issued and traded? True

2. What are the 2 types of the equity market? Primary equity market and Secondary equity market.

3. What do they do in the equity market? Shares are issued and traded.

4. By whom are these companies monitored? By Federal agencies.

5. What is a secondary market? A place where securities change hands amongst investors.

6. When we’re talking about “Issuance of shares to the existing shareholder on the record date without any consideration is known as a bonus issue,” what are we talking about? Bonus Issue.

7. It is a disadvantage that leads to malpractices: The pressure of beating the stock performance record.

8. These are investors of the secondary market: Undertakings, Government bodies, Joint-stock companies.

9. Example of an equity market: The New York Stock Exchange (NYSE), Tokyo Stock Exchange, London Stock Exchange, or the Mexican Stock Exchange.

10. Advantage of equity markets for the companies: It helps the company to avert debts and consistent payments by parting with the company’s ownership.

11. What are the two primary functions of the equity market? Listing of new shares in the primary markets and trading already listed shares in the secondary market.

12. Advantage for investors of the equity market: The stock market opens up a window to invest in a growing company by sharing ownership.

Commodity Market

What is the commodities market?

A marketplace for buying, selling, and trading raw materials or primary products (known in Spanish as Mercado de materias primas).

Commodities are often split into two broad categories: hard and soft.

  • Hard: Include natural resources that must be mined or extracted. Example: gold, rubber, oil.
  • Soft: Agricultural products or livestock. Example: corn, wheat, coffee, sugar, soybeans.

How does the commodity market work?

It allows producers and consumers of commodity products to gain access to them in a centralized and liquid marketplace. These market actors can also use commodities derivatives to hedge future consumption or production. Speculators, investors, and arbitrageurs also play an active role in these markets.

Types of commodity market

  • Spot markets: Also referred to as “physical markets” or “cash markets,” this is where buyers and sellers exchange physical commodities for immediate delivery.
  • Derivatives markets: Where buyers and sellers exchange cash for the right to future delivery of that product. Oftentimes, derivatives holders will roll over or close out their positions before delivery can happen. Forwards trade over-the-counter and are customized between counterparties. Futures and options are listed on exchanges and have standardized contracts that are more highly regulated.

Forwards and futures

These are contracts that give the owner control of the underlying asset at some point in the future, for a price agreed upon today. Only when the contracts expire would physical delivery of the commodity or other asset take place, and often traders will roll over or close out their contracts in order to avoid making or taking delivery altogether. Forwards and futures are generically the same, except that forwards are customizable and trade over-the-counter (OTC), whereas futures are standardized and traded on exchanges.

Functions

  • To serve as a platform for different types of investors to buy and sell the commodities through fair price discovery.
  • To acquire and disseminate commodity news in order to help traders in making decisions.
  • Exchanges also help in settling disputes between the traders.
  • Exchanges are also responsible for grading the commodities available for trade. This allows dealers and other parties to enter into an agreement quickly.

Examples of commodities markets

  • Chicago Board of Trade (CBOT): Commodities traded on the CBOT include corn, gold, silver, soybeans, wheat, oats, rice, and ethanol.
  • Chicago Mercantile Exchange (CME): Trades commodities such as milk, butter, feeder cattle, cattle, pork bellies, lumber, and lean hogs.
  • New York Mercantile Exchange (NYMEX): Trades commodities on its exchange such as oil, gold, silver, copper, aluminum, palladium, platinum, heating oil, propane, and electricity.
  • ICE Futures U.S.: Commodities include coffee, cocoa, orange juice, sugar, and ethanol trading on its exchange.

Derivatives Market

What is the derivatives market?

Refers to the financial market for financial instruments such as futures contracts or options that are based on the values of their underlying assets.

Why are derivatives markets important?

Derivatives are very important as they not only help investors to hedge their risks but also help in global diversification and hedging against inflation and deflation.

What is an example of a derivatives market?

Derivatives contracts are used by wheat farmers and bakers in order to hedge their risk. The farmer fears that any fall in price would impact his income; hence, he enters the contract to lock in the acceptable price for the given commodity. On the other hand, the baker, in order to hedge his risks on the upside, enters the contract so that he does not suffer losses with a rise in the price.

What is the difference between the spot market and the derivatives market?

The spot market is where financial instruments, such as commodities, currencies, and securities, are traded directly for delivery. On the other hand, the derivatives market is based on the delivery of the underlying asset at a future date.

Use of derivatives

a) Hedge your securities. The derivative contracts can be used to hedge your securities from price fluctuations. The shares which you possess can be protected on the downside by entering into a derivative contract.

b) Transfer of risk. Helps transfer risk from risk-averse people to risk-seeking investors. The risk-seeking investor can enter into a risky contrarian trade to gain short-term profits, while the risk-averse investor can enhance the safety of their position by entering into a derivative contract.

c) Benefit from arbitrage opportunities. Arbitrage trading simply means buying low in one market and selling high in another market. With the help of derivative contracts, you can take advantage of price differences in two markets; this helps in creating market efficiency.

Participants in the derivative market

  • Hedgers: These are traders who wish to protect themselves from the risk or uncertainty involved in price movement. They try to hedge their position by entering into an exact opposite trade and pass the risk to those who are interested to bear the same.
  • Speculators: They are extremely high-risk seekers who anticipate future price movement in the hope of making large and quick gains.
  • Arbitrageurs: Arbitrage is a low-risk trade that involves buying securities in one market and simultaneously selling them in another market. This happens when the same securities are trading at different prices in two different markets.

Types of derivative contracts

  • Forward contracts: These are customized contractual agreements between two parties where they agree to trade a particular asset at an agreed-upon price and at a particular time in the future. These contracts are not traded on an exchange but privately traded over the counter.
  • Future contracts: These are the standardized versions of the forward contract which takes place between two parties where they agree to trade a particular contract at a specified time at an agreed-upon price. These contracts are traded on the exchange.
  • Options: It is an agreement between a buyer and a seller which gives the buyer the right but not the obligation to buy or sell a particular asset later at an agreed-upon price.
  • Swaps: Swaps are derivative contracts that involve two holders, or parties to the contract, to exchange financial obligations. Interest rate swaps are the most common swap contracts entered into by investors. Swaps are not traded on the exchange market. They are traded over the counter because of the need for the swap contracts to be customizable to suit the needs and requirements of both parties involved.