Financial Markets: Role In The Economy, Importance, Types And Examples

Financial Market is a broad term used to denote the marketplace of trading securities. They trade in varied types of securities and are quite essential for the smooth functioning of the economy. A failure of financial markets may lead to a recession in the economy and other problems such as unemployment etc.

There are several types of financial markets. Major ones include bond markets, forex, markets, stock markets, etc. When all these markets are taken into account as a whole, they are referred to as financial markets. We shall go through the significant aspects of financial markets in detail.

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Financial Markets: Key Takeaways

The financial market refers to the marketplace of trading financial holdings including stocks, securities, bonds, forex reserves, etc.
Depending upon the variants of financial holdings traded, they are classified into several types. For instance, there are stock markets, bond markets, forex markets, etc.
Financial markets are instrumental in the growth or fall of an economy and heavily influence the financial stability of a country’s economy.
A good financial market promotes capitalism and positive financial growth. On the other hand, poorly performing financial markets may lead to a recession in the economy.

Understanding Financial Markets: Definition and Importance

financial markets

A financial market refers to a market place where people trade securities and other financial holdings at transaction costs. Some of the key financial holdings include bonds, stocks, cryptocurrencies, derivatives,and commodities.

Financial markets can be classified into two types: Primary Markets and Secondary Markets. While primary markets deal in fresh financial assets such as bonds and stocks, secondary markets facilitate trading existing securities.

Financial markets facilitate liquidity and provide financial participation and capital that is essential for the growth and stability of the economy. In the absence of financial markets, the efficient allocation of capital is not possible. Economic activity such as tade, investment, commerce and growth opportunities would diminish greatly if not for financial markets.

The Different Types of Financial Markets

There are varied types of financial markets, each dealing in a fixed financial asset or holding and having its own importance. They are discussed as follows:

Stock Market

Probably, the most notable of all financial markets are stock markets. It is here that companies list the share of their companies and financial entities to trade with investors who buy them in exchange for investments. It is the most revered financial market of all capitalists, businessmen, traders and investors.

There are different ways to trade stocks. It can be done either on listed exchanges such as NSE (National Stock Exchange), BSE (Bombay Stock Exchange), etc. or via regulated exchanges. Regulated exchanges allow money flow in the economy and thus affect it.

Bond Market

The bond market is also called the fixed income market, debt market or credit market. States, sovereign governments, municipalities and corporations all issue bonds for financing their operations.

A bond is a security in which money is invested for a defined period on a predefined rate of interest. It is a kind of financial agreement between the lender and the borrower that contains details of the loan and its payment.

Over-the-Counter Market

An over the counter market is a decentralized, electronically run market with no physical offices or locations. Such markets do not have brokers involved and market securities are traded directly among the market participants.

Though most stocks are traded on exchanges, some stocks are traded in such markets. Further, many derivatives markets are set over-the-counter exclusively. Transactions taking place in OTC (Over-the-Counter) markets are more opaque, less regulated and less liquid.

Money Market

Money markets are those financial markets that trade in highly liquid financial holdings with a very short maturity time, generally less than a year. Money markets offer lower rates of interest when compared to other financial markets and are considered highly safe.

Large volume trades between investors and traders take place at the wholesale level of money markets. On the other hand, retail trading in money markets involves mutual funds and money market accounts.

Forex Market

The forex or foreign exchange market is where traders and investors can compare, exchange, buy or sell varied currency pairs of the world. Also referred to as the currency markets, it deals in more cash than the equity and futures markets combined, with a whopping amount of $7.5 trillion in transactions per day.

Since cash is the most liquid entity of all financial assets, the forex market is the most liquid financial market. It incorporates central banks, hedge funds, investment management companies, commercial firms, investors, and forex brokers.

Commodities Market

Commodities markets are important financial markets that deal in physical assets such as energy products (carbon credits, gas, oil), agricultural products (livestock, corn), soft commodities (sugar, coffee, cotton), and precious metals (platinum, silver, gold), etc.

There are also called spot commodity markets in which money is used to trade physical products as mentioned above. However, the bulk trading of commodities takes place in the derivatives market where the spot commodities are an underlying asset.

Derivatives Market

A derivative refers to a contract between a number of parties in lieu of a financial asset like securities or index (a set of financial assets).

They do not deal in stock trading directly. Instead, they deal in futures and options contracts and other financial products that derive their value from underlying assets. These can be bonds, market indexes, currencies, commodities, interest rates, and stocks.

Cryptocurrency Market

Crypto exchanges are centralized platforms that deal in the exchange of cryptocurrencies among themselves or with fiat money like euros and dollars. These markets are highly vulnerable to fraudulent activities and hacks.

These facilitate peer-to-peer (P to P) trading with no exchange authority in real for the transactions. Some major cryptocurrencies also allow futures and options trading.

Financial Markets: Role in the Economy

Financial markets and the economy are interrelated, one affecting the other at all levels. A financial market plays a quintessential role in an economy’s growth and provides a platform to businesses, individuals and governments to buy and sell to make financial gains.

Financial markets facilitate economic expansion by forming capital and redistributing funds, efficiently allocating resources, managing financial risks, and providing liquidity.

A financial market allows the efficient redistribution of its assets and capitals, offers insights into cryptocurrencies and stock exchanges, facilitates greater liquidity and provides numerous opportunities to make financial gains and stabilise the economy.

A Notable Example of Financial Markets

Financial markets are broad in scope and scale and have a major role to play in the economy of a country. Let us understand the critical role of the Over-the-Counter (OTC) Derivatives Market in the financial crisis of 2008-09.

Over-the-Counter Derivatives and the Financial Crisis 2008-09

One of the major causes identified in the financial crisis of 2008-09 was mortgage backed securities. The crisis came into account because of a number of events that led to the near-about collapse of the banking system.

Among the major causes was the 1970s community Development Act that loosened the credit requirements for low-income consumers. It created the set for subprime mortgages and the debt expanded around the 2000s when the Federal Reserve Board cut interest rates.

A real estate bubble was created with soaring high prices of houses because of the spurring of cheap money and loosened credit requirements. In the wake of the 2001 recession, investment banks created a MBS type called CDOs (Collateralized Debt Obligations).

When investors realised that MBS and CDOs were ineffective because of their debt, they tried unloading the obligations. However, this had started to already reach the upper banking tiers. As a result, two major investment banks collapsed. Several other major banks were saved from failure via bailout.

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Financial Markets FAQs

Q1. What are the various types of financial markets?

Ans: The major types of financial markets include bond markets, stock markets, commodities markets, cryptocurrencies markets, derivatives markets, over-the-counter markets etc.

Q2. What is the function of a financial market?

Ans: The main function of financial markets is to allocate assets and capital in an economy. They are instrumental in running the global economy and sustaining capitalism.

Q3. What do you mean by a financial market?

Ans: A financial market is a marketplace of trading securities, bonds, stocks, derivatives, and other financial holdings. They are quite essential for businesses, traders, investors, and the economy.