A financial market is a collective term that refers to a system composed of traders, regulators, and investors, coming together to carry out transactions involving standard assets such as bonds, equities, derivatives, and currencies (forex). The financial markets are where businesses and investors can raise money to expand their operations or increase their profits.

Financial markets and their categorization are determined by the characteristics of the assets traded and the requirements of the various market players. The different sorts of markets are distinguished by the types of instruments traded and the length of time they are expected to be in existence.

In the financial markets, independent regulatory agencies enforce tight rules and regulations, which are meant to streamline operations, promote integrity, and safeguard investors’ assets. Reporting and compliance criteria are not only extremely strict but are also necessary for this kind of environment.

Below, let’s look at how the markets are classified.

The commodities market

The commodity market is a market that offers corporations a way to cushion themselves against oscillations in commodity prices. Because commodities such as oil, soybean, iron, and copper have seasonal cycles of volatility, commodities markets provide a means through which investors can lock in a price of a specific commodity.

Commodities are tangible and are broadly divided into mined resources like metals and oils or agricultural products like soybean, cotton, corn, etc.

Derivatives market

These are markets that offer investors an opportunity to benefit from the price movement of assets without actually owning them. Here, investors can profit or make losses based on the price movement of the underlying assets. 

Because they do not exist in a physical form, derivatives are created due to contracts entered between two entities. The price of a commodity decides the value of the derivative contracts. Derivatives are typically packaged in the form of swaps, options, forward contracts, and futures. 

Capital market

Capital markets are platforms that provide investors with exposure to trading in equities and debt. Investments in these markets are usually made with a medium-term to long-term perspective. 

The capital market also stimulates greater production by creating liquidity and provision of a well-regulated environment that can build investor confidence in the security of a wide variety of assets.  The liquidity inventory in these markets includes long-term loans of financial institutions, government-issued bonds, shares, debentures, etc.

The richness of the capital markets is based on its incorporation of different entities with different financial capabilities, different investment goals, and objectives. Players in these markets include individual investors, hedge funds, banks, mutual funds, financial institutions, regulators, among others. 

Capital markets can either be primary or secondary, as described below:

  • Primary markets – These are markets where long-term financial instruments are issued first-hand. This is where bonds, shares, and debentures are bought from the issuing entity. 
  • Secondary – This is also known as the stock market. Here, the instruments previously acquired from the primary market are traded faster and with larger daily volumes. Some of the assets, such as bonds, are traded over-the-counter, while others are traded in the form of ETFs. 

The stock market is a marketplace where investors can buy and sell shares of ownership in large corporations. These shares are tethered to the performance of their respective companies. 

Therefore, when the companies are profitable, their shares appreciate and vice versa. However, the stock market is also impacted by market sentiment and speculation, which means that at times stock prices may not be a true reflection of companies’ actual performance. 

The stock market is often monitored by traders using market indexes, which track the performance of particular market segments. Examples of indexes include the Dow Jones Industrial Average, NIKKEI Index, and S&P 500.

Forex market

Trading in currencies takes place on the foreign exchange market, often known as the forex market, which is a global marketplace. There are more than $6 trillion worth of transactions every day, making it the world’s largest and most liquid market. Every currency in the world is represented, and it is open to trading by any individual, business, or country.

Advantages and disadvantages of financial markets

Advantages

  • When buyers and sellers meet on these trading platforms, they are able to transact business in well-regulated environments. Price movement is dictated by forces of demand and supply, which safeguards the integrity of these markets.
  • These markets incentivize investors to mobilize their resources towards various investments, and the transparency of market data promotes investor confidence.
  • Trading on a financial market platform allows traders to identify possible buyers and sellers of their assets, which saves both time and money by eliminating the need to search for buyers and sellers on their own.
  • Investments in the financial market are easily sold and converted into cash, resulting in increased liquidity for tradable assets.
  • The markets provide an avenue through which institutions can raise capital for their various project needs.

Disadvantages

  • Because of macroeconomic variables such as taxation and inflation, the price of a stock in the financial market may not reflect its true value.
  • Market sentiment often disproportionately interferes with the value of assets. For example, the market may react to a negative report regarding a company by dumping its stock, only to realize later that the actual role played by the company is negligible.  This creates an element of risk in these markets.

In summary

Our ability to make informed decisions about where and how to invest is aided by the transparency afforded by financial markets. These markets are broad and have a wide variety of tradable assets, which enables them to accommodate all kinds of investors, big and small. The robust nature of these markets creates possibilities for diverse sectors to expand, encouraging competition.