
Financial markets for dummies
Are you new to finance and want to learn more about how financial markets work? Well you've come to the right place. Financial markets are a type of market that provides a way to sell and buy assets such as bonds, stocks, currencies, and derivatives.
They can be physical or abstract markets that connect different economic agents. In simple terms, investors can turn to financial markets to raise more funds to grow their business in order to earn more money.
To put it more clearly, financial markets are like a bank that holds the accounts of its customers and can use the deposits to finance other people and organizations and charge interest fees. The depositors themselves earn and see their money grow through the interest paid to it. Therefore, the bank serves as a financial market that benefits both depositors and debtors.
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The role of financial markets
Financial markets are virtual or physical platforms on which economic actors exchange financial products. On the one hand, these transactions make it possible to finance businesses. On the other hand, investors can invest their savings and hope for financial or wealth gains. Shares, bonds and other debt securities are issued by Nations, public authorities and companies before being acquired by buyers. This is called the primary market.
These first buyers can then resell these securities in return for cash on what is called the secondary market. For example, when a company goes public or increases its capital, it is on the primary market. Once the shares are acquired, negotiations between investors are carried out on the secondary market.
Financial markets make it possible to complete transactions in a few thousandths of a second. This is what makes it possible to reconcile the financing needs and the investment needs of the different players. To summarize, financial markets play a fundamental role in financing the global economy. Here is what you generally need to remember:
- Financial markets provide a place where participants such as investors and debtors, regardless of size, will receive fair and appropriate treatment.
- They provide individuals, businesses and government organizations with access to capital.
- Financial markets contribute to lowering the unemployment rate because of the many job opportunities they offer
How to understand how financial markets work?
Here are the important elements for understanding how financial markets work: market structure, market participants, liquidity, pricing and spread.
The structure of the financial market
Financial markets are generally subdivided into various categories based on the type of instrument being traded. Futures markets, for example, started as a place to trade commodities like oil, metals, and agriculture, but now include stock indices like the Dow Jones Industrial Average, FTSE 100, and DAX.
The foreign exchange market, the largest and most liquid in the world, is where investors trade global currencies and is open 24 hours a day, 24 days a week. Finally, through the equity and debt markets, investors can trade assets including individual company stocks, options, and government bonds.
Market participants
The Financial Markets consist of various participants. It includes governments, central banks, major global banks, hedge funds and retail traders. Each of these participants has a different motive and interest than the others. These motivations can range from market speculation to commercial risk hedging.
For example, the trader can hedge the exchange rate risk on foreign transactions, such as the acquisition of equipment or a sale in foreign currency. A central bank, on the other hand, can buy a currency to supplement its reserves.
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Professional market players are generally divided into "buy side" and "sell side". The buy side is made up of hedge funds and pension funds. Their goal is to generate a return on investment for their investors and partners by investing funds in the market.
The offering is dominated by the world’s major banks, whose job is to facilitate investor trading. Retail traders are typically non-professionals who trade with their own capital in order to make a profit on their investment. They access the market through online brokers and may trade full-time or part-time to supplement their main income.
Liquidity and price
Market liquidity is directly correlated with the volume of trades taking place at any given time. High liquidity means that an investor can easily place their trade at the desired price and indicates that there are a high number of matching trades to match. Low liquidity, on the other hand, means that the volume of trades is low and it will be difficult to match one investor’s trade with another.
The spread
The spread is the difference between the buying and selling price, often called the bid and ask price. When an investor buys a security, he will pay the ask price, but when he sells it, he will pay the bid price. Therefore, in the investment process, the investor loses the spread.
It is in the investor’s best interest to keep the spread as low as possible when trading gold for example. This can be achieved by investing through a reputable broker or bank, as well as investing in the most liquid markets.
The different types of financial markets
There are so many financial markets, every developed country is home to at least one, although they vary in size. Some are small while others are internationally known, like the New York Stock Exchange (NYSE) which trades billions of dollars daily. Here are some types of financial markets one can have.
1. The stock market
The stock market trades shares of public companies. Each share has a price, and investors make money from stocks when they perform well in the market. Buying stocks is easy. The real challenge is choosing the right stocks that will make money for the investor.
There are various indices that investors can use to monitor the performance of the stock market. If you are an investor then you should know that you can use indices such as the Dow Jones Industrial Average (DJIA) and the S & P 500. When stocks are bought at a lower price and sold at a higher price, the investor gains from the sale.
2. The bond market
The bond market provides opportunities for businesses and governments to raise money to finance a project or investment. In a bond market, investors buy bonds from a company, and the company repays the bond amount within an agreed period of time, plus interest. When organizations need to obtain very large loans, they turn to the bond market. When stock prices rise, bond prices fall.
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There are many types of bonds, including Treasury bonds, corporate bonds, and municipal bonds. Bonds also provide some of the liquidity that keeps the economy running smoothly.
It is important to understand the relationship between Treasury bonds and Treasury bond yields. When Treasury bond values fall, yields rise to compensate. When Treasury yields rise, mortgage interest rates also rise. Worse yet, when Treasury values fall, the value of the dollar also falls. This pushes up import prices, which can trigger inflation.
3. The commodity market
A commodities market is where companies offset their futures risks when buying or selling natural resources. Because the prices of things like oil, corn, and gold are so volatile, companies can lock in a price known today.
Since these exchanges are public, many investors also trade commodities for profit only. For example, Most investors are not willing to accept large shipments of pork bellies.
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Oil is the most important raw material in most economies. It is used for transportation, industrial products, plastics, heating, and electricity generation. When oil prices rise, you will see the effect on gas prices about a week later.
If oil and gas prices stay high, you will see the impact on food prices in the coming weeks. The commodity futures market determines the price of oil. Futures contracts are a way to pay for something today that is delivered tomorrow. They increase a trader's leverage by allowing them to borrow money to buy the commodity.
4. The derivatives market
Such a market involves derivatives or contracts whose value is based on the market value of the asset being traded. The futures contracts mentioned above in the commodities market are an example of a derivative. Derivatives are complex financial products that base their value on underlying assets. Sophisticated investors and hedge funds use them to amplify their potential gains. In 2007, hedge funds gained popularity due to their supposed higher returns for high-end investors.
Because hedge funds invest heavily in futures contracts, some have argued that they reduce volatility in the stock market and, therefore, the U.S. economy. Hedge fund investments in subprime mortgages and other derivatives caused the global financial crisis of 2008.
Conclusion
Financial markets create an open, regulated system for companies to acquire large amounts of capital. This is done through stock and bond markets. The markets also allow these companies to offset risks. They do this with commodities, currency futures, and other derivatives.
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