Financial markets have evolved significantly over several hundred years and are undergoing constant innovation to improve liquidity..
Both general markets (where many commodities are traded) and specialized markets (where only one commodity is traded) exist. Markets work by placing many interested buyers and sellers in one "place", thus making it easier for them to find each other. 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 such as a gift economy.
In finance, financial markets facilitate –
– and are used to match those who want capital to those who have it.
Typically 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 or dividends.
The term "market" is sometimes used for what are more strictly exchanges, organizations that facilitate the trade in financial securities, e.g., a stock exchange or commodity exchange. This may be a physical location (like NYSE) or an electronic system (like NASDAQ). Much trading of stocks takes place on an exchange; still, corporate actions (merger, spinoff) are outside an exchange, while any two companies or people, for whatever reason, may agree to sell stock from the one to the other without using an exchange.
Trading of currencies and bonds is largely on a bilateral basis, although some bonds trade on a stock exchange, and people are building electronic systems for these as well, similar to stock exchanges.
Financial markets can be domestic or they can be international.
The capital 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.
Without financial 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.
More complex 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.
The following table illustrates where financial markets fit in the relationship between lenders and borrowers:
|Relationship between lenders and borrowers|
|Lenders||Financial Intermediaries||Financial Markets||Borrowers|
Companies 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.
There are 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.)
Companies borrow money to aid short term or long term cash flows. They also borrow to fund modernisation or future business expansion.
Governments 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).
Governments 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.
Many borrowers have difficulty raising money locally. They need to borrow internationally with the aid of Foreign exchange markets.
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 economics.
Seemingly, 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.
The picture of foreign currency transactions today shows:
Much effort 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.
The scale of changes in price over some unit of time is called the volatility. It was discovered by Benoît Mandelbrot that changes in prices do not follow a Gaussian distribution, but are rather modeled better by Lévy 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 deviation.
Only negative 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.
Stories that 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.
Financial 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.