In this section of our website, you will find articles all about the financial world and, in particular, the financial markets. But what are the financial markets? What are the different types of financial markets?
In this overview of the financial markets, we will provide answers to these questions, exploring in detail the different financial markets and how they interact with each other.
Table of Contents
What Are Financial Markets?
The financial markets are where people and institutions convene to trade financial securities such as stocks, commodities and foreign currency.
The financial markets play a key role in our economies - providing capital for businesses to grow and entrepreneurs to fund ventures, whilst creating a potential return for those who have excess funds to lend or invest.
Types of Financial Markets
When most people hear the term “financial markets”, chances are the first thing they think of is the stock market. Whilst this is a financial market, it is merely one of many. Below are listed some of the main types of financial markets which we will explore in greater detail in the following sections.
- Capital Markets
- Money Markets
- Derivatives Markets
- Spot Market
- Commodity Markets
- Foreign Exchange Market
- Cryptocurrency Market
What Are Capital Markets?
The capital markets are the financial market where capital is exchanged between those who have capital to invest, investors, and borrowers who need capital for long-term use, such as businesses or governments.
In exchange for their capital, investors receive either shares or bonds and the issuer uses the newly-raised capital to fund a specific project or simply to help fuel future growth.
Bonds vs Stocks
Both stocks and bonds are issued by entities in order to raise capital, and are purchased by investors seeking to make gains. But the ways in which they achieve this are very different.
In the table above, we have provided definitions of both shares and bonds, but let’s take a quick look in more detail at the similarities and differences between the two.
As shareholders, investors own equity in the company, essentially becoming part-owners of the business in question.
Shareholders, therefore, share in the fortunes of the company, meaning that the success of their investment depends on the success of the company. Furthermore, buying shares usually (but not always) comes with voting rights, meaning that shareholders can vote on certain decisions made by the company.
On the other hand, when an investor purchases a bond, they are lending money to the bond issuer. In exchange for the debt, the bond issuer agrees to repay the full amount, together with any applicable interest, by a fixed date in the future.
Once issued, the repayment amount and the interest rate remain fixed, meaning that, unlike stocks, the bondholder’s investment is not impacted by the issuing entity’s performance (unless the issuing entity are forced to default on the debt).
So, the capital market is made up of both the stock market and the bond market, but we can further segment each of these financial markets into the primary and secondary capital market.
Primary Capital Market Definition
In the primary capital market, investors purchase newly created bonds and shares directly from the issuer, in what is known as the primary offering.
In the case of shares, when a previously privately-owned company decides to turn into a publicly-owned one, many choose to do so via an Initial Public Offering (IPO). During an IPO a company creates new shares which they sell in the primary market mainly to institutional investors.
Once a company has gone public, they can create and sell shares more shares in the primary market to raise capital in what is known as a Follow-on Public Offering (FPO).
Similar processes take place when companies borrow money by issuing new bonds.
Secondary Capital Market Definition
So, what about the secondary capital market?
The secondary market is the part of the capital market where existing assets, which were originally purchased in the primary market, can be bought and sold amongst investors.
The majority of retail investors will operate mainly, or exclusively, in the secondary capital market, as the primary market is typically occupied by institutional and other large investors.
Money Market Definition
Whereas the capital markets facilitates long-term borrowing for governments and corporations, the money market provides short-term loans, generally for a period of up to one year.
Products exchanged in the money markets are commonly referred to as “paper”. These products are highly liquid, low-risk and, consequently, have relatively low returns in comparison to other financial instruments.
Examples of products which are exchanged in the money markets include:
- Certificate of Deposit (CD): CDs are usually sold by banks and have specific fixed terms as well as usually having a fixed rate of interest. CDs tend to be held until maturity at which point they are repaid together with interest.
- Commercial Paper: This is an unsecured promissory note, much like an “IOU”, which undertakes to repay a set amount by its maturity, which is usually up to 270 days, together with any applicable interest. Commercial paper is usually sold at a discount to its face value and can be bought and sold after it has been issued. Due to their unsecured nature (i.e. they are not backed by collateral), organisations can only sell commercial paper for a reasonable price if they have a solid credit rating.
- Treasury Bills: Short-term debt sold by governments which do not pay interest but are sold at a discount to the face value.
As well as these instruments, and others, retail investors can choose to invest in money market funds, which are funds designed to invest specifically in the money markets. These types of funds are suitable for investors with a short time horizon and a low appetite for risk.
What Is the Derivatives Market?
So far, the two types of financial markets we have examined serve the purpose of matching those seeking to borrow money with those looking to invest, whether that be over the short-term or long-term.
The next type of financial market we will look at is the derivatives market, which serves a very different purpose to both the capital markets and money markets.
Instead of matching borrowers and lenders, the derivatives market is mainly used for speculating on the price of various different assets and hedging against risk. Derivatives fit these roles perfectly as they can be used by traders to speculate on both rising and falling prices by going either long or short.
A derivative product represents a contract between two or more parties, whose price is derived from an underlying asset. Unlike other financial products such as stocks and bonds, a derivative product itself has no intrinsic value, but rather bases its value on that of the underlying asset.
Derivatives can be traded on a wide variety of assets - including stocks, bonds, commodities and foreign currency – and allow traders to speculate on changes in price without ever having to take ownership of, or deliver, the underlying asset. They are either traded on exchanges or “Over-the-Counter” (OTC) - which refers to trading conducted directly between two parties without the supervision of an exchange.
In the following sections, we will take a look at three of the most popular types of derivative products:
- Futures Contracts
- Options Contracts; and
- Contracts for Difference (CFDs).
What Are Futures Contracts?
Futures contracts, or simply futures, represent a legally binding agreement between two parties, a buyer and a seller, to exchange an asset on a fixed date in the future at a predetermined price.
Futures contracts are bought and sold on futures exchanges and are standardised for both quantity and quality. This characteristic of being standardised means that all contracts for a particular asset will have the same terms, regardless of who the parties are.
Traders can trade futures on margin, meaning that they only need to deposit a fraction of the value of the contract in order to open a position. However, due to their standardised nature, contracts tend to be for large quantities and, therefore, high prices. This, coupled with various other factors, make futures less suitable for less-experienced traders.
As futures have an expiry date, traders are limited as to how long they can hold a position open before being compelled to either exit the market, honour the contract or “rollover” the futures contract to a later month (a process which essentially involves closing their current position and opening a position for the same value in a contract with a further-out month of expiry – incurring any losses, or receiving any gains, in the process).
The price of a futures contract, therefore, as well as being based on the underlying asset, is also influenced by how long is left until its maturity date. This also makes futures contracts, like most other derivative products, less than ideal for long-term exposure.
What Are Options Contracts?
Like futures, options are bought and sold on exchanges and represent an agreement regarding the exchange of an underlying asset in the future.
Unlike futures, however, an option provides its holder with the right, but not the obligation, to buy or sell (depending on the type of option) the underlying asset for a fixed price, known as the strike price, by the expiration date.
There are two types of options: calls and puts.
The seller of an option is known as a writer and is obligated to conduct their side of the transaction if the buyer of the call or put chooses to exercise their right to buy or sell.
What Are Contracts for Difference?
Contracts for Difference (CFDs) are an example of an OTC derivative product. A CFD represents an agreement between two parties to exchange the difference in the price of an asset from the time at which the contract is opened until it is closed. Upon the contract’s closure, the difference in price is settled in cash.
Unlike futures and options, CFDs usually have no expiration date and, therefore, can theoretically be held open indefinitely. However, due to being a leveraged product, traders are charged swap fees for positions which are held open overnight, making CFDs more appropriate for traders operating over a shorter time horizon.
CFDs can be traded on most financial assets and, indeed, can also be traded on other types of derivative products. For example, it is possible to trade CFDs on various types of futures contracts, in which case the CFD will share an expiry date with the future contract in question. However, since traders often do not actually own the underlying futures contract, they are not obligated to deliver, or take delivery of, the underlying asset when the contract expires.
What Is the Spot Market?
Standing in contrast to the derivatives market is the next on our list of types of financial markets: the spot market.
Whereas the derivatives market deals largely with speculation on the future prices of various assets and hedging against risk, the spot market is the type of financial market where assets are bought and sold for immediate delivery.
In the spot markets, which are also sometimes referred to as cash or physical markets, settlement of the transaction usually takes place T+2 (the day of the trade + two working days), but both parties agree to the transaction “right now”.
From the spot market we get the term spot price, which is used in the financial markets to refer to the price at which an asset can be immediately bought or sold. In spot markets which have heavy trading volumes – such as crude oil, for example – the spot price will constantly fluctuate throughout the trading day as new orders are constantly being placed and filled.
Although the term may be new to you, a spot market is simply any financial market where assets are exchanged immediately. For example - stock exchanges, such as the New York Stock Exchange - are examples of spot markets, as both traders and investors exchange shares for immediate delivery.
Spot Market vs Derivatives Market
Despite being very different financial markets in terms of how they operate, the derivatives market and the spot market are very closely linked.
This is because the prices of all derivative instruments are based on the spot prices of their underlying asset. For example, the price at which a futures contract is bought and sold for will depend largely on what the current spot price of the underlying asset is, as well as several other factors such as the amount of time until the contract’s expiry.
On the other hand, CFDs simply track the spot price of their underlying asset with no other considerations (with the exception of CFDs which are traded on other derivative products).
Commodity Market Definition
The commodity market is one of the oldest types of financial markets on our list, dating back as far as 4500 BC and predating the capital markets by many, many centuries. The commodity market refers to any location where producers and purchasers meet to exchange physical commodities, a practice which has been going on since the early days of civilisation.
Commodities are basic goods, or raw materials, which are essentially the building blocks for producing other more complicated goods and services. There are four main types of commodities:
Commodities are also often categorised as either soft or hard commodities. Soft commodities refer to agricultural commodities and livestock, whereas hard commodities refers to metals and energy.
The exchange of commodities can take place either on the spot market, with physical commodities such as gold being bought and sold for immediate delivery, or via derivatives such as futures and options, with the future delivery of commodities being agreed upon.
These days, the majority of commodity trading takes place electronically via commodity exchanges such as the Chicago Mercantile Exchange (CME) and the Intercontinental Commodity Exchange (ICE).
What Is the Foreign Exchange Market?
With a daily turnover of $6.6 trillion in 2019, the Foreign Exchange (Forex) market is by far the largest type of financial market in the world.
As the name implies, the Foreign Exchange market is where participants from all around the world meet in order to buy and sell foreign currency and, therefore, it in this market that the foreign exchange rates for every currency in the world are determined.
The Forex market is decentralised, with transactions taking place around the world electronically and over-the-counter, as opposed to through a single exchange. Forex trading takes place via both the spot and derivatives market.
As well as being the largest and most liquid financial market in the world, another stand out feature of the Forex market is that it operates around the clock, facilitating trading 24 hours a day between Monday and Friday.
This combination of liquidity, volume and around the clock trading make it an incredibly popular destination for speculators, as it provides an abundance of trading opportunities.
As well as being the largest and most heavily traded financial market in the world, it is also possibly the most important, as it facilitates global trade and foreign investment through currency conversion. For example, the Forex market allows a business in the United Kingdom to import goods produced by a business in China and pay them in Chinese yuan, despite obviously earning its income in Great British pounds.
Foreign currencies are traded in pairs, meaning that no absolute value is assigned to a currency, but rather its value is shown relative to another currency. For example, the GBP/USD (Great British Pound / United States Dollar) currency pair shows the value of the GBP priced in USD. So, if the GBP/USD currency pair equated to 1.5000, this would mean that one unit of GBP would cost 1.50 USD.
Major, Minor and Exotic Currency Pairs
Different currency pairs have different levels of popularity amongst market participants and, therefore, different levels of trading volume and liquidity. Currency pairs are often split into: Major Pairs, Minor Pairs and Exotic Pairs.
Major currency pairs are the six most popular and heavily traded currency pairs which are partnered with the US dollar.
Minor currency pairs refer to pairs which are not partnered with the US dollar and have less trading volume than the major pairs. Some examples of popular minor currency pairs include EUR/GBP, GBP/JPY and EUR/CHF.
Exotic currency pairs are pairs which involve currencies from emerging economies and are traded far less frequently than the majors and minors. Examples of exotic currency pairs include USD/MXN (US dollar / Mexican Peso), USD/BRL (US dollar / Brazilian real) and USD/RUB (US dollar / Russian rouble).
Forex Market Participants
So, who are the main participants within the Forex market itself? We can identify five major players.
- Banks: The greatest volume of currency trading takes place within what is known as the interbank market, where banks trade currencies between each other on their own, and their clients’, behalves.
- Governments and Central Banks: Governments and central banks are active within the Forex market too. Governments generally participate to facilitate payments for international trade, whilst central banks participate in order to influence domestic currency. Central banks can do this by buying or selling large amounts of currency reserves in an attempt to strengthen or weaken their currency.
- Hedge Funds and Investment Managers: Hedge funds and investment managers trade large volumes of currencies in order to purchase foreign assets and may also speculate on Forex as part of their overall strategy.
- International Companies: Large international businesses are responsible for a lot of trading volume in the Forex market. Companies which employ workers in foreign countries must buy currency in order to pay them and, likewise, companies which import components from abroad must do the same.
- Individual Speculators: And, right at the bottom of the food chain, are individual speculators, who trade Forex in an attempt to profit. Whilst this segment of the market is no doubt the smallest, it is a segment which has grown rapidly thanks to advances in technology which have made the financial markets much more accessible in recent years.
Forex Sessions
As we noted above, during the week, the Forex market is open for trading around the clock. Trading takes place via a vast global network of banks, exchanges and brokers and the trading day is split into different sessions depending on which countries are trading at that time.
There are four major trading sessions, with the name of each session given to the city which acts as the major financial hub during the relevant session. These four sessions are named as follows:
- Sydney
- Tokyo
- London
- New York
As one of these major Forex sessions begins to wind down, the next opens, before the cycle starts all over again and then ends for the weekend. The hours for each session always remain the same in their local time but, because of daylight savings, the hours of foreign sessions vary depending on what time of year it is.
What Is the Cryptocurrency Market?
Of all the different types of financial markets, the cryptocurrency market is the new neighbour on the block, making lots of noise and attracting lots of attention – some good and some bad.
At first this attention was strictly limited to a handful of retail traders and investors but, in recent months, the market has grown, making more of a name for itself and attracting attention from more established players within the markets. Arguably the most notable event in cryptocurrency’s short history was the introduction of Bitcoin as legal tender in El Salvador towards the end of 2021.
But what is cryptocurrency?
Cryptocurrency, colloquially referred to as crypto, is a decentralised digital currency which uses cryptography in order to secure transactions, verify coin ownership and control the creation of new coins. Due to its decentralised nature, crypto operates without reliance or regulation from a central bank or government, allowing its value to be determined purely by market forces without intervention.
Bitcoin was the first cryptocurrency which was initially released in 2009, and it remains the most well-known cryptocurrency and the largest in terms of market capitalisation. However, since Bitcoin’s inception, a multitude of other cryptocurrencies have followed – including Ethereum, Litecoin and Dogecoin.
Cryptocurrency can be traded via centralised crypto exchanges, however, there have been numerous cases where users on such platforms have been the victims of hacking. Decentralised exchanges also exist, which allow traders to exchange crypto directly without a third party enabling the transaction. Furthermore, crypto can be traded using derivative products such as futures, options and CFDs.
Cryptocurrency has a reputation of being incredibly volatile and, therefore, is an asset which should be approached with caution by traders. Given its unpredictability in price, there are still many within the financial world who remain sceptical about cryptocurrency’s prospects as a long-term investment.
However, the high level of volatility has made cryptocurrencies increasingly popular with short-term traders, many of whom seek these exact conditions in order to profit from short-term movements in price by using derivative products, such as CFDs, to go both long and short.
Final Thoughts
In this article, we have highlighted the main different types of financial markets and explained them all in detail.
Financial markets are essential to the successful and efficient running of capitalist economies, ensuring that capital flows to where it is needed the most.
This capital allows companies to operate efficiently and grow, it allows governments to build and maintain their country’s infrastructure, it allows savers and investors to grow their wealth and it allows families to borrow money to buy their homes.
When the financial markets falter, the flow of capital slows, and economies suffer as a result. Businesses underperform and output falls, which can result in recessions and an increase in unemployment.
Hopefully, as well as being aware of the different financial markets, you understand more about how they support the economy and their importance in the modern world. Now that you have a better understanding of all of this, feel free to explore the other articles in this section of our website to take a deeper dive into the various goings on of the financial world.
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