The ChoosaBroker Trading Academy

An Introduction to Financial Markets

Course Description

Imagine you are in the mood for an apple. You visit the fruit market, where you find hundreds of vendors. You approach one and ask, ”How much for an apple?” The vendor replies,”$1 for 2.”

Another vendor right next says, ”I’ll give you 3 for a dollar!” Yet another seller pokes in and says, ”Forget them. I’ll give you 4 apples for $1.”

To your delight, there is a little bidding war going on. But suddenly, in walks another customer and tells the vendors that she works for a restaurant and is going to buy 50 apples. All the sellers quickly forget about you and start bidding for the bigger customer.

This is a simple example of a market. Financial markets are no different from the apple market. They just sell different products. In this lesson, we will cover:

  • Financial Markets Definition and Types
  • Their Significance in an Economy
  • How Retail Investors can Participate in a Financial Market?

What is a Financial Market?

A financial market is a broad term to describe a place where people meet to buy and sell financial assets like stocks, commodities and foreign currencies. A financial market may be a physical location like the New York Stock Exchange, or a virtual network like the NASDAQ. Here, people who own a specific good they wish to sell interact with people who want to buy it. The price at which the transaction will take place is determined by forces of demand and supply. If market demand for the good is stronger, its price will rise. If supply exceeds demand for the good, the price will fall.

Why Do Financial Markets Exist?

At its most basic level, financial markets exist in order to provide a platform where providers of capital such as savers and investors can interact with users of capital such as government and  companies. This is because individuals with excess cash always seek avenues to make their money grow, while individuals with a cash deficit look for ways to raise funds. A financial market thus exists to mutually benefit both parties.

To better understand the concept, let us look at the example of a company that sells pizzas to consumers in Manchester. Business is thriving and the promoters of the company want to expand to other cities in the United Kingdom. But expansion requires capital. The promoters now have two options – either seek a loan from a bank, or bring fresh investors in to the company. They opt for the latter, and list shares of the company in the London Stock Exchange. Smart investors, sensing that the company provides a good opportunity to appreciate their capital, buy in to the shares. The London Stock Exchange, in this case, is the financial market where the seeker of capital raises funds from the investor. Upon listing, if the share price rise, the investor profits. While the promoters of the pizza business also meet their objective of acquiring funds to expand.

Different Types of Financial Markets

A financial market works by placing the buyer and seller of an asset at one place, so that they can easily find each other and transact. There are 5 broad categories of financial markets, classified on the basis of assets they offer.
  • Capital markets, which consist of:
  • Equity or Stock markets, which enable companies to raise funds through the issuance of common stock or shares, and allow the subsequent buying and selling thereof. Shanghai Stock Exchange is a fast growing emerging financial market.
  • Bond markets, which help both governments and companies to raise funds through the issuance of bonds. Most bond trading takes place in decentralized over-the-counter markets, where dealers directly transact with dealers.

Commodity markets, which facilitate investing and trading in commodities like gold, silver, copper and crude oil. Example, London Metal Exchange.

Money markets, which provide a platform to invest in short-term debt instruments with maturities of one year or less. Trading is done over the counter.

Derivatives markets, which facilitate trading in futures and options contracts that are derived from other underlying assets. Example, Chicago Board Options Exchange.

Foreign exchange market, which is a globally decentralized over-the-counter market for trading and investing in foreign currencies like the US Dollar, Euro and Japanese Yen. Among international financial markets, the foreign exchange market is the largest and the most liquid. To transact in these markets retail investors typically work with one of the leading forex brokers.

Key Functions of Financial Markets

Financial markets perform the following 4 major economic functions:

1. Mobilisation of Savings and Channelization in to Productive Uses – If an economy lacks proper institutional machinery to mobilize and invest savings, a significant proportion of its idle capital risks being misdirected in to unproductive channels. Finan cial markets give an impetus to economic growth by mobilizing savings and allocating them to the best available resources. 

2. Price Discovery – Price discovery is the mechanism by which the price of a financial asset is determined by the interaction of buyers and sellers. Competing buyers and sellers in a financial market absorb new information about an asset to determine its equilibrium price. Economists define the equilibrium price as the price at which the demand for an asset matches its supply. Since financial markets are dynamic, the equilibrium price is also constantly changing. Theoretically, the greater the number of active participants in a market, the faster is the price discovery.

3. Generation of Liquidity – An asset’s liquidity can be defined as the ease with which investors can buy and sell it. The presence of a proper financial market-place where buyers and sellers can interact creates liquidity for an asset. An investor can invest his money, whenever he desires, in the securities he deems would yield a profit. The issuer of the security on the other hand also finds stable demand for his asset. In the absence of such an institutional structure, these conditions would cease to exist.

4. Reduction in Transaction Cost – Numerous types of data and information are needed before an investor can decide to buy or sell a security. Much time and money is spent to obtain the same. A financial market makes available this information for free, thereby reducing the transaction cost of the investor. 

How to Participate in Financial Markets?

Any investor who wishes to participate in the financial markets has to go through a 3 stage process:

1. Pre-Trade – An investor has to first decide what they wish to buy and at what price.

2. Trade – Once an asset has been shortlisted, the investor is then connected to another investor who’s will ing to sell the same asset. A broker (or a dealer) facilitates this process. For most financial instruments, the broker will use a regulated exchange to complete the transaction. they provide a transparent way for these individual investors to grow their wealth. There is a comprehensive list of the top online brokers available.

3. Post Trade – The final stage involves a settlement process that enables the financial asset to be le forms, gally transferred to the buyer and the cash to be credited to the seller.

Final Notes

Financial markets provide an open and regulated system for both governments and companies to fulfil their capital requirements. This is done through the stock and bond markets. Financial markets also allow these governments and businesses to offset their risk. This is done through the derivatives, commodities and foreign exchange markets. Retail investors also participate in large numbers. They trade and invest to profit from fluctuations in prices of assets. Since financial markets are public plat

Multiple Choice Quiz Questions

Module 1