Types of Financial Markets

Part 2 Types of Financial Markets
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Financial markets is a loose term that is used to describe a whole range of different markets or asset characteristics, many of which can fit into more than one category. In its simplest form we can say that a market describes any platform that brings together buyers and sellers or borrowers and investors for the purpose of trading.

Financial Market Categories:

    • Money Markets
      – Short Term Debt Market
    • Capital Markets
      – Equity Markets
      – Primary And Secondary Markets
      – Bond Market
    • Spot And Futures Markets
    • Commodities Markets
    • Foreign Exchange Markets (Forex)
    • Derivatives Markets
      – Exchange Traded And Over The Counter
    • Insurance Markets

These are the broad categories of markets which can be further defined or categorised based on: the products within them, the participants or a characteristics such as the timeframes for settlement of trades.

For example the capital markets have the equity markets (stock markets) which can be further divided into primary and secondary markets.

In this article – the second in our Trading Basics Series – we will explain what each of these markets are and their defining characteristics.

Table of Contents

What Are Money Markets?

The defining characteristics of Money Markets are the type of asset – debt – and the timeframe, which is defined as less than a year in duration. In effect money markets are short term debt markets characterized by high levels of safety and low levels of return.

Money markets are short term debt markets characterized by high levels of safety and low levels of return.

Purpose of Money Markets

The primary purpose of the money market is to provide short term funding for cash flow or working capital. This is a crucial mechanism for the good health of the financial markets and helps to provide stability in the financial markets.

This is a huge market and the timeframe for lending is often less than a day in the case of overnight lending markets between the large financial institutions (and between the central bank and commercial banks).

Borrowers use this market to fund short term cash flow obligations but it is also useful for investors with excess capital to make some return on their money without locking it up for long periods of time.

Main purpose of Money Markets is for managing cash flow.

Further reading: for more information on the money markets, have a look at this article from the Corporate Finance Institute. 

What Are The Capital Markets?

Capital Markets are those markets that exist to enable long term capital allocation. There are two main categories of capital markets: the equity capital market and the debt capital market (bond market). The equity capital market can be further divided into primary and secondary markets.

Note: The allocation of capital is one of the purposes of financial markets which is the topic of the next unit in this series: Purpose Of Financial Markets.

Equity Capital Markets

Well if you were waiting for stock markets here they are. The equity markets are the most well known markets amongst the general public for the obvious reason that this is where the shares of the companies that we interact with in our daily lives are traded like Apple, Google, Facebook and so on.

Despite it’s fame, these markets are not the largest markets in the world and there are larger markets both in terms of the amount of capital and trade volumes.

However, these markets are still very large. The market value of the US stock markets was over $36T (Source: https://siblisresearch.com/data/us-stock-market-value/). The US markets are the largest in the world comprises over half of global equity:

Statistic: Distribution of countries with largest stock markets worldwide as of January 2020, by share of total world equity market value | Statista
Find more statistics at Statista

Primary and Secondary Markets

You will often hear these terms describing a market. What these terms are describing is the initial creation of a financial product and access to it. A primary market is where a product is sold for the first time and in effect created.

In the example of a company that would be an IPO (initial public offering) where investors buy the shares of that company for the first time. The secondary market is then where the shares can be sold on to other investors and on and on…

Secondary markets are very important for the functioning of the financial system as investors would be reluctant to invest money into companies, debt or other projects if there wasn’t a way to sell their investments at a later date if they wished to.

As retail investors it is unlikely that you will have access to primary markets, except in the case of some particular cases like crowdfunding. There are benefits and risks to both types of markets.

Primary markets can offer a higher return but at the risk of illiquidity in the short term (as it may take time before an investment can move to the secondary market /or no secondary market is available).

The other con is having to hold for a longer time and incur the opportunity cost of capital – which is basically having your capital locked up in one investment when a better opportunity may be available.

Taking part in the secondary market may feel like missing out but there is a great benefit in that these markets are much more liquid meaning you can get out of your investment easier and move on to another opportunity.

Takeaway: Primary and secondary markets can be defined as markets themselves or as subsets of markets. For example both the Bond and Equity markets will have primary and secondary markets.

Debt Capital Markets

Debt markets are often referred to as Bond Markets. Bonds are simply a term used to describe a debt instrument that is issued by a government or a company. A bond is an agreement to loan money for a period of time in exchange for a small return or interest payments.

A bond is an agreement to loan money for a period of time in exchange for a small return or interest payments.

Everyone knows about debt, credit card debt and mortgages are familiar to the consumer but the sheer scale of the debt market may surprise many people – it is hard to quantify but by some estimates there was over $200 trillion in debt in the world in 2019.

The majority of money creation in the economy is via the commercial banks though loan creation (this is covered in article 4 of the Trading Basics Series – Financial Market Participants).

In fact, you could propose that money can be seen as a form of debt as whenever money is created the opposite side to that transaction is a debt obligation. This is known as the credit creation theory of banking (you can read more about that here).

What are the main types of debt?

 

All types of debt are traded in the debt markets and they can be grouped into three main categories: government debt, corporate debt and consumer debt.

Government and corporate debt is the main proponent of the capital debt markets. Where this debt is related to shorter term working capital requirements then this debt will be sought via the money markets.

The same is true for a lot of short term consumer debt. Longer term consumer debt such as mortgages, would be classified as capital market debt but it would be in the form of mortgage securities which are a combination of hundreds or thousands of mortgage debts bundled together.

Capital Market Funding Example

Let’s look at an example of a company that is looking for long term funding to invest for growth – say a new warehouse.

In this case this is a long term investment so they wouldn’t go to the money markets, they would look at the capital markets.

The company could generate money by selling new shares in the company – the equity market – but in this case they don’t want to give up equity in their business. So the company issues a bond into the market.

The company is paid upfront for the bond and agrees to pay it back over a period of time with interest. 

Spot (Cash) And Futures Markets

This is an example of a characteristic that is often described as a market itself. Spot and Futures descriptors describe the settlement terms of trades. In a spot market, there is immediate settlement of the trade (on the spot) whereas in the futures markets the trade is settled or the product delivered at a future date.

As always nothing is that simple in financial markets and although we say immediate settlement this can mean one month one less in some cases. The spot market is sometimes also referred to as the Cash Market.

What Is The Futures Market?

Futures markets are those in which contracts are traded which have a settlement or expiry at a certain date in the future. In summary this can be defined as an agreement between two parties for the delivery of goods at a set time in the future for a price agreed in the present.

Most commodities are traded as futures contracts and in these cases settlement of the trade ends with the physical delivery of goods.

Futures market refers to a contract that is settled or expires at a certain date in the future.

However there are also futures markets in non physical goods which includes some forex markets and bond markets.

The futures markets (and in particular the commodities markets) are some of the oldest types of markets and serve an important market function which we will look at again in our next article – Purpose of financial markets.

Commodity Markets

What are commodity markets?

Commodities are primary products or raw materials. These cover a wide range of products and include all mined and farmed products.

Commodities are generally grouped into three main categories:

  • Energy
  • Metal
  • Agricultural

Energy products are things such as oil and natural gas. There are a wide range of metals traded including gold, silver, copper, platinum and so on. These mined products are often referred to as Hard Commodities.

Agricultural products cover all farmed or grown goods. These are often referred to as Soft Commodities. The definition of soft commodities is not fixed and may differ between exchanges.

Some may only include sugar, cocoa, coffee, and orange juice as soft commodities whereas others may add other agricultural products such as wheat and corn and also livestock. Lumber is also part of the agricultural category.

Forex Markets

The foreign exchange market or Forex market, is the world’s most traded and liquid market with some estimates saying that there is a daily trading volume of $5 trillion!

The forex market is where currencies are traded or exchanged against each other. As such these markets are always referred to in pairs. For example Euro / US Dollar, British Pound / US Dollar, US Dollar / Japanese Yen and so on. When we describe a currency pair the first currency in the pair is known as the reference currency. 

So in the example of the EUR/USD, the Euro is the reference currency and if we say the EUR/USD is down, we mean that the Euro has lost value in relation to the dollar.

Many currencies and currency pairs are referred to by specific names in trading circles such as Cable, Loonie, Ninja, Kiwi and so on. We have included a handy guide to currency pairs and a free pdf download (click the image below).

What Drives The Forex Markets?

There are many factors that affect the forex markets market and these mostly fall into the are of Macro-Economic factors (which we discuss in Part 6 of this series – What Factors Impact the Financial Markets)

Ultimately, currencies, like any other asset are prices due to supply and demand. Because currencies are always prices against each other the value of a currency cannot be easily defined by itself.

This means that a currency may be both strengthening and weakening at the same time depending on on which other currencies you are trading against.

Derivatives

Although many people talk about derivative markets, this is really a description of a type of product. Derivatives is a term that is used for any financial product whose value is based on (derived from) an underlying asset or product.

Derivatives is any financial product whose value is based on (derived from) an underlying asset or product.

Derivatives can come in many forms and can be found on Exchanges and OTC markets. Derivatives have many uses including risk management and hedging, to create liquidity in an illiquid market or to allow access to restricted markets or products. Many derivatives are institutional products which are very complex and risky and many are not even traded on public markets.

Most retail traders will be trading using a form of derivative product whose value is based on tracking the price of an underlying asset. Contracts for difference (CFDs), futures, ETFs and options are all examples of derivative products.

These products allow retail traders to trade across the full range of market types without having to own the underlying asset. For example a gold CFD allows you to trade the price of gold without having to take delivery or store any actual gold during the trade!

You can read more about derivatives in the first unit of the Trading Basics Series, Introduction to Financial Trading. In that article we also explained that there are two broad categories of marketplaces: Exchanges and OTC markets. Exchanges are generally more highly regulated and centralised and OTC markets are decentralised marketplaces (but not unregulated).

Exchanges are the most well known markets – everyone has heard of the New York Stock Exchange for example. OTC markets capture all other marketplaces that bring together borrowers and investors outside the exchanges.

There isn’t one type of category of product that is traded in either of these markets. For example you can have futures contracts traded on a formal exchange such as the CME and you can trade futures contracts on an OTC market through a broker and derivatives are traded on both.

Insurance Markets

Insurance markets exist to facilitate the re-allocation of risk. In terms of a trade one side of the trade (the customer) buys protection against a potential loss and the other side (the insurer) receives a premium (income) in return for taking on that risk.

The insurance market generates trillions of dollars of premiums every year and plays and important function in the markets for risk management.

Related Questions

Financial markets are a huge topic and we cover the fundamentals of these are covered in the first six units of the Trading Basics Series so it is well worth reading them all to get a full overview.

Resources

More Trading Basics

There is loads more to learn and we will uncover more terms in the rest of the Trading Basics blog series. Read our previous or next unit. 

Justina Nothard

Justina Nothard

Hi, I’m Justina Nothard, a retail investor trading Stock Index Futures.

I understand how hard it can be for the ordinary trader to learn the basics and find useful tools and practical information.

This is why I decided to create Nothard Trading to help you take control of your trading.

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