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An Introduction to the Financial Markets

Definition, Types and Function

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Financial markets

Trading floor at the New York Stock Exchange.

Photo: Spencer Platt/Getty Images
What are the financial markets? That's a good question, because financial markets go by many terms, including capital markets, Wall Street, even simply "the markets". Whatever you call them, financial markets are where traders buy and sell stocks, bonds, derivatives, foreign exchange and commodities. These markets are where businesses go to raise cash to grow, companies reduce risks, and investors make money.

Types of Financial Markets

The Stock Market is a series of exchanges where successful corporations go to raise large amounts of cash to expand. Stocks are shares of ownership of a public corporation that are sold to investors through broker dealers. The investors profit when the companies increase their earnings, which keeps the U.S. economy growing. It's easy to buy stocks, but takes a lot of knowledge to buy stocks in the right company.

To a lot of people, the Dow is the stock market. However, the Dow, which is the nickname for the Dow Jones Industrial Average, is just one way of tracking the performance of a group of stocks.There is also the Dow Jones Transportation Average and the Dow Jones Utilities Average. Many investors ignore the Dow, and instead focus on the S&P 500 or other indices to track the progress of the stock market. The stocks that make up these averages are traded on the world's stock exchanges, two of which include the New York Stock Exchange and the NASDAQ. Find out more about How the Stock Market Works.

Mutual funds give you the ability to buy a lot of stocks at once. In a way, this makes them an easier tool to invest in than individual stocks. By reducing stock market volatility, they have also had a calming effect on the U.S. economy. Despite their benefits, you still need to learn how to select a good mutual fund.

The Bond Market is where organizations go to obtain very large loans. Generally, when stock prices go up, bond prices go down. However, there are many different types of bonds, including Treasury Bonds, corporate bonds, and municipal bonds. Bonds also provide some of the liquidity that keeps the U.S. economy functioning smoothly.

It's important to understand the relationship between Treasury bonds and Treasury bond yields. Basically, when Treasury bond values go down, the yields go up to compensate. When Treasury yields rise, so do mortgage interest rates. Even worse, when Treasury values decline, so does the value of the dollar. This makes import prices rise, which can trigger inflation. Treasury yields can also predict the future -- an inverted yield curve usually heralds a recession.

The Commodities Market is where companies offset their risk of purchasing or selling natural resources for future use. Since the prices of things like oil, corn and gold are so volatile, companies can lock in a known price today. Since these exchanges are public, many investors also trade in commodities for profit only, with no intention of purchasing large quantities of pork bellies, for example.

Oil is the most important commodity in the U.S. economy. It is used for transportation, industrial products, plastics, heating and electricity generation. When oil prices rise, you'll see the effect in gas prices about a week later. If oil and gas prices stay high, you'll see the impact on food prices in about six weeks.

The price of oil is determined in the commodities futures market. What are futures? They are a way to pay for something today that is delivered tomorrow. This helps to remove some of the volatility in the U.S. economy by allowing businesses to control future costs of the critical commodities they use every day.

However, futures also increase a trader's leverage by allowing him or her to borrow the money to purchase the commodity. This leverage can create outsize gains, if traders guess right. It also magnifies the losses if traders guess wrong. If enough traders guess wrong, it can have a huge impact on the U.S. economy, actually increasing overall volatility. Commodities trading was responsible for record-high oil prices in 2008 and 2011, which resulted in food riots and even the Arab Spring.

Another important commodity is gold. It's bought as a hedge against inflation. Gold prices also go up when there is a lot of economic uncertainty in the world. In the past, every dollar could be traded in for its value in gold. However, once the U.S. went off the gold standard, it lost this relationship to money. Nevertheless, this history means that many people still look at gold as safer alternative to cash or currency.

Derivatives are complicated financial products that derive their value from underlying stocks and bonds. They are primarily used by sophisticated investors and hedge funds to magnify their potential gains. In 2007, hedge funds increased in popularity due to their supposed higher returns for high-end investors. Since hedge funds invest heavily in futures, some argued they decreased the volatility of the stock market and therefore the U.S. economy. However, hedge fund investments in subprime mortgages and other derivatives caused the 2008 global financial crisis.

Even before this, hedge funds had demonstrated their risky nature. In 1997, the world's largest hedge fund at the time, Long Term Capital Management, practically brought down the U.S. economy.

Functions of Financial Markets

Financial markets create an open and regulated system for companies to obtain large amounts of financial capital to grow their businesses. This is done through the stock and bond markets. Markets also allow these businesses to offset risk with commodities and foreign exchange futures contracts, as well as other derivatives.

Since the markets are public, they provide an open and transparent way to set prices on everything traded. These prices assume that all available knowledge about everything traded is taken into consideration. This reduces the cost of getting information, because it's already incorporated into the price.

The sheer size of the financial markets provide liquidity. In other words, sellers can easily unload assets whenever they need to raise cash. The size also reduces the cost of doing business, since companies don't have to go far to find a buyer, or someone willing to sell. (Source: Iowa State University, Six Basic Functions of Financial Markets) Article updated September 4, 2013

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