Day 139 Financial markets

Financial markets

As an investor, we are all familiar with the term ‘financial market’, since it is the battleground where we are seeking for profits. However, many new investors only understand the mechanism of one or a few specific markets such as the stock market, bond market or foreign exchange market. So I would like to bring up a brief explanation about the function and various types of the financial market. 

The fundamental role of the financial market is to enable the capital transfer from the surplus unit to the deficit unit in the economy. This process is completed through diversified arrangements, procedures and institutions. In fact, the market itself ensures that the efficient allocation of scarce resources in the economy. In addition, it also provides accessibility and liquidity to the securities, thus they can be traded in secondary markets. It depends on whether the transaction is proceeding through a financial intermediate or not, we could distinguish the direct financing and indirect financing approach. For instance, the direct approach is lending the money directly to the borrowers, by purchasing financial instruments or through brokers. Therefore, bonds, futures and shares are typical direct financing method. In contrast, the in-direct method is when lenders deposit their funds into a financial intermediate, and that intermediate will provide the capital to borrowers in the form of loan. 

Besides the direct and indirect financing method, there are several types of financial markets that create an immense amount of opportunities for investors. For example, the primary market raise funds for IPO from governments and financial institutions, and secondary market allow the existing shares to be traded. Moreover, the foreign exchange market transfers purchase power between different currencies, where the major types of transitions are called the spot(present settlement) and the forward(future execution within more than two days). Furthermore, the derivative market consists of four types of investments: future, forward, options and swap contract. These contracts are the legal binding agreements to buy and sell the underlying instruments or commodity in the future with agreed price, quantity and many other features. The major differences of these four contracts are the future is a formal agreement, forward is informal contract, option gives the holder choices to exercise it or not and swap normally exist between two entities as to exchange products. 

In conclusion, the financial market can be categorized into two major divisions: money market and the capital market. Where money market deals with the financial instruments with maturity period less than a year, and capital market obviously comprises long-term investments.