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Financial Markets

Financial Markets

Have you ever had to exchange currencies when you travel to another country? Have you or your parents ever purchased insurance? Do you know someone who borrowed money for higher education? All of these transactions are possible due to the existence of the financial markets. What are financial markets, exactly? What specific role do they play in our society today? We will explain everything in this explanation.

What are financial markets?

Financial markets are markets of short-term, long-term, or undated financial assets or securities.

Financial markets exist to satisfy the individuals’, corporations’, and governments’ needs for lending and borrowing. Thanks to financial markets, businesses and governments can raise capital for their financial needs while the investors (buyers of financial assets) can earn some interest on their idle income.

What are the main roles of financial markets?

A market exists to meet the need of buyers and sellers.

In the past, one could only trade goods and services in nearby locations. Nowadays, a market can operate without geographical boundaries. With the help of the Internet, modern markets have become truly global, allowing transactions to be carried out 24/7.

The UK plays host to many international financial institutions, including the British International Investment and European Bank for Reconstruction and Development, but there are also smaller financial markets within the national borders like the Money Market of UK Treasury Bills and Commercial Bills.

Everywhere around the world, financial markets operate around six main functions:

  • Facilitating savings: financial markets provide a means for people to transfer their money power from the present to the future. For example, you can put aside some money for savings or invest in bonds and shares to earn future interest.
  • Providing loans: in the capital market, corporations or the government can issue loans and bonds in exchange for public money. Bonds, in the case of a corporation, are loans made by an investor to a business in need of cash for operations and growth.
  • Allocating capital to more productive use: people can invest their extra cash in a business function to collect interests instead of sitting idle in a bank account.
  • Facilitating transactions: financial markets provide a way for buyers and sellers to interact and exchange funds for their transactions.
  • Providing forward markets: in forward markets, you can offer to buy a product in the future at a pre-determined price to avoid price volatility.
  • Providing a market for equities: an equity market is a market of shares. A company can sell shares to the public in exchange for capital to grow. An individual investing in the company’s shares can also earn a return on investment, usually in the form of dividends - a fixed amount of money paid at a certain period provided the business performs well.

Types of financial markets in the UK

In the Financial Sector explanation, we discussed briefly the different financial markets in the UK.

Let’s review with a diagram:

Financial Markets Financial market components StudySmarterFigure 1. Main financial markets in the UK, StudySmarter Original

As you can see in Figure 1, the UK financial market is divided into three: the money market, which trades short-dated financial assets and the capital market, which supplies long-dated or undated financial assets. In addition, there are foreign exchange markets for currency exchanges.

The UK’s money market

The UK’s money market supplies short-dated financial assets with maturities (date of asset expiration) ranging from one day to a year.

The assets in the money market are highly liquid, meaning they can be converted to cash easily without losing value. Some examples include treasury bills (short-term securities issued by the governments) and commercial bills (short-term securities issued by commercial banks). In the money market, banks serve as an intermediary between savers and borrowers.

London interbank market is a major component of the UK’s money markets. It sets the LIBOR (London Interbank Offered Rate) interest rate which is the interest rate banks charge when lending to each other.

To learn more, read our article on The Money Market.

The UK’s capital market

The UK’s capital market issues shares and bonds to help businesses and the government raise medium to long-term capital.

There are two types of capital markets: primary markets of newly issued bonds and shares and secondary markets trading existing financial assets.

One major secondary market in the UK is the London Stock Exchange (LSE) which allows public limited companies (PLCs) to raise capital for their long-term growth. Government finance is facilitated by the bond market through gilts (UK government bonds).

To learn more, read our article on The Capital Market.

Foreign exchange markets

Foreign exchange markets or Forex (FX) facilitate the global trading of different currencies in an economy.

We can classify foreign exchange markets into spot markets and forward markets. Spot markets handle current foreign exchanges, whereas forward markets buy and sell foreign exchanges that will take place at a later date. The foreign exchange rate in forward markets is settled now but applied in the future when the transaction is carried out.

Large international and commercial banks are major participants in foreign exchange markets.

Examples of financial markets

Let’s now take a look at some examples of financial markets.

Money market example

Treasury bills are debt securities issued by the Debt Management Account in the UK on a weekly or ad hoc basis.1

The maturity of Treasury bills can range from one day to a year. However, most bills mature in one, three, or six months.

Capital market example

Bonds are a component of a capital market. A bond is a loan that investors give to a firm or the government to cover their long-term financial needs.

In the UK, government bonds are referred to as gilts. Gilts are safer to invest in than most financial assets, though they are not risk-free due to inflation, interest rate, and liquidity issues.

Figure 2 demonstrates the increase in UK government bonds’ value from 2000 to 2020, measured in million British pounds. In 2020, the total bond value nearly reached 2 trillion British pounds.

Financial market British government bonds StudySmarterFigure 2. British government stock (gilts). Source: Office for National Statistics UK, ons.gov.uk, StudySmarter Original

Forex market example

The forex market is the global market for foreign exchange transactions. Foreign exchange is the trading of one currency for another. For example, in Figure 3, we see the exchange rates between the British pound GBP and Euro over a 20-year period.

In 2000, the exchange rate was 1.6, which means for every British pound you could acquire 1.6 Euros. Ten years later, it had dropped to 1.2: one British pound was equivalent to 1.2 Euro. Such a fall in the exchange rate is called depreciation - a decline of one currency’s value relative to another.

Financial markets foreign exchange rate example StudySmarterFigure 3. Average Sterling Exchange Rate: Euro, from 2000 to 2020. Source: Office for National Statistics UK, ons.gov.uk, StudySmarter Origin

Financial markets’ failures

Financial market failures happen when the market fails to operate efficiently. This results in a significant loss in economic output.

Like many types of markets, the financial market is largely influenced by a price mechanism. That is, the system through which the prices of goods and services are determined based on the market demand and supply. When the price of a financial asset deviates too far from its actual value, financial market failures will occur.

Financial market failures are grouped into four main types: financial crisis, market bubbles, asymmetric information, and market rigging.

Financial crisis

A financial crisis happens when the prices of financial assets reduce sharply, leaving businesses and consumers alike unable to pay off their debts. During a financial crisis, banks and other financial institutions may experience liquidity shortages. Financial crises can be triggered by systemic failures, uncontrollable human behaviours, or the lack of governmental regulations.

Some examples include the Argentine Great Depression and the Lebanese Currency Crisis.

Market bubble

A market bubble happens when a financial asset is overvalued due to overly optimistic projections about the future, followed by a drastic drop in the price.

The Dot-com Bubble is a famous example of a market bubble. In the 1990s, there was a surge in investment in technology-based companies and the Internet, which quickly drove up the price of the stock in this sector. However, after the market peaked, the price nosedived, sparking a panic among investors and up to 10% of loss in the stock market.

Asymmetric information

Asymmetric information is the state where one party has information that the other does not have. In a transaction, when either the buyer or seller has asymmetric information, they can use this to drive more benefits for themselves.

For example, an owner of a used laptop doesn’t reveal to their buyer its defects. As a result, the buyer may pay a higher price than they should.

Market rigging

Market rigging happens as firms raise or fix prices to generate higher profits for themselves. The practices of market rigging are often referred to as price-fixing or collusion.

In the case of price-fixing, a market leader can increase the price of a product, which allows smaller firms to raise the price as well, causing customers to pay a higher price for the commodity.

Financial Markets - Key takeaways

  • Financial markets are markets where the trading of financial assets take place.
  • There are three main types of financial markets: money markets, capital markets, and foreign exchange markets.
    • Money markets issue short-dated financial assets such as treasury bills and commercial bills.
    • Financial markets issue medium to long-dated or undated financial assets such as bonds and shares.
    • Foreign exchange markets facilitate the exchange of one currency for another.
  • Financial markets operate around six main functions:
    • Facilitating savings
    • Providing loans
    • Facilitating transactions
    • Allocating capital to more productive use
    • Providing a market for equity
    • Providing forward markets
  • Financial market failures happen when the market fails to operate efficiently resulting in a significant loss in economic output.
  • Financial market failures are grouped into four main types: financial crisis, market bubbles, asymmetric information, and market rigging.

References

1. Georgina Hutton and Ali Shalchi, Financial services: contribution to the UK economy, House of Commons Library, 2021.

Frequently Asked Questions about Financial Markets

A financial market is a market where financial assets or securities are traded. Thanks to a financial market, businesses and governments can raise short or long term capital for their financial needs. 

Bonds and shares are the main financial instruments traded in the capital markets. Bonds are loans issued by the government or corporations whereas shares are equities representing ownership of a company. Bonds in the capital market have a maturity of one year or more and offer a fixed interest rate. Shares have no maturity dates and pay shareholders dividends as part of the company's profit. A firm can choose to pay out dividends or retain them for future investment. 

The financial market has many roles in an economy, including: 

  • Facilitating savings
  • Providing loans
  • Facilitating transactions 
  • Allocating capital to more productive use
  • Providing a market for equity
  • Providing forward markets

Final Financial Markets Quiz

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What kind of financial assets is issued in the capital market?

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Medium to long-term or undated financial assets such as bonds and shares. 

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What is a capital market? 

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The capital market faciliates the lending and borrowing of medium to long-term or undated financial assets. 

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What is the most significant difference between the capital market and the money market?

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The capital market facilitates the trading of medium to long-term or undated financial instruments whereas the money market supplies short-term securities which mature in less than one year. 

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How is the capital market classified?

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Into the primary market and the secondary market.

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What is the difference between the primary market and the secondary market?

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The primary market issues and trade securities in public for the first time whereas the secondary market trades the existing securities. 

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Where do investors purchase securities from in the primary market? 

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They can buy securities directly from the issuer. 

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What does initial public offering (IPO) mean?

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The first issue of a private company's stock on the market is called IPO. 

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Give some examples of stock exchanges.

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New York Stock Exchange, London Stock Exchange, NASDAQ.

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What is a bond? 

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Bonds are loans issued by the government or companies to fund their future spending or investment.  

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What are some types of bonds?

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Corporate bonds, foreign bonds, municipal bonds, and government bonds.

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Are government bonds risk-free?

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It's generally safer to invest in government bonds than other securities. However, they are not risk-free due to issues related to interest rates, inflation, or liquidity. 

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If a US firm issues a foreign bond in the UK, what will be the currency of the capital raised? 

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British pound sterling

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Which bond is often issued by a large and influential firm?

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Investment-grade bond

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What kind of share (equity) gives the shareholder a voting right in the company?

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Ordinary share 

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What is bond yield?

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Bond yield is the long-run interest rate earned by bond holder. 

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What are two ways to calculate bond yield?

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  • Current yield
  • Yield to maturity

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What is the relationship between bond price and long-term interest rates (bond yield)?

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Bond yield and interest rates have an inverse relationship, meaning they move in opposite directions.

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What are the main functions of the capital market?

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  • Raise capital
  • Connect buyers and sellers of securities
  • Boost economic growth
  • Consumption smoothing

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What are financial markets?

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Answer

Financial markets are markets of financial assets or securities. 

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What are the key functions of financial markets?

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  • Facilitate savings
  • Provide loans
  • Facilitate transactions. 
  • Allocate capital to more productive use
  • Provide a market for equity
  • Provide forward markets

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What do financial markets include?

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Money markets

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What are foreign exchange markets?

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Foreign exchange markets are markets where foreign currencies are traded.  

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What financial assets are in the money market?

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Treasury bills

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Which is not included in the capital market?

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Bonds

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What is the biggest secondary market (stock exchange) in the UK?

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London Stock Exchange (LSE)

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What is another name for UK government bonds?

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Gilts

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What is the difference between spot markets and forward markets?

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Spot markets handle current foreign exchanges whereas forward markets buy and sell foreign exchanges that will take place at a later date.

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What are major participants in foreign exchange markets?

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Large international and commercial banks are major participants in foreign exchange markets.  

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What is LIBOR stand for? 

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London Interbank Offered Rate, which is the interest rate banks charge when lending to each other. 

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How long does it take for financial assets in the money market to expire? 

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Financial assets in money markets have maturities ranging from one day to a year. 

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What are the characteristics of financial assets in money markets?

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These assets are highly liquid, meaning they can be converted into cash easily without losing value. 

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What institutions play an important role in the money market?

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Banks. 

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Which type of market supplies short-dated financial assets?

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The money market.

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What is money and its main function?

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Money is a medium of exchange or a means of payment. It is also a store of value for future transactions.  

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What does the 'store of value' function of money mean?

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Money is an asset that allows people to store their wealth. Most people prefer to hold their money instead of investing in financial assets such as bonds, shares, real estate, or art. 

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What's the problem with holding cash?

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Money stored in cash is subject to inflation, which means your cash will be worth less in the future. 

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What are the functions of money?

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A medium of exchange.

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What is the 'unit of account' function of money?

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Money can be used as a measure of value or a standard of deferred payment. 

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What are money markets?

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Money markets are markets that facilitate the trading of short-dated financial assets (from one day to a year). 

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What are the characteristics of financial assets in money markets?

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  • Highly liquid and can be cashed out with ease. 
  • Short-dated (one year or less).

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What are money market funds?

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Money market funds are mutual funds that invest in highly liquid and short-term debt instruments such as Certificates of Deposit (CDs), Commercial Paper (CP), Bankers' Acceptances (BA), and Repurchase Agreement (RP). 

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What are some short-term financial assets in the money market?

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  • Certificates of Deposit (CDs)
  • Commercial Paper (CP)
  • Bankers' Acceptances (BA)
  • Repurchase Agreement (RP)

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What are Repurchase Agreements (RP)?

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Repurchase agreements (RP), also known as Repo loans, is a debt instrument in which a financial institution sells securities to someone else with the promise to buy them again at a later date. In exchange, the buyer can earn interest on the purchase. 

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What kind of firms can sell Commercial Paper?

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Firms with high credit ratings to ensure they can pay back the face amount of the commercial paper on the maturity date.

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Explain briefly how banks create money. 

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Every time you deposit a certain amount of money, instead of letting it sit idle, the bank will make loans to those in need, e.g. another individual, a company or the government. Though banks don't actually transfer money from your account to another account. Instead, they create new money (yes, out of thin air!) and deposit it into the borrower's account. 

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What is the 'Reserve Requirement' of a bank?

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To ensure the money is available in case of sudden withdrawals, banks hold a number of funds in reserves, known as reserve requirements

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What are the roles of money markets in an economy?

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  • Provide funds for trading and the industry.
  • Balance the supply and demand in short-term financial transactions.
  • Boost economic growth by allowing corporations to access funds quickly.  
  • Provide the government with non-inflationary finance sources.
  • Facilitate monetary policy implementation.
  • Help with the money creation process. 

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What are money market accounts?

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Money market accounts are basically savings accounts that yield higher interest than a standard savings account. The issuer of money market accounts may limit the number of times the account holder can withdraw cash or write checks during the lending period. 

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What are interest rates?

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Interest rates are the reward for lending and the cost of borrowing money. It's a percentage paid for your investment in a loan.  

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How does the supply and demand of credit influence the interest rate? 

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The increase in credit demand will cause the interest rates to rise while a fall in credit demand will result in a drop in the interest rates. Similarly, an increase in the credit supply will reduce the interest rates whereas a decrease in credit supply will increase them.

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