2. What are Financial Markets?

Curated By
Vivek Gadodia
System trader and algo specialist

Skill Takeaways

  • Role of financial markets in the economy
  • Various types of markets
  • Participants in financial markets
  • Brief idea about instruments traded in the markets

Financial markets, as the name suggests, are markets where financial assets such as the following can be traded:

  • Stocks
  • Bonds
  • Foreign currencies
  • Commodities
  • Derivative instruments

'Financial market' is a broad term that includes many categories of markets within its fold. A well-developed and integrated financial market is pivotal for business and economic development.

Role of financial markets

Channelising savings and investments: Money loses value if it is not deployed in useful economic activity. The purpose of a financial market is to efficiently channelise savings and investments in the country towards the capital formation and enhance the production of goods and services.

Create liquidity: A robust financial market with a large number of participants provides ample liquidity for both entrepreneurs and investors.

Efficient capital raising: A wide variety of instruments available in the financial market makes it possible for enterprises to raise capital more efficiently.

Easy access: Financial markets provide easy access through various institutions and infrastructures to interested parties.

Hedge: Hedges are used as risk management tools. Financial market instruments can be used to protect investments from unforeseen circumstances.

Participants in financial markets

Individuals are, by far, the most important participant as they generally deploy their savings into banks or invest in securities.

Business enterprises access the market for funds to run their operations and for expansion. They also invest their surpluses in financial securities.

Banks deposit and lend to people in need of capital. They also deploy a part of their deposits or surpluses in various securities like shares, bonds and mutual funds.

Financial institutions raise money by issuing long-term bonds and other international sources and lend to key sectors like agriculture, small industries, housing development, etc.

Insurance companies account for a huge chunk of the national savings. The premiums received by insurance companies are for a long duration, which they deploy in long-term bonds and securities. As the subject matter of insurance is risk, insurance companies deploy their funds in long-term securities.

Mutual funds are used either as savings or growth instruments. They deploy funds mobilised from unit holders across the financial market like shares, bonds, exchange-traded funds etc. Mutual funds are considered to be reasonably safe by investors as they deploy their funds across a wide range of securities and sectors and thereby mitigate risk to some extent.

Government is the largest borrower in the system. It not only collects taxes but also borrows by issuing bonds to fund development and infrastructure projects. It is the largest issuer of bonds to which other market participants subscribe.

Regulatory bodies such as the Reserve Bank of India (RBI), the Securities and Exchange Board of India (SEBI) and the Insurance Regulatory and Development Authority of India (IRDAI) regulate and monitor the above-mentioned participants.

Intermediaries such as stock exchanges, clearing agents, brokers, custodians, depositories, credit rating agencies, etc., also are some important participants in the financial markets that facilitate their smooth functioning.

Types of financial markets

Financial markets can be classified as:

Capital market: A capital market is one where medium to long-term resources are raised. It can be classified as a bond market and stock market based on the type of instruments issued. The bond market deals with debt instruments such as debentures or government securities, while the stock market deals with equities or common shares.

The capital market has two segments - primary market and secondary market. The primary market facilitates mobilising of resources by creating and issuing securities such as bonds or equities before they are listed on exchanges. The secondary market, or stock exchange, is a place that provides the infrastructure where these bonds and stocks can be easily traded regularly and transparently.

Derivatives market: Derivatives are financial contracts that derive their value from underlying assets such as stocks, bonds, commodities, currencies, etc. The purpose of a derivative is primarily to hedge the portfolio or investments or any exposure in foreign currencies due to price fluctuations or other unforeseen market conditions.

Commodities market: The commodities market deals with primary products rather than manufactured products. It can be said that it deals in raw products used as inputs in manufacturing finished products. It can be broadly classified as agricultural commodities like cereals, pulses, cotton, rubber, and sugar; metal commodities including precious metals like copper, zinc, nickel, gold, silver, etc.; and energy products such as crude oil, natural gas, coal, etc. Commodities are traded in the spot (or cash) market as well as in the form of derivatives. Many commodities are increasingly being traded in derivatives as it helps in locking the risk for the producer and the consumer.

Money market: The money market deals with short-term funds. The maturity period of money market instruments ranges from a few days to up to a year. Unlike a stock market or commodity market, this market does not have an exchange where instruments are traded. It is a network of banks and financial institutions, such as insurance companies and non-banking financial companies, called OTC (Over-The-Counter) market. One needs to understand that the money market does not deal in cash but in instruments that can be converted into cash.

Recently, the Reserve Bank of India (RBI) has allowed individuals to directly gain exposure to money markets by transacting via the RBI Retail Direct Platform in a simplified manner.

Here are the various money market instruments:

Commercial Papers (CP): CPs are unsecured instruments that are issued by corporates to finance their short-term working capital requirements with a maturity period ranging from 15 days to one year.

Certificate of Deposits (CDs): CDs are issued by commercial banks and special financial institutions with maturity ranging from 91 days to one year.

Treasury Bills (T-bills): T-bills are short-term promissory notes issued by the Reserve Bank of India that are secured and have a maturity of 91 days, 182 days or 364 days. All the above instruments are freely transferable.

Call Money: This is a facility enjoyed by banks to meet their temporary requirement of cash. The maturity can be as short as one to 15 days.

Currency Market: A hefty chest of foreign currency reserves is essential for any country to pay for its imports. Transactions have to be settled in the agreed currency. Here’s where the currency market comes into the picture. It is where foreign currencies of various countries are traded. Currencies are traded in pairs like rupee-dollar or euro-dollar. This is one of the largest markets in terms of value, which is highly liquid but, at the same time, highly sensitive to global events. Apart from corporates, banks, speculators, and governments also participate in this market through their respective reserve banks.

Digital Currency Market: Emerging technology-driven digital currencies based on blockchain technology have caught the fancy of many investors. These currencies are not traded on a formal exchange and are, therefore, unregulated. One needs to be careful while dealing with these as they are not part of the regularised financial markets yet.

Points to remember

  • Financial markets contribute to economic development
  • Helps in the creation and growth of wealth
  • With education and exposure to financial markets, more savings are channelised into the financial markets
  • This helps in capital formation and growth
  • In today’s highly connected world, any financial system is vulnerable
  • Social, political or economic changes on the global scene have ramifications
  • A robust financial system that can withstand shocks is therefore essential for a country’s development

 

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