Understanding Financial Markets

Whether it’s the neighborhood grocery store, the weekend farmer’s market, an auction or even an online marketplace like Amazon or your state’s health insurance exchange, markets work to bring together interested buyers and sellers so mutually beneficial transactions can take place.

Financial markets are no different. However, instead of involving a tangible good or service, financial markets facilitate transactions for financial instruments, such as stocks and bonds.¹

In this guide, you’ll learn what financial markets are and how they function.

Primary vs. Secondary Markets

When talking about financial markets, it’s important to differentiate between the primary market and secondary markets. Technically speaking, there are third and fourth markets, but those exist solely for large institutional investors, making them a nonissue for the average retail investor.²

What Is a Primary Financial Market?

A primary financial market consists of a company selling its stock directly to investors. It’s often used synonymously with the term “initial public offering” (IPO), although there are cases when a company sells additional shares later on through a follow-on public offering (FPO).²

In the primary financial market, companies raise capital by trading away equity—ownership in the underlying business—in exchange for cash. This cash is often used to fund business expansions. Sometimes owners of a privately held company “cash out” their stake in a business by holding an IPO². This lets them sell some or all of their company ownership.

What Is a Secondary Financial Market?

Secondary financial markets let investors trade previously issued financial instruments, such as stocks, bonds or other highly liquid assets among themselves.² For example, at the New York Stock Exchange, traders buy and sell stocks based on whether they believe prices will rise or fall.

Financial Market Functions

Financial markets perform a number of important functions that help to keep the economy humming and businesses growing.

Setting Prices

Imagine that you want to purchase a share of stock from Amazon. You find a seller who’s willing to part with one share in exchange for $20. In the absence of competition, you have no idea if this price is too high or too low. A robust marketplace lets buyers and sellers arrive at a market price that takes into account multiple variables, such as:¹

• Cash flow
• Debt levels
• Senior leadership
• Market position
• Competitive advantages

Observers can use these factors to predict a company’s future performance.

Allocating Capital

One of the most important functions of primary financial markets is to efficiently allocate capital.¹ In other words, they provide investors with information that they can use to make informed investing decisions. This causes capital to flow toward the businesses most likely to achieve success.

Raising Liquidity

Financial markets help organizations raise liquidity, which refers to cash or assets that are easily convertible to cash.¹ Ready access to funds is an important element of business growth. While there are other avenues to raising liquidity, they generally entail incurring debt. Servicing a loan repayment with various interest rates can make it harder for a business to grow. In contrast, selling equity lets businesses access a large amount of funds in a short time with no debt obligations.

Connecting Buyers to Sellers

Once human cultures reach a certain size, marketplaces tend to spring up naturally because they serve a fundamental function. By connecting buyers to sellers, marketplaces provide both parties with convenience, security and efficiency.

Sharing Information

By bringing together a large number of interested parties, marketplaces facilitate information sharing. This was particularly important when face-to-face trading dominated financial marketplaces. The modern move to online trading has lessened its importance somewhat since information is increasingly distributed through outside channels. Trading-related news is picked up on and reported by blogs, outlets, and industry publications in real time. This lets traders access valuable data without entering the marketplace. However, financial marketplaces still serve as an important conduit for disseminating trade-related information to investors.

Types of Financial Markets

There are a plethora of financial marketplaces. Many deal with a single type of financial instrument. Some are constrained by geography or industry. The most common types of financial marketplaces include:

Stock Markets

Stock markets bring together investors in publicly traded companies.¹ Stock, or equities, represents fractional ownership in a company, such as Coca-Cola or Apple. Major stock market exchanges may see trillions of dollars in annual trading. The New York Stock Exchange, the Nasdaq Composite and the Tokyo Stock Exchange are well-known examples of major stock exchanges.

Bond Markets

Bond markets let traders and investors buy and sell bonds, otherwise known as debt securities.¹ A bond is issued by an organization like a corporation or a government body. Investors purchase bonds with the expectation that they’ll recoup their principal payment plus interest at the end of the bond's maturation period.

Forex Markets

Forex stands for “foreign exchange.”¹ Forex markets let you buy and sell currencies from different countries.¹ Traders try to make money by taking advantage of fluctuating exchange rates.

Derivatives Markets

A derivative is a claim to an asset that has value.¹ For example, futures contracts state that one party will buy an asset from the other party at a certain date. Futures are often used in the agricultural sector by farmers seeking to hedge their risk while buyers are betting that the price of the underlying asset exceeds the price specified in the contract.

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