Financial Literacy

The Main Functions of Financial Markets

There are a wide range of different financial markets. Each plays a role in the transfer of wealth and liquidity across economies. These markets all touch each other in some way, and it’s worth knowing how each functions—both alone and as part of the economy at large. Here’s a look at the primary functions of financial markets and their purposes.

Discover the main functions of financial markets

1. Money Markets

Money markets are highly liquid short-term maturities. They represent short-term loans and other debt investments. The money market is an important pillar of the greater financial economy because it provides the tangible liquidity needed to facilitate cash swaps between banks and corporations. Investments in the money market usually vest fully in less than a year. The primary function of the money market is to provide liquidity to the many other financial markets. 

2. Capital Markets

Capital markets are where investors and companies exchange cash for financial instruments. Namely, equity investments (stocks) or debt securities (bonds). Both are capital raising tools for companies and investment vehicles for wealth building. 

2a. Stock Market (Equity)

The stock market is part of the secondary market and the spot market. It’s a marketplace for equity securities, bought, sold and traded between investors. The main function of the stock market is to provide vehicles for investors and opportunities to raise capital for companies. Equity shares (stocks) serve both purposes. Investors leverage the earning power of the company to grow their wealth; companies use investment capital to grow and return value to shareholders. 

The buying and selling that takes place also helps to set the price for securities. Stocks are worth only what buyers are willing to spend and the price sellers are willing to exit their position for. Constant supply and demand mean the price of securities is always changing. 

2b. Bond Market (Debt)

The bond market is a capital raising debt market. Many investors think of it as a mirror to the stock market—debt securities vs. equity securities. The bond market is much more stable than the stock market thanks to the relatively fixed terms of debt securities. 

Like an equity market, the bond market is a financing avenue for corporations and government entities. Instead of offering equity, issuers offer debt notes that promise a return on investment when the bond matures. Investment-grade bonds are virtually guaranteed, which makes them a worthwhile long-term investment for patient investors. This surety comes at a lower ROI than equity securities, which tie into a company’s performance. 

3. Foreign Exchange Market

The foreign exchange market is the largest market in terms of daily trading volume and value. Investors can trade the exchange rates of any two currencies in the world 24 hours a day. As they do, they assist international trade and investments by enabling currency conversion. The value of any single currency tracks all others, which means the forex market helps to establish fair and honest exchange rates. It’s an entirely self-regulated market that’s decentralized. Forex is a major player in the underlying global financial economy. 

4. OTC Market

Over-the-counter (OTC) markets represent financial products not listed on exchanges. This market gives investors access to unlisted financial instruments. For example, this includes stocks, bonds and derivatives. Buying and selling happens directly. This allows small, venture and foreign companies to connect with investors. Furtermore, it allows investors to participate in a market that’s more accessible. OTC markets are also a place to hedge more traditional investments. 

5. Derivatives Market

There are three main purposes for the derivatives market. First, is risk mitigation. There’s no need to hold an underlying asset to capitalize on its profit-generating capabilities. Second, is information discovery. Derivatives provide insight into factors that may affect the future of a security’s price. Third and last, is speculation. Investors can make money by capitalizing on price movements in the underlying security.

5a. Futures Market

The futures market is a derivative market that mitigates the risk of defaults on contracts. It’s an agreement to buy or sell an asset at a certain date for an agreed-upon price. Futures are great for diversification and hedging. Moreover, they allow speculators to make money without direct ownership over an asset. Futures contracts can also safeguard investors against asset depreciation.

5b. Options Market

Another derivative market, the options market lives up to its moniker. Options give investors the right to exercise a purchase agreement for a specific asset at a specific price. Note that it guarantees the right, not an obligation. Investors can choose to exercise their option or simply let it expire. This market, like other derivatives, is a hedge against volatility. Options are cheap to purchase and can safeguard against huge losses. 

7. Cryptocurrency Market

The newest financial market to emerge is the cryptocurrency market. This market allows retail investors to purchase decentralized currency using fiat currency. Crypto behaves like a security and not a currency. Therefore, it’s often considered a volatile investment. Its value isn’t pegged to any other currency, other than for comparative value.

While the future of cryptocurrency remains unclear, early investors hope to capitalize on future uses for crypto or its underlying blockchain technology. In the meantime, it serves as an investment vehicle separate from traditional capital markets. 

The Functions of Financial Markets Are Interrelated

There’s a reason trouble in the stock market affects the bond market or sends the futures market spinning. In fact, everything connects! It’s worth understanding the main functions of financial markets, as well as how they connect as a whole. No matter which market you’re active in, your investments are part of something much bigger. Together, all financial markets make up a network of capital that keeps economies around the world turning.

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