Financial markets bring buyers and sellers together to set prices for financial assets. These include equities (shares in a company) and debt instruments like bonds issued by corporations or governments.
Investing in such assets gives you more return on your money than keeping it in a bank account. A well-developed financial market is essential for economic growth.
Money Market
The money market involves trading in short-term debt investments. These include Treasury bills, commercial paper, bankers’ acceptances, certificates of deposit and repurchase agreements. The main function of this market is to make available the short-term money needed for trade and commerce.
Government institutions and commercial banks rely on money market instruments to generate short-term funds for various purposes. These instruments are used to finance domestic and international trade as well as for supplying working capital to industries.
Money market instruments are extremely low risk, often being backed by FDIC insurance or by a high credit rating from a reputed company. However, the low-risk nature of these investments translates into relatively lower rates of return, compared to other investment classes.
The money market is also a crucial component in controlling inflation and deflation. To combat inflation, central banks pump up the money supply through purchasing bonds and securities in the market. Similarly, to tackle deflation, the central bank buys back bonds and securities in the money market.
Capital Market
A capital market is an exchange system platform that transfers funds from those investors who wish to employ their excess capital to firms that require funding for various projects or investments. The instruments traded in the capital market are typically long-term in nature (lock-in period more than a year) and include equity securities like shares and debt instruments like bonds and debentures.
The capital market facilitates the transfer of savings from surplus units to deficit units by mobilizing the funds from savers through intermediaries, and helps in channelizing their savings into investments for economic development. It helps in increasing the rate of wealth creation and provides a choice to the investors to invest their excess funds in long term investments, thus encouraging them to save more. The capital market also offers a range of options to the investors regarding their risk profiles to suit their own risk tolerance. The capital markets are usually heavily regulated to protect investors from frauds and other financial malpractices.
Bond Market
The bond market is a place where people and companies borrow money. Bonds are a form of debt, and when they mature they pay back the original amount invested plus interest. A well-functioning bond market allows corporations and governments to borrow more affordably, which helps support growth and jobs. But a malfunctioning bond market could cause serious problems. If the market can’t handle a sudden rush of new bonds, financial institutions have to sell existing holdings on their books at steep discounts (under the “mark-to-market” principle).
In general, changes in bond prices reflect shifts in a country’s monetary policy and expectations about economic growth. Bonds may also rise or fall in price based on their credit rating, which is determined by organizations that rate each issuer’s ability to repay. The most prominent bond markets include government bonds, corporate bonds and mortgage-backed securities. The bond market also includes provincial/local government bonds, which are popular in developed markets, and “quasi-government” bonds, such as those issued by agencies that pursue a specific investment goal, such as affordable housing or small business development.
Derivatives Market
The derivatives market is a trading platform for financial instruments that derive their value from other assets. It features exchange-traded derivatives as well as over-the-counter (OTC) products. It is a great way for investors to hedge against risks, increase their leverage and take advantage of arbitrage. There are four types of participants in the derivatives market: hedgers, speculators, arbitrageurs and margin traders.
A derivative is a financial instrument like options, swaps and futures contracts that depend on the performance of a group of assets or an underlying asset to gain value. It is a great tool for speculators to assume risk and generate profits. Using it, they can replicate the performance of an entire index without having to invest the money to buy all the stocks in the index. They also provide protection against market volatility by locking in a price for their purchases. However, there are some downsides to the derivatives market, including liquidity risk and leverage risk.
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