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Financial markets are markets where financial transactions are conducted. Financial transactions generally refer to creation or transfer of financial assets, also known as financial instruments or securities. Financial transactions channel funds from investors who have an excess of available funds to issuers or borrowers who must borrow funds to finance their spending.
Since the early 1970s, financial markets in various countries have experienced significant development. As a result, world financial markets are larger, are highly integrated, and have a wide range of financial instruments available for investing and financing.
The Structure of Financial Markets
Financial markets comprise five key components: the debt market, the equity market, the foreign-exchange market, the mortgage market, and the derivative market. From the 1980s, each component market has been expanding in size, and an extensive array of new financial instruments have been initiated, especially in the mortgage market and the derivative market.
Debt instruments are traded in the debt market, also often referred to as the bond market. The debt market is important to economic activities because it provides an important channel for corporations and governments to finance their operations. Interactions between investors and borrowers in the bond market determine interest rates. The size of the world bond market was estimated at around $37 trillion at the start of 2002 (all currency figures are in U.S. dollars). Bonds denominated in dollars currently represent roughly half the value of all outstanding bonds in the world.
Equity instruments are traded in the equity market, also known as the stock market. The stock market is the most widely followed financial market in the United States. It is important because fluctuations in stock prices effect investors’ wealth and hence their saving and consumption behavior, as well as the amount of funds that can be raised by selling newly issued stocks to finance investment spending. The size of world developed equity markets expanded from $892 billion in 1974 to $25,276 billion at the end of 2001, with the U.S. market accounting for 57 percent of the world developed equity market in 2001.
Foreign-exchange markets are where currencies are converted so that funds can be moved from one country to another. Activities in the foreign-exchange market determine the foreign-exchange rate, the price of one currency in terms of another. The volume of foreign-exchange transactions worldwide averages over $1 trillion daily.
A mortgage is a long-term loan secured by a pledge of real estate. Mortgage-backed securities (also called securitized mortgages) are securities issued to sell mortgages directly to investors. The securities are secured by a large number of mortgages packaged into a mortgage pool. The most common type of mortgage-backed security is a mortgage pass-through, a security that promises to distribute to investors the cash flows from mortgage payments made by borrowers in the underlying mortgage pool. A 1980s innovation in the mortgage-backed security market has been the collateralized-mortgage obligation (CMO), a security created by redistributing the cash flows of the underlying mortgage pool into different bond classes. Mortgage-backed securities have been a very important development in financial markets in the 1980s and 1990s. The value of mortgage principal held in mortgage pools increased from $350 billion in 1984 to nearly $2,500 billion in 1999.
Financial derivatives are contracts that derive their values from the underlying financial assets. Derivative instruments include options contracts, futures contracts, forward contracts, swap agreements, and cap and floor agreements. These instruments allow market players to achieve financial goals and manage financial risks more efficiently. Since the introduction of financial derivatives in the 1970s, markets for them have been developing rapidly. In 2001 global exchange-traded futures and options contract volume reached 4.28 billion contracts, and the top three types of contracts—equity indices, interest rates, and individual equities—are all financial derivatives. Together they accounted for 88.7 percent of total contract volume.
Classification of Financial Markets
Financial markets can be categorized in different several ways, revealing features of various market segments. One popular way to classify financial markets is by the maturity of the financial assets traded. The money market is a financial market in which only short-term debt instruments (original maturity of less than one year) are traded. The capital market is a market in which longer-term debt (original maturity of one year or greater) and equity instruments are traded. In general, money-market securities are more widely traded and tend to be more liquid.
Another way to classify financial markets is by whether the financial instruments are newly issued. A primary market is a financial market in which a borrower issues new securities in exchange for cash from investors. Once securities are sold by the original purchasers, they may be traded in the secondary market. Secondary markets can be organized in two ways. One is as an organized exchange, which brings buyers and sellers of securities together (via their representatives) in one central location to conduct trades. The other is as an over-the-counter (OTC) market, in which over-the-counter dealers located at different sites but connected with each other through computer networks undertake transactions to buy and sell securities “over the counter.” Many common stocks are traded over the counter, although shares of the largest corporations are traded at organized stock exchanges, such as the New York Stock Exchange.
The Role of Financial Markets
By channeling funds from investors to issuers and borrowers, financial markets enhance production and allocation efficiencies in the overall economy. Financial markets also perform the important function of price discovery. The activities of buyers and sellers in a financial market determine the prices of the traded assets, which provide guidance on how funds in the economy should be allocated among financial assets.
Additionally, financial markets provide a mechanism for managing risks. Various financial assets traded in financial markets provide different payment patterns, and this redistributes and reallocates the risk associated with the future cash flows among issuers and investors.
Financial markets also offer liquidity by providing a mechanism for investors to sell or purchase financial assets. The presence of organized financial markets reduces the search and information costs of transactions, such as the money spent to advertise the desire to sell or purchase a financial asset. In an efficient market, the market price reflects the aggregate input of all market participants (Fabozzi and Modigliani 2003).
The Internationalization of Financial Markets
The internationalization of financial markets has become an important trend. The significant growth of foreign financial markets has been driven mainly by deregulation of markets in financial centers worldwide and technological advances enabling more efficient communication, as well as market monitoring and analysis.
The internationalization of financial markets has also been prompted by numerous studies on the benefits of diversification that includes international stocks. Specifically, including securities from different countries in a portfolio may lower the portfolio’s risk without reducing its expected return. The benefits of diversification arise from the fact that asset prices across international financial markets are not highly correlated.
The nature and extent of the internationalization of financial markets are well reflected by developments in international bond markets and world stock markets. Eurobonds are long-term debt securities sold outside the borrower’s country to raise long-term capital in a currency other than that of the country where they are sold. Eurobonds are relatively new instruments in the international bond market, yet the volume of new issues of Eurobonds grew nearly four times from $167 billion in 1990 to $642 billion in 2001, and the market capitalization of Eurobonds stood at $7 trillion at the start of 2002. As for stock markets, while the U.S. stock market remains the largest in the world, foreign stock markets are becoming increasingly important. Japan and the United Kingdom have the largest markets outside of the United States. As of the end of 2001, the size of Japanese market was $2,528 billion, and that of British market was $2,275 billion. Stock markets in many developing economies, also known as emerging markets, picked up their pace of development in the 1980s. In 2001 the combined market value of emerging markets was around $2,400 billion, accounting for 8.7 percent of total world market capitalization that year.
Because financial markets are internationalized, issuers and investors in any country need not be limited to their domestic financial markets. The internationalization of financial markets is having a profound effect by leading the way to a more integrated world economy in which flows of goods and technology between countries are more commonplace (Mishkin and Eakins 2000).
- Chance, Don M., 2003. Analysis of Derivatives for the CFA Program. Charlottesville, VA: Association for Investment Management and Research.
- Fabozzi, Frank, and Franco Modigliani. 2003. Capital Markets: Institutions and Instruments. Upper Saddle River, NJ: Prentice Hall.
- Mishkin, Frederic S., and Stanley G. Eakins. 2000. Financial Markets and Institutions. Boston: Addison Wesley Longman.
- Solnik, Bruno, and Dennis McLeavey. 2003. International Investments. Boston: Pearson Education.
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