What Are Financial Markets? & How does it work? - Pillow.Fund

December 15, 2022
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Everything You Need to Know About Financial Markets

Financial markets are the largest platforms in the investment space that drive a nation’s economy and provide a robust platform for both financial providers and investors. Here's a detailed guide to what financial business markets are all about!

Financial markets, such as money and capital markets, are spaces in which assets are traded. These markets also trade securities and include, but are not limited to the stock market, bond market, and foreign exchange market. Financial markets provide returns to those with surplus funds, such as investors and lenders, and make those funds available to borrowers.

Let's learn more about what financial markets are, their types, and the pros and cons of investing in these markets in this blog!

What are Financial Markets?

A financial market is where stocks, bonds, assets, or similar securities are traded. There are several types of financial markets, such as foreign exchange, money, stock, and bond markets.

These markets help the functioning of capitalist nations by including assets or securities that can be traded over the counter (OTC) or by listing methods on regulated exchanges. The collapse of financial markets can lead to economic disruptions such as recession and unemployment.

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Types of Financial Markets

Let us understand the various kinds of financial markets:

1. Stock Markets

Stock markets are omnipresent. You will find these financial markets in almost every developing country; these are the places where organizations list their shares that are then traded by investors. Companies enter the secondary market and build capital using Initial Public Offerings (IPOs) and the stock market.

Stocks can be traded on public exchanges such as the Nigerian Stock Exchange and NASDAQ or over the counter. Most stock trading is done through regulated exchanges and indicates the overall health of the economy.

These financial business markets provide investors with capital gains and dividend income. Typical participants in the stock market are investors and traders, market makers (MM), brokers (who facilitate transactions between buyers and sellers), and professionals who maintain liquidity and provide an interactive market.

2. Over-the-Counter Financial Markets

These are decentralised markets where there are no physical locations, and transactions are done digitally or electronically. There's no intervention of a broker or a middle person, and most of the trading is done through exchanges.

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3. Bond Financial Markets

A bond can be thought of as a contract between a lender and a borrower in which an investor borrows money for a specified period at a predetermined interest rate.

Bonds are issued by organizations and local, state, and sovereign governments to accumulate funds for projects and operations, which are also known as the debt, credit, or bond market.

Take the example of the FGN Savings Bonds, which are considered one of the safest forms of investment as they are backed by the complete trust and credit of the Federal Government of Nigeria.

There's no risk of default, ensuring that interest and principal are paid when due. Also, there are no state and local taxes on investments. You can invest in FGN bonds through the brokerage of the Nigerian Stock Exchange.

4. Money Markets

Money markets typically trade short-term securities which have a maturity that is less than one year. These instruments have high liquidity, a high degree of security, and low-interest rates.

The money market involves large-scale transactions between institutions and dealers and can also be purchased by individual investors who can invest in the money market by purchasing short-term certificates of deposit (CDs), municipal bonds, or treasury bills.

There are two types of money markets:

  • Discount money market

A discount money market is an establishment that deals with non-conditional orders in writing or bills of exchange. Discount vouchers are accommodated by purchasing below face value. There's always a gap between the maturity value and discount value. Acceptance points (commercial banks) accept bills of exchange against fees.

  • Parallel money market

A parallel money market is a borrowing and lending practice between horizontal sectors tailored between interbank deposits. Banks that have surplus funds can offer lending funds to banks that have a deficit.

Let's look at examples of money market investments:

Treasury Securities

Treasury bills, commonly referred to as T-bills, are short-term government-guaranteed securities issued by CBN. T-Bills sell below par and are generally considered a low-risk and safe investment.

These are issued when the Nigerian government needs to borrow money for some time and has a maximum term of 364 days.

Certificate of Deposit (CD)

A CD is a type of savings/term account that offers higher interest rates for a specific period than a regular savings account. You should invest your money in a CD that you're sure you won't need anytime soon.

The usual maturity period of CDs is 1, 3, and 5 years, so if you want to grow your funds safely within a certain period for a specific purpose, a CD is a good choice. However, premature withdrawal of CDs will only be possible after paying a fee.

5. Derivatives Financial Markets

A derivative is a contract between two or more parties that has a value based on an agreed-upon underlying financial asset.

Derivatives are secondary securities whose value is derived from the value of the related primary security - they by themselves have no value. Instead of trading stocks directly, the derivatives market trades futures and options contracts and other sophisticated financial instruments that derive value from underlying assets.

Futures contracts are listed and traded on the futures market using standardised contract specifications. These markets are well-regulated and use clearinghouses to settle and confirm trades.

The Nigerian Stock Exchange lists and regulates contracts in a similar manner, wherein options/futures exchanges can list contracts for different asset classes such as stocks, bonds, and commodities.

6. Forex Financial Markets

The foreign exchange (FX) market is one of the most liquid financial markets, where you can purchase, hedge, sell, and speculate on exchange rates between different currencies of the world.

The forex market deals with instant cash and processes more financial transactions than the futures and stock markets combined.

Forex markets financial include banks, trading houses, hedge funds, and investors. Just like the OTC market, these markets are decentralised and include a large network of participants from across the globe

7. Commodity Financial Markets

Commodity markets are where buyers and sellers choose between agricultural commodities, energy products, precious metals, or consumable commodities as trading items.

Let's look at a couple of financial markets and instruments of commodity financial markets here:

Plastic Recycling

Nigeria produces about 2.5 million tons of plastic waste each year, making it one of the world's largest emitters of plastic pollution.

You can come up with ideas for plastic recycling solutions, like introducing an on-site facility to reprocess the plastic into new products that remove plastic from the environment. Recycling plastic promotes eco-friendly sustainability and creates wealth.

Oil and gas

Nigeria is one of the world's largest oil producers, offering domestic and foreign investors a huge opportunity to earn millions of Naira annually.

Being a highly regulated sector, it is more complex to invest in than other sectors, requiring proper research, expertise, financial competence, and a lot of paperwork.

However, one way to invest in oil is to buy an energy ETF or mutual fund or buy shares in oil and gas companies.

Functions of Financial Markets

Financial markets are a solid platform where investors and organisations meet to raise large amounts of capital mainly through the exchange of stocks and bonds in financial markets.

Financial markets have the basic function of allowing companies to balance risks on the traded commodities, currency futures, and other derivatives.

These markets are transparent places that reflect appropriate knowledge about everything traded, thus reducing the cost of information gathering. They thrive on liquidity, which means that sellers can offload assets whenever they need to raise cash. Businesses don't have to go far to find buyers and sellers.

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Let's look at the role of financial markets:

These markets help you utilize your savings more productively

Do you think saving your money in bank accounts and saving deposits is the only way to keep your money safe and earn interest?

Financial markets such as banks are opening their doors to individuals and businesses needing mortgages, student loans, or business loans.

You can invest your savings in markets that generate higher returns and give you the benefit of taking higher risks.

Determine the price of a security

When you buy goods and services, the price range is generally calculated by demand and supply.

But financial markets are different as the primary objective here is to earn profit from securities. Thus, the prices of securities are calculated considering the markets' financial situation.

High liquidity of financial assets

Buyers and sellers can choose to trade securities at any time. They can use financial markets to sell securities or invest as they please.

Reduce transaction costs

Financial business markets allow you to get a wealth of information about securities without spending any money.

What Are the Advantages and Disadvantages of Financial Markets?

Financial markets provide a venue where participants, such as investors and debtors, regardless of size, are treated fairly and appropriately.

These markets provide access to capital for individuals, businesses, and government agencies. They help in mitigating unemployment as they provide many job opportunities.

Plus, financial business markets allow traders to raise funds in long-term and short-term programs to grow their businesses. They do not limit an investor's choice of security or asset class by offering them a variety of assets to buy, sell, or invest in.

The cons are that you must follow a set of rules and regulations set by authorities like the Nigerian Stock Exchange. There are several protocols to follow for interested traders.

Despite having a stringent set of rules to follow, the process is transparent and trustworthy, which encourages more individuals and organizations to participate in the trading process.

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In summary, financial markets are thriving spaces that boost a nation's economy. These markets help organisations gather funds and investors make money while eventually helping lower unemployment as they provide many new job opportunities.

They also provide a platform where participants such as investors and companies are treated fairly and appropriately regardless of size. Besides, they extend access to capital for government agencies, businesses, and individuals.

Want to grow your wealth and make the most of the financial markets? Start with Pillow. Besides that, you can invest in any of the markets mentioned above and build a strong financial corpus to meet your short-term and long-term objectives.

Frequently Asked Questions

How do financial markets work?

Financial markets cover several securities and asset classes and have different rules, protocols, and structures. They normally work by grouping buyers and sellers into assets or contracts and allowing them to trade against each other through a price discovery mechanism.

What are the main functions of financial business markets?

Financial markets enable free markets for capital, financial debt, and money flows. These markets are responsible for enabling the effective allocation of capital and assets in the financial economy.

They can run and boost the global economy and help investors derive fruitful capital gains over time.

Why are financial markets important?

Without financial markets, capital cannot be allocated efficiently, and economic activities such as trade, commerce, investment, and growth opportunities are severely restricted.

Who are the main participants in financial markets?

The main participants are investors and companies (which can also include government agencies) who use the stock and bond markets to raise money. Brokers often act as intermediaries, matching buyers and sellers and earning commissions or fees for their services.

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