Updated July 13, 2023
Introduction to Classification of Financial Markets
The term “financial market” refers to a business where different financial securities occur. These financial securities include equity shares, derivatives, bonds, etc. In a capitalistic economy, financial markets play the key role of intermediaries between the collectors and investors that ensure the economy’s smooth functioning. In other words, the financial markets mobilize the flow of capital between those who have excess funds and those who require business funds. As a result, there are various types of financial market instruments. This article will provide you a brief understanding of the most common categories of products. in this topic; we will see a different way of classification of financial markets.
Classification of Financial Markets
The financial markets can be broadly classified on the basis of the following:
- Issuance of securities
- Maturity Period
- Types of financial instruments
Based on Issuance of Securities
In the primary market, the issuers directly issue financial securities to the buyers. The newly issued securities are made available to investors in this market first. The issuing companies receive the cash proceeds from the sale and utilize it either to fund existing operations or fuel business expansion. Finally, The buyers purchase the newly issued securities in the form of:
- Initial Public Offering (IPO): During an IPO, the company issues shares to investors as it undergoes the process of listing on an exchange, transitioning from a private company to a public one.
- Follow-on Public Offer (FPO): In an FPO, the company issuing shares provides shares to the investors of an already publicly listed company.
- Rights Issue: In this type of share issuance, the company’s existing shareholders can buy its new shares at a pre-decided price. The number of the newly issued share would be proportionate to the existing shareholding of the investors.
In the secondary market, the financial securities issued in the primary market trade over the counter or through an exchange. For instance, ABC Inc. issued new shares in the primary market through an IPO, and David purchased 100 company shares. David decided to sell off 50 of these shares and book some profit. However, since he can’t sell these shares back to the issuer (ABC Inc.), he must go to the secondary market and find an investor interested in buying ABC Inc’s shares. This is how a secondary market works.
Essentially, the secondary market provides an exit option to the existing investors of the securities. Thus, it brings together the existing investors willing to sell and the prospective investors willing to buy. In this way, the secondary market also helps discover the market price of the securities based on their demand and supply.
The trades on a recognized exchange are known as Exchange Traded Contracts, while the trades between two parties outside the exchange are known as Over Counter (OTC).
Based on the Maturity Period
In the money market, financial securities are traded short-term, meaning a maturity period of less than one year. The securities traded in this market include commercial paper, treasury bills, certificates of deposits, etc. Given the low maturity period, these securities offer reasonable returns at a relatively lower risk for the investors. Government bodies, banks, and corporates invest in short-term surpluses or fund temporary funding shortfalls using money markets.
In the capital market, financial securities trade on a medium or long-term basis, which means a maturity period of more than one year. This market facilitates the maximum interchange of money and provides funds for various business operations. The securities traded in this market primarily include bonds, notes, and equity shares. In addition, the primary and secondary markets discussed in the previous section are parts of the capital market.
Based on Types of Financial Instruments
Equity/ Stock Market
In the equity market (the stock market), company shares are issued and traded, mostly on stock exchanges. It is a crucial market for any economy as it provides companies access to capital while offering investors a slice of ownership in those companies. Both risks and returns are very high in this market as the returns depend on the companies’ future performance.
Bond/ Debt Market
In the bond market (also called the debt market), the companies (borrowers) issue bonds while the subscribers (lenders) invest in them. The issuing companies promise periodic interest payments and principal repayment on maturity. In this type of market, the participants buy and sell debt securities through an exchange or over the counter.
Foreign Exchange/ Currency Market
In the foreign exchange market (also called the currency market), currency trading occurs over the counter across the globe decentralized. Effectively, this financial market functions as an anchor of trading between a wide range of participants from different parts of the world and trading around the clock. Banks, pension funds, hedge funds, private speculators, and corporations are the main participants in this market.
In the derivative market, buying and selling of derivatives take place. Derivatives are financial instruments driven by the underlying asset’s value, which can be stocks, bonds, mortgages, commodities, interest rates, or even weather. Derivatives are traded either through an exchange or over the counter.
Over the period, financial markets have evolved a lot and gained importance in the functioning of an economy. It meets the companies’ funding requirements and offers good investment opportunities for those with excess funds. Financial markets aid high liquidity, investor protection, and market pricing discovery. Given its importance, this article intends to provide insights into financial markets and their various classifications based on different dimensions.
This is a guide to the Classification of Financial Markets. We also discuss the definition and top 3 Ways of Classification Financial Markets. You may also have a look at the following articles to learn more –