Introduction to Classification of Financial Markets
The term “financial market” refers to a business place where different types of financial securities take place. 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 financial securities are directly issued to the buyers. In this type of market, the investors get the first crack at the newly issued securities. The issuing companies receive the cash proceeds from the sale and utilize it either to fund exiting operations or fuel business expansion. Finally, the newly issued securities are purchased by the buyers in the form of:
- Initial Public Offering (IPO): In an IPO, the investors are issued shares of a company when it is in the process of getting listed on an exchange, which means that a private company is going public.
- Follow-on Public Offer (FPO): In an FPO, the investors are issued shares of an already publicly listed company.
- Rights Issue: In this type of share issuance, the company’s existing shareholders are offered an option to 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 that are issued in the primary market are traded 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 shares of the company. Now, 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 will have to 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 who are willing to sell and the prospective investors who are willing to buy. In this way, the secondary market also helps in the discovery of the market price of the securities based on their demand and supply in the market.
The trades that take place on a recognized exchange are known as Exchange Traded Contract, while the trades that take place between two parties outside the exchange are known as Over the Counter (OTC).
Based on Maturity Period
In the money market, the financial securities are traded on a short-term basis, which means 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 their short-term surpluses or fund their temporary funding shortfalls using money markets.
In the capital market, the financial securities are traded 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, 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 (also called the stock market), the 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 debt market), the companies (borrowers) issue bonds while the subscribers (lenders) invest in them. The issuing companies promise periodic interest payments and repayment of the principal on maturity. In this type of market, the participants buy and sell debt securities, either through an exchange or over the counter.
Foreign Exchange/ Currency Market
In the foreign exchange market (also called currency market), trading of currencies takes place over the counter across the globe in a decentralized way. Effectively, this financial market functions as an anchor of trading between a wide range of participants who are from different parts of the world and are 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 whose value is driven by the underlying asset’s value, which can be in the form of 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 intended to provide you some insights into financial markets and their various classifications based on different dimensions.
This is a guide to the Classification of Financial Markets. Here 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 –