Modules for Beginners
Basics of Stock Market
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Types and Functions of Financial Markets
Well, now that you have a fair idea of what financial markets are and what their functions look like, it’s time to up the game. This brings us to the question: Just how many financial markets are there?
To decipher the answer to this query, it is important for us to know more about how the financial markets are classified. Since the term ‘financial markets’ collectively describes the various avenues that are used for the purchase and sale of financial assets, experts have broadly classified the markets based on various benchmarks.
Here’s a closer look at the four main criteria that determine what type of financial market you’re dealing in. Let’s see how there are eight different types of financial markets based on these elements.
By nature of claim
Financial markets can be classified based on the type of claim that you have over the assets you’ve invested in. Broadly speaking, your claim on your investments can be any one of two types: fixed or residual. This paves way for two kinds of financial markets, as you’ll see below.
In a debt market, debt instruments like bonds and debentures are bought and sold. These instruments are issued by companies and government entities. And when you buy a debt instrument, your claim on the assets of the issuing entity is fixed. In other words, it’s limited to a specific amount.
For example, say you invest in a bond with a face value of Rs. 5,000 and a coupon rate of 10%. Each year, you’ll receive a fixed amount of Rs. 500 (10% of Rs. 5,000).
Stocks of public limited companies are traded in the equity market. Here, you can carry out a variety of trades such as intraday transactions, delivery trades, Initial Public Offers (IPOs) and Follow on Public Offers (FPOs). Your claim on the stocks you buy in the equity market is residual.
What this means is that when you buy a company’s stock, you effectively become a shareholder in that company. And in the event that the company calls it quits and is liquidated, whatever remains in the business after all fixed liabilities have been paid off belongs to shareholders like you.
By maturity of claim
Anybody who has ever had a garden at home will tell you that not all plants grow at the same rate. Some, like the marigold, flower within a few weeks. Others, like the Himalayan Lily, take years to bloom.
Much like this, different investments also offer returns at different tenures. In this context, maturity refers to the period after which an investment matures. Some assets have a shorter tenure, while others may have a longer maturity period. Based on this, there are two types of financial markets.
This is the market where monetary assets like treasury bills, commercial papers and certificates of deposits can be bought and sold. The investment horizon for these assets does not exceed a year. As a result, the risk associated with these instruments is also quite low. In addition to this, they offer returns in the form of interest.
In a capital market, assets with medium-term and long-term investment horizons are traded. For instance, investors can buy assets like equity share capital and preference share capital and hold them over the long term. Capital markets are once again divided into the following two subcategories: primary market and secondary market.
Here’s where newly listed companies issue securities for the first time, through Initial Public Offers (IPOs). It’s also here that companies that are already listed make fresh issues of securities through Follow on Public Offers (FPOs). Essentially, transactions in the primary markets occur between companies and their shareholders.
In a secondary market, existing securities of listed companies are traded over stock exchanges between investors. It’s where you buy stocks or sell them in the course of your everyday trading.
By timing of delivery
This kind of classification is based on when you take delivery of the asset you’re buying. Typically, the timing of delivery only comes into play in the secondary market, where you trade financial assets with other investors/traders. And based on this factor, we have the cash market and the futures market.
In the cash market, transactions are settled on a real-time basis. To complete your transaction in the cash market, you’ll need to pay the investment amount upfront, either using your own capital or through borrowed funds, which are collectively known as margin money.
In the futures market, you may pay the money at the time of making your transaction, but the delivery of the asset happens at a later date. In most cases, you need not even pay the whole price of the asset when you enter into the transaction. Instead, a percentage of the price, known as the margin, is often deemed sufficient. Some examples of assets traded in the futures market include options and futures. We’ll delve into the details of these assets in one of the upcoming lessons.
By organisational structure
This one’s quite easy to decipher. It’s essentially a classification of markets based on the way the transactions are organised and conducted therein. Here, there are two types of financial markets, as explained below.
In an exchange-traded market, transactions occur through an exchange. It’s essentially a centralised market that runs on standardised procedures. Here, the buyer and the seller do not interact directly with each other. Rather, they trade through an intermediary. And they can only trade in the standard products that are already available to buy or sell. There’s no scope for customised products in an exchange-traded market.
Think of this like an e-commerce site, where you do not really meet the seller. Instead, you buy your products from the platform, which is the intermediary.
These are decentralised markets where buyers and sellers can interact with one another and engage in the trade of customised products, as per their requirements. There is no intermediary involved and transactions occur electronically, over the counter.
This is much like your local tailor’s store, where you personally go and give your measurements, so you can get a customised outfit. That makes it clearer to understand, doesn’t it?
Function of Financial Markets
The financial markets perform a variety of roles to keep the economy of a country functioning well. Here’s a closer look at some of the key functions of financial markets.
- They help put idle money to good use
Without the financial markets, investors’ funds would remain idle. The markets help mobilize funds and allow investors to earn returns in the process.
- They ensure fair pricing of financial assets
Unregulated buying and selling of financial assets could drive prices irrationally high or send them plummeting. Thankfully, market forces ensure that the securities are priced more fairly.
- They give businesses easier access to capital
Companies and businesses that list their securities in the markets find it an easier and more efficient way to raise the capital they need for their business operations or expansion.
- They make financial assets more liquid
The financial markets also ensure that securities and financial assets are generally liquid. Otherwise, investors would find it harder to convert their assets to cash.
That brings us to the end of the chapter on the different types of financial markets and their functions. In our next chapter, we’ll see who the key players in the stock market are. Keep reading and keep learning!
A quick recap
- Financial markets can be classified according to any one of these four parameters: the nature of claim, the maturity of claim, the timing of delivery and the organisational structure.
- By nature of claim, there are debt markets, where debt instruments are traded and equity markets, where stocks are traded.
- By maturity of claim, there are money markets, where short-term instruments are traded and capital markets, where medium-term and long-term assets are traded.
- Capital markets can be primary or secondary.
- By timing of delivery, markets can be either cash markets, where delivery of the asset happens real-time, or futures markets, where the delivery happens at a later date.
- By organisational structure, there are exchange-traded markets, where assets are traded through an exchange and over-the-counter markets, where assets are traded over the counter, in a decentralised manner.