The Five Basic Financial Markets
I.Introduction
Every economy must solve the basic problems of production and distribution of goods and services. Financial markets perform an important function by allocating or channeling funds for production and distribution. To produce goods, purchase inventory, pay wages and other costs, and invest in new machinery, firms must first obtain funds in financial markets. Most financial markets consist of people who have money and are willing to lend these resources, as well as people who need funds and are willing to borrow money. The financial industry is a service industry helping business and government finance their production and exchange.
Another important function which financial markets perform is in reducing individual risks. Whenever assets are held or transacted, certain risks can arise. Financial markets can help spread these risks among a large group of people. Financial markets do not lower the total amount of risk in the economy, but they can efficiently distribute the risk over many individuals. Ideally, financial institutions will not contribute to total risk in the economy, but recently we have seen that without some degree of supervision financial firms may become hopelessly entangled in a web of commitments that threaten the very solvency of the system. At a smaller scale, financial institutions help to efficiently distribute risks over a large group of people and reduce the risk that any one firm or household may become insolvent.
Financial markets also help to separate the ownership of assets from the management and use of assets. People who have little knowledge of how to produce a particular good can nevertheless own a company that makes the good. These owners are called stockholders and they only care that the good has been produced efficiently and sold so as to make the highest profit for them. These stockholders, who are the owners, hire specialized managers whose job it is to earn profits for them.
Therefore, financial markets help to allocate funds for production and distribution, reduce individual risks to investors and asset holders, and separate the ownership from the management of productive assets.
II.The Five Basic Markets
The five basic financial markets that we first study are the stock market, the bond market, the money market, the futures market, and the options market. They are not the only financial markets. We often also consider the foreign exchange market and the credit market (i.e., the market for bank loans). Most financial websites like those associated with Yahoo Finance, Bloomberg, or CNBC will provide detailed information about transactions occurring in each of these markets. You can even download historical daily transactions data going back many years from these sites.
Each of the five financial markets has a supply and demand. To effectively analyze and fully understand the information published about these markets, one must study both sides of the market. Another important point to note is that the markets are not independent of each other. The stock market can affect, and can be affected by, the bond market and money market. There is also a close relation between the stock market and the options market. Finally, the emergence of financial futures has made the stock and bond markets closely linked to the futures market. Learning how to link these markets together can be interesting and profitable.
The five financial markets are particularly important to the economy because nearly all industries in the economy make use of them. When financial markets experience problems, all sectors of the economy are affected. Stable financial markets are essential to a stable economy. The recent financial crisis of 2008 made it very clear that financial markets can very much affect the lives of people who seldom think about stocks, bonds, money, futures, and options. Some people have said that Wall Street has become more important to our lives than Main Street. There is certainly no question that financial services have grown as a part of GDP. This is something which we will discuss in greater detail later on.
III.Stock, Bond, and Money Markets
The stock market of a country is a good place to begin one’s look at financial markets. The stock market is where ownership claims on corporations are issued and traded. Issuing stock is an important way for companies to finance their investment in new machines, plant and equipment. Each ownership claim is called a share of stock and entitles the buyer to a pro rata share in the profits of the company. These distributed profits are called dividends. Dividends can come in the form of cash or additional shares of stock.
The stock market affects the economy in many ways. First, it is an important source of funds for firms. Second, changes in the value of stock affect the wealth of consumers and thus their spending decisions. Third, it affects the cost of capital to firms. A booming stock market makes it easy for firms to issue additional shares to the public and still maintain a relatively high stock price. Finally, changes in the stock market can affect the expectations of business and households about the future direction of the economy. We often say that the stock market is a leading indicator of the health of the economy.
In contrast to the stock market, the bond market does not sell ownership claims, but rather issues and trades in debt claims. Both private firms and the government borrow money in the bond market. Individuals who purchase these bonds can later sell them for cash in the bond market to other individuals. Those individuals who own the bonds are entitled to the interest paid semi-annually on them. Traders in the bond market deal exclusively in debt whose maturity is longer than one year. There is no reason to think that the stock and bond market must move in opposite directions to each other. It is perfectly reasonable for bond price to be moving up at the same time that stock prices are rising. This is true even though investors can always move their funds from one market to the other.
The bond market is very important to the economy since longer term interest rates are determined in this market. Higher long term interest rates can cause firms to postpone their plans to build new factories or buy new equipment. Moreover, government bonds are important since they are an alternative to taxes in financing government spending. Finally, large increases in the value of government bonds may affect wealth, and hence spending in the economy.
The money market is very much like the bond market, except that it deals only in short term debt having a maturity of less than or equal to one year. The shortest maturity in the money market is just 24 hours. The money market is important because it is here that the government uses it monetary policy to influence short term interest rates, as well as the amount of short term credit. By changing short term interest rates, the government may indirectly change long term interest rates and thus investment and consumer durable spending.
IV.Futures and Options
Both futures and options markets were originally designed to help reduce the individual risks of farmers and investors. If a farmer could sell a fixed amount of corn or wheat at a fixed future price, then he could better know how much to plant and how much his future income would be. The weather would still be an uncertain factor, but at least it would not significantly affect profits. Selling corn or wheat futures allowed these farmers to hedge their price risks. They could contract to sell a fixed amount of a commodity at both a fixed price and a fixed time in the future.
Options are somewhat different from futures, but they also help reduce individual risks. A call option on corporate stock gives the option holder the right to buy a fixed amount of stock from a person called the write of the option at a fixed price anytime within a specified period of time. A put option is like a call option, but the holder of a put has the right to sell to the writer of the option rather than buy the stock from the writer. Call and put options can be used by investors to reduce the risk of unexpected price changes in the stock they hold. Reducing risk without substantially lowering return is probably the most important concept in all of finance. Options are one means of achieving this.
V.Speculation and Efficient Markets
In addition to the usual suppliers and demanders in financial markets, another important group which influences the markets is composed of speculators. These people buy and sell financial assets in hopes of making short term capital gains. Some economists believe that because speculators make profits when markets are unstable, competition between speculators will reduce such profits and therefore stabilize the market. If this is true, then speculators help to stabilize financial markets. This is probably true when speculators have different expectations about the market. However, if they have the same expectation about the direction of the market, then a speculative bubble may arise. A bubble occurs when most speculators react to rise in an asset's price by expecting an additional rise in price in the future. Under these conditions, the price will rise until a sufficient number of speculators become bearish. The bubble bursts with the price of the asset plummeting. Considerations such as these lead us to believe that speculators do not always help to stabilize financial markets. Remember the simple rule — different expectations lead to stability while the same expectations lead to instability and bubbles.
Speculators play another important role. They accept the financial risks of other investors who are more risk averse. A risk averter is someone who would not accept an even chance of making or losing a given sum of money. Although there is an equal probability of gaining or losing, the risk averter fears his loss more than he desires his gain. Risk aversion is a key concept in the theory of finance. Speculators are people who are more willing to accept these risks than the average investor. They have a lower degree of risk aversion.
Because speculators are constant looking for short term capital gains, they will consider all information relevant to asset prices. If an asset is found to be undervalued, speculators will react quickly by attempting to buy it. Its price will rise and therefore will better reflect the asset's underlying value. Information is thus incorporated into the price very efficiently. We often say that the market has discounted this information and that such information can no longer further affect the price. An efficient market is one in which all relevant information about the asset is currently reflected in its price.
Financial markets are generally considered good examples of efficient markets. Their prices appear to contain all relevant information we would use in predicting future prices. This makes it nearly impossible to forecast better than just using current prices. Naturally, this raises the value of inside information since it gives the holder of inside information a significant lead on the competition. Trading on inside information is illegal, although such laws are hard to enforce.
Discussion Questions:
#1. What are the three functions which financial markets perform?
#2. What are the five big financial markets and does Taiwan have these markets?
#3. Why are financial markets more important than other markets?
#4. What is the difference between the stock market and the bond market?
#5. How does the bond market differ from the money market?
#6. What function do futures and options play in the economy?
#7. Who are speculators and what function do they play in financial markets?
#8. What is a speculative bubble and what causes it?
#9. What is an efficient market?
#10. What is inside information? Give some examples.