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Financial Markets and How they Work

Financial Markets and How they Work
Financial Markets and How They Work

A financial market is any marketplace where people trade securities (tradable financial assets like stocks, currencies, and derivatives). Almost everyone has heard of stocks and the stock market, but there are other kinds of financial markets that you might not be as familiar with. In this article, we’ll review a few different types of financial markets and discuss why they are an important part of a healthy free-market economy.

What Are the Different Kinds of Financial Markets?

“Financial market” is a broad term that describes a variety of marketplaces with significant differences. They range in size from small markets with relatively little activity to massive trillion-dollar operations. Some of the most frequently discussed financial markets are the stock market, the derivatives market, the foreign exchange market, and the cryptocurrency market.

Stock Market

The stock market comprises various venues where companies can list their share prices and where investors and traders can purchase and sell those shares. When a company lists its shares for the first time, it provides an IPO, or initial public offering, which sets the initial price of purchasing shares, or stocks. Once purchased by investors from the company, stocks can be traded between investors within a secondary market, with subsequent pricing determined by supply and demand.

Once they have entered the secondary market, stocks are either traded on centralized listed exchanges, like the New York Stock Exchange, or on a decentralized over-the-counter (OTC) market. An OTC market differs from a listed exchange in that it does not take place in a physical location and is not controlled by a central authority. Instead, participants buy and sell securities directly, usually by electronic means, without the use of a broker to facilitate the trades.

Derivatives Market

Another type of financial market is the derivatives market. Derivatives are a type of security that is a bit more complex than stocks. While a stock represents a share of ownership in a company, a derivative is more like a contract that derives value from an underlying financial asset. A derivative technically holds no value on its own—its value is linked to the value of a separate agreed-upon financial asset.

The derivatives market does not involve the direct trading of securities between investors, but it enables them to speculate on the values of financial instruments such as stocks, bonds, currencies, and commodities.

Foreign Exchange Market

The foreign exchange (forex) market is where traders can exchange currencies and speculate on exchange rates. The forex market is one of the largest markets in the world and handles trillions of dollars worth of transactions on a daily basis. The forex market is an OTC market, which means it is decentralized. It is made up of a network of banks, brokers, computers, investors, and firms from all over the world.

Cryptocurrency Market

One of the newest types of financial markets is the cryptocurrency market. Cryptocurrencies are ledger-based digital financial assets powered by blockchain technology. There are hundreds of different kinds of cryptocurrencies that are traded on a global scale via independent cryptocurrency exchanges.

Even though cryptocurrency is lauded by its supporters as a decentralized currency, exchanges are centralized by nature. Crypto exchanges allow investors to trade cryptocurrency tokens or exchange them for fiat currency, but also expose buyers and sellers to the possibility of fraud. However, there are decentralized OTC crypto marketplaces that allow participants to buy and sell cryptocurrency tokens directly without going through an exchange.

Why Are Financial Markets Important?

Financial markets benefit a capitalist economy by allocating financial resources and enabling easier liquidation of assets. They help facilitate the flow of capital throughout the economy that drives the production of goods and services.

One way financial markets help economies grow is by providing the opportunity for new businesses to secure funding. When investors purchase stock in a company, their collective financial investment provides the means for the company to grow. This is why a company is said to “go public” when they begin selling stock.

A healthy system of financial markets is an integral component of a functional free-market economy. If financial markets fail, the whole system could crumble as a result—America’s most severe financial crisis, the Great Depression, was infamously caused by a bad stock market crash.

In short, financial markets are important because they help direct financial assets where they are needed most within the economy. Without the markets to provide stimulation, the economy would look very different on both a national and global level.

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Written by cheatcode

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