How Financial Markets Work

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Financial markets are both wholesale and retail, on which the participants are financial institutions comprising central banks, investment banks, asset management companies, institutional investors, insurers, hedge funds. Corporations as issuers, the primary market, or as investors and finally individuals.

Transactions take place either on organized markets (futures and stock exchanges), where transactions are conducted on standard assets. And  the stock market or futures market intervenes as universal intermediary between buyers and sellers. This is done either by agreement between participants and a central counterparty.

The financial markets foster activities involving the raising of capital in the capital markets, international trade in currency markets and the transfer of risk in the derivatives markets.
   
Major markets in this domain are stock markets, foreign exchange markets, commodities markets and interest rate markets. And the largest volume of trade now takes place via derivatives such as forwards, futures, options and swaps, etc. These derivatives are growing rapidly since the early 1980s.

Forex trades in the major interbank financial markets and the majority of transactions are carried out over-the-counter, and it is the first market to have developed electronic trading. Financial markets are now almost entirely paperless and electronic.
   
The total daily volume of foreign exchange markets in 2004 were more than $1,900 billion of which $600m was in cash and $1.3 billion in derivatives. These figures entailed an increase from previous years mainly due to the phenomenon of mergers and acquisitions and speculation.

The daily volumes in equity markets and the derivatives account for significantly less than $500 billion, even though they have a natural volatility slightly higher than that of other financial markets, it still renders them insignificant in comparison.

Arbitrage and speculation can reduce overall risk, increase volatility in the short term and medium term. As well as provide continuous and oscillatory markets, as opposed to large unambiguous markets.

Trading of currencies and bonds for the most part is based on bilateral arrangements, although certain bonds trade on the stock exchange platforms, while electronic trading is constantly evolving.

Since the 1930s, the financial system was essentially linked with banks, and the financing of the economy was performed almost solely through the balance sheets of banks. And the financial institutions often controlled part of the capital of large companies, especially in countries such as Japan and Germany, financial markets had a stroke of very low importance. The financial markets only started gaining in prominence in the 1970’s.

 

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