Financial markets

In this chapter, you’ll learn the main funding options available to organizations, from short-term to long-term choices. You’ll also learn about the financial markets where organizations and investors buy and sell financial assets and liabilities.

Financial markets

Financial markets are physical or digital places where financial assets and liabilities are bought and sold. They’re commonly grouped into these categories:

• Capital markets
• Money markets
• Derivatives markets
• Commodity markets
• Foreign exchange markets

Markets are also often described as primary or secondary markets. We’ll explain that distinction later in the chapter. For now, let’s focus on the market types listed above.

Capital markets

Capital markets are where long-term financial assets and liabilities are bought and sold.

For example:

• If a company wants to issue (sell) shares, it does so through the capital market.
• If investors want to buy shares, they buy them through the capital market.

Capital markets aren’t limited to equity. Debt instruments are also issued and traded in capital markets. We’ll look at these instruments later in the chapter.

Money markets

Money markets focus on the short term. They’re where short-term financial assets and liabilities are bought and sold.

In money markets, funds can be lent for very short periods, including overnight. Maturities can be as short as one day, but they’re generally under one year. We’ll explore money market instruments in the next few pages.

Derivatives markets

Derivatives markets trade instruments that are often used for hedging (protecting against risk).

A derivative is a financial instrument whose value is determined by an underlying asset.

Derivatives are often short term, but they differ from money market instruments because their main purpose is typically risk management rather than short-term borrowing and lending.

We’ll explore derivatives in more detail later. More detail is also covered in F3 strategic level, where it’s tested in maximum length.

Commodity markets

Commodity markets are where commodities such as gold and oil are bought and sold.

These markets won’t be explored further in your exam, but it’s useful to know that many commodities trade in dedicated markets.

Foreign exchange markets

Foreign exchange markets facilitate the trading of currencies between countries. We’ll explore this in the upcoming chapter.

The role of financial intermediaries

When people hear “financial intermediary,” they often think of banks. Banks are major players in most economies, but they aren’t the only intermediaries. Other organizations - such as some cryptocurrency companies - can also perform bank-like functions, sometimes faster and at lower cost.

Financial intermediaries perform several important roles, including the following.

Risk reduction

Banks deal with large numbers of customers, often in the millions. Because they lend to many different borrowers, the risk is spread out.

This diversification reduces the chance that the bank becomes insolvent due to non-payment. Even if some borrowers fail to repay, others will repay.

Compare that with lending $5000 to a friend: if that one borrower doesn’t repay, you bear the full loss.

Aggregation

Large companies often need to borrow very large amounts.

For example, in 2022 Elon Musk bought Twitter for $44 billion, and much of it was funded by debt. A sum that large is unlikely to come from a single individual, because most people don’t have that amount available.

Banks can provide large loans because they aggregate funds collected from many customers.

Maturity transformation

Lenders often prefer to get their money back sooner to reduce the risk of delayed repayment. Borrowers usually prefer longer repayment periods so they can use the funds for longer.

These preferences conflict, and financial intermediaries help bridge the gap. Banks can:

• allow depositors to access funds relatively quickly, and
• provide borrowers with longer-term loans.

Management of money supply

Banks play a key role in managing money in the economy. Governments and central banks use the banking system to influence the money supply.

This links to what you learned in Chapter 4 about how banks are involved in managing interest rates.

We’ve covered some of the most common roles of financial intermediaries. You can probably think of others as you work through examples in the rest of the chapter.