How do financial markets work?

Just like any other markets, financial markets work through demand and supply. The commodities which are traded are financial assets, or financial securities, such as stocks and bonds. The demand side of the market comes from investors who demand financial securities. Investors wish to hold securities in their portfolios and are willing to pay a price which is appropriate, given the expected return on that security and its risk. The supply side of the market comes from firms that issue securities, stocks and bonds, and other assets. Again, the prices at which these securities can be sold depend on the expected return and on the risks associated with these securities.

The price of assets in financial markets is therefore determined by the matching of demand and supply.

There are many different types of financial markets. Firstly, there are capital markets, which are markets where stocks, bonds, and long term financial securities with a maturity of more than one year, are traded. We also have money markets, which specialise in raising short term finance, and where bonds with a maturity of less than one year are bought and sold. When the asset being traded is a commodity, such as oil, gold, or coffee, then we have a commodity market. Other financial securities, such as futures and options, can be very versatile hedging instruments, and these are traded in the derivatives markets. We’ll be studying derivatives in week three of this course.

Finally, you can buy yourself currencies such as US dollars, euros, Japanese yen on foreign exchange markets. The price at which foreign currencies are traded is the exchange rate.

We all know banks. They are financial institutions which receive deposits and make loans. We can distinguish between commercial banks, which specialise in providing services to individuals and to small businesses, and investment banks, which specialise in providing financial services to corporate clients. Banks offer a variety of payment services, and can also offer financial advice. In recent years, banks have had to rethink the way they conduct their business because of the increased use of online and mobile banking to carry out banking operations. Investment banks specialise in offering banking services to institutional clients such as large corporations. They buy and sell securities on their behalf and offer financial advice, for instance, when a corporation is considering acquiring or merging with another company.

Building societies, they mostly deal with mortgage lending. Originally, they were set up to allow their members to pool their resources so that houses could be built for them. At a later stage of development, outside investors were also called in. And nowadays, building societies compete with commercial banks in offering a wide variety of services.

Insurance companies form a very important category of financial institutions. By paying a premium, you buy insurance against the occurrence of an adverse event, which could involve a loss. If the event does occur, you receive compensation to offset your losses fully, or in part. Insurance contracts are therefore very important for risk management and for hedging. We also have pension funds. A pension fund is effectively a financial plan, usually sponsored by a company, to provide an income to its members upon their retirement. You pay contributions throughout your working life and receive a benefit in the form of a pension when you retire. Employers often also contribute to the pension fund.

In a broad sense, investors are any individuals or institutions that lend money. In practise, we may all invest in ways we will not be fully aware of. For instance, when we purchase insurance, we are lending to the insurance company, and therefore we are investing. The same applies when we contribute to a pension plan. Some forms of lending are more obvious, such as when we save money with a bank, or when we buy government bonds or corporate stocks.