Financial markets: What are they and how do they work?

Financial markets are spaces where assets or financial instruments are exchanged. These assets represent rights to future money flows. In other words, they are a way of investing or financing in the present with the expectation of obtaining a return or profit in the future.

In the economic sphere, financial markets have an essential function because they allow savings to be channelled into investment, facilitate risk management, contribute to the formation of prices, and promote growth and development. But, like everything, they need regulations and supervision so that they do not generate instability or lead to crises.

Do you want to know more about financial markets? Keep reading!

Types of financial markets

Financial markets can be classified according to different criteria, such as term, liquidity, organization, transparency or the degree of intervention. Below, we discuss the most common types:

• Money or monetary market: it is the market where financial assets are traded in the short term, that is, in less than a year. These assets have low risk and return, and high liquidity. It serves to finance the treasury needs of economic agents, and to regulate the money supply by central banks.
• Capital or fixed and variable income markets: works with medium and long-term financial assets (more than one year). It has a higher risk and return than the money market, and lower liquidity. It is useful for financing investment projects by companies and governments, and for allowing investors to participate in the profits or losses of such projects.
• Foreign exchange or exchange market: as its name indicates, it is related to the currencies of different countries. These currencies have a price relative to each other, which is called the exchange rate. This market serves to facilitate international trade, financial operations between countries, and speculation on currency fluctuations.
• Derivatives market: commercial transactions are carried out with contracts that derive their value from another financial asset. Contracts can be of different types, such as futures, options or swaps. It is important to know that they have high risk and high return, and low liquidity. It is usually used to hedge the risk of changes in the prices of underlying assets, and to speculate on these variations.

Characteristics of financial markets

At this point, you must keep in mind that there are elements that characterize and differentiate financial markets. Take note that we tell you:

• Liquidity: it is the ease with which a financial asset can be bought or sold without its price being affected.
• Depth: it is the ability of a market to absorb large volumes of buying and selling of financial assets without their price changing significantly.
• Breadth: refers to the degree of diversity of the financial assets traded in a market.
• Transparency: is associated with the information offered to market participants about the characteristics, prices and conditions of the financial assets that are traded.
• Efficiency: indicates the ability of a market to reflect all the available information in the prices of financial assets, so that these prices are a reliable indicator of the real value of the assets.

Functions of financial markets

Financial markets fulfil the function of allocating resources between economic agents who have a savings surplus and those who have an investment deficit. In this way, the use of available resources is optimized and production and consumption increase. In addition, they manage the risks associated with economic activities, using financial instruments that ensure or modify future money flows, or through participation in secondary markets where the assets they own can be sold or bought.

On the other hand, they also have the function of forming prices of financial assets. The prices of financial assets reflect the present value of the future money flows generated by these assets, and also incorporate available information about market conditions and expectations. Finally, they transmit relevant information to economic agents about market conditions and expectations, so that their investment, consumption, savings and production decisions are guided, and their responsible, innovative and sustainable behaviour is encouraged.

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