Investing 101: What are the Financial Markets? Looking at Capital Markets.

The term financial markets is a fancy one that’s frequently banded around, but what does it mean?

What are they? Let’s start at the very beginning…

A market is a space dedicated for the exchange of assets between market agents (buyers and sellers). Examples of this include car dealerships, supermarkets, or an open market (like the Birmingham flea market or German Christmas Markets that pop up each winter in many cities around the globe). Markets make trading more efficient by allocating a common platform for bartering and exchange. This saves time and energy, as prices and traders are readily available in the area, removing the burden of searching for different suppliers and prices. These efficiencies result from easier access to market information ( one can walk around the market and get a range of prices from different sellers), higher information symmetry (everyone in the market can see everyone’s prices transparently), physically closer (quicker to trade), and higher assurance for goods (one will most likely find desired products quicker wandering through a market than by searching in various stores across town).

Financial markets are no different, except they are primarily used for investing rather than consuming. Financial markets transfer agents’ surplus funds to agents with funding deficits – e.g. transferring surplus money from an investor to a start-up business requiring money – this is known as raising financial capital. Institutions sell financial assets, known as securities, in exchange for liquidity (money to spend); there are many different types of securities but essentially, there two main types - debt and equity. Ultimately these securities are contracts promising payments back to the owner, and these are traded on capital markets.

Debt securities (government or corporate bonds for example) promise repayments to owners, whereas equity assets (shares in a business) promise ownership of a company, and usually dividends (optional payment of a business’ profits) to the shareholders. In simple terms, the main difference is that debt assets promise monetary repayments, whereas equity assets promise ownership of business capital.

Debt securities increase assets and liabilities for the business whilst retaining ownership, whereas equity securities increase the business’ assets at the loss of ownership but keeping liabilities unchanged. Again, to simplify this, we’ll use an example. Tesco, the British supermarket, can raise money through either debt or equity. By issuing shares, it allows shareholders to purchase equity in the company, which grants them part ownership of Tesco. Or, alternatively, it can issue debt – it may say to creditors, “if you buy our 10 year corporate bond for £500 today, we’ll promise a coupon (yearly repayment) of £10, and to return the £500 on maturity of the bond (after 10 years when it expires).” In this way, Tesco gains the £500 (an asset) to invest, but will owe repayments over the years and the face value (£500) and at maturity (liabilities).

Financial markets are used for financing/investing – two sides of the same coin. For security buyers, an initial outlay (cost) is spent in expectation of receiving future income that should exceed the initial outlay – this is their investment. For sellers, liabilities or ownership is sold in exchange for liquidity. This liquidity is then invested to grow the business and generate future profits. Some of these profits are transferred to debtholders as interest on repayments, and to shareholders in the form of dividends, with the latter being optional and the former being a business liability.

There are three main type of capital markets

Primary markets provide the initial issuance of assets directly to buyers; this is where financial assets such as equities, bonds, and derivatives are created, and first supplied directly from the supplier for a fixed price. This process generates liquidity for an institution (money gained from selling the financial product) so that they have money to invest. Alternatively, institutions may issue these products as part of capital restructuring – adjusting debt and equity values to change the financial structure of the business. IPOs are executed on the primary market – however, they are generally unavailable to small investors. Normally, only larger institutions have access to this market with the task of matching buyers to the seller.

Secondary markets are for reselling; prices are floating, changing with supply and demand of the asset. This market mainly acts to transfer securities from older investors to newer investors. They are more accessible to smaller investors, generally with larger institutions providing the assets. Examples of common secondary markets are the New York Stock Exchange (NYSE), London Stock Exchange (LSE), or NASDAQ. Profit from capital gains can also be earned here (capitalising on price action (price movements)).

The Over the Counter (OTC) market, unlike the public primary and secondary securities markets, is private. They are generally used by larger institutions pertaining higher value transactions and more complex financial products. For example, credit SWAPs, CDOs (collateralised debt obligations) and other derivative products. Although there are less transactions in the OTC market, they are of much higher value. The OTC market is estimated to be over seven times larger than the exchange markets; in December 2015, OTC was valued at $492.9 trillion USD and the size of the exchange traded market was $63.3 trillion USD.

These financial markets play a crucial role in the transfer of surplus funds to fund deficient institutions, with the majority of the market value being privately held. I hope this provides a broadened insight into the financial markets, past just the exchange markets. Although this article focuses on the capital markets, the fundamental concepts of debt and equity securities can be carried into the other financial markets, such as the money markets, as they follow the same premise.

Closing comments:

Derivatives are the third main type of financial security – its function is different to that of debt and equity securities; more on derivatives will be covered in later articles.

If you have any questions, please drop a comment down below.

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