What are financial markets?

Every day trillions of dollars get moved about electronically on the world’s financial markets, the nature of which acts as a heart rate monitor for our global economic health.

In the past couple of years, the world has been obsessed with this heart rate as it has tried to climb out of recession.

So what exactly are these financial markets that play such a crucial role in the economic world?

The financial markets

‘Financial markets’ is the term used to describe the exchanges where buyers and sellers come to trade financial products.

These traded products include shares, money (loans), commodities (oil, wheat, cotton etc), risk management (insurance, derivatives) and currencies.

But unlike say a supermarket, most financial markets have no physical location.

Some physical trading is done at places like the New York Stock Exchange and the Chicago Mercantile Exchange. But the vast majority is done through computer systems.

Some trading by-passes exchanges altogether in what’s called over-the-counter (OTC) transactions – often the more complex and sometimes controversial arrangements.

Most countries have their own financial markets but the ones that tend to dictate the world’s status are based in New York (Wall Street), London, Paris, Frankfurt, Tokyo and Hong Kong.

What are their functions?

On the whole, financial markets are good for society because they bring buyers and sellers together in an efficient manner.

Capital (money) markets, for instance, facilitate the lending of money. Lenders or depositors (people and companies) use middlemen such as banks and funds to give loans to borrowers.

Currency markets involve more of a trading focus. Goods exporters and importers used to be the main traders of currency. However, these days they only make up about 3% of the trading.

Most of it is done by banks moving money around, and speculators gambling on the rates. Governments, exporters/importers and tourists make up the rest.

Commodity markets are where buyers and sellers of commodities (oil, tin, corn, milk, wool etc) negotiate their future supply quantities and prices.

The final group is derivative markets – a form of managing risk and minimising costs.

These are a horrible concept to get one’s head around, but are essentially contracts between two parties whose value is based on a future event or the price movement of an asset – wool, a loan interest rate or a payment default for example.

This market is valued globally at over US$500 trillion and is both a blessing and a curse.

On the one hand it enables companies to save money on borrowing or minimise their risk by contractually protecting themselves against heavy cash flow changes – a practice known as ‘hedging’.

But on the other hand, there are very few rules around its trading. And there is an abundance of white-collar gamblers taking massive bets on these derivatives, which are often based on complex mathematical equations.

It’s a predominantly “shadow market” that President Obama and the US Congress are currently trying to change with their new financial laws passed last Friday (and set to be approved this week).

Credit default swaps, for example, are a type of a derivative based on the event of mortgage payment defaults. These largely brought down the world economy in 2008.

Characteristics of financial markets

Here are a few characteristics of the movements of financial markets:

• In times of economic uncertainty (like now), financial markets all over the world tend to follow each other from day to day, with American markets generally dictating movements.

• When markets fall due to bad economic news or feeling, the value of gold and the US Dollar usually goes up as they are seen as safe havens. This is because people always want gold and the Dollar is required in so many global transactions.

• The value of a country’s currency rises and falls with its interest rates. This is because people can earn more from bank deposits in that country if local interest rates rise, but they have to buy the local currency first.

• Whenever global demand goes down, so do share markets and the price of commodities (and vice-versa).

• Share prices generally reflect the foreseeable earnings of that company 6-12 months in advance.

• The cost of borrowing money (interest rate) essentially depends on two things: how much money is around (supply) and the likelihood the lender will get it back (risk).

As turbulent economic conditions continue this year – with European spending cuts at one end and emerging countries such as the BRICs trying to fuel growth at the other – financial markets and a large chunk of the world’s population will share the same roller-coaster ride.

By The Casual Truth