Financial markets: what they are and how they work today

The financial markets are spaces where financial assets or instruments are traded. These assets represent rights over future cash flows. In other words, they are a way to invest or obtain financing in the present with the expectation of earning a return or profit in the future. 

In the economic field, financial markets play an essential role since they allow the channeling of savings into investment, facilitate risk management, contribute to price formation, and foster growth and development. However, like everything else, they require regulation and supervision to prevent instability or 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 degree of intervention. Below, we explain the most common types:  

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

Characteristics of financial markets

At this point, you should keep in mind that there are elements that characterize and differentiate financial markets. Take note, we’ll tell you what they are:  

• Liquidity: it is the ease with which a financial asset can be bought or sold without its price being affected.  
• Depth: it is the capacity of a market to absorb large volumes of buying and selling of financial assets without their prices changing significantly. 
• Breadth: it refers to the degree of diversity of financial assets traded in a market.  
• Transparency: it is associated with the information offered to market participants about the characteristics, prices, and conditions of the financial assets being traded.  
• Efficiency: it indicates the ability of a market to reflect all 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 serve the function of allocating resources among economic agents who have a surplus of savings and those who have an investment deficit. In this way, the use of available resources is optimized, and production and consumption are increased. In addition, they manage risks associated with economic activities by using financial instruments that allow them to secure or modify future cash flows or through participation in secondary markets where owned assets can be sold or bought.  

Furthermore, they also perform the function of price formation for financial assets. The prices of financial assets reflect the present value of future cash 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, helping to guide their decisions on investment, consumption, saving, and production, and to encourage responsible, innovative, and sustainable behavior. 

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