Financial Markets Classification
Financial Markets is a marketplace where creation and trading of financial assets including shares, bonds, debentures, commodities, etc take place is known as Financial Markets. Financial marketsFinancial MarketsThe term "financial market" refers to the marketplace where activities such as the creation and trading of various financial assets such as bonds, stocks, commodities, currencies, and derivatives take place. It provides a platform for sellers and buyers to interact and trade at a price determined by market forces. act as an intermediary between the fund seekers (generally businesses, government, etc.) and fund providers (generally investors, households, etc.). It mobilizes funds between them, helping in the allocation of the country’s limited resources. Financial Markets can be classified into four categories –
- By Nature of Claim
- By Maturity of Claim
- By Timing of Delivery
- By Organizational Structure
Let us discuss each one of them in detail –
#1 – By Nature of Claim
Markets are categorized by the type of claim the investors have on the assets of the entity in which they have made the investments. There are broadly two kinds of claims, i.e. fixed claim and residual claim. Based on the nature of the claim, there are two kinds of markets, viz.
Debt market refers to the market where debt instruments such as debentures, bondsBondsA bond is financial instrument that denotes the debt owed by the issuer to the bondholder. Issuer is liable to pay the coupon (an interest) on the same. These are also negotiable and the interest can be paid monthly, quarterly, half-yearly or even annually whichever is agreed mutually., etc. are traded between investors. Such instruments have fixed claims, i.e. their claim in the assets of the entity is restricted to a certain amount. These instruments generally carry a coupon rate, commonly known as interest, which remains fixed over a period of time.
In this market, equity instruments are traded, as the name suggests equity refers to the owner’s capital in the business and thus, have a residual claim, implying, whatever is left in the business after paying off the fixed liabilities belongs to the equity shareholdersEquity ShareholdersShareholder’s equity is the residual interest of the shareholders in the company and is calculated as the difference between Assets and Liabilities. The Shareholders' Equity Statement on the balance sheet details the change in the value of shareholder's equity from the beginning to the end of an accounting period., irrespective of the face value of shares held by them.
#2 – By Maturity of Claim
While making an investment, the time period plays an important role as the amount of investment depends on the time horizon of the investment, the time period also affects the risk profile of an investment. An investment with a lower time period carried lower risk as compared to an investment with a higher time period.
There are two types of market-based on the maturity of claim:
Money marketMoney MarketThe money market is a market where institutions and traders trade short-term and open-ended funds. It enables borrowers to readily meet finance requirements through any financial asset that can be readily converted into money, providing an organization with a high level of liquidity and transferability. is for short term funds, where the investors who intend to invest for not longer than a year enter into a transaction. This market deals with Monetary assets such as treasury billsTreasury BillsTreasury Bills or a T-Bill controls temporary liquidity fluctuations. The Central Bank is responsible for issuing the same on behalf of the government. It is given at its redemption price and a discounted rate and is repaid when it reaches maturity., commercial paperCommercial PaperCommercial Paper is a money market instrument that is used to obtain short-term funding and is often issued by investment-grade banks and corporations in the form of a promissory note., and certificates of deposits. The maturity period for all these instruments doesn’t exceed a year.
Since these instruments have a low maturity period, they carry a lower risk and a reasonable rate of return for the investors, generally in the form of interest.
Capital marketCapital MarketA capital market is a place where buyers and sellers interact and trade financial securities such as debentures, stocks, debt instruments, bonds, and derivative instruments such as futures, options, swaps, and exchange-traded funds (ETFs). There are two kinds of markets: primary markets and secondary markets. refers to the market where instruments with medium- and long-term maturity are traded. This is the market where the maximum interchange of money happens, it helps companies get access to money through equity capital, preference share capital, etc. and it also provides investors access to invest in the equity share capital of the company and be a party to the profits earned by the company.
This market has two verticals:
- Primary Market – Primary MarketPrimary MarketThe primary market is where debt-based, equity-based or any other asset-based securities are created, underwritten and sold off to investors. It is a part of the capital market where new securities are created and directly purchased by the issuer. refers to the market, where the company lists security for the first time or where the already listed company issues fresh security. This market involves the company and the shareholders to transact with each other. The amount paid by shareholders for the primary issue is received by the company. There are two major types of products for the primary market, viz. Initial Public OfferInitial Public OfferInitial Public Offering (IPO) is when the shares of the private companies are listed for the first time in the stock exchange for public trading and investment. This allows a private company to raise the capital for different purposes. (IPO) or Further Public Offer (FPO).
- Secondary Market – Once a company gets the security listed, the security becomes available to be traded over the exchange between the investors. The market that facilitates such trading is known as the secondary market or the stock market.
In other words, it is an organized market, where trading of securities takes place between investors. Investors could be individuals, merchant bankers, etc. Transactions of the secondary market don’t impact the cash flow position of the company, as such, as the receipts or payments for such exchanges are settled amongst investors, without the company being involved.
#3 – By Timing of Delivery
In addition to the above-discussed factors, such as time horizon, nature of the claim, etc, there is another factor that has distinguished the markets into two parts, i.e. timing of delivery of the security. This concept generally prevails in the secondary market or stock market. Based on the timing of delivery, there are two types of market:
In this market, transactions are settled in real-time and it requires the total amount of investment to be paid by the investors, either through their own funds or through borrowed capital, generally known as margin, which is allowed on the present holdings in the account.
In this market, the settlement or delivery of security or commodity takes place at a future date. Transactions in such markets are generally cash-settled instead of delivery settled. In order to trade in the futures market, the total amount of assets is not required to be paid, rather, a margin going up to a certain % of the asset amount is sufficient to trade in the asset.
#4 – By Organizational Structure
Markets are also categorized based on the structure of the market, i.e. the manner in which transactions are conducted in the market. There are two types of market, based on organizational structure:
Exchange-Traded MarketExchange-Traded MarketAn exchange-traded fund (ETF) is a security that contains many types of securities such as bonds, stocks, commodities, and so on, and that trades on the exchange like a stock, with the price fluctuating many times throughout the day when the exchange-traded fund is bought and sold on the exchange. is a centralized market, that works on pre-established and standardized procedures. In this market, the buyer and seller don’t know each other. Transactions are entered into with the help of intermediaries, who are required to ensure the settlement of the transactions between buyers and sellers. There are standard products that are traded in such a market, there cannot need specific or customized products.
This market is decentralized, allowing customers to trade in customized products based on the requirement.
In these cases, buyers and sellers interact with each other. Generally, Over-the-counter market transactions involve transactions for hedging of foreign currency exposure, exposure to commodities, etc. These transactions occur over-the-counter as different companies have different maturity dates for debt, which generally doesn’t coincide with the settlement datesSettlement DatesThe settlement date is the date on which the cash and assets that have been exchanged or traded are settled by netting out a process that happened a few days ago. Commonly for shares, it is two business days after the trade. of exchange-traded contracts.
Over a period of time, financial markets have gained importance in fulfilling the capital requirements for companies and also providing investment avenues to the investors in the country. Financial markets provide transparent pricing, high liquidity, and investor protection, from frauds and malpractices.
This has been a guide to the Classification of Financial Markets. Here we discuss the top 4 classifications of financial markets 1) By Nature of Claim 2) By Maturity of Claim 3) By Timing of Delivery 4) By Organizational Structure. You can learn more about Corporate Finance from the following articles –