Classification Of Financial Markets

What Are The Classification Of Financial Markets?

The financial market is a marketplace where the creation and trading of financial assets, including shares, bonds, debentures, commodities, etc., is held. 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.read more are intermediaries between fund seekers (generally businesses, government, etc.) and fund providers (typically investors, households, etc.).

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It mobilizes funds between them, helping allocate the country’s limited resources. Thus, they are a meeting point for both the buyers and sellers where they can purchase and sell financial assets. This helps in proper capital allocation, mobilization of resources, and price discovery.

Classification Of Financial Markets Explained

The financial market is a platform or an arrangement in which various types of financial instruments are bought and sold among market participants. These instruments may be bonds, commodities, stocks, derivatives, currencies, etc. The buyers and sellers meet in these platforms to exchange the assets. They form an important part of the financial market and help the participants achieve investment objectives, assess the risk tolerance and develop an outlook towards the market.

The classification of international financial markets can be of four categories: –

1. By Nature of Claim
2. By Maturity of Claim
3. By the Timing of Delivery
4. By Organizational Structure

However, these markets are very well regulated by the regulatory bodies and the government of the country. This ensures a transparent and fair-trading practice in the system, proper investor protection and maintenance of market integrity. The entire global financial system operate through these markets, which guides the individuals, corporates as well as economies to manage risk, create profitable investment opportunities and facilitate capital allocation.

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Types

Let us discuss classification of international financial markets in detail –

#1 – By Nature of Claim

Markets are categorized by the type of claim the investors have on the entity’s assets in which they have made the investments. There are broadly two kinds of claims, i.e., fixed and residual. Based on the nature of the claim, there are two kinds of markets, viz.

Debt Market

A debt market is when debt instruments such as debenturesDebenturesDebentures refer to long-term debt instruments issued by a government or corporation to meet its financial requirements. In return, investors are compensated with an interest income for being a creditor to the issuer.read more, bondsBondsBonds refer to the debt instruments issued by governments or corporations to acquire investors’ funds for a certain period.read more, etc., are traded between investors. Such instruments have fixed claims, i.e., their share in the entity’s assets is restricted to a certain amount. In addition, these instruments generally carry a coupon rate, commonly known as interest, which remains fixed over some time.

Equity Market

In this market, equity instruments are traded. As the name suggests, equity refers to the owner’s capital in the business. It thus has a residual claim, implying that whatever is left in the industry 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.read more, irrespective of the face value of their shares.

#2 – By Maturity of Claim

While investing, time plays an important role as the amount of investment depends on the time horizon of the acquisition. The time also affects the risk profile of an investment. An investment with a lower time carries a lower risk than an investment with a higher period.

There are two types of market-based on the maturity of claim: –

Money Market

The Money marketMoney MarketThe money market is a financial market wherein short-term assets and open-ended funds are traded between institutions and traders.read more 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 assetsMonetary AssetsMonetary assets are short-term assets that can be easily and quickly liquidated, such as cash and cash equivalents, short-term investments, and receivables. They have a fixed monetary value.read more such as treasury billsTreasury BillsTreasury Bills (T-Bills) are investment vehicles that allow investors to lend money to the government.read more, 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.read more, and certificates of deposits. The maturity period for all these instruments does not 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 interest.

Capital Market

The 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.read more is when instruments with medium- and long-term maturity are traded. It is the market where the maximum interchange of money happens. It helps companies access money through equity capitalEquity CapitalEquity Capital refers to the capital collected by a company from its owners and other shareholders in exchange for a portion of ownership in the company.read more, preference share capital, etc. It also provides investors access to invest in the company’s equity share capital and be a party to the profits earned by the company.

This market has two verticals:

• Primary Market – Primary market Primary 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.read more refers to the market where the company lists security for the first time or the already listed company issues fresh security. It involves the company and the shareholders transacting with each other. In addition, the company receives the amount paid by shareholders for the primary issue. For the primary market, there are two major types of products, viz. Initial Public OfferInitial Public OfferAn initial public offering (IPO) occurs when a private company makes its shares available to the general public for the first time. IPO is a means of raising capital for companies by allowing them to trade their shares on the stock exchange.read more (IPO) or Further Public Offer (FPO).
• Secondary Market – Once a company gets the security listed, the deposit becomes available to be traded over the exchange between the investors. The market that facilitates such trading is the secondary market Secondary MarketA secondary market is a platform where investors can easily buy or sell securities once issued by the original issuer, be it a bank, corporation, or government entity. Also referred to as an aftermarket, it allows investors to trade securities freely without interference from those who issue them.read more or the stock market.

In other words, it is an organized market where securities trading occurs between investors. Investors could be individuals, merchant bankers, etc. Transactions of the secondary market do not impact the company’s cash flow position; as such, 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., another factor 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. Depending on the timing of delivery, there are two types of markets:

Cash Market

In this market, transactions are settled in real-time. Therefore, it requires the total amount of investment to be paid by the investors, either through their funds or borrowed capital, generally known as margin, which is allowed on the present holdings in the account.

Futures Market

In this market, the settlement or delivery of security or commodity occurs later. Therefore, transactions in such markets are generally cash-settled instead of settled delivery. For trading in the futures marketFutures MarketA futures market is a financial marketplace where participants trade futures contracts for commodities, stock indices, currency pairs, and interest rates at a pre-determined rate and agreed-upon future date. It, thus, protects investors and traders from losing money on a transaction even if the price of the commodity or financial instrument rises or falls later.read more. Rather, a margin going up to a certain percentage of the asset amount is sufficient to trade in the asset.

#4 – By Organizational Structure

Markets are also categorized based on the market structure, i.e., how transactions are conducted. There are two types of the markets, based on organizational structure: –

Exchange-Traded Market

An exchange-traded market Exchange-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.read more is a centralized market that works on pre-established and standardized procedures. In this market, the buyer and seller do not know each other. Transactions are entered 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. Therefore, they cannot need specific or customized products.

Over-the-Counter Market

This decentralized market allows customers to trade customized products based on their requirements.

In these cases, buyers and sellers interact with each other. Generally, over-the-counter market transactions involve hedgingHedgingHedging is a type of investment that works like insurance and protects you from any financial losses. Hedging is achieved by taking the opposing position in the market.read more foreign currency exposure, exposure to commodities, etc. These transactions occur over-the-counter as different companies have different maturity dates for debt, which generally does not 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.read more of exchange-traded contracts.

Over time, financial markets have gained importance in fulfilling the capital requirements for companies and providing investment avenues to the investors in the country. Financial markets offer transparent pricing, high liquidity, and investor protection from frauds and malpractices.

Examples

Let us understand the concept with the help of some suitable examples.

Example #1

Let us assume the Jack is an investor who wants to invest funds now in such a way that after 20 years, the fund multiplies enough to meet the educational requirements of his daughter. He contacts the financial advisor who suggests him to invest in long term bonds, which will provide him with a regular interest payment that can be reinvested to increase the amount further. It is also comparatively less risky that stocks but return is more than certificate of deposits.

Thus, here we see that bonds, which are a type of debt market instrument, is giving Jack the opportunity of good and profitable investment.

Example #2

Let us assume that Mike wants to invest in some shares of ABC Ltd, which is a financially strong company and the shares are in an uptrend. Thus, Mike decides to buy 200 shares of the company at $100 each. After 3 months, the share price reaches $150, giving Mike a gain of $50 per share. This is a capital market instrument, which allow investors to gain from share price fluctuation.

Thus, the above examples show two different types of financial market and how investors can invest in them to meet their financial goals.

Frequently Asked Questions (FAQs)

Recommended Articles

This article is a guide to what are the Classification Of Financial Markets. We explain their different types along with some suitable examples. You can learn more about corporate finance from the following articles: –

• Real Estate Commissions
• Compare – Primary Market vs Secondary Market
• Top Functions of Financial Markets
• Money Market vs Capital Market
• Marking to Market