What it means
Financial markets do two jobs at once. They move capital from savers to borrowers, and they discover prices by aggregating what thousands of participants think an asset is worth at a given moment.
Markets are usually split into primary and secondary. In the primary market, an asset is created and sold for the first time, such as a company issuing new shares or a government issuing bonds, and the money raised goes to the issuer.
In the secondary market, existing assets change hands between investors, and the issuer receives nothing from the trade. They are also split by what is traded.
Equity markets deal in ownership stakes, debt markets in loans and bonds, foreign exchange markets in currencies, commodity markets in physical goods such as oil and wheat, and derivatives markets in contracts whose value depends on something else. The quality of a market is usually judged by its liquidity, meaning how easily you can buy or sell a meaningful quantity without moving the price against yourself.
Liquidity shows up most visibly in the bid-ask spread, the gap between the best price a buyer will pay and the best price a seller will accept. Thin markets have wide spreads and unpredictable execution.
For a business that is not a financial firm, markets still matter directly. They set the interest rate on borrowing, the exchange rate on imports, the price of hedging fuel or metals, and the valuation multiple a buyer might one day apply to the company itself.
In practice
Real-world examples.
Example
A mid-sized furniture importer buys euros forward through the foreign exchange market to fix the cost of a shipment due in four months. The rate is locked, so a later currency move cannot damage the gross margin already promised to retailers.
Example
A local authority raises $80 million by issuing 20-year bonds to fund a water treatment upgrade. Pension funds buy the bonds in the primary market, and a decade later those same bonds trade between investors in the secondary market at prices reflecting current interest rates.
Example
A private founder tracks the share prices of three listed competitors to sense what buyers might pay for her own business. The public market gives her a valuation benchmark she could not otherwise obtain.
Formula
Calculation
The most commonly quoted market measure is the bid-ask spread:
Spread = Ask Price - Bid Price
Spread Percentage = Spread / Midpoint Price
Suppose a share is quoted with a bid of $49.90 and an ask of $50.10.
Spread = $50.10 - $49.90 = $0.20
Midpoint = ($50.10 + $49.90) / 2 = $50.00
Spread Percentage = $0.20 / $50.00 = 0.4%
Now put that into money terms. A fund buying 10,000 shares pays the ask, $50.10 x 10,000 = $501,000. If it changed its mind and sold immediately at the bid, it would receive $49.90 x 10,000 = $499,000, a round-trip cost of $2,000 before any commission.
That $2,000 is the price of using the market, and it is why liquidity is treated as a real cost rather than an abstraction.Case study
Seen in the real world.
Harborlight Beverages is a fictional drinks manufacturer used here purely as an illustration. It buys large volumes of aluminium for canning and had always paid the prevailing spot price, which meant its input cost swung with the metals market and its quarterly margin swung with it.
The finance team began using the commodity futures market to fix the price of roughly 60% of the following year's aluminium requirement, leaving the remainder floating so the company could still benefit if prices fell. Margins did not improve on average, but the range narrowed considerably, and the sales team could hold list prices for a full year instead of renegotiating every quarter.
The illustrative lesson is that a financial market is not only somewhere to invest. For an ordinary operating business it is often a tool for making next year's costs predictable.
Watch out
Common mistakes.
- Assuming a financial market means the stock market, when debt, currency, commodity and derivatives markets are far larger by value traded.
- Believing a company receives money every time its shares change hands, when secondary market trades pass cash between investors and never reach the issuer.
- Ignoring the bid-ask spread when comparing investments, so a thinly traded asset looks cheaper than it really is once trading costs are counted.
Questions
People also ask.
What makes a market liquid?
A large number of willing buyers and sellers at any moment, which narrows the spread and lets sizeable orders trade without a big price move.
Are financial markets always efficient?
Not perfectly, though prices in heavily traded markets absorb public information quickly enough that consistently beating them is difficult.
Do private companies use financial markets?
Yes, through borrowing, hedging currency and commodity exposure, and by using listed comparable companies as valuation reference points.
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