Whether it’s the neighborhood grocery store, the weekend farmer’s market, an auction or even an online marketplace like Amazon or your state’s health insurance exchange, markets work to bring together interested buyers and sellers so mutually beneficial transactions can take place.
Financial markets are no different. However, instead of involving a tangible good or service, financial markets facilitate transactions for financial instruments, such as stocks and bonds.1
In this guide, you’ll learn what financial markets are and how they function.
Primary vs. Secondary Markets
When talking about financial markets, it’s important to differentiate between the primary market and secondary markets. Technically speaking, there are third and fourth markets, but those exist solely for large institutional investors, making them a nonissue for the average retail investor.2
What Is a Primary Financial Market?
A primary financial market consists of a company selling its stock directly to investors. It’s often used synonymously with the term “initial public offering” (IPO), although there are cases when a company sells additional shares later on through a follow-on public offering (FPO).2
In the primary financial market, companies raise capital by trading away equity—ownership in the underlying business—in exchange for cash. This cash is often used to fund business expansions. Sometimes owners of a privately held company “cash out” their stake in a business by holding an IPO2. This lets them sell some or all of their company ownership.
What Is a Secondary Financial Market?
Secondary financial markets let investors trade previously issued financial instruments, such as stocks, bonds or other highly liquid assets among themselves.2 For example, at the New York Stock Exchange, traders buy and sell stocks based on whether they believe prices will rise or fall.
Financial Market Functions
Financial markets perform a number of important functions that help to keep the economy humming and businesses growing.
Setting Prices
Imagine that you want to purchase a share of stock from Amazon. You find a seller who’s willing to part with one share in exchange for $20. In the absence of competition, you have no idea if this price is too high or too low. A robust marketplace lets buyers and sellers arrive at a market price that takes into account multiple variables, such as:1
- Cash flow
- Debt levels
- Senior leadership
- Market position
- Competitive advantages
Observers can use these factors to predict a company’s future performance.
Allocating Capital
One of the most important functions of primary financial markets is to efficiently allocate capital.1 In other words, they provide investors with information that they can use to make informed investing decisions. This causes capital to flow toward the businesses most likely to achieve success.
Raising Liquidity
Financial markets help organizations raise liquidity, which refers to cash or assets that are easily convertible to cash.1 Ready access to funds is an important element of business growth. While there are other avenues to raising liquidity, they generally entail incurring debt. Servicing a loan repayment with various interest rates can make it harder for a business to grow. In contrast, selling equity lets businesses access a large amount of funds in a short time with no debt obligations.
Connecting Buyers to Sellers
Once human cultures reach a certain size, marketplaces tend to spring up naturally because they serve a fundamental function. By connecting buyers to sellers, marketplaces provide both parties with convenience, security and efficiency.