2-Financial Markets Page 25 Wednesday, February 4, 2004 1:15 PM
Overview of Financial Markets, Financial Assets, and Market Participants 25FINANCIAL MARKETS
Financial assets are traded in a financial market. Below we discuss how
financial markets can be classified and the functions of financial mar-
kets.Classification of Financial Markets
There are five ways that one can classify financial markets: (1) nature of
the claim, (2) maturity of the claims, (3) new versus seasoned claims, (4)
cash versus derivative instruments, and (5) organizational structure of
the market.
The claims traded in a financial market may be either for a fixed
dollar amount or a residual amount and financial markets can be classi-
fied according to the nature of the claim. As explained earlier, the
former financial assets are referred to as debt instruments, and the
financial market in which such instruments are traded is referred to as
the debt market. The latter financial assets are called equity instruments
and the financial market where such instruments are traded is referred
to as the equity market or stock market. Preferred stock represents an
equity claim that entitles the investor to receive a fixed dollar amount.
Consequently, preferred stock has in common characteristics of instru-
ments classified as part of the debt market and the equity market. Gen-
erally, debt instruments and preferred stock are classified as part of the
fixed income market.
A second way to classify financial markets is by the maturity of the
claims. For example, a financial market for short-term financial assets is
called the money market, and the one for longer maturity financial
assets is called the capital market. The traditional cutoff between short
term and long term is one year. That is, a financial asset with a maturity
of one year or less is considered short term and therefore part of the
money market. A financial asset with a maturity of more than one year
is part of the capital market. Thus, the debt market can be divided into
debt instruments that are part of the money market, and those that are
part of the capital market, depending on the number of years to matu-
rity. Because equity instruments are generally perpetual, a third way to
classify financial markets is by whether the financial claims are newly
issued. When an issuer sells a new financial asset to the public, it is said
to “issue” the financial asset. The market for newly issued financial
assets is called the primary market. After a certain period of time, the
financial asset is bought and sold (i.e., exchanged or traded) among
investors. The market where this activity takes place is referred to as the
secondary market.