This article focuses on capital markets and introduces the concepts of stocks and bond markets. Capital markets consist of primary and secondary markets, and are considered a critical factor in American capitalism. There is an exploration of the Capital Asset Pricing Model which compares individual assets and market returns based upon their respective risk and return trade-offs. In closing, there is a discussion of the impact of global capital markets.
The success of the financial market is important to citizens worldwide. "We live in a world that is shaped by financial markets and we are profoundly affected by their operation. Our employment prospects, our financial security, our pensions, the stability of the political systems and nature of the society we live in are all greatly influenced by the operations of these markets" (Fenton-O'Creevy, Nicholson, Soane, & Willman, 2005, p. 1-2). If the market is not healthy, there is potential for crises.
Financial markets can be defined in two ways. The term can refer to organizations that facilitate the trade of financial products, or it can refer to the interaction between buyers and sellers to trade financial products. Many who study the field of finance will use both definitions, but economics scholars tend to use the second meaning. Financial markets can be both domestic and international.
"Financial market" can be seen as an economic term because it highlights how individuals buy and sell financial securities, commodities, and other items at low transaction costs and prices that reflect efficient markets. The overall objective of the process is to gather all of the sellers and put them in one place so that they can meet and interact with potential buyers. The goal is to create a process that will make it easy for the two groups to conduct business.
When looking at the concept of "financial markets" from a finance perspective, one could view financial markets as a way to facilitate the process of raising capital, transferring risk, and conducting international trade. The overall objective is to provide an opportunity for those who desire capital to interact with those who have capital. In most cases, a borrower will issue a receipt to the lender as a promise of repayment. These receipts are called securities and can be bought or sold. Lenders expect to be compensated for lending the money. Their compensation tends to be in the form of interest or dividends.
Types of Financial Markets
There are different categories of financial markets, and some of them are:
- Capital markets -- Capital markets consist of primary and secondary markets and are considered a critical factor in American capitalism. New securities are bought and sold in the primary market, and investors sell their securities in the secondary markets. Companies rely on these markets to raise the funds needed to purchase the equipment required to run the business, conduct research and development, and assist in securing other items needed for the operations of the company.
- Stock markets -- In order to raise a large amount of cash at one time, public corporations will sell shares of ownership to investors. Investors gain profits when the corporations increase their earnings. Many view the Dow Jones Industrial Average as the stock market, but it is only one of many components. Two other components are the Dow Jones Transportation Average and the Dow Jones Utilities Average. Stocks are traded on world exchanges such as the New York Stock Exchange and NASDAQ.
- Bond markets -- Bonds are the opposite of stocks. Usually, when stocks go up, bonds go down. The different types of bonds include Treasury Bonds, corporate bonds, and municipal bonds. Mortgage interest rates are affected by bonds.
Financial Market Analysis
When one is analyzing the financial market, he or she has the option of using one of two approaches. Fundamental and technical analyses are two types of analysis, but they have different approaches in terms of whether or not to trade or invest in financial markets. Overall, the process focuses on how to select markets and tools in order to trade or invest and time when it is appropriate to open and close trades or investments in order to maximize returns.
According to Investorwords.com (2009), technical analysis is defined as:
A method in which to evaluate securities by relying on the assumption that market data (i.e. charts of price, volume, and open interest) may assist in predicting future (usually short-term) market trends. Unlike fundamental analysis, the intrinsic value of the security is not considered. Technical analysts believe that they can accurately predict the future price of a stock by looking at its historical prices and other trading variables. Technical analysis makes the assumption that market psychology influences trading in a manner that allows an analyst to predict when a stock will rise or fall. For that reason, many technical analysts are also market timers. Market timers believe that technical analysis can be applied just as easily to the market as a whole as to an individual stock.
According to Investopedia.com (2009), fundamental analysis is defined as:
A method in which to evaluate a security by attempting to measure its intrinsic value by examining related economic, financial, and other qualitative and quantitative factors. Fundamental analysts study those things that may affect the security's value, including macroeconomic factors (i.e. the overall economy and industry conditions) and individually specific factors (i.e. financial condition and management of companies). For example, the goal of fundamental analysis is to identify a value that an investor can compare with the security's current price with the expectation of determining what position to take with that specific security.
Specific Uses of Each Approach
Which is better? Both types of analysts have been successful in the designated fields. The "right" answer depends on what the investor is interested in. For example a long-term investor looking for strong companies, growth, and income potential may be interested in the fundamental approach. However, long-term investors who diversify, or spread their investments across multiple organizations in order to minimize risk, or short-term investors waiting for a change in sentiment, may not be overly concerned about a company's current status. These types of investors would probably support the technical approach. Given the strengths of both approaches, many investors tend to find benefits from each type of analysis. Technical analysts can provide information on the broad market and its trends (macro level), whereas, fundamental analysts can assist an investor in determining whether or not an issue has the basics in order to meet the investor's needs (micro level). In order to get a glimpse of the "big picture," it may be beneficial to take the best from both approaches.
Capital Asset Pricing...
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