Financial Markets

Financial markets provide a way for people, companies, institutions, and even governments to get the money necessary to pay for a variety of purchases for goods, services, and large capital projects. The financial markets provide a mechanism for people to buy and sell financial instruments such as stocks, bonds, commodities, and other securities. In earlier times the financial marketplace was physical, but with the advent of computers it has become “virtual” as well.

Modern financial markets evolved from older trading markets. The modern markets are more efficient because they have been able to assemble a much larger number of investors than in earlier times; they are also able to offer a much wider array of securities for trading. Financial markets have undergone many changes in the last 300 years. Many of these changes are designed to protect capital, to increase fungibles, to increase liquidity, and to provide for trading at low transaction costs. Access to financial markets has also grown enormously with the advent of computers.

Students of financial markets have developed the efficient-market hypothesis (EMH). Developed by Eugene Fama of the University of Chicago, the hypothesis claims that financial markets are “infor-mationally efficient.” In effect this proposes that information on stocks, bonds, commodities, property, and other traded assets is well enough understood that the prices of the traded items result from full knowledge. The EMH is similar to assumptions of classical economics that said that an economy had perfect mobility of labor, capital, information, and other market affecting factors. These assumptions were rather gratuitous and not completely realistic.

Another assumption of the EMH is that it is impossible to outperform the market with knowledge that the market already has. News affects financial prices. It is unknowable and acting without it is like acting with the expectation that luck will provide the answers. The rise of news sources in the 1700s accompanied the development of the Industrial Revolution. News of ships affected insurance rates; news of weather, wars, and world problems affected prices. The individual who possessed advanced knowledge could beat the market in some instances. The case of Nathan Rothschild trading on news of the outcome of the Battle of Waterloo is a classic case of trading on knowledge before others get the news.

Markets may be general or specialized. Trading in general markets includes all manner of securities. Trading in specialized markets is limited to only one or a few commodities or securities. When markets are made they create a “space” for people to engage in exchange. The market may have only a few traders or a great many bidding for the values being traded. Free markets allow individuals to trade with few or no restrictions. Command economies seek to dictate the course of the trading or its outcome. Many of the financial markets today are the product of mixed economies. That is, they are free markets that are regulated and in many instances directed. In such cases the market, instead of being the aggregate of possible buyers and sellers who are trading something, includes government directions for political, moral, or social purposes, which, however nobly justified, distort the market.

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