Financial Market: How the capital market works

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Financial Market: How the capital market works

The financial market is an umbrella term that includes all markets where capital is traded. In contrast to commodity markets, only money is exchanged here.

In this respect, the term capital market is misleading; finally, capital is also traded in other areas. The term “credit market” appears more appropriate.

Capital on a financial market is traded in various forms. This can be securities, securitized rights, but also credit agreements – and this is the case on a capital market.

Financial market as the umbrella term: money, foreign exchange, and capital market

The financial market is divided into three areas, the capital market. The money and foreign exchange market are also being added.

The money market comprises the trading of securities and loans and is distinguished by the duration of its periods against the other sub-divisions – foreign exchange and capital markets.

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For example, loans have a maturity of at least one day and a maximum of one year, while securities are traded on the money market.

Trading on the money market is mainly used to bridge payment bottlenecks and is mainly used by banks and industrial companies.

Currencies are exchanged on the foreign exchange market. This exchange takes place either as a cash transaction – in exchange for the domestic currency – or as a term business.

Transactions on the foreign exchange market are predominantly carried out in the off-exchange market and are now fully electronic.

The capital market as a sub-sector

On the capital market, providers offer their capital buyers who, in turn, appear as entrepreneurs. These can be companies, state institutions, but also private individuals. Contrary to the money market, loans are medium to long-term.

The providers pursue the goal of increasing their capital through lending transactions, whereby their yield may be fixed or vary depending on the type of investment and the nature of the capital market.

The risk is a major factor: the return on investment is usually higher. Caution is therefore required for offers that advertise with very low risk and high yield.

Risk and return on the capital market

In principle, a distinction is made between two types of investment which influence the risk and the return potential:

Thus, the vendor can provide his capital as equity or debt.

In the case of a provision as equity, the offerer receives from the demander company shares in the form of shares. This can have the advantage of being able to profit from the success of the company, but it also bears a higher risk of loss.

The return is mostly fixed as debt, but the risk is often lower.

Low-risk bonds, for example, are considered as sovereign bonds, which, however, tend to have a higher yield potential depending on the economic health of the issuing state.

The different risk exposures are also linked to the issuer risk. If the borrower is insolvent, this can mean for the provider that his money is also lost.

However, in the event of an insolvency, creditors who give priority to leverage may, in the event of insolvency, expect the payment of existing receivables rather than owners of equity, including shareholders.