Financial Markets: Functions, Assets, and Indexes Explained

Functions of Financial Markets

Price Determination

• When a company has assets listed in a financial market, it can determine their worth.
• Investors can ascertain the value of their investments.
• Markets offer liquidity for investors' assets.

Financial Assets Characteristics

Liquidity

Ease with which an asset can be converted into cash.

Return and Liquidity Relationship

• If an asset is very liquid, the return asked by investors is very low.
• When assets are less liquid, investors demand higher returns.

Risk

The probability of not recovering the principal or the coupons.

Rating agencies analyze the risk associated with issuers.

Types of Financial Markets

Primary Markets

These markets facilitate the issuance of new securities. Investors pay for the assets to the companies offering them, and the companies issue shares or bonds in return.

Secondary Markets

These markets facilitate the trading of existing securities. An investor sells their shares to another investor. The company is not directly involved and receives no financial flow from this transaction. Investors observe secondary markets to gauge a company's performance.

Free Float

The percentage of stock available to be bought or sold because it is not held by major shareholders.

Stock Indexes

Purpose

Stock indexes show past market performance and are used in relative terms to compare different periods of time.

Computing Market Return

Indexes provide an average idea of the market's performance over a specific time period.

Benchmarking Portfolio Performance

When making an investment, the index performance allows comparison with the investment's result. The index is useful for assessing the management of a specific portfolio.

Index Examples

Examples include the US Nasdaq, Spain's Ibex 35, and the Euro Stoxx 50 (representing the 50 largest companies within the EU).

Opening vs. Closing Prices

Opening prices attempt to incorporate all news that occurred while the stock market was closed, hence they are often different from closing prices.

Composition of Indexes

Index composition is not fixed. The criteria for inclusion or exclusion are primarily size and trading volume. A large company with a small free float might be excluded. Since these criteria evolve, index revisions occur approximately twice a year, resulting in companies entering or leaving the index.

Market Capitalization

This measures the value of a company in the market based on its latest price. It indicates the company's size and allows for meaningful comparisons.