Basics of Financial Markets

Basics of Financial Engineering | 2025.02.05

Financial markets are important economic infrastructures that enable the efficient allocation of capital by connecting suppliers and demanders of funds.

Various theories and techniques in financial engineering operate within these financial markets, and understanding the characteristics and structure of the market is an essential foundation for learning financial engineering.

This page will explore the definitions, functions, main types, participants, characteristics of global financial markets, theories of market efficiency, regulation of financial markets, as well as recent trends and future outlook.

1️⃣ Definition and Functions of Financial Markets

Financial markets are markets that provide a mechanism for the transfer of funds from economic agents with surplus funds (savers) to those with a shortage of funds (borrowers). This does not merely refer to a place of transaction but encompasses the entire system in which the prices of various financial products are determined and traded.

The main functions of financial markets are as follows:

Core Functions of Financial Markets

• Efficient Allocation of Resources
  Financial markets provide a channel to convert savings into productive investments, thereby enhancing the efficiency of resource allocation across the economy. They promote economic growth through mechanisms that direct funds to their most valued uses.

• Price Discovery
  They offer a process for discovering the 'fair value' of financial assets through the collective intelligence and information of market participants. This serves as an important signal for the decision-making of economic agents.

• Liquidity Provision
  By providing an environment for investors to easily convert assets into cash when needed, they facilitate long-term investments and support capital formation.

• Risk Management and Diversification
  They offer mechanisms through various financial products and derivatives that allow economic agents to manage and diversify risks.

• Mitigation of Information Asymmetry
  By disseminating information through market prices and trading activities, they help reduce the information gap among market participants.

• Market Signal Transmission
  The price fluctuations in financial markets provide important signals regarding economic conditions, policy effects, future prospects, and more.

These functions are interrelated, and when the financial system operates efficiently, it contributes to the overall stability and growth of the economy.

2️⃣ Major Types of Financial Markets

Financial markets can be classified into various types based on different criteria. Here, we will look at the most common classification methods.

Classification by Maturity

Classification of Financial Markets by Maturity

• Money Market
  This is a market where short-term (generally within one year) financial instruments are traded. Major trading instruments include Commercial Paper (CP), Certificates of Deposit (CD), Repurchase Agreements (Repo), and short-term government bonds. This market plays a crucial role in managing short-term liquidity for companies and financial institutions.

• Capital Market
  This is a market where medium to long-term (generally over one year) financial instruments are traded. Representative products include stocks, bonds, and long-term government bonds. The capital market plays an important role in corporate long-term financing and the long-term asset formation of investors.

Classification by Transaction Timing

Classification of Financial Markets by Transaction Timing

• Spot Market
  This is a market where the trading and settlement of financial instruments occur almost simultaneously. Most transactions in the stock market and bond market fall under this category.

• Futures or Forward Market
  This is a market where contracts are traded that promise to buy or sell an asset at a predetermined price at a specific point in the future. This plays a crucial role in managing price risk.

Classification by Product Type

Financial Market Classification by Product Type

• Stock Market
  A market where shares representing ownership in a company are traded. Investors can acquire a portion of ownership in a company through the purchase of shares and can earn income in the form of dividends and capital gains.

• Bond Market
  A market where debt securities issued by governments, public institutions, and corporations are traded. Investors earn income through regular interest payments and the repayment of principal at maturity.

• Derivatives Market
  A market where financial contracts based on the value of underlying assets (such as stocks, bonds, commodities, interest rates, and exchange rates) are traded. Various products, including options, futures, and swaps, are available and are used for purposes such as hedging, speculation, and arbitrage.

• Forex Market
  A market where various currencies are traded, making it the most liquid and highest volume financial market in the world. It operates 24 hours globally and is an important venue where exchange rates are determined.

• Commodity Market
  A market where physical assets such as crude oil, gold, and agricultural products are traded. The commodity futures market provides producers and consumers with a means to manage price risk.

Classification by Trading Method

Financial Market Classification by Trading Method

• Exchange-Traded Market
  A market where trading occurs on formal exchanges with standardized rules and centralized clearing systems. Stock exchanges and futures exchanges fall into this category.

• Over-The-Counter (OTC) Market
  A market where trading occurs through direct negotiations between participants without going through exchanges. Customized derivatives, certain bonds, and foreign exchange trading primarily take place in the OTC market.

These diverse financial markets are interconnected, and the prices and trading activities of each market affect other markets. Financial engineering plays an important role in understanding and modeling the interconnections and interactions between these markets.

3️⃣ Key Participants in Financial Markets

Financial markets consist of various participants with different purposes and roles. Their interactions shape market dynamics and influence price determination.

Key Participants in Financial Markets

• Individual Investors
  Individuals who seek to grow their assets by investing their savings, participating in the market through financial intermediaries such as brokerages or banks. Recently, the development of online platforms and mobile apps has made direct investing easier.

• Institutional Investors
  Professional investment institutions that pool funds from others for management, including pension funds, mutual funds, hedge funds, insurance companies, and endowments. They have significant influence in the market due to their large-scale capital and expertise.

• Government and Public Institutions
  They participate in financial markets through funding via the issuance of government bonds, executing monetary policy, and implementing market stabilization measures. Central banks are crucial participants that directly affect market interest rates through monetary policy.

• Corporations
  They raise funds through issuing stocks and bonds and participate in the financial market through activities such as managing excess funds, hedging against exchange rate risks, and mergers and acquisitions (M&A).

• Financial Intermediaries
  Banks, brokerages, asset management firms, and others play a role in connecting fund providers and demanders. They offer a variety of services such as investment advice, trade execution, liquidity provision, and market making.

• Market Makers
  They provide liquidity to the market by continuously quoting buy and sell prices for specific financial products. They earn profits through the bid-ask spread.

• Algorithmic Traders
  Participants who use computer algorithms to execute automated trading strategies, whose share in the market has significantly increased recently. High-frequency trading (HFT) falls into this category.

• Regulatory Agencies
  Institutions that establish and supervise rules to maintain fairness, transparency, and stability in financial markets, such as Korea’s Financial Services Commission, Financial Supervisory Service, and the U.S. SEC and CFTC.

Each participant has different information, goals, constraints, and time horizons, and this diversity creates market dynamics. Financial engineering provides methodologies to model and analyze the behaviors and interactions of these diverse participants.

4️⃣ Characteristics of the Global Financial Market

The modern financial market has evolved into a global network that transcends borders, which has increased the complexity of the environment that financial engineering must address.

Key Characteristics of the Global Financial Market

• 24-Hour Trading Environment
  A trading environment has been created that allows for nearly continuous trading almost 24 hours a day, as financial centers around the world are interconnected. In particular, the foreign exchange market operates 24 hours a day by leveraging the time differences of major financial centers such as New York, London, and Tokyo.

• Increased Interconnectivity
  The development of information technology and financial innovation has greatly increased the connectivity among various countries and markets. This can lead to a 'contagion effect' where shocks in one market quickly spread to others.

• Acceleration of Capital Movements
  Easing of capital controls and the development of digital finance have made cross-border capital movements much faster and easier. While this contributes to economic development, it also increases the risk of instability due to rapid capital inflows and outflows.

• Possibility of Regulatory Arbitrage
  The differences in financial regulatory environments among countries have made 'regulatory arbitrage' possible. Financial institutions sometimes relocate specific activities to countries or regions with less stringent regulations.

• Importance of International Standards
  The importance of international standards and norms, such as the Basel Accords and IFRS (International Financial Reporting Standards), has increased for the stable operation of the global financial market.

• Globalization of Financial Crises
  As seen in the 2008 global financial crisis, an environment has been created where a financial crisis that starts in one country or region can quickly spread worldwide.

• Diverse Market Participants
  The entry of various global participants, such as sovereign wealth funds (SWFs), global hedge funds, and multinational financial institutions, has made market dynamics more complex.

These characteristics of the global financial market have increased the necessity for financial engineering to develop more complex and sophisticated analytical tools and models. In particular, methodologies for risk management that consider interconnectivity and interdependence among countries and markets are becoming increasingly important.

5️⃣ Market Efficiency Theory

An important theoretical framework for understanding how financial markets operate is the Efficient Market Hypothesis (EMH). This theory serves as the foundation for many models and analytical methodologies in financial engineering and was formalized by Professor Eugene Fama.

Three Forms of Market Efficiency

• Weak Form Efficiency
  This asserts that market prices already reflect all past price information and trading volume information. In this form, generating excess returns through the analysis of past price patterns (technical analysis) is impossible.

• Semi-Strong Form Efficiency
  This asserts that market prices reflect not only past information but also all publicly available information (such as corporate disclosures, economic indicators, news, etc.). In this form, generating excess returns through the analysis of public information (fundamental analysis) is impossible.

• Strong Form Efficiency
  This is the most extreme assertion that market prices reflect all relevant information, including insider information as well as public information. In this form, no investor can consistently outperform the market.

The Meaning of Market Efficiency Theory

The market efficiency theory provides important implications for the fields of financial markets and financial engineering:

Meaning of Market Efficiency Theory

• Effect of Information Reflection in Prices
  In an efficient market, prices are the best estimate of the expected value of an asset. When new information arrives, the market quickly incorporates it into prices.

• Random Walk Theory
  In an efficient market, price movements are unpredictable and random. This is because new information arrives unpredictably.

• Basis for Passive Investment Strategies
  If consistently beating the market is difficult, it may be rational to adopt passive investment strategies that track market indices. This forms the theoretical basis for index funds and ETFs.

• Arbitrage Infeasibility
  In a fully efficient market, risk-free arbitrage opportunities do not exist, or if they do, they disappear within a very short time.

Challenges and Anomalies to Market Efficiency

In real financial markets, several "anomalies" have been observed that do not align with the predictions of market efficiency theory:

Market Anomalies

• Momentum Effect
  Well-performing assets tend to continue to show strong performance in the short term.

• Value Effect
  Assets priced lower relative to their fundamental value (such as book value) tend to show higher returns in the long term.

• Small Firm Effect
  Stocks of small firms tend to exhibit higher risk-adjusted returns compared to large firms.

• Seasonal Effects
  There are specific price patterns that recur at certain times, such as the January effect and weekend effect.

• Excess Volatility
  The volatility of market prices is often much greater than the volatility of fundamental values (such as dividends).

These anomalies have led to the development of a new research field called Behavioral Finance. Behavioral finance studies the impact of psychological elements, such as cognitive biases, emotions, and social influences, on financial markets.

Financial engineers are working to understand the balance between market efficiency and inefficiency and to develop various models and strategies that reflect this understanding.

6️⃣ Regulation of Financial Markets

Financial markets play a crucial role in the stability and efficiency of the economic system, thus requiring appropriate regulation and supervision. Financial regulation also significantly influences the scope and methods of financial engineering.

Purpose of Financial Regulation

Main Purposes of Financial Regulation

• Maintaining Financial Stability
  Reduces systemic risks and prevents the occurrence and spread of financial crises.

• Protecting Investors
  Protects individual investors from unfair treatment in situations of asymmetric information.

• Ensuring Market Integrity
  Maintains fairness and trust in the market by preventing unfair practices such as insider trading and market manipulation.

• Preventing Financial Crimes
  Prevents criminal activities that exploit the financial system, such as money laundering and terrorism financing.

• Consumer Protection
  Ensures transparency in financial products and services and protects the rights and interests of financial consumers.

Key Areas of Financial Regulation

Key Areas of Financial Regulation

• Capital Adequacy Regulation
  Regulations that require financial institutions to hold sufficient capital, such as the Basel Accords. This enhances the institutions' ability to absorb risks.

• Market Conduct Regulation
  Regulations that promote fair trading practices and prohibit unfair activities such as market manipulation and insider trading.

• Information Disclosure Requirements
  Regulations that mandate appropriate information disclosure by companies and financial institutions, enabling investors to make informed decisions.

• Consumer Protection Regulation
  Regulations that protect financial consumers by ensuring the suitability of financial products, providing transparent information, and preventing unfair contract terms.

• Systemic Risk Management
  Macroprudential regulations aimed at maintaining the overall stability of the financial system, strengthened after the 2008 financial crisis.

• Derivatives Market Regulation
  Regulations aimed at increasing transparency in OTC derivatives and promoting trading through central clearinghouses (CCPs).

Relationship Between Regulation and Financial Engineering

Financial regulation significantly impacts financial engineering:

Relationship Between Regulation and Financial Engineering

• Cost of Regulatory Compliance
  As the costs to meet regulatory requirements increase, financial engineering is evolving in a way that enhances regulatory efficiency.

• Development of Risk Management Models
  The development of internal models to meet the risk management standards required by regulatory agencies has become a key application area of financial engineering.

• Balancing Innovation and Regulation
  Financial engineering seeks ways to enable innovation within the regulatory environment, sometimes leading to financial innovations that exploit regulatory gaps (regulatory arbitrage).

• Advancement of Regulatory Technology (RegTech)
  Financial engineering contributes to the development of 'RegTech,' which are technical solutions that streamline regulatory compliance.

7️⃣ Recent Trends and Future Outlook in Financial Markets

Financial markets are constantly evolving in response to technological advancements, changes in economic structures, and social demands. In the field of financial engineering, new theories and methodologies are continually being developed to address these changes.

Recent Key Trends in Financial Markets

Key Trends in Financial Markets

• Digital Transformation
  The rise of fintech companies and the digital innovation of existing financial institutions are fundamentally changing the way financial services are provided. New financial services such as mobile banking, robo-advisors, and P2P lending have emerged.

• Spread of Algorithmic Trading
  Automated trading using computer algorithms now accounts for a significant portion of market trading volume. In particular, high-frequency trading occurs at speeds measured in milliseconds.

• Increase in Passive Investment
  With a significant rise in passive investment strategies through index funds and ETFs, new impacts on market price formation mechanisms and market efficiency are observed.

• Emergence of Sustainable Finance
  As investments that consider ESG (Environmental, Social, Governance) factors expand, the financial performance of companies, as well as their social and environmental impacts, become important evaluation criteria.

• Decentralized Finance (DeFi) and Crypto Assets
  The emergence of a decentralized finance ecosystem based on blockchain technology and various crypto assets poses challenges to traditional financial intermediation functions.

• Data-Driven Finance
  Data analysis utilizing big data, artificial intelligence, and machine learning is becoming increasingly important across all areas of finance, including investment decisions, risk management, and customer service.

• Expansion of Cross-Border Financial Services
  The advancement of digital technology has made it easier to provide financial services that transcend borders, accelerating the integration of the global financial market.

Directions for the Development of Future Financial Markets

Directions for the Development of Future Financial Markets

• Enhancement of Financial Inclusion
  With technological advancements allowing marginalized groups in traditional financial systems to access financial services, financial inclusion will expand.

• Personalized Financial Services
  Financial products and services tailored to individual needs, utilizing big data and artificial intelligence, are expected to become more sophisticated.

• Deepening Integration of Finance and Technology
  As the boundaries between finance and technology become increasingly blurred, financial services will evolve into an "Embedded Finance" model, integrated with other services.

• Evolution of Regulatory Environment
  Regulatory frameworks will continue to evolve in response to new financial technologies and services, with innovation-friendly approaches such as "regulatory sandboxes" becoming more prevalent.

• Emergence of Central Bank Digital Currencies (CBDCs)
  Central banks in various countries are reviewing or piloting digital currency issuance, which could bring significant changes to financial systems and monetary policies.

• Impact of Quantum Computing
  As quantum computing technology advances, there is potential for revolutionary changes in various areas of the financial market, including financial modeling, optimization, and encryption.

• Climate Change and Finance
  As the impact of climate change on financial markets and asset values becomes more significant, the analysis and management of climate-related financial risks will become a core element of the financial system.

These trends and directions will present new challenges and opportunities for financial engineering, making it increasingly important to develop effective models and tools in a more complex and interconnected financial environment.

8️⃣ Conclusion: The Importance of Understanding Financial Markets

Financial markets play a central role in the modern economy and possess complex and dynamic characteristics. A deep understanding of the structure, function, participants, and operating principles of these financial markets is essential for effectively learning and applying financial engineering.

Understanding financial markets is important for the following reasons:

Importance of Understanding Financial Markets

• Contextualizing Models
  Financial engineering models must reflect the realities of financial markets, making it crucial to understand the market's characteristics and constraints.

• Assessing the Appropriateness of Assumptions
  Many financial models are based on specific assumptions regarding market efficiency, liquidity, transaction costs, etc. Understanding the actual market environment is necessary to evaluate the appropriateness of these assumptions.

• Identifying and Measuring Risks
  Identifying and measuring various financial risks, such as market risk, liquidity risk, and credit risk, requires insights into market structure and dynamics.

• Predicting the Direction of Innovation
  By understanding trends and developments in financial markets, it is possible to predict and develop the financial engineering techniques and models needed in the future.

• Considering Ethical and Social Impacts
  Financial markets are not just technical systems but part of the socioeconomic structure, making it important to consider the ethical and social impacts of applying financial engineering.

In the upcoming foundational series on financial engineering, we will delve more deeply into core topics of financial engineering such as various financial products, options pricing theory, portfolio theory, risk management, and time series analysis based on this fundamental understanding of financial markets.

As financial markets are constantly changing, it is important for finance professionals and financial engineers to remain vigilant to market changes and develop the ability to adapt. This will contribute to more effective financial decision-making and the development of innovative financial solutions.

9️⃣ References and Recommended Materials

For a deeper understanding of financial markets, the following materials may be helpful:

Recommended Books

• "Financial Market Theory" (Kim Jong-seon, Park Youngsa)
• "Understanding Global Financial Markets" (Ahn Chang-guk, Shin Yeongsa)
• "Financial Markets and Institutions" (Frederic S. Mishkin, Stanley G. Eakins)
• "The Economics of Money, Banking, and Financial Markets" (Frederic S. Mishkin)
• "A Random Walk Down Wall Street" (Burton G. Malkiel)
• "Efficiently Inefficient: How Smart Money Invests and Market Prices Are Determined" (Lasse Heje Pedersen)

Online Resources

• Bank of Korea Economic Education Portal: https://www.bokeducation.or.kr/
• Financial Supervisory Service Financial Education Center: https://www.fss.or.kr/edu/
• Coursera: Financial Markets (Yale University): https://www.coursera.org/learn/financial-markets-global
• Khan Academy - Finance and Capital Markets: https://www.khanacademy.org/economics-finance-domain/core-finance

Major Financial Information Sites

• Bloomberg: https://www.bloomberg.com/
• Financial Times: https://www.ft.com/
• The Wall Street Journal: https://www.wsj.com/
• Korea Exchange: https://www.krx.co.kr/
• Korea Financial Investment Association: https://www.kofia.or.kr/

Disclaimer

• The content of this blog is written for educational and informational purposes and should not be considered an investment recommendation or a substitute for financial advice. For actual financial decisions, please seek the advice of a professional.