Financial Markets bring together individuals who want to save money with other individuals or companies who want to raise money. The bond market and the stock market are the two most important types of financial markets. They provide capital through the issuing of bonds or stocks, respectively. Two fundamentally different approaches, that each have their own advantages and disadvantages. This will become apparent as we look at the difference between bond markets and stock markets below.
The Bond Market
The bond market is a financial market where participants can issue and trade bonds. Bonds are certificates of indebtedness of the issuer to the holder. They are a type of loan, where big corporations or governments act as the borrower and the general public acts as the lender (i.e. creditor). Hence, the sale of bonds is also referred to as debt finance.
Bonds have to be repaid once they reach their so-called date of maturity. Once the bond matures, the amount borrowed (i.e. the principal) has to be paid back to the lender. The length of time before this happens is called the bond’s term. The creditors expect to be paid interest in exchange for lending their money. This periodical payment is called the coupon. The coupon rate depends on the bond’s term and perceived risk. As with any investment, there is always a certain risk of default. In other words, there is a certain possibility that the borrower fails to meet their legal obligations (e.g. coupon payments or repayment of the principal). The probability that this happens is called the credit risk. In case of bankruptcy however, bondholders are in a relatively good position – according to the circumstances – because they are creditors and therefore repaid before shareholders.
When corporations issue new bonds we speak of the primary market. Once these bonds are issued they can be bought and sold (i.e. traded) freely by participants in the market. This is called the secondary market, or aftermarket.
The Stock Market
The stock market is a financial market where participants can issue and trade stocks (i.e. shares). Stocks represent partial ownership in a company. Therefore, the sale of stocks is also referred to as equity finance. Because the owner of a stock is also partial owner of the company, they are entitled to a proportion of the firm’s profits. However, in the case of bankruptcy, shareholders will get their money back only after all debt (including bonds) is repaid.
Unlike bonds, stocks don’t have a date of maturity, i.e. they generally don’t have to be repaid at a certain time. However, the shareholders still expect to be compensated for investing their money. As mentioned above, they are entitled to a proportion of the firm’s profits, which is referred to as a dividend. Dividends are usually paid once a year. In addition to that, shareholders can also profit from an increase in the company’s stock price. Stocks are traded on organized stock exchanges, like the New York Stock Exchange (i.e. Wall Street) or the London Stock Exchange. The prices at which they trade are defined by supply and demand.
Ultimately, the price of a stock reflects people’s assumption of the company’s future profitability. Because of this, the stock market is often used as an indicator of future economic developments. There are hundreds of stock indices available to monitor the overall price levels in any particular stock market. A stock index is usually calculated as a weighted average of the prices of certain stocks that are considered typical of that particular market. Popular examples of stock indices include the Dow Jones Index, the NIKKEI Index, the DAX, and many more.
In a Nutshell
Financial Markets bring together individuals who want to save money with other individuals or companies who want to raise money. The bond market and the stock market are the two most important types of financial markets. The bond market allows participants to issue and trade bonds, i.e. certificates of indebtedness of the issuer to the holder (debt finance). Whereas the stock market is a financial market where participants can issue and trade stocks, i.e. partial ownership in a company (equity finance).