What are Functions of Financial Markets?
The word “financial market” is a broader term used to define where buying and selling financial assets occur. In other words, the financial market refers to a virtual platform that facilitates the trading of financial instruments and securities. Some of the most common financial instruments and securities examples include equity stocks, commercial papers, bonds, debentures, etc.
All countries have their own financial markets, and they invariably play a key role in the country’s economic growth story. A financial market acts as the intermediary between the investors who are willing to put in their money and the companies who need the money to expand their business. The size of the financial markets varies across economies wherein it is relatively smaller in the developing nations but large and organized in the developed economies of the world, like NASDAQ. Nevertheless, irrespective of their size, their contribution to the economy continues to remain the same across the globe.
Besides the primary function of facilitating liquidity in the market, the financial markets also perform various other functions that include price discovery of different financial instruments, mobilization of funds, providing easy access to capital, lowering the cost of the transaction, and sharing various trade-related risks. All these functions will be discussed in greater detail in the following section.
List of Functions of Financial Markets
The following is a list of the functions (with brief explanation) performed by a typical financial market:
1. Price discovery
The financial market facilitates the price determination of the various financial securities that are being traded. The underlying principle is the manifestation of the basic economic concept of demand and supply, which helps in identifying what the market is willing to pay for a particular financial instrument. So, the financial market is the platform where the prices of the financial securities are determined irrespective of whether it is newly issued or an existing financial asset.
2. Funds mobilization
Another major criterion for capital allocation is the return expected by the investors, and the participants in the financial market determine it. The companies seeking capital must be aware of the required rate as it is a critical factor while raising funds. Consequently, the financial market determines how the available funds from the investors will get allocated to the companies or individuals who need funds to support their business requirements. In this way, the financial market helps in mobilizing the funds from the savings of the investors to the capital of the businesses.
In the absence of an organized financial market, the investors will not be able to trade and hence will be forced to hold the financial securities or instruments until any liquidity event. In the case of debt instruments, the liquidity event will be when the issuer is contractually obligated to pay at the time of maturity. In the case of equity instruments, the liquidity event will be when at the time of the liquidation of the company, either voluntarily or involuntarily. This is where the financial market comes into play as it provides trading opportunities to the investors so that they can easily buy and sell the financial instruments at their fair value as per the market at any point in time. Thus, the financial market provides liquidity to the investors wherein they can sell their holdings freely and convert the securities into cash.
4. Risk sharing
The individuals who undertake the investments are different from the investors who lend their money. Through the risk-sharing function, the financial market ensures that the investors are well aware of the risks associated with the investment before entering into one. In this way, the financial market helps in transferring the risk of the investment from the person undertaking the investments to the investors who are making those investments.
The industries require funds for expanding their business, and for this purpose, they need investors. On the other hand, the investors require a healthy return on investments, and for this, they need the industries. So, both industries and investors need each other to fulfill their goals. Consequently, the financial market acts as an intermediary and provides the perfect platform where the industries can easily raise the funds they need while the investors can find the investment opportunities that they seek for good returns.
6. Market efficiency
Investors seek different types of information before they start putting their money into buying and selling any financial securities. In the absence of the financial market, this information can only be obtained in exchange for a significant amount of time and money. However, the financial market ensures that all these data are made available to investors without any substantial amount of money. In this way, it helps in reducing transaction costs.
7. Capital formation
The funds that will otherwise sit idle as savings are converted into capital for businesses with the help of the financial market. In other words, it provides the channel through which the savings flow from the investors to the businesses and help them in their capital formation.
So, it can be seen that the financial market performs different functions that provide opportunities to the investors to make more money while it also helps the companies raise funds to finance their growth. It is an intermediary between the investors and the industries that help in price discovery, funds mobilization, providing liquidity, etc. It clearly plays a very critical role in allocating the limited available funds within an economy to spur industrial growth.
This is a guide to Functions of Financial Markets. Here we also discuss the definition and top 7 list of the functions performed by a typical financial market with an explanation. You may also have a look at the following articles to learn more –