Financial Market


A business is a part of an economic system that consists of two main sectors – households which save funds and business firms which invest these funds.

A financial market helps to link the savers and the investors by mobilizing funds between them.

In doing so it performs what is known as an allocative function.

It allocates or directs funds available for investment into their most productive investment opportunity.

When the allocative function is performed well, two consequences follow:

[1] The rate of return offered to households would be higher

[2] Scarce resources are allocated to those firms which have the highest productivity for the economy.

There are two major alternative mechanisms through which allocation of funds can be done: via banks or via financial markets.

Households can deposit their surplus funds with banks, who in turn could lend these funds to business firms.

Alternately, households can buy the shares and debentures offered by a business using financial markets.

The process by which allocation of funds is done is called financial intermediation.

Banks and financial markets are competing intermediaries in the financial system, and give households a choice of where they want to place their savings.

 

A financial market is a market for the creation and exchange of financial assets.

Financial markets exist wherever a financial transaction occurs.

Financial transactions could be in the form of creation of financial assets such as the initial issue of shares and debentures by a firm or the purchase and sale of existing financial assets like equity shares, debentures and bonds.

 

Functions of financial market—

Financial markets play an important role in the allocation of scarce resources in an economy by performing the following four important functions.

[1] Mobilisation of Savings and Channeling them into the most Productive Uses—

A financial market facilitates the transfer of savings from savers to investors.

It gives savers the choice of different investments and thus helps to channelise surplus funds into the most productive use.

[2] Facilitate Price Discovery—

The forces of demand and supply help to establish a price for a commodity or service in the market.

In the financial market, the households are suppliers of funds and business firms represent the demand.

The interaction between them helps to establish a price for the financial asset which is being traded in that particular market.

 

[3] Provide Liquidity to Financial Assets—

Financial markets facilitate easy purchase and sale of financial assets.

In doing so they provide liquidity to financial assets, so that they can be easily converted into cash whenever required.

Holders of assets can readily sell their financial assets through the mechanism of the financial market.

[4] Reduce the Cost of Transactions—

Financial markets provide valuable information about securities being traded in the market.

It helps to save time, effort and money that both buyers and sellers of a financial asset would have to otherwise spend to try and find each other.

The financial market is thus, a common platform where buyers and sellers can meet for fulfillment of their individual needs.

 

Financial markets are classified on the basis of the maturity of financial instruments traded in them.

Instruments with a maturity of less than one year are traded in the money market.

Instruments with longer maturity are traded in the capital market.

Money market

Capital market