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What Are Financial Markets

Financial markets allow businesses and investors to raise money and make money, respectively. They provide avenues for buying and selling assets like stocks, bonds, currencies, and derivatives. Specifically, financial markets perform several important functions: 1) They mobilize savings and channel them into productive uses by businesses and individuals; 2) They determine the prices of securities through supply and demand; 3) They provide liquidity by allowing assets to be easily sold. Financial markets are crucial for capital formation and economic growth.

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0% found this document useful (0 votes)
112 views12 pages

What Are Financial Markets

Financial markets allow businesses and investors to raise money and make money, respectively. They provide avenues for buying and selling assets like stocks, bonds, currencies, and derivatives. Specifically, financial markets perform several important functions: 1) They mobilize savings and channel them into productive uses by businesses and individuals; 2) They determine the prices of securities through supply and demand; 3) They provide liquidity by allowing assets to be easily sold. Financial markets are crucial for capital formation and economic growth.

Uploaded by

yared haftu
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© © All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
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What are Financial Markets?

Financial markets, from the name itself, are a type of marketplace that provides an avenue for
the sale and purchase of assets such as bonds, stocks, foreign exchange, and derivatives. Often,
they are called by different names, including “Wall Street” and “capital market,” but all of them
still mean one and the same thing. Simply put, businesses and investors can go to financial
markets to raise money to grow their business and to make more money, respectively.

To state it more clearly, let us imagine a bank where an individual maintains a savings account.
The bank can use their money and the money of other depositors to loan to other individuals
and organizations and charge an interest fee.

The depositors themselves also earn and see their money grow through the interest that is paid
to it. Therefore, the bank serves as a financial market that benefits both the depositors and the
debtors.

Types of Financial Markets

There are so many financial markets, and every country is home to at least one, although they
vary in size. Some are small while some others are internationally known, such as the New York
Stock Exchange (NYSE)  that trades trillions of dollars on a daily basis. Here are some types of
financial markets.

1. Stock market

The stock market trades shares of ownership of public companies. Each share comes with a
price, and investors make money with the stocks when they perform well in the market. It is easy
to buy stocks. The real challenge is in choosing the right stocks that will earn money for the
investor.

There are various indices that investors can use to monitor how the stock market is doing, such
as the Dow Jones Industrial Average (DJIA) and the S&P 500. When stocks are bought at a
cheaper price and are sold at a higher price, the investor earns from the sale.

2. Bond market

The bond market offers opportunities for companies and the government to secure money to
finance a project or investment. In a bond market, investors buy bonds from a company, and the
company returns the amount of the bonds within an agreed period, plus interest.

3. Commodities market

The commodities market is where traders and investors buy and sell natural resources or
commodities such as corn, oil, meat, and gold. A specific market is created for such resources
because their price is unpredictable. There is a commodities futures market wherein the price of
items that are to be delivered at a given future time is already identified and sealed today.

4. Derivatives market

Such a market involves derivatives or contracts whose value is based on the market value of the
asset being traded. The futures mentioned above in the commodities market is an example of a
derivative.

Functions of the Markets

The role of financial markets in the success and strength of an economy cannot be
underestimated. Here are four important functions of financial markets:

1. Puts savings into more productive use

As mentioned in the example above, a savings account that has money in it should not just let
that money sit in the vault. Thus, financial markets like banks open it up to individuals and
companies that need a home loan, student loan, or business loan.

2. Determines the price of securities

Investors aim to make profits from their securities. However, unlike goods and services whose
price is determined by the law of supply and demand, prices of securities are determined by
financial markets.

3. Makes financial assets liquid

Buyers and sellers can decide to trade their securities anytime. They can use financial markets to
sell their securities or make investments as they desire.

4. Lowers the cost of transactions

In financial markets, various types of information regarding securities can be acquired without
the need to spend.

Importance of Financial Markets

There are many things that financial markets make possible, including the following:

 Financial markets provide a place where participants like investors and debtors,
regardless of their size, will receive fair and proper treatment.
 They provide individuals, companies, and government organizations with access to
capital.
 Financial markets help lower the unemployment rate because of the many job
opportunities it offers
Functions of Financial Markets
Home » Corporate Finance » Equity Capital » Functions of Financial Markets

What are the Functions of Financial Markets?

There are different functions that the financial markets perform which includes

determination of the prices where financial markets help in price discovery of various

financial instruments, mobilization of the funds, providing an opportunity to different

investors to buy or sell their respective financial instrument at the fair value that is

prevailing in market, providing the various types of information to traders, and the

sharing of the risk, etc Top 7 Functions of Financial Markets

1. Price Determination

2. Funds Mobilization

3. Liquidity
4. Risk sharing

5. Easy Access

6. Reduction in transaction costs and provision of the Information

7. Capital Formation

Let us discuss each of the financial market functions in detail –

#1 – Price Determination
The financial market performs the function of price discovery of the different financial

instruments which are traded between the buyers and the sellers on the financial market. The

prices at which the financial instruments trade in the financial market are determined by the

market forces i.e., demand and supply in the market.

So the financial market provides the vehicle by which the prices are set for both financial

assets which are issued newly and for the existing stock of the financial assets.

#2 – Funds Mobilization
Along with the determination of the prices at which the financial instruments trade in the

financial market, the required return out of the funds invested by the investor is also determined

by participants in the financial market. The motivation for persons seeking the funds is

dependent on the required rate of return which is demanded by the investors.

Because of this function of the financial market only, it is signaled that how funds which

available from the lenders or the investors of the funds will get allocated among the persons

who are in need of the funds or raise the funds through the means of issuing financial
instruments in the financial market. So, the financial market helps in the mobilization of the

savings of the investors.

#3 – Liquidity
The liquidity function of the financial market provides an opportunity for the investors to sell

their financial instruments at its fair value prevailing in the market at any time during the

working hours of the market.

In case there is no liquidity function of the financial market, then the investor forcefully have to

hold the financial securities or the financial instrument until the conditions arise in the market to

sell those assets or the issuer of the security is obligated contractually to pay for the same i.e., at

the time of maturity in case of the debt instrument or at the time of the liquidation of the

company in case of the equity instrument is until the company is either voluntarily or

involuntarily liquidated.

Thus, in the financial market investors can sell their securities readily and convert them into cash

thereby providing the liquidity.

#4 – Risk sharing
Financial market performs the function of the risk-sharing as the person who is undertaking the

investments are different from the persons who are investing their fund in those investments.

With the help of the financial market, the risk is transferred from the person who undertakes the

investments to those persons who provide the funds for making those investments.
#5 – Easy Access
The industries require the investors for raising the funds and the investors require the industries

for investing its money and earning the returns from them. So the financial market platform

provides the potential buyer and seller easily, which helps them in saving their time and money

in finding the potential buyer and seller.

#6 – Reduction in Transaction Costs and Provision of the Information


The trader requires various types of information while doing the transaction of buying and

selling the securities. For obtaining the same time and money is required.

But the financial market helps in providing every type of information to the traders without the

requirement of spending any money by them. In this way, the financial market reduces the cost

of the transactions.

#7 – Capital Formation
Financial markets provide the channel through which the new savings of the investors flow in

the country which aid in the capital formation of the countryple

Let’s consider an example of the company XYZ ltd, which requires the funds to start a new

project but at present, it doesn’t have such funds. On the other side, there are investors who

have spare money and want to invest in some areas where they can get the required rate of

expected returns.

So, in that case, the financial market will function where the company can raise funds from the

investors and the investors can invest their money through the help of the financial market.

 
Important points of the Functions of Financial Markets

1. Financial Markets is the market, an arrangement or institution where the traders are

involved in the buying and selling of the financial assets like shares, bonds, derivatives,

commodities, currencies, etc.

2. It facilitates the exchange of financial instruments and financial securities.

3. There are different types of the financial market which can exist in any country that

includes, Money Markets, Over the Counter Markets, Derivatives Market, Bonds Market,

forex Market, and commodities market.

4. Financial Markets have different roles to play which include price determination, funds

mobilization, risk sharing, easy access, liquidity, capital formation and reduction in

transaction costs and provision of the required information, etc.

5. With respect to the size of the financial market, many financial markets are very small in

size facilitating the very little amount of the activity, and many of the financial market

trade huge amounts of securities daily

6. The financial market may have or not have the physical location and the exchange of the

financial instruments and the financial securities may be exchanged between the parties

over the phone or the internet as well. With respect to the size of the financial market,

many financial markets are very small in size facilitating the very little amount of the

activity, and many of the financial markets trade huge amounts of securities daily.o

Financial Markets perform various functions in any country which gives an opportunity to

the companies and traders for buying and selling the different financial instruments and

the financial securities. It plays a crucial role in the allocation of the limited resources

available in the economy of any country. It acts as an intermediary between savers and
the investors by mobilizing the funds between them and helps in the determination of

the prices of securities.

 Difference Between Money Market and Capital Market

Money Market vs Capital Market

Both the money market and the capital market are the two different types of the financial

markets where in the money market is used for the purpose of short term borrowing and

lending whereas the capital market is used for the long term assets i.e., the assets which

have the maturity of more than one year.

Money market and Capital market are types of financial markets. Money markets are used

for short-term lending or borrowing usually the assets are held for one year or less whereas,

Capital Markets are used for long-term securities they have a direct or indirect impact on the

capital. Capital markets include the equity market and the debt market.ney Market?

Money markets are unorganized markets where banks, financial institutions, money dealers and

brokers trade in financial instruments for a short period of time. They trade in short-term debt

instruments like trade credit, commercial paper, certificate of deposit, T bills, etc. which are

highly liquid and can be redeemed in the period less than 1.

Trading in the money market is done mostly through over the counter (OTC) i.e. no or little use

of exchanges. They provide businesses with short-term credit and play a major role in providing

liquidity in the economy over the short term. It helps the business and industries with working

capital requirements.tal Market?


The capital market is a type of financial market where financial products like stocks, bonds,

debentures are traded for a long duration of time. They serve the purpose of long-term

financing and long-term capital requirement. The Capital market is a dealer and an auction

market and consists of two categories:

 Primary market: A primary market where the fresh issue of securities are offered to the

public

 Secondary market: A secondary market where issued securities are traded between the

investors.ferences

 Short-term securities are traded in money markets whereas long-term securities are

traded in capital markets

 Capital markets are well organized whereas money markets are not that organized

 Liquidity is high in the money market whereas liquidity is comparatively low in capital

markets

 Due to high liquidity and low duration of maturity in money markets, Instruments in

money markets are a low risk whereas capital markets are the comparatively high risk

 A central bank, commercial banks and non-financial institutions are majorly work in

money markets whereas stock exchanges, commercial banks, and non-banking

institutions work in capital markets

 Money markets are required to fulfill the capital needs in the short-term especially the

working capital requirements and capital markets are required to provide long-term

financing and a fixed capital for purchasing land, property, machinery, building, etc.
 Money markets provide liquidity in the economy where capital markets stabilize the

economy due to long-term financing and mobilization of savings

 Capital markets generally give higher returns whereas money markets give a low return

on investments.tive Table

Basis for
Money Market Capital Market
Comparison

Capital market is part of the financial


It is the part of financial market
market where lending and
Definition where lending and borrowing takes
borrowing takes place for the medium-
place for short-term up to one year
term and long-term

Money markets generally deal


Capital market deals in equity
Types of instruments in promissory notes, bills of
shares, debentures, bonds, preference
involved exchange, commercial paper, T bills,
shares, etc.
call money, etc.

The money market contains It involves stockbrokers, mutual funds,


Institutions
financial banks, the central bank, underwriters, individual investors,
involved/types of
commercial banks, financial commercial banks, stock exchanges,
investors
companies, chit funds, etc. Insurance Companies

Nature of Market Money markets are informal Capital markets are more formal

Liquidity of the Capital Markets are comparatively less


Money markets are liquid
market liquid

The maturity of capital markets


The maturity of financial
Maturity period instruments is longer and they do not
instruments is generally up to 1 year
have stipulated time frame

Since the market is liquid and the Due to less liquid nature and long
Risk factor
maturity is less than one year, Risk maturity, the risk is comparatively high
involved is low

The market fulfills the short-term The capital market fulfills the long-term
Purpose
credit needs of the business credit needs of the business

The money markets increase the The capital market stabilizes the
Functional merit
liquidity of funds in the economy economy due to long-term savings

Return on The return in money markets are The returns in capital markets are high

investment usually low because of higher duration

 Both are part of the financial markets. The main aim of the financial markets is to

channelize funds and to generate returns. The financial markets stabilize the money

supply by lending borrowing mechanism i.e. surplus funds are provided to borrowers by

the lenders.

 Both are required for the betterment of the economy as they fulfill the long-term and

short-term capital needs of the business and industry. The markets encourage individuals

to invest money to gain good returns.

 Investors can tap into each of the markets depending on their needs. Capital markets are

generally less liquid but provide good returns at higher risk whereas money markets are

highly liquid but provide lower returns. Money markets are also considered safe assets.

 However, due to market anomalies and inefficiency due to some aberrations above may

not hold. Investors try to look for arbitrage opportunities due to such anomalies to get

higher returns. Money markets are considered safe but they sometimes give negative

returns. Thus, investors should study the pros and cons of each financial instrument and

the condition of the financial market before putting their money for the short term or

long term.

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