Financial Markets, their functions and their classifications
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Financial market is a market for creation and exchange of financial assets.
Financial markets act as a forum to facilitate financial transactions through
the creation, sale and transfer of financial securities. If you buy or sell
financial assets, you will participate in financial markets in some way or the
other.
Financial
markets play a key role in the economy by stimulating growth influencing
economic performance of the actors, affecting economic welfare. This is achieved
by financial infrastructure, in which entities with funds allocate those funds
to those who have potentially more productive ways to invest those funds. A
financial system makes it possible a more efficient transfer of funds.
Functions of Financial
Markets:
Financial
markets play a pivotal role in allocating resources in an economy by performing
three important functions.
1) Financial Markets facilitate Price Discovery:
The
continual interaction among numerous buyers and sellers who throng financial
markets helps in establishing the prices of financial assets. Well organized financial
markets seem to be remarkably efficient in price discovery. That is why
economists say: “If you want to know what the value of a financial asset is,
simply look at its price in the financial market”.
2) Financial Markets provide liquidity to
financial assets:
Investors
can readily sell their financial assets through the mechanism of financial
markets. In the absence of financial markets which provide such liquidity, the
motivation of investors to hold financial assets will be considerably
diminished. Thanks to negotiability and transferability of securities through
the financial markets, it is possible for companies and other entities to raise
long term funds from investors with short term and medium term horizons. While one investor is substituted by another
when a security is transacted, the company is assured of long term availability
of funds.
3) Financial Markets considerably reduce the cost
of transacting:
The
two major costs associated with transacting are search costs and information
costs. Search costs comprise explicit costs such as the expenses incurred on
advertising when one wants to buy or sell an asset and implicit costs such as
the effort and time one has to put in to locate a customer. Information costs
refer to costs incurred in evaluating the investment merits of financial
assets.
Classification of
Financial Markets:
There
are different ways of classifying financial markets. One way is to classify
financial markets by the type of financial claim.
The
Debt market is the financial market
for fixed claims of debt instruments and the Equity market is the financial market for residual claims or equity
instruments.
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second way is to classify financial markets by the maturity if claims. The
market for short-term financial claims is referred to as Money Market and the market for long-term financial claims is
called as Capital market. Traditionally,
the cutoff between short-term and long-term financial claims has been one year –
though the dividing line is arbitrary, it is widely accepted. Since short-term
financial claims are invariably debt claims, the money market is the market for
short-term debt instruments. The capital market is the market for long-term
instruments and equity instruments.
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third way to classify financial markets is based on whether the claims
represent new issues or outstanding issues. The market where issuers sell new
claims is referred to as the Primary
market and the market where investors trade outstanding securities is
called the Secondary market.
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fourth way to classify financial markets is by the timing of delivery. A Cash or Spot market is one where the delivery occurs immediately and a Forward or Futures market is one where the delivery occurs at a pre-determined
time in future.
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fifth way to classify financial markets is by the nature of its organizational structure.
An Exchange-traded market is characterized
by a centralized organization with standard procedures. An Over-the counter market is a decentralized market with customized procedures.
