Functions of financial market

Borrowing and Lending: Financial markets permit the transfer of funds (purchasing power) from one agent to another for either investment or consumption purposes.


Information Aggregation and Coordination: Financial markets act as collectors and aggregators of information about financial asset values and the flow of funds from lenders to borrowers.


Risk Sharing: Financial markets allow a transfer of risk from those who undertake investments to those who provide funds for those investments.


Efficiency: Financial markets reduce transaction costs and information costs.


Transfer of Resources: Financial market facilitate the transfer of real economic resources from lenders to ultimate borrowers.


Enhancing income: Financial markets allow lenders to earn internet or dividend on their surplus invisible funds, thus contributing to the enhancement of the individual and the national income.


Productive usage: Financial market allow for the productive use of the funds borrowed. The enhancing the income and the gross national production.


Capital Formation: Financial market provide a channel through which new savings flow to aid capital formation of a country.


Sale Mechanism: Financial markers provide a mechanism for selling of a financial asset by an investor so as to offer the benefit of marketability and liquidity of such assets.


Price determinants: Financial market allow for the determination of price of the traded financial asset through the interaction of buyers and sellers. They provide a signal for the allocation of funds in the economy, based on the demand and supply through the mechanism called price discovery process.


Information: The activities of the participants in the financial market result in the generation and the consequent dissemination of information to the various segments of the market. So as to reduce the cost of transaction of financial assets.


*** Providing the borrower with funds so as to enable them to carry out their investment plans.

*** Providing the lenders with earning assets so as to enable them to earn wealth by deploying the assets in production debentures.

*** Providing liquidity in the market so as to facilitate trading of funds.


Price discovery function: Price discovery function means that transactions between buyers and sellers of financial instruments in a financial market determine the price of the traded asset. At the same time the required return from the investment of funds is determined by the participants in a financial market. The motivation for those seeking funds (deficit units) depends on the required return that investors demand. It is these functions of financial markets that signal how the funds available from those who want to lend or invest funds will be allocated among those needing funds and raise those funds by issuing financial instruments.


Liquidity function: Liquidity function provides an opportunity for investors to sell a financial instrument, since it is referred to as a measure of the ability to sell an asset at its fair market value at any time. Without liquidity, an investor would be forced to hold a financial instrument until conditions arise to sell it or the issuer is contractually obligated to pay it off. Debt instrument is liquidated when it matures, and equity instrument is until the company is either voluntarily or involuntarily liquidated. All financial markets provide some form of liquidity. However, different financial markets are characterized by the degree of liquidity.


Reduction of transaction: The function of reduction of transaction costs is performed, when financial market participants are charged and/or bear the costs of trading a financial instrument. In market economies the economic rationale for the existence of institutions and instruments is related to transaction costs, thus the surviving institutions and instruments are those that have the lowest transaction costs


Transfer of Funds :Financial markets facilitate the transfer of funds from savers and investors to spenders.  In the terminology used by some a textbook authors, the funds are transferred from a surplus spending units ( SSU’s ) to deficit spending units ( DFU’s ).  These funds transfers occur in the primary financial markets.


SSU = net saver

DSU = net spender


•           3 Major Sectors


*          Households     –           typically net SSU’s

*          Business                      –           typically net DSU’s

*          Government    –           almost always net DSU’s




Providing of liquidity: The financial markets provide liquidity for sellers of securities in the secondary market.  Liquidity is usually defined as the ease with which you can sell an asset on short notice without a loss in its value.


•           Assets with good liquidity:

*          Stock issues included in the Dow Jones Averages or the NASDAQ 100 index

*          Options on popular stocks

*          Gold coins

*          Treasury Bills, Notes, and Bonds


•           Assets with poor liquidity:

*          Enron Common Stock

*          Russian bonds issued by the Czar in 1905


Securities pricing: Financial markets facilitate pricing of various financial securities.  Securities pricing is accomplished through the supply-demand forces in a potential market.


Behind the supply and demand forces, however, individual investors make decisions about what they feel are the intrinsic values of different financial assets.  Where the supply and demand curves meet the market arrives at an equilibrium price.




Saving mobilization: Obtaining funds from the savers or surplus units such as household individuals, business firms, public sector units, central government, state governments etc. is an important role played by financial markets.


Investment: Financial markets play a crucial role in arranging to invest funds thus collected in those units which are in need of the same.


National Growth: An important role played by financial market is that, they contributed to a nation’s growth by ensuring unfettered flow of surplus funds to deficit units. Flow of funds for productive purposed is also made possible.


Entrepreneurship growth: Financial markets contribute to the development of the entrepreneurial claw by making available the necessary financial resources.


Industrial development: The different components of financial markets help an accelerated growth of industrial and economic development of a country, thus contributing to raising the standard of living and the society of well being.


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