Financial Markets, their functions and their classifications
A 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.
A 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.
A 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.
A 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.
A 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.