We are starting a series on financial markets to help you get instant information about what constitute financial markets, what are the types of markets, who are the major players and what kind of financial instruments are traded or exchanged in these markets. To begin with, we start with an overview of the financial markets.

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Financial Markets: Exchange Money

Financial market is a market for the exchange of money. It brings together two kinds of people:

People who need money are Borrowers

Borrowers in the financial market can be individuals (who need money for personal consumption like buying a house, car, etc.), private & public companies (which need funds for expansion, setting up manufacturing facilities, launching a new product, R&D, etc.), governments and other local authorities like municipalities (to spend on public service and infrastructure like roads, healthcare, sanitation).

People who have surplus money are Lenders

Lenders in the financial market are actually the investors who have extra funds and want to use the additional money to earn more money. Their invested money is used to finance the requirements of borrowers. In return the investors expect to earn in the form of interests, dividends, company ownership, etc. Some of these types of investments are depositing money in bank accounts, paying premiums to insurance companies, investing in shares of different companies, corporate bonds, government bonds, pension funds, and mutual funds, etc. Let us take the example of bank deposits and see how the extra funds flow from the lender to the borrower:

 

Financial markets bring together borrowers & lenders

Let us  assume X has surplus money with which he opens a fixed deposit in a bank. On the other hand there is person Y who needs extra funds to buy a car. Y approaches the bank to borrow the required funds. The bank which has taken fixed deposits from multiple customers like X puts together the funds and lends it to Y in the form of an auto loan. In return the bank charges an interest on the loan from Y and pays a part of it as interest earned to its customers (like X) who have a fixed deposit with the bank. The difference of the interest earned from Y and paid to customers like X becomes the revenue for the bank. This is how money flows from the lender (X) to the borrower (Y) through an intermediary (Bank). Roles of intermediaries have been discussed in further details below.

Financial markets bring together borrowers & lenders

Financial market is a broad term describing any marketplace where buyers and sellers participate in the trade of financial products such as equities, bonds, currencies and derivatives. A financial market includes among others, the following:

  • Capital markets which include: Equity Markets, Credit Markets and Money Markets
  • Foreign exchange markets (Forex)
  • Commodity exchanges
  • Derivative markets

The list can be endless. Financial markets can be found in nearly every nation in the world. Some are very small, with only a few participants, while others – like the New York Stock Exchange (NYSE) and the Forex markets – trade trillions of dollars daily.

Functions of Financial Markets

Financial markets serve five basic functions. These functions are briefly listed below:

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

Information Aggregation and Coordination: Financial markets act as collectors and aggregators of information about financial product values and the flow of funds from lenders to borrowers. This is an important function when it comes to transparency and results in better price discovery.

Price Determination: Financial markets provide the platform by which prices are set both for newly issued as well as existing financial products. This function is similar to the way price mechanisms work in other markets through demand and supply. A higher demand for a particular financial product results in a higher price and vice versa. The price of financial products is also based on a variety of factors viz., political developments, prices of commodity products, economic events, etc.

Risk Management: Financial markets allow a transfer of risk from one person to another. Examples of risk sharing are present in foreign currency transactions, derivatives etc. If an exporter is worried about the Indian Rupee appreciating, he can lock in the exchange rate by booking a forward contract. This is just one of the various ways by which one can manage the risk.

Liquidity: Financial markets provide the holders of financial assets with a chance to resell or liquidate these assets. For example, in the absence of efficient financial markets, Lender A would not be comfortable in investing his excess funds in buying shares of company X (any other company). While he would want to invest his money and earn high returns, he is not sure whether he will be able to find a buyer to sell off his shares if the need arises to liquidate (convert his assets to cash). This is because there is no market to bring the buyer and seller together. As an outfall of this, Company X which needs the funds will not be able to raise the same, which in turn will impact whatever growth plan it had (whatever it was going to use the funds for). Thus the transfer of funds from lender to borrower will cease and in turn affect overall economic growth.

In attempting to characterize the way financial markets operate, one must consider both the various types of financial institutions that participate in such markets and the various ways in which these markets are structured.

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