Sample Economics Paper on Functions and Significance of Financial Markets

Introduction

A financial market refers to a market in which the creation, buying, and selling of financial assets takes place. Financial assets refer to liquid assets that are intangible and their value is derived from a binding contractual claim of what they are understood to represent. Examples of financial assets include: bonds, shares, debentures, bank deposits, and derivatives, among others. While a majority of countries have at least one financial market, others have more. Various stakeholders engage in the financial markets such as brokers, dealers, financial intermediaries, and investment banks, among others. The financial market is subdivided into smaller markets which collectively play various functions and have an undeniable significance in an economy. Financial markets play a crucial role in the growth and development of a country’s economy and improving the people’s living standards.

Discussion

Classification of Financial Markets

The first criterion for classification is based on the nature of claims, which takes into consideration fixed claims and residual claims. Here, two types of markets exist: the debt and equity markets. Foremost, transactions involving debt instruments occur in the credit market. Credit instruments include bonds (Pilbeam, 2018).The second market, the equity market, facilitates trade in equity instruments such as shares are traded. It can also be referred to as the market for residual claims. The second criteria of classification is the maturity of the claim. Here, four main markets exist. First is the capital market through which long and medium-term financial assets are traded. The capital market is further divided into two, namely: the primary market for trading fresh or initial securities issued by a listed company and the secondary market or the stock market for trade in already issued securities by listed companies. Second is the money market through which monetary assets with a maturity period of a year or less (short-term) are traded. Transactions in this market are done over virtual networks since a physical market for these transactions does not exist.

The next criterion is the timing of delivery in which there are two types of markets. The first market type is the cash market whereby transactions carried out between buyers and sellers are settled by the involved parties in real-time. The second sub-market type is the futures market whereby the delivery or settlement between buyers and sellers of commodities traded occurs at a future date agreed upon by the involved parties. The fourth criterion of classification is based on the nature of the financial asset. This criteria classifies financial markets into four groups: stock, bond, commodity, and derivative markets. Shares issued by corporations for the first time are traded in the securities exchange or stock market. The bond market allows for trading of bonds issued by the government and companies (Nobes, 2014). Thirdly, commodities like corn and barley are traded in the commodities market. Lastly, the derivatives market deals with contracts or derivatives whose values are dependent on the underlying asset. The final financial markets classification criterion is based on the market’s organizational structure. Here, two types of markets exist: the exchange-traded market, which has a centralized organization with standardized procedures, and the over-the-counter market, which has a decentralized organization with customized procedures (Dodd, 2020). The principal financial markets that are in operation in a standard economy include; the share market, derivatives market, foreign exchange market, and the debt market.

Functions of Financial Markets

Price Determination

Price determination is the main function of a financial market. Though investors supply funds by purchasing financial assets or instruments, the companies, firms, and industries require the funds, and hence, they issue these securities. Therefore, in this case, the investors are on the supply side of the market while the demand side includes the firms, companies, and industries that require the funds for the running of their activities. This function may also be referred to as price discovery since the financial market provides the vehicle through which the prices of both newly-issued securities and existing securities are determined (Kennon, 2019). Additionally, any fluctuation in prices of the securities in the financial markets is as a result of change in either their demand or supply in combination with other minor forces. Financial markets also help in determining the rate of return that an investor will expect depending on the riskiness of the borrower and the prevailing inflation rate.

Savings Mobilization

Financial markets mobilize savings and channel them into productive uses. They provide a route via which savings can be converted into funds through the purchase of financial assets (Kelly& Mavrotas, 2008). Therefore, they help in linking entities with enough funds, also known as the lenders or investors, with those who need the funds. The ones in need of the funds issue financial interments in the financial market which are then bought by the investors. As a result, the individuals or companies in need of funds are able to access a large additional amount of funds determined by the issued financial assets. Therefore, the financial market encourages savings among people who may later on wish to invest their idle lying funds in productive activities. Eventually, this leads to the growth of an economy.

Liquidity

The liquidity function of the financial markets enables investors to sell their financial assets or instruments at the prevailing market prices at any time of the day and convert the money into cash. Therefore, financial assets have high liquidity which renders them very enticing to invest in (Geithner, 2007).In the absence of liquidity, the lender is forced to hold the financial securities until conditions for sale of these securities arises in the financial markets. Similarly, the issuer has to pay for the securities issued at the time of maturity in the case of debt instrument or at the time of liquidation of a company either voluntarily or involuntarily in the case of equity instruments making the market very rigid. This function of the financial markets also means that investors can invest their money in financial instruments at the prevailing prices at any time, as well as sell them at the prevailing prices at any time.

Cost and Time-Friendly Market

Financial markets provide a low cost and time-friendly market by reducing the costs and time involved in the transactions of securities. In any given market setting, traders require the provision of information regarding the trade and provision of the required information. This requires physical presence which consumes both time and money. A financial market avails every type of the required information to traders without the requirement of physical presence making it both time-saving and cost-reducing. Financial markets save investors and borrowers time by providing a ready pool of potential, ready, and willing lenders and borrowers. Moreover, since the market deals with an extremely large number of transactions, it gains economies of scale, which, in turn, reduces the transaction costs and fees for the investors making it a very attractive venture for them.

Capital Formation

Financial markets are a major source of capital formation. The savings of investors in the financial markets of a given country aid in capital formation for the country. Businesses borrow funds to expand, invest in capital, and invest in research and development to enable their growth. Investors then avail these borrowed funds to the businesses by investing in financial instruments. Notably, companies may require additional capital during their formation. In order to access the funds, they sell financial instruments in the financial market. As a result, they are able to raise the required capital and even more than is required. The government of a given country often requires more capital in order to run infrastructure projects and raise economic activity. This capital is availed by the investors through the buying of financial instruments sold by the government in the financial markets.

Risk Sharing

Financial markets enable the transfer of risks between the lenders of funds and the issuers of securities. Notably, the investors are different people or entities. Whenever companies, businesses or even the government decide to undertake investments in capital and/or in research and development, they must consider the risk involved. The issuing of financial assets in the financial market to be bought by lenders of funds at a given price enables the issuers to transfer the risk of investment to the lender of the funds.

Significance of Financial Markets

Encourages Savings and Investments

Savings and investments play a major part in the economic growth process of a country. Idle savings are useless unless they are converted into investments. A major significance of financial markets is that they help savers to become investors. Financial markets provide a channel through which savers can invest their money and get returns in the near future. Therefore, it provides a risky yet very profitable alternative for savers instead of leaving their money lying idle and unutilized. Returns on the investment are paid at a certain rate of interest determined by the forces of demand and supply in the market. It is important to note that investment is a major component of the Gross Domestic Product (GDP). Therefore, financial markets encourage the culture of investing among the people of a given country, which, in turn, increases the investment component of the GDP of a given country.

Helps Businesses to Raise Capital

Financial markets also help businesses to raise the capital needed for expansion. Businesses may not always have enough capital to expand to greater heights. As a result, they may borrow from financial markets by issuing financial assets for sale. The funds lent to them are then put into productive uses so as to increase such businesses’ production of goods and services. They may also direct funds into research and development so as to identify their niche in the society. Also, they may work on specialization in a certain area in the market or even diversify their activities so as to cater for the needs of the people. An important aspect to note is that financial markets also indirectly encourage innovation in business. For most people intending to startup businesses, lack of funds is a major barrier to realizing their goals. However, the presence of fully-functioning financial markets solves the problem of lack of funds for innovators by readily providing investors. However, the innovators are required to start up their businesses and offer financial assets in return for an unlimited amount of funds.

Promotion of Economic Growth and Development

Economic growth and development are gradual processes that are indirectly encouraged by the effective operation of financial markets. Financial markets are a source of capital formation required by businesses and companies to expand their activities such as production of commodities and services. The availability of capital, therefore, increases production, which, in turn, increases the Gross Domestic Product (GDP) of a country. Additionally, financial markets also encourage innovation thereby creating employment which leads to an increase in the production of goods and services. The effect of these innovations is a decrease in the unemployment rate, which results in an increase in general living standards because the newly-employed people are able to purchase better products and access quality services (Monacelli, Quadrini, & Trigari, 2011).For governments to facilitate infrastructural projects, they may require capital from the financial markets. Hence, the presence of fully-functioning financial markets ensures that the required capital is readily available. Therefore, there is efficient capital allocation in the economy. Improved infrastructure indirectly increases the production level of a country for both goods and services leading to increased GDP. Additionally, as more citizens of a country and save and channel their savings into investments in the financial markets, the country’s investment level rises. This increases the country’s GDP thus promoting economic growth (Krueger, 2006). By ensuring that savings do not lie idle and are instead injected into investment, financial markets ensure that the country experiences economic growth and expansion. Hence, there exists a positive relationship between economic growth and an increasing investment culture in a country. With an increase in production and innovation levels, a decrease in unemployment, improved living standards, and an increase in savings and investments, any given country would gear towards economic development (Demirguc-Kunt, Feyen, & Levine, 2011). As the process repeats itself, the social systems of the country also begin to change as well as the mental capacity of the involved stakeholders. Therefore, while financial markets help in economic growth and expansion, they also lead a country towards economic development.

Conclusion

Financial markets are classified using five main criteria with each criterion having various markets. Financial markets have several significances such as boosting the economic growth of a country, encouraging an investing culture and innovation, and providing necessary funds to businesses. Additionally, such markets have an extensive list of key functions that they play in any given economy. Therefore, financial markets are a crucial part of a country’s financial sector. It is, therefore, crucial for any parties that want to engage in financial markets to gather relevant information that would give them a competitive edge in such markets.

 

 

 

References

Demirguc-Kunt, A., Feyen, E., & Levine, R. (2011). Optimal Financial Structures and Development: The evolving importance of banks and markets. World Bank, mimeo.

Dodd, R. (2020, February 24). Markets: Exchange or Over-the-Counter. International Monetary Fund. Retrieved from https://www.imf.org/external/pubs/ft/fandd/basics/markets.htm

Geithner, T. F. (2007, February 28). Liquidity and financial markets. Federal Reserve Bank of New York. Retrieved from https://www.newyorkfed.org/newsevents/speeches/2007/gei070228

Kelly, R., & Mavrotas, G. (2008). Savings and financial sector development: panel cointegration evidence from Africa. The European Journal of Finance14(7), 563-581.

Kennon, J. (2019, November 16). How Stock Prices Are Determined. The Balance. Retrieved from https://www.thebalance.com/how-stock-prices-are-determined-358144

Krueger, A. O. (2006, September 28). Financial markets and economic growth, by Anne O. Krueger, special advisor to the managing director. International Monetary Fund. Retrieved from https://www.imf.org/en/News/Articles/2015/09/28/04/53/sp092806

Monacelli, T., Quadrini, V., & Trigari, A. (2011). Financial markets and unemployment (No. w17389). National Bureau of Economic Research.

Nobes, C. (2014). International classification of financial reporting. Routledge.

Pilbeam, K. (2018). Finance & financial markets. Macmillan International Higher Education.