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Function of Financial Market

Function of Financial Market – 6 Major Functions Explained in Detail | Finance

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Functions of Financial Market

The financial market is a market in which people trade financial securities commodities and their tangible items of value at low transaction costs and a price that reflects supply and demand. Simply we can say the financial market is the market in which short-term as well as long-term financial instruments are traded.

Some of the major functions of the financial market are as follows:

Borrowing and lending

The financial market channels funds from households, firms, governments, and foreigners that have saved surplus funds to those who encounter a shortage of funds. Simply we can say it transfers funds from savers(surplus units) to borrowers(deficit units) in time of need.

Financial markets provide a platform for borrowers to access funds and for lenders to invest or save their money. Individuals, businesses, and governments can raise capital by issuing financial instruments such as bonds, stocks, and loans. Savers, on the other hand, can earn interest or dividends by lending their money to borrowers through these markets.

  • Facilitates the transfer of funds from savers (lenders) to borrowers.
  • Allows individuals, businesses, and governments to access capital they need for various purposes.
  • Promotes economic growth by channeling funds to productive investments.
  • Diversifies investment options for savers and borrowers.

Price Determination

Financial markets help to determine the price of the financial assets. The secondary market plays an important role in determining the prices for newly issued assets. The financial markets ensure the accurate and justifiable price of a stock that is about to be sold in the market for the first time.

Financial markets help establish prices for financial assets, such as stocks, bonds, commodities, and currencies. These prices are determined by the forces of supply and demand in the market. Prices reflect information about the underlying assets, economic conditions, and investor sentiment, making them a critical factor in resource allocation.

  • Financial markets determine the prices of financial assets (e.g., stocks, bonds) through supply and demand.
  • Efficient price discovery ensures that assets are valued fairly and reflect their underlying fundamentals.
  • Prices serve as signals for investors, helping them make informed decisions.

Coordination and Provision of Information

The exchange of funds is characterized by a high amount of incomplete and asymmetric information. The financial market collects and provide much information to facilitate this exchange.

Financial markets act as information hubs, where relevant financial and economic information is gathered, processed, and disseminated to market participants. This information assists investors, businesses, and policymakers in making informed decisions regarding investments, financing, and economic policies.

  • Financial markets gather and disseminate information about companies, governments, and economic conditions.
  • Investors rely on this information to make investment decisions.
  • The market acts as a mechanism for aggregating diverse opinions and expectations about future financial performance.

Risk Sharing

Trade in financial markets is partly motivated by the transfer of risk from leaders to borrowers who use the obtained funds to invest. The financial intermediaries use their experiences to reduce the level of risk. So,the ultimate suppliers of the funds feel themselves to be secured while mobilizing their savings through financial intermediaries to ultimate users.

Financial markets allow investors to diversify their portfolios and spread risk by investing in a variety of assets with different risk profiles. For example, investors can invest in stocks, bonds, real estate, and other assets to reduce their exposure to specific risks. By doing so, financial markets help promote risk-sharing and stability in the economy.

  • Allows individuals and organizations to spread their financial risks.
  • Investors can diversify their portfolios by holding a mix of assets with different risk levels.
  • Risk-sharing instruments like insurance and derivatives are traded in financial markets.

Liquidity

The existence of financial markets enables the owners of assets to buy and resell these assets. Generally, this leads to an increase in the liquidity of these financial instruments. Financial markets ensure adequate liquidity in the market through proper channeling of funds from the savers to borrowers.

Liquidity refers to the ease with which an asset can be bought or sold without significantly affecting its price. Financial markets provide liquidity by creating a platform where investors can readily buy or sell assets. Liquidity is essential for investors to enter or exit positions and for the efficient functioning of markets.

  • Provides a platform for buying or selling financial assets quickly without significantly impacting their prices.
  • Liquidity ensures that investors can convert their investments into cash when needed.
  • Enhances the overall efficiency of capital allocation.

Efficiency

The facilitation of financial transactions through financial markets leads to a decrease in informational costs and transaction costs which from an economic point of view leads to an increase in efficiency.

  • Financial markets allocate capital to its most productive uses by directing funds to where they are needed most.
  • Efficient markets ensure that resources are not wasted on unproductive investments.
  • Promotes competition, innovation, and economic growth by rewarding efficient firms and investments.

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