Financial markets are the place that facilitates buying and selling of financial instruments, claims, or services. It caters to the credit needs the individuals, firms, and institutions.
Financial markets are critical for producing an efficient allocation of capital, allowing funds to move from people who lack abundant investment opportunities to people who have them.
The financial market deals with financial assets or instruments of different types, such as currency deposits, cheques, bills, bonds, etc. It consists of individual investors, financial institutions, and other intermediaries linked by formal trading rules and communication networks for trading the various financial assets and credit instruments.
Functions of Financial Markets
Some of the main functions performed by financial markets are as below:
- Borrowing and Lending: Financial markets facilitate the transfer of funds from one person or entity to another for either investment or consumption purposes.
- Price Determination: It provides means by which prices are set for newly issued and existing financial securities.
- Liquidity: It gives the holders of financial securities a chance to resell or liquidate these assets.
- Efficiency: It reduces transaction costs and information costs.
- Risk Sharing: It allows risk transfer from those undertaking investments to those providing funds.
Types of Financial Markets
A financial market consists of six major segments:
- Money Market,
- Capital Market,
- Derivatives Market,
- Commodities Market,
- Foreign Exchange Market, and
- Spot Market.
Money Market
A money market is a place for short-term funds, which deals in financial assets with a maturity period of up to one year. It should be noted that the money market does not deal in cash or money but provides a need for credit instruments such as bills of exchange, promissory notes, commercial paper, treasury bills, etc. These financial instruments are a close substitute for money. These instruments help the business units, other organizations, and the government to borrow funds to meet their short-term requirement.
The money market does not imply any specific marketplace. Instead, it refers to the whole networks of financial institutions dealing in short-term funds, which provides an outlet to lenders and a source of supply for such funds to borrowers. Most money market transactions occur via telephone, fax, or the Internet.
Capital Market
A capital Market may be defined as a marketplace that deals in medium and long-term funds. It is an institutional arrangement for borrowing medium to long-term funds and provides facilities for marketing and trading securities. It constitutes all long-term borrowings from banks and financial institutions, borrowings from foreign markets, and raising of capital by issuing various securities such as shares, debentures, bonds, etc.
A capital market consists of two segments: primary and secondary. The primary market deals with new or fresh securities and is known as the New Issue Market. In contrast, the secondary market provides a place to purchase and sell existing securities and is often termed a stock market.
Derivatives Market
A derivatives Market is a type of financial marketplace that deals with trading financial derivative contracts like; Futures, Options, Forward contracts, Swaps, etc. These financial derivatives could be sold at a recognized stock exchange or Over The Counter. A derivative instrument derives its value from an underlying asset like an equity share, share index, commodity, currency, etc. Financial derivatives are often used to manage financial risk due to a price movement.
Commodity Market
The commodity market facilitates the physical trading of commodities like gold, oil, wheat, rice, etc. Items could be traded at a spot exchange called a mandi or on an exchange like Stock Exchange. In the spot market, commodities are traded in exchange for cash; on a sale, they are sold in the form of derivative contracts, like Commodity Futures and Options.
Foreign Exchange Market
The Foreign Exchange Market facilitates the trading of currencies. These markets are operated through financial institutions and determine foreign exchange prices for most international currencies in both spot and derivatives markets. A foreign exchange market, including spot and derivatives, is the biggest financial market in the world.
Spot Market
Spot Market is a market where transactions are done on the spot and in cash only. There is a spot market for almost all financial assets and securities types.
Conclusion: Financial Market is an integral part of an Economy
The financial system plays a critical role in the economy. It enables the financial intermediation process, which facilitates the flow of funds between savers and borrowers, thus ensuring that financial resources are allocated efficiently towards promoting economic growth, development, and stability.
Financial stability describes the condition where the financial intermediation process functions smoothly and confidence in the operation of key financial institutions and markets within the economy.
This situation helps improve the situation for financial securities and their valuation, for example, a stable stock market and, resultantly, wealth creation for investors.
