What is Financial Market? and how exactly the Financial Market works?
Hello everyone and welcome to FinanceBread. As you can see from the title, today we are going to learn about
WHAT IS FINANCIAL MARKET?
A financial market helps to connect households (savers) and business firms (investors) by mobilizing funds between them.
In a way, financial market performs ‘allocative function‘.
To clarify, it allocates or directs funds available for investments into their most productive investment opportunity.
Now we know what is financial market? And later in post we will get to now how financial market works ?
But when the allocative function is performed, teo consequences follow:-
- The rate of return offered to households would be higher.
- Scarce resources are allocated to those firms which have the highest productivity for the economy.
TWO ALTERNATIVES FOR ALLOCATION OF FUNDS
Two major alternatives through which allocation of funds can be done.
(1) via Banks –
Households or savers can deposit their funds with banks, who in turn could lend these funds to business firms.
(2) via Financial markets –
Households can buy the shares and debentures offered by businesses using financial markets.
The process by which allocation of funds is done is called ‘financial intermediation‘.
In the systems, banks and financial markets are intermediaries and hence households are given a choice where they want to put their savings.
A financial market is a market for the creation and exchange of financial assets.
Let understand above two terms i.e. creation and exchange through a table.
|Creation of financial assets||Exchange of financial assets|
|Creation of financial assets takes place when a company issues new shares and debentures.||Exchange of financial assets implies purchase and sale of existing shares, debentures and bonds.|
You might be saying by now ‘” Yes, I understand that financial market is a market of creation and exchange of financial assets but what are its functions and how financial market works?
Don’t worry there is only a handful of them and they are easy to understand.
FUNCTION OF FINANCIAL MARKET
- Mobilization of savings and channeling them into most productive uses:
As we discussed in the beginning of our post, financial market facilitates the transfer of savings from savers to investors.
In fact, it gives the savers choice of where they want to put their savings and thus helps to channelise surplus funds into the most productive uses.
2. Facilitating price discovery:
In the financial markets, the households are suppliers of funds and business firms represents the demand.
The interaction between them helps to establish a price for the financial asset which is being traded in the market.
The second one was a bit technical and so are the coming few but stick with me, we can do this.
3. Providing liquidity to financial assets:
liquidity plays an important role in financial assets. Financial markets facilitates easy purchase and sale of financial assets.
In doing so, they provide liquidity to financial assets so that they can be easily converted into cash whenever required.
Holders of assets can readily sell their financial assets through the mechanism of financial market.
4. Reducing the cost of transactions:
Financial markets provide valuable information about being securities being traded in the market. It helps to save time, effort and money both buyers and sellers of a financial assets which would been to otherwise spend to try and find each other.
The financial market is thus, a common platform where buyers and sellers can meet for their individual needs.
Imagine you want to eat pizza and you are having your freinds with you.You dont want to waste time on asking everyone what their choice is and where is the best place to find one.
You opened app and order pizza. That sounds familiar with above, Doesn’t it?
Its same with reducing cost of transaction.
TYPES OF FINANCIAL MARKET
Financial markets are classified on the basis of the maturity of financial instruments traded in them.
The money market is a market for short term funds which deals in monetary assets whose period of maturity is up to one year e.g Treasury Bills, Call money, Commercial paper, Commercial Bill and certificate of deposits.
Features of money market instruments:-
- Close substitutes of money
- Short term debt instruments
- Low risk
- Highly liquid
It refers to facilities and institutional arrangements through which medium and long term funds, both debt and equity are raised and invested.
Capital market can be further divided into two parts:-
A. Primary Market
B. Secondary Market
The primary market is also known as the new issues market. It deals with new securities being issued for the first time.
- The essential function of the primary market is to facilitate the transfer of investible funds from savers to entrepreneurs seeking to establish new enterprises or to expand existing ones through the issue of securities for the first time.
- The investors in this market are banks, financial institutions, insurance companies, mutual funds, and individuals.
- A company can raise capital through the primary market in the form of equity shares, preference shares, debentures, loans, and deposits.
- Funds raised may be for setting up new projects, expansion, diversification, modernization of existing projects, mergers and takeovers, etc.
The secondary market is also known as stock market or stock exchange. It is a market for the purchase and sale of existing securities.
- For helping existing investors to disinvest and fresh investors to enter the market.
- It also provides liquidity and marketability to existing securities.
- It also contributes to economic growth by channelizing funds towards the most productive instruments through the process of disinvestment and reinvestment.
MARKET MONEY INSTRUMENTS
Call money is a short-term finance repayable on demand, with a maturity period of 1-15 days, used for inter-bank transactions.
A treasury bill is an instrument issued by RBI ( in the form of the promissory note) on behalf of the Central Government to meet its short term requirement of funds. It has a maturity period of less than one year.
A commercial bill is a bill of exchange used to finance the working capital requirements of business firms. It is short-term, negotiable, and self-liquidating which is used to finance the credit sales of firms.
Commercial paper is an instrument used by large and creditworthy companies to short-term funds at lower rates of interest than the market rates.
CERTIFICATE OF DEPOSIT
Certificates of deposits (CDs) are unsecured, negotiable, short-term instruments in bearer form, issued by the commercial banks and development financial institutions.
SECURITIES AND EXCHANGE BOARD OF INDIA (SEBI)
The Securities Exchange Board of India (SEBI) was established by Government of India on 12 April, 1988 as an interim adminstrative body to promote orderly and healthy growth of securities market and for investor protection from trading malpractices, e.g. price rigging, insider trading, etc.
- Price rigging – Making manipulations with the sole objective of inflating or depressing the market price of securities.
- Insider trading – The insiders to the company (Directors, Promoters, etc) using inside information (e.g. bonus issue) to make personal profits.
OBJECTIVES OF SEBI
The overall objectives of SEBI are to protect the interests of investors and to promote the development of, and regulate the securities market.
- To regulate stock exchanges and the securities market to promote their orderly functioning.
- For protecting the interests and rights of investors and particularly to individual investors, and to guide and educate them.
- To prevent trading malpractices (like price rigging, insider trading, making misleading statements, etc.) and achieve a balance between self-regulation by the securities industry and its statutory regulations.
- For regulating and develop a code of conduct and fair practices by intermediaries like brokers, merchant bankers, etc with a view to make them competitive and professional.
FUNCTIONS OF SEBI
- PROTECTIVE FUNCTION
Prohibition of fraudulent and unfair trade practices like price rigging, making misleading statements etc.
Controlling insider trading and imposing penalties on such practices.
- REGULATORY FUNCTION
Registration of brokers and sub-brokers and other players in the market.
Registration of collective investments and mutual funds.
- DEVELOPMENT FUNCTION
Training of intermediaries of the securities market.
Conducting research and publishing information useful to all market participants.
Undertaking measures to develop the capital markets by adapting all flexible approach.
A financial market helps to link the household and business firms by mobilizing funds between them. It helps in price discovery, providing liquidity to financial assets, and reduces the cost of transactions.
Financial markets are classified into money and capital market. The capital market further divided into primary and secondary markets.
The government of India established SEBI in 1988 on April 12. Its objective is to promote orderly and healthy growth of securities market and for investor’s protection.
There you go, now you know enough about what is financial market and how financial market works. Thank you very much for spending your precious times with Financebread.
I hope that I was able to give you some insights and understanding how financial market works in my best knowledge.
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