Introduction
Financial markets are an important component of the financial system. Efficient financial markets are essential for rapid economic development, as they enhance the overall efficiency of capital formation. By facilitating the smooth flow of savings into productive investments, financial markets strengthen the economic structure. They are often considered the backbone of the economy because they provide the monetary support necessary for sustainable growth.
Financial Market
A financial market refers to any marketplace where buyers and sellers participate in the trading of financial assets such as shares, bonds, currencies, and other financial instruments. It acts as a link between surplus and deficit units essentially bringing together lenders and borrowers.
Financial markets are broadly classified into two major categories:
- Capital Market – Deals in long-term securities with a maturity period of more than one year.
- Money Market – Deals in short-term debt instruments with a maturity period of less than one year.
Financial markets play a crucial role in the economic development of a nation. They serve as facilitating institutions in the savings–investment process and function as an integral part of the financial system. One of the key advantages of financial markets is that they provide quick and easy liquidity of funds. With the advancement of internet-based technologies, Demat accounts and online trading platforms have made the buying, selling, and conversion of securities into cash (and vice versa) much faster. Individuals, financial institutions, corporations, and governments participate in financial markets either directly or indirectly through brokers and dealers.
Definitions of Financial Market
- A financial market is defined as a marketplace for the exchange of capital and credit, which includes both money markets and capital markets.
- A financial market refers to a platform where the creation and trading of financial assets such as shares, debentures, bonds, derivatives, and currencies take place. It plays a vital role in allocating scarce resources within the economy. By mobilizing funds between savers and investors, it acts as a key intermediary.
Concept and Functioning
In simple terms, the financial market includes the entire network of organizations and institutions that provide short, medium, and long-term funds. It is a market for the creation and exchange of financial assets.
Financial transactions in these markets occur in two forms:
- Creation of financial assets
- Exchange of existing financial assets
In an economic system, there are two major sectors:
- Households – The savers
- Business Firms – The investors
The financial market acts as a bridge between these two sectors. It enables savers to invest their surplus funds and allows investors to borrow funds to meet their financial needs. This linking role is known as the allocative function of financial markets—mobilizing funds from savers to investors.
Funds can be allocated and mobilized from households to business firms through two mechanisms:
- Banks – Households deposit their surplus funds in banks, and banks lend these funds to business firms.
- Financial Markets – Households directly purchase securities issued by business firms, thereby providing them with funds.
The entire process of channelling funds from savers to investors is known as Financial Intermediation.
Functions of Financial Market
- Mobilization of Savings and Channelling Them into Productive Uses - Financial markets facilitate the transfer of savings from households (savers) to businesses (investors). By directing surplus funds toward productive activities, they ensure efficient utilization of financial resources.
- Price Determination - Financial markets enable continuous interaction between buyers and sellers of financial assets. This interaction helps in determining the prices of securities such as shares, debentures, and bonds based on demand and supply forces.
- Providing Liquidity to Financial Assets - Financial markets allow easy buying and selling of financial instruments. This ensures liquidity, meaning investors can quickly convert their securities into cash whenever needed.
- Reducing the Cost of Transactions - Financial markets provide valuable and reliable information about various securities. This reduces the time, effort, and money involved in searching for buyers or sellers, thereby lowering transaction costs.
In Simple Words
Financial markets mobilize savings, channel them into productive uses (allocative function), facilitate price discovery, provide liquidity, and reduce transaction costs.
Types of Financial Market
Financial markets can be classified based on the maturity period of the financial instruments traded in them:
- Money Market – Deals in short-term financial instruments with a maturity period of less than one year.
- Capital Market – Deals in long-term financial instruments with a maturity period of more than one year.
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