In this article we will discus about:- 1. Meaning and Composition of Financial Markets 2. Types or Classification of Financial Markets 3. Efficiency 4. Functions 5. Working 6. Role in Economic Development.
- Meaning and Composition of Financial Markets
- Types or Classification of Financial Markets
- Efficiency of Financial Markets
- Functions of Financial Markets
- Working of Financial Markets
- Role of Financial Markets in Economic Development
1. Meaning and Composition of Financial Markets:
Financial market is an institution or arrangement which facilitates the exchange of financial assets such as deposits and loans, stocks and bonds, government securities, cheques, bills, etc. Financial markets operate through brokers, banks, non-banking financial institutions, merchant banks, mutual funds, discount houses, central bank, etc.
There are two types of institutions in financial markets: first, depository i.e., keeping deposits, and second, non-depository.
Depository institutions are those which accept deposits from individuals and, firms and use these funds for advancing loans in the debt market or purchasing other debt instruments such as Treasury Bills.
The main depository institutions are as follows:
1. Commercial Banks:
They are the largest and most important depository institutions which keep deposits of individuals and firms in various types of accounts in the form of cash and assets, and use them for advancing loans.
2. Saving and Loan Associations:
They are operated by individuals by collecting their savings in mutual association. They convert their saving funds into mortgage loans.
3. Mutual Savings Banks:
They operate like savings and loan associations. The only difference is that they are established on the basis of co-operation by employees of some company, trade union or other institutions.
4. Co-operative Credit Societies:
The members of credit societies purchase shares of co-operative societies, deposit their savings with them and borrow from them.
Non-depository institutions operate in financial markets as financial intermediaries and provide insurance against financial risks.
The major non-depository institutions are as follows:
1. Mutual Funds:
Mutual funds sell their shares to individuals and firms and invest the proceeds in various types of assets. Some mutual funds, known as money market mutual funds, invest in short-term safe assets such as Treasury Bills, certificates of deposit of banks, etc.
2. Insurance Companies:
Insurance companies protect individuals and firms against risks. The premium they receive from individuals by insuring their lives, they invest the same in advancing loans for long-term assets, mortgages, construction of houses, etc. On the other hand, the premium received by them for insurancing against loss from fire, theft, accident, etc. of trucks, cars, buildings, etc. is invested in short-term assets.
3. Pension Funds:
Private and government corporates, and central, state and local governments deposit some amount in pension funds by deducting a certain amount from the salaries of their employees. Pension fund institutions or corporates invest these funds in long-term assets.
4. Brokerage Firms:
Brokerage firms link buyers and sellers of financial assets. As such, they function as intermediaries and earn a fee for each transaction, known as brokerage. They operate only in the secondary debt market and equity market.
2. Types or Classification of Financial Markets:
Financial markets can be classified in a number of ways:
1. Money and Capital Market:
One method is related to the type of assets traded, i.e., short-term or long- term assets. The market in which short-term financial instruments are traded is called money market whereas the market in which long-term financial instruments are traded is called capital market. This is also called functional classification of financial markets.
2. Primary and Secondary Markets:
Financial markets are also classified in to primary and secondary markets. In a primary market, new issues of financial assets are bought and sold, whereas existing financial assets are bought and sold in a secondary market.
When a new company issues its shares or an existing company sells its new shares that have not been bought by anyone earlier, they are bought and sold in the primary market. On the other hand, when a person sells his already purchased shares of a company, they will be bought in the secondary market. Financial markets are further classified on the basis of traded instruments. This classification consists of debt, equity and financial service markets.
3. Debt Markets:
In the debt market, lenders provide funds to the borrowers for a certain period. In return for the funds, the borrower agrees to pay to the lender the principal amount of the loan and a certain rate of interest. People borrow new cars, houses, etc. from debt markets. Companies borrow from investors for working capital and new equipment’s by issuing bonds. Central, state, and local governments obtain funds from debt markets to finance various public projects.
The purchase of new bonds issued by companies and governments takes place in primary debt market and the purchase and sale of bonds is done in the secondary debt market. Further, debt markets are classified as short-term, medium-term and long-term markets according to the period of bonds. For instance, the period of one year or less refers to short-term, that between 1 and 10 years is called medium-term and of more than 10 years is called long-term. As discussed above, the equity market is classified as primary market and secondary market in which sale and purchase of shares takes place through brokers and stock centres.
4. Equity Markets:
Shares of corporates are bought and sold in an equity market. Equity market is further divided into primary and secondary market. New shares are sold in the primary market and existing shares are traded in the secondary market.
5. Financial Service Markets:
Individuals and firms use financial service markets through banks and brokers that enhance the operations of debt and equity markets. Besides providing bank deposit and withdrawal facilities, some offer financial services. They participate in debt markets by providing loans and also purchase bonds and shares on behalf of their customers. Banks charge some fee for these services.
However, banks participate only in the primary market. Therefore, there is no secondary market in financial service market. The second financial service is provided by brokers. They help in selling and purchasing of an individual’s shares, bonds and debentures, etc. They charge commission for these services.
3. Efficiency of Financial Markets:
A financial market is efficient when security prices fully reflect all available information. It is a perfect market which achieves efficiency.
An efficient financial market has the following characteristics:
1. Information is available to all buyers and sellers of securities.
2. Transactions must be executed without significant price changes.
3. Security prices are independent of individual buyers and sellers.
4. There are no transaction costs. In other words, there are no brokerage fees, transfer charges or taxes, etc. when securities are bought and sold.
5. Prices of securities are promptly adjusted to equalize their yields. In other words, risk adjusted expected returns on all investments are equalised. If, for example, a bond earns a higher risk-adjusted expected rate of return in comparison with any other bond, the investor will try to buy that bond immediately. This will increase its price and its expected return (yield) will be lower. Thus the returns from bonds of equal risk are equalised.
6. The efficient-market resources are used in a non-wasteful manner.
7. Its resources are allocated to the socially most productive uses.
The concept of efficient financial markets is closely related to rational expectations hypothesis. According to it, expectations should be based on relevant information in an efficient market. The present price of bond portfolios in an efficient market will provide the relevant information. People who make rational expectations about the future price of bond on the basis of information will purchase the bond when its price falls and will sell it when its price rises.
Given the available information, the price of bond will rise or fall from the equilibrium level to reflect the relative demand for and supply of bond. Thus risk-adjusted expected returns on various bonds would be equal in equilibrium.
If there is any temporary disequilibrium, the market pressures will correct it. For example, when people forecast in the expectation that inflation will rise, they will try to sell their bond portfolio immediately. This will increase the interest rate quickly and this information will lead to a fall in bond prices.
The efficiency of a financial market can be judged from the following:
1. Proper Valuation:
There should be proper valuation of financial assets in an efficient market. This requires that the market price of a financial asset must equal its intrinsic value. Its intrinsic value is the present value of its future stream of cash flows from investment made in it. Its present value is calculated by discounting its future cash flows at an appropriate rate of discount.
The equality between the market price and intrinsic value of an asset is possible in a perfectly competitive financial market.
2. Operationally Efficient:
An efficient market should be operationally efficient.
(i) Minimisation of administrative and transaction costs;
(ii) Providing maximum convenience to lenders and borrowers while transmitting resources; and
(iii) Providing a fair return to financial intermediaries for these services.
3. Allocationally Efficient:
An efficient market should be allocationally-efficient. For this, it should channelize its financial resources into such investment projects and uses where the marginal efficiency of capital, after adjusting for risk differences, is the highest.
4. Insurance against Risk:
A market to be efficient must hedge and reduce risks against possible future contingencies.
5. Information Arbitrage:
Market efficiency depends on information arbitrage. If a person gains much on the basis of commonly available information, the financial market is not efficient. It is only under perfect competition that a market is efficient where prices of financial assets reflect fully all relevant and available information and possibilities of such a gain are very rare.
Types of Efficient Markets:
There are three types of efficient markets. They represent the levels of efficiency:
1. Weak Form of Efficient Market:
In the weak form of efficient market, the best forecasting of bond price of the next period is the price of this period. Any past information on bond price cannot improve this forecasting. It is very difficult to forecast returns to bonds on the basis of past data on bonds prices.
2. Semi-strong Form of Efficient Market:
In the semi-strong form of efficient market, the current price of bonds does better forecasting of future prices. However, any available information will not be helpful in forecasting of future prices or returns to bonds or assets. Such information consists of past prices of assets, rates of interest, profit, etc. But a broker of any stock may earn profit in future by selling or purchasing bonds on the basis of internal information of the company.
3. Strong Form of Efficient Market:
In the strong form of efficient market, any available current information cannot improve forecasting of future value of the assets by using recently known value of that asset price. In other words, any internal information may not be helpful in forecasting stock price movements.
In reality, the strong form of efficient market is not possible because nobody can forecast future stock prices according to internal information. This is because the weak and semi-strong forms of efficient markets are mostly seen in financial markets.
4. Functions of Financial Markets:
Financial markets are the transmission mechanism between ultimate lenders and ultimate borrowers. Funds flow from ultimate lenders to ultimate borrowers through financial market institutions. In other words, financial markets are conduits through which ultimate lenders lend their surplus funds to ultimate borrowers.
Financial markets mobilise the savings of surplus units (ultimate lenders) and channel them in the hands of deficit units (ultimate borrowers) through a wide variety of financial techniques, instruments and institutions.
Surplus units gain by earning dividend or interest on their funds lent to deficit units. On the other hand, deficit units benefit by getting funds from surplus units to finance their investment plans which otherwise would not be available to them. In the absence of financial markets, surplus units would simply hoard their excess funds and deficit units would borrow internally. But financial markets provide additional options to both the ultimate lenders and ultimate borrowers.
Ultimate lenders can acquire financial assets, i.e., buy securities or repay debts by selling them through financial markets, similarly, ultimate borrowers can sell their financial assets like securities in financial markets to finance their investment plans.
Ultimate lenders are households, business firms, central, state and local government bodies and financial institutions. The financial market in which transactions take place between the surplus and deficit units deals in central, state and local body bonds, corporate bonds and equities, mortgages, bills, etc. But the financial institutions act as financial intermediaries (FIs) between ultimate lenders and borrowers in the financial market.
They transfer funds from ultimate lenders to borrowers and purchase primary securities issued by ultimate borrowers and transfer them to ultimate lenders. They acquire the savings or surplus units and offer, in return, claims on themselves. They also purchase primary securities from non-financial spending units by the creation of claims on themselves through indirect or secondary securities. Thus FIs issue secondary securities. FIs are, therefore, dealers in securities.
They purchase primary securities and sell their secondary securities in financial markets. Thus FIs function as dealers by buying funds from ultimate lenders in exchange for their own secondary securities and selling funds to ultimate borrowers in exchange for the latter’s primary securities.
The purchase of primary securities by surplus units is called direct finance and by financial intermediaries as indirect finance. Both primary and secondary securities are referred to as financial assets in the financial markets.
Fig. 1. illustrates the flow of funds from ultimate lenders to ultimate borrowers through financial markets. Ultimate lenders are shown on the left side and ultimate borrowers on the right side of the figure. Funds flow from ultimate lenders in the left to ultimate borrowers in the right either directly or indirectly through financial institutions or intermediaries. On the other hand, primary securities issued by ultimate borrowers and purchased by ultimate lenders and financial institutions are shown to flow in the opposite or reverse direction.
They flow from ultimate lenders in the left either directly or indirectly through financial institutions in the financial market. For smooth flow of funds from ultimate lenders to ultimate borrowers and vice-versa, the financial market must be fully developed, perfect and easily accessible to all the participants, as is the case in developed countries. But financial markets in under-developed countries are under-developed, imperfect and inaccessible to both ultimate lenders and ultimate borrowers.
But the market participants lack adequate information and knowledge about lending and borrowing channels, opportunities, sources and institutions. Consequently, the flow of funds does not take place adequately, properly and smoothly.
The need is to develop money and capital market instruments and institutions for smooth and healthy functioning of financial markets through which funds should flow to meet the financial needs of a developing economy.
5. Working of Financial Market:
Financial market deals in financial assets whose prices are expressed in terms of an interest rate. The interest rate is the price of credit or of loanable funds. The fall or rise in the rate of interest depends on the relative demand and supply of loanable funds in the financial market.
The demand for loanable funds is in the form of mortgages, corporate bonds, central government securities, bonds of state governments and local bodies, business loans for working capital and capital equipment, government loans for services, investment in infrastructure, etc., consumer loans and so on.
These groups are the primary demanders of loanable funds. The demand for loanable funds depends on interest rates on alternative source of funds, business expectations; expectation of inflation rate; business profitability; shift in consumers tastes; tax deduction of interest payments (if interest payments are not taxable, demand for funds will be more); cost and availability of funds; actual and derived capital stock, etc.
The supply of loanable funds comes from commercial banks, savings and loan associations, mutual funds, savings banks, insurance companies, pension funds, credit unions, non-bank financial companies, individuals and so on.
The supply of loanable funds depends on interest rate on alternative uses of funds; expected inflation rate; tax rate on interest income; wealth of lenders; liquidity and risk investment; level of individual income; distribution of income; corporate and personal tax rates and so on.
Given these factors an efficient financial market is in equilibrium when the demand for and supply of loanable funds is equal. In Fig. 2, D is the demand curve for loanable funds and S is the supply curve of loanable funds. They intersect at equilibrium point E and OQ quantity of funds is demanded and supplied at OR interest rate, If the interest rate is OR, higher than the equilibrium rate OR lenders of funds are anxious to lend more but borrowers of funds are not willing to borrow.
The supply of loanable funds (R1s) being more than the demand for them (R,s > R1d), the interest rate will fall to OR. On the contrary, if the interest is OR2, lower than OR, the borrowers will be eager to borrow more than the lenders are willing to lend. The demand, for loanable funds (R2d1) being more than their supply (R2s1) the interest rate will rise to OR. Thus in an efficient financial market, the demand for and the supply of funds is equal.
Since demand and supply of funds depends on financial market conditions which are assumed to be competitive, it is successive changes in demands and supplies of funds and interest rates which equalize the two. These involve forecasting of likely demand and supply of funds at current interest rates. This depends on interest-elasticity of demand and supply. Suppose in Fig. 3(A), the interest rate is OR1. If both demand and supply are interest elastic, a small rise in interest rate to OR will reduce the demand (R1d) for loanable funds and increase the supply (R1s) of funds to bring the two to equality at point E.
6. Role of Financial Markets in Economic Development:
Financial markets play a special role in economic development.
1. Capital Formation:
Economic development depends upon capital formation for which saving is essential. For capital formation only saving is not enough, their accumulation is also necessary. This is done by financial institutions which operate in financial markets.
Mere accumulation of savings does not lead to capital formation. Savings by different groups of society are required to be channelized in productive investments. Financial markets help in the three processesâ€”to save, to accumulate and to investâ€”of capital formation which lead to rapid economic development.
Financial markets are unorganised and undeveloped in developing countries. The majority of people are poor and they cannot save. Those who save, invest their savings in real estate, speculation, foreign exchange and conspicuous consumption. Under the circumstances, financial markets undertake the task of encouraging the flow of personal savings for unproductive to productive uses. They encourage households to hold financial assets instead of physical assets.
The extent to which households switch from the purchase of physical assets to financial assets by saving more, the more resources are released for development purposes. Thus financial markets reduce cash hoardings of people kept in their homes and encourage their habits of saving and investment which are very helpful for capital formation and economic development.
2. Non-financial Business Sector:
Financial markets help the non-financial business sector by facilitating the sale and purchase of shares, bonds, debentures, etc. Financial institutions like commercial banks, mutual funds, savings and loan associations, insurance companies, merchant banks, unit trusts, etc. operate in the financial markets and transfer funds from savers to business by lending their surplus funds.
Savers earn interest and/or dividend which they again reinvest in shares, bonds, etc. On the other hand, businessmen also borrow from financial institutions to carry out their investment plans. In this way, they also help in capital formation and economic development.
3. Help to Governments:
Financial markets help state governments, local bodies and central government financially by buying and selling their bonds and securities through which they invest in various local, state level and central projects to accelerate economic development.
4. Create New Assets and Liabilities:
Financial markets create new assets and liabilities which provide financial help to business, trade and industry that tend to raise the level of economic development. For instance, banks create credit by buying primary securities which they sell to businesses, traders and industry. They create liabilities by the multiplicity of primary securities they hold.
According to Prof. Ackley, FIs in the financial market through intermediation between ultimate savers and direct investors add greatly to the stock of financial assets available to savers. For every extra asset, they create an equal new financial liability.
Since FIs also own each others’ liabilities, they create increments of assets and liabilities. Ackley concludes that although the increment of assets and liabilities does not increase real wealth or income, even then by financially helping the different categories of the economy they increase economic welfare and promote economic development.
5. Provide Liquidity:
Financial markets provide liquidity to the economy which is very essential for the economic development of the country. When FIs in the financial markets convert an asset into cash easily and quickly without loss in its money value, they provide liquidity in the economy. When FIs, especially banks, issue claims against themselves and supply funds, they always try to maintain their liquidity.
Banks do so by following two rules:
(a) They make short-term loans and by issuing claims against themselves for longer periods provide financial help to business, traders, industries, etc.
(b) They give loans to various types of borrowers according to their needs.
Economic development depends upon capital formation in which investment is an important means, and investment depends on the interest rate. The lower the interest rate, the higher will be the investment. When there is competition for funds, securities, etc. in the financial market, their prices rise and the interest rate declines. With the fall in interest rate, investment is encouraged. Consequently, there is increase in the rate of capital formation and of income for economic development.
6. Help Central Bank:
Financial markets through their proper working help the central bank of the country in executing its monetary and credit policies and hence in promoting its economic development. When FIs create large financial assets and liabilities by transferring funds from savers to users, they provide the financial markets with money and near-money assets.
Since financial markets govern the working of the economy, the monetary and credit policies of the central bank are changed in such a manner from time to time that the financial markets function smoothly in the country. In brief, the economic development of a country depends upon the proper functioning of the financial markets which leads to rapid capital formation and to the speeding up of the rate of economic growth.
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