Functions of Financial Markets

Functions of Financial Markets

There are two types of assets: physical assets and financial assets. Physical assets are productive in nature. Land, buildings, plants, and patents are examples of physical assets. Financial assets are the right to claim on income and assets of the issuers of financial assets. Shares and debentures issued by companies to raise funds are examples of financial assets. Owners of debentures have a right to claim income (interest) and assets in case of the default of payment interest due and principal. Similarly, owners of shares have the right to claim the residual value of the company on its liquidation. So, financial assets are the liabilities for the issuing companies and assets for investors.

Markets are the places or locations where physical assets and financial assets are exchanged (bought and sold). So, there are markets for physical and financial assets. We call the market for financial assets financial markets. Thus, financial markets are those markets where firms and governments sell financial assets to raise funds and investors buy financial assets to invest their money. Investors are the surplus units of the economy and firms and government are the deficit units. Thus, financial markets channel the funds from surplus units to deficit units in the economy. In addition, another function of financial markets is to allocate capital efficiently and to improve the well-being of consumers. We discuss all these three functions below.

Channeling the funds from surplus units to deficit units. This is the fundamental function of financial markets. As stated earlier, financial markets channel funds from deficit units to surplus units in the economy. Households, business firms, government organizations, and non-government organizations are the surplus units in the economy. Among these surplus units in the economy, households are the major surplus units. Surplus units have income in excess of their expenses, which results in a surplus of the current income. Business firms, government, and non-government organizations may have their income in excess of their expenses. In such conditions, they have a surplus and want to invest their surplus in financial assets.

In general, business firms, government, and government agencies are deficit units rather than surplus units in the economy. In other words, business firms need funds to finance their profitable projects and working capital, and government organizations need funds to finance their deficit budget. Some of the households in the economy may short their income to finance their daily family expenses and need long-term funds to finance their residential building. Households also are deficit units in the economy but mainly they stand as the surplus units.

Surplus units channel the funds either directly to the deficit units or they can do it indirectly. In direct channeling of funds the saving units such as households, firms, and government channel the funds to the deficit units of households, business firms, and government without the use of financial intermediaries. Deficit units (households, business firms, government organizations, and non-government organizations) are the borrowers and surplus units are the lenders of the funds. Borrowers sell the financial assets and raise the funds to finance their financial needs. We call this modality of channeling the funds from surplus units to deficit ones direct finance. We show this direct finance route in Figure 1.1.

In direct finance, borrowers directly borrow funds from lenders in financial markets by selling securities. As we know the owners of securities (financial instruments/assets) have a right to claim on the future income and assets of the borrowers. For example, owners of the bonds issued by borrowers have the right to claim the income of borrowers on the default of payment of due interest and principal amount. We stated earlier that securities are the assets of lenders and liabilities of borrowers. In this modality of finance, borrowers and lenders meet each other in the financial markets without the help of any financial intermediaries.

In direct finance, borrowers have to search for appropriate lenders and lenders have to search for appropriate borrowers to lend the surplus funds. This is time-consuming. After the development of financial intermediaries, lenders lend their funds to financial intermediaries in financial markets. Borrowers also borrow the funds from financial intermediaries. Here, financial institutions such as commercial banks, development banks, finance companies, microfinance development banks, and saving and credit cooperatives are the financial intermediaries. We call lending and borrowing through financial intermediaries as indirect finance. In other words, indirect finance is lending and borrowing through financial intermediaries.

We show the indirect finance in Figure 1.2. It shows that funds move lenders to financial intermediaries and from financial intermediaries to deficit units in the economy. Here, it is considerable that financial intermediaries take the risk of lending. Financial intermediaries borrow the funds from surplus households, business firms, and government and non-government organizations in different forms (deposits, shares, and loans) and issue the financial instruments, which are their liabilities, to the lenders. Similarly, financial intermediaries lend the funds to deficit business firms, households, and government and non-government organizations. They may lend the funds to deficit units by buying different types of securities and contracting directly with borrowers in the financial markets. As shown in Figure 1.2, financial intermediaries channel the funds to deficit units by selling different securities and contracting directly with the deficit units. In both Figure 1.1 and Figure 1.2, the arrows show the direction of the movement of the funds from surplus units to deficit units. We show both direct finance and indirect finance in Figure 1.3.

Efficient allocation of capital. Financial markets allocate capital efficiently. Savers can earn something if they get the opportunity to invest their savings. It is possible to invest the funds and earn on the investment only because of the existence of the financial markets. For example, let us suppose Mr. A earns 1,000,000 in this fiscal year. He saves Rs 250,000 out of his current income. He does not earn if he does not invest his savings and put it on his shelf. If he uses his savings to buy bonds issued by a hydropower company and earns on investment Rs 40,000. Out of Rs 40,000, it pays him Rs 25,000 as the coupon bond. In this example, Mr. A earns Rs 25,000 interest on his savings and the hydropower company also earns an additional Rs 15,000 from his money. Such productive use savings of households, business firms, and government and non-government organizations is possible only through financial markets. Thus financial markets allocate the capital efficiently to productive use.

Improve the well-being of consumers. We discussed earlier that financial markets allocate capital efficiently. In addition to efficient allocation of capital and channeling the funds from surplus units to deficit units of the economy, financial markets improve the well-being of consumers. Even though, funds are not used for productive purposes, mobilization of funds can increase the well-being of the borrowers. For example, your current savings may not be sufficient to purchase an apartment, but your income is enough to purchase the same apartment in monthly installments. In this case, you can purchase the apartment; finance your purchase with the mortgage loan payable in monthly installments for 20 years; and enjoy the apartment. Thus, the financial markets improve the well-being of consumers by providing loans to finance home equipment, appliances, and residences.