Business does not run in isolation. It runs within a society and it takes resources from the society such as men, material and machinery. It also requires money. Businesses need money from the very start. It requires money for setting up the business and then to run the business, expands it, open up a branch and even during closure of a business (for paying legal charges). These needs for funds are classified into two major categories – working capital requirements and fixed capital expenditure.
Working capital requirements: working capital requirements of the firm are for the day to day activities of the business such as getting the raw material for production of finished goods, paying salaries to the employees etc.
Fixed capital expenditure: fixed capital expenditure is for the capital assets i.e. to buy or maintain and also for improving the capital assets. For example vehicle, building, machinery, land etc.
Companies do not have the full capacity to invest the funds in business solely from their own savings or earnings and that is why they need to raise funds from the market and there are several ways to raise the funds in which financial market are an important source of raising the funds.
In an economy, there are two main sectors. One, who save the funds, and second, who invest the funds. These are known as households and business firms respectively. Here comes the role of financial markets as it links the two sectors i.e. the savers and the investors. It helps in mobilising the funds between them. While doing so there is a function which is performed by the financial markets known as allocative function. Allocative function simply means to direct the funds from the savers to the best possible use/most productive areas. Allocative function has it effects when it is performed very effectively. These effects are:
- The rate of return offered to the savers i.e. households will be higher.
- Resources are allocated to the high productivity firms in an economy.
Allocation of funds can be done through banks and other financial institutions or through financial markets.
- Banks: the households/savers who want to save their funds will deposit their funds with the banks and the banks will lend these funds to the businesses at a higher interest rate.
- Financial markets: the households/savers who want to invest their funds can also buy the shares or debentures of the company. The businesses offer these shares or debentures in exchange of the funds and offer them an interest rate or dividends. This is done through financial markets in between.
This whole process is called financial intermediation. Wherein, an institution serves as a middleman and helps in the financial transactions between the parties with funds. The financial transaction can take place for new issues i.e. creation of a financial asset in an economy or sale and purchase of the existing financial asset.
Functions of financial markets
There are various functions performed by the financial markets in an economy and they are as under:
Mobilisation of savings and then channelling them into most productive use
The allocative function plays a very important role in an economy. Mobilisation of funds will help in reduction of wastage or funds and also help in putting the funds into most productive areas. The financial markets including the banks and financial institutions helps in channelling the funds of the savers into most productive use by taking the funds from the households who have excess funds and putting them to the areas with scarce resources.
Facilitate price discovery
The transactions done in n financial markets help in determining the price of the financial asset. The forces of demand and supply help to decide the price of a commodity. Similarly, in a financial transaction, the demand is made by the businesses for the funds and the households or the savers act as the suppliers of the funds and thus this demand and supply of the funds and in turn expectation for a return over their investment help in determining the price of the financial asset such as share or debentures etc.
Provide liquidity to financial asset
Financial market is a place where the buyers and sellers are available all the time, day and night. Whenever the savers or the households want to invest their money they can do so by contacting the broker or an agent. Similarly, the buyers r the businesses who are in need of the funds will also be available all the time and can raise the funds immediately whenever required after fulfilling certain legal requirements. This active market thus helps in converting the financial assets into cash immediately and thus provides liquidity to financial assets.
Reduce the cost of transactions
If there were no financial markets, then the buyers or the business firms and the sellers or the households would have to find each other. This finding of the person in need would increase the cost, will lead to wastage of time, efforts and money. Thus, financial markets as a platform helps both the parties to transact with each other and reduces the time taken to find each other and thus helps in reduction in overall cost of the transaction.
Types of financial markets
Financial markets are mainly of two types. These are: capital markets (primary and secondary) and money markets.
It is market for short term funds. The period of maturity for these funds is up to one year. Here the assets which are traded includes low risk and are unsecured but are highly liquid and are actively traded. For example: Treasury bill, call money, commercial paper, commercial bill etc.
Capital markets are for long term funds including debt and equity. It includes two markets under it:
- Primary market
- Secondary market
Financial markets are thus the platforms where the funds are transacted. Saving of excess funds and the investment of those funds into the most productive areas helps in growth of the economy by production of goods and services.