Role of Financial Markets

Financial markets play a crucial role in the economy by facilitating the efficient allocation of resources and capital. Investors exchange financial instruments in a financial market. The more popular term used for the exchanging of financial instruments is that they are “traded.”

Financial markets provide the following three major economic functions:

1. Price discovery
2. Liquidity
3. Reduced transaction costs

(1) Price Discovery

Price discovery means that the interactions of buyers and sellers in a financial market determine the price of the traded asset. Equivalently, they determine the required return that participants in a financial market demand in order to buy a financial instrument.

Financial markets signal how the funds available from those who want to lend or invest funds are allocated among those needing funds. This is because the motive for those seeking funds depends on the required return that investors demand.

(2) Liquidity

Second, financial markets provide a forum for investors to sell a financial instrument and therefore offer investors liquidity.

Liquidity is the presence of buyers and sellers ready to trade. This is an appealing feature when circumstances arise that either force or motivate an investor to sell a financial instrument.

Without liquidity, an investor would be compelled to hold onto a financial instrument until either:

• (1) conditions arise that allow for the disposal of the financial instrument, or
• (2) the issuer is contractually obligated to pay it off. For a debt instrument, that is when it matures, but for an equity instrument that does not mature—but rather, is a perpetual security—it is until the company is either voluntarily or involuntarily liquidated.

All financial markets provide some form of liquidity. However, the degree of liquidity is one of the factors that characterise different financial markets.

(3) Reduced Transaction Costs

The third economic function of a financial market is that it reduces the cost of transacting when parties want to trade a financial instrument.

In general, we can classify the costs associated with transacting into two types: search costs and information costs.

Search Costs

Search costs in turn fall into two categories: explicit costs and implicit costs. Explicit costs include expenses to advertise one’s intention to sell or purchase a financial instrument.

Implicit costs include the value of time spent in locating a counterparty—that is, a buyer for a seller or a seller for a buyer—to the transaction. The presence of some form of organised financial market reduces search costs.

Information Costs

Information costs are costs associated with assessing a financial instrument’s investment attributes. In a price-efficient market, prices reflect the aggregate information collected by all market participants.