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Financial Markets: Meaning, Types

and Working
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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.
Contents:
1. Meaning and Composition of Financial Markets
2. Types or Classification of Financial Markets
3. Efficiency of Financial Markets
4. Functions of Financial Markets
5. Working of Financial Markets
6. 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:
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:
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 equipments 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
individuals 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.

This requires:
(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 latters 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
processesto save, to accumulate and to investof 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.