NATURE AND IMPORTANCE OF FINANCIAL MARKET
The Financial Market
Nature of Financial Market
Financial Market refers to the channels or places where funds and financial
instruments are exchanged between willing individual and entities.
It also includes existing mechanisms and conventions to facilitate transfer of funds
and/or financial instruments between market participants.
Financial market intends to establish a consistent, efficient, and cost-effective bridge
between fund providers and fund demanders.
Its main economic function is to serve as a channel to transfer excess funds from fund
providers to fund demanders.
- Financial Market becomes the mechanism that bridges surplus and deficit of
funds directly and indirectly via financial intermediaries.
Financial Markets also provide additional options to lenders and borrowers.
- Fund providers may deposit funds in bank
- Fund demanders may issue new securities in the financial markets to obtain
funds.
Participants
Ultimate lenders and Borrowers
- Household
- Government and Businesses
- Financial Intermediaries
- Brokers and Dealers
- Regulators
- Fund Managers and Financial Exchanges
Trading is the more common term for the exchange of financial instruments.
Example of Financial Markets are:
- New York Stock Exchange
- Philippine Stock Exchange
Three Major Economic Functions of Financial Market
Price Discovery
- It refers to the interaction of the buyers and sellers in the financial market to
come up with price of the traded financial instrument.
- Price is set at the level wherein buyers are willing to buy, and sellers are
willing to sell (agreement is important).
- The determined required return of funds of providers serves as the minimum
rate of the purchase of financial instruments.
- The function of the financial market determines how the available funds are
allocated towards the fund demanders based on their willingness to accept the
return required by the fund providers.
Liquidity
- Financial market serves as a forum where buyers and sellers meet to facilitate
transactions. Because of this, holders can sell their own financial instruments
to other investors to earn cash.
- Easy access to an avenue where holders can sell their financial instruments for
cash is an appealing feature that pushes investors to sell financial instrument.
This offers liquidity to the investors.
- Without liquidity, investors are forced to hold to financial instrument up until
such time that conditions in the agreement occurs that will permit the disposal
of the instrument.
Reduction in Transaction Costs
- Transaction costs are cost incurred of parties’ transaction to trade a financial
instrument. It could be classified into two types:
Search Cost
Cost incurred to look for financial instruments that can be
purchased or sold by a party.
Information Cost
Cost related in evaluating investment characteristics of a
financial instrument.
Three Key functions of Financial Market
Offer financial convenience.
Assist in the creation and allocation of credit and liquidity.
Help achieve balanced economic growth.
Serves as intermediaries for the mobilization of savings.
MONEY MARKET VS. CAPITAL MARKET
These two are types of financial markets based on the instruments being traded.
Money Market
A sector of the financial system where financial instruments that could be redeemed or
matured in one year or less from issuance date are traded (short-term).
It caters fund demanders who need short-term funds.
Once money market securities are issued, they are traded in the secondary market.
It is not only limited for short-term investors. Long-term investors also need the money
market as they tend to invest in this market to meet short-term liquidity needs.
Importance of Money Market
Provides immediate cash for individuals, government, and corporations since
immediate cash requirement do not necessarily coincide on the timing of their cash
receipt.
On the other hand, excessive holding of cash by fund providers also generates
opportunity cost in the form of foregone interest. As a result, they tend to maintain
only minimum cash requirements as needed for its day-to-day operations and invest
the excess cash in financial instruments that can be quickly and cheaply converted ti
cash when needed with minimal risk of loss in value involved.
It serves as a conduit to efficiently transfer large amount of money from fund
providers to fund demanders for short maturity term quickly and at cheap cost from
the parties involved.
Offers an investment opportunity that yields a higher return than just mere holding of
cash.
Money Market Instruments
Very liquid
Easily convertible to cash
Very little default risk
Examples:
- Treasury Bills
- Commercial Papers
- Certificates of Deposit
- Repurchase Agreement
- Bankers’ Acceptances
Capital Market
A sector of the financial markets where financial instruments issued by governments and
corporations that will mature beyond one year from issuance date are traded (long-term).
It caters fund demanders who are in need of long-term financial instruments.
Dealers and Broker Market
They made the foundation of the capital market that creates a venue for bond and
stock transactions.
Capital Market Securities are classified into two:
Equity
Debt
It is expected to be a liquid market where fund demanders can interact with potential
investors to acquire external financing resources.
Investors believed that it should allocate funds to its most productive use. In an efficient
market, the price of securities is believed to be the fair estimate of its real value.
