Fundamentals of Financial Markets
In a country, there are households, companies and government agencies who have available funds because they spend less than
their income. Essentially, these are the fund providers. On the other hand, there are also households, companies and government
agencies that have fund shortage because of deciding to spend more than their income. These are the fund demanders. Matching
the difference in spending (excess funds from one party to the fund gap of another party) is the main reason for the existence of a
financial system.
The financial system permits an efficient method to move funds between entities who have funds and entities who need funds.
Financial systems serve as a regular, time-efficient and cost-effective link between fund providers and fund demanders. Within the
financial system, funds are efficiently transferred from one party to another through innovative schemes on savings and investments
that investors are willing to partake in.
A basic overview of how a financial system works as illustrated by (Mishkin, 2004) in Figure 2. As Mishkin illustrated, the primary
fund provider / lender-savers in the financial system are households but business firms, government and foreigners with spare funds
can also lend out. On the other end, the main fund demanders or borrower-spenders are business firms and government.
Businesses use the borrowed fund to support growth and expansion projects while government use the money to finance
infrastructure and other community welfare projects. Households also become borrower-spenders when they borrow money to buy
their cars and houses. Market participants will be further discussed in the later chapters.
Funds can flow from lender-savers to the borrower-spenders in two routes: via direct financing or indirect financing:
• Direct Financing. In this route, the borrower-spenders borrow and deal directly with lenders through selling financial
instruments (or securities). Financial instruments represent claims on the future income or assets of the borrower.
Borrowers recognize financial instruments as liabilities while lenders recognize these as an asset. Buying stocks directly
from a company is also considered as direct financing.
• Indirect financing. In this route, the borrowing activity between both parties still happens though indirectly through the
intervention of a financial intermediary.
People who save frequently are not the same people who have
access to profitable investment opportunities (i.e.
entrepreneurs). The transfer of funds from providers to
demanders allow both parties to gain some return. For
example, fund providers can charge interest on the fund they
are willing to loan out while fund demanders can earn from the
investment they are going to pursue using the funds obtained
from the provider. Without the financial system, fund providers
will not earn interest and fund demanders cannot pursue their
investment because of lack of funds. The existence of financial
system is important for the growth of the economy because of this reason.
Financial markets help in creating more efficient allocation of capital which results in higher production and efficient that ultimately
leads to economic growth. Capital can be physical or financial, either of which are used to produce more wealth. Efficient allocation
of capital occurs when funds are invested in productive investments that yield return for the fund providers and fund demanders.
A properly functioning financial system also enhances welfare of individual consumers as they have immediate access to funds
allowing them to purchase things as they prefer. Funds are made available to young people to purchase what they want without
making them wait to save for the entire purchase price. As a result, funds flow back much faster to business enterprises (through
profit), government (through taxes) and investors (through interest or dividends). Efficient financial markets enhance the economic
well-being of all members of the society.
To become more efficient, the financial system of a country commonly addresses the problem of information asymmetry. Information
asymmetry occurs when one stakeholder to a transaction holds superior information than the other party. Information asymmetry
causes inefficient allocation of financial resources as one party may be in a better negotiating position because of the lacking
information of the other party.
