The Role and Importance of Financial Markets

The landscape of financial markets is huge and complex. They form the pillar of modern economics, financial transactions, and investments. They comprise several platforms and tools for participants to buy, sell, and trade multiple financial resources. Therefore, it is crucial to understand financial markets and their relevance to gain valuable insights into the functioning and investment management approaches of different economies.

Financial markets must function efficiently to establish monetary growth and stability. They help businesses expand their capital by allowing funds to flow smoothly between lenders and borrowers. Through financial markets, individuals can make investments, and governments can manage their financial transactions.

To learn more, let’s understand financial markets and identify their roles and importance in the economy.

What is the Financial Market?

Financial markets are platforms for individuals, entities, and governments to trade stocks, bonds, commodities, and several other financial assets at market-driven prices. Participants buy and sell financial assets through these markets, thus promoting capital allocation and price discovery. Through the exchange of assets, financial markets are the foundation of shaping a capitalist society.

Financial markets rely on transparent pricing, strict laws, clear guidelines, costs, and fees to ensure fair and effective trading practices. They also depend on providing authentic market-related information to every participant.

What are the Roles of Financial Markets in the Economy?

While understanding what is meant by financial markets, it is crucial to know that they play a major role in serving important functions in the economy worldwide. Following are some of the key roles of financial markets:

1. Price Determination

Financial markets are a platform for buyers and sellers to analyse the supply and demand of financial assets, leading to price determination. Such interactions lead to accurate price determination, wherein investors can make informed decisions on the fair valuation of assets. This eliminates the possibilities of over- or undervaluation of investments. 

Market prices display the collaborative evaluation of market participants concerning the assets’ value and prospects. In this regard, price determination is a crucial process as it aids effective resource allocation and advises investment decisions. 

2. Capital Formation

Financial markets provide a platform for individuals, entities, and governments to boost capital. Investment options are subject to risks and returns, and after analysing them, investors can choose the one that offers the highest probabilities of growth and profit.

Companies issue stocks or bonds to expand their businesses, create jobs, or fund research and development. Governments can issue bonds to finance public programs, whereas individuals can invest their savings in ventures with high returns, thus promoting economic growth and development.

3. Liquidity Provision

Liquidity provisions in financial markets enable investors to buy and sell assets smoothly. They improve the marketability and credibility of securities and transform them into lucrative investment choices. 

It allows investors to exit positions and convert their investments into cash easily and whenever needed. Thus, it provides flexibility and prevents any obstacles in the flow of funds in the economy. The provision of liquidity attracts investors to participate in trade actively.

4. Risk Management

Another vital role of financial markets is to minimise risks through their various tools and instruments. Price fluctuations in commodities, currencies, or interest rates can cause investors to incur severe losses. 

Derivatives like options and futures help investors with added tools to hedge against such damages. Thus, by transferring or diversifying participants’ risks, financial markets offer stability and resilience amidst unpredictable conditions.

What is the Importance of Financial Markets?

While discussing the various components of financial markets, understanding their importance is also crucial. Financial markets allocate resources and create liquidity to facilitate financial operations, economic expansion, and innovation. Keep reading to find out more!

1. Economic Growth

Financial markets promote economic growth through capital allocation and investment. They serve as gateways for entities to access funds for business expansion, development, and job creation.

2. Financial Stability

Efficient financial markets improve financial stability through effective risk management and mitigating financial setbacks. This stability boosts investor confidence and allows the economy to function smoothly.

3. Improved Living Standards

Organisations can finance their business by issuing stocks and bonds for expansions, innovations, and job creation. This leads to higher incomes and improved living standards for individuals.

What are the Different Types of Financial Markets?

The structure of financial markets is categorised under different types, each serving unique functions and needs.

1. Stock Markets

Also known as equity markets, they are venues where entities can list their shares for trading. By purchasing these shares, investors can become partial owners of any company and trade them on the stock market. The supply and demand from the buyers and sellers determine the share price.

It allows entities to raise capital through initial public offerings (IPOs) and investors to share in the company’s profit and growth. Various types of stocks, such as growth stocks and value stocks, are available for investors to invest in according to their needs.

2. Bond Markets

They are venues where fixed-income securities or bonds are issued and traded. Debt instruments issued by governments, municipalities, and corporations to raise capital are known as bonds. Here, an investor can loan money to the government or any corporation and charge interest on it. The principal amount is supposed to be paid back at a future date.

The government and other entities issue bonds to raise money for various projects and daily expenses. Bond issuers are subjected to pay interest to the bondholders, primarily after every six months (twice a year).

The interest rate depends on several factors, such as the issuer’s creditworthiness and the current market interest rate. Separate credit rating firms rate the issuer’s creditworthiness.

3. Money Markets

They allow the trading of short-term, high-liquid financial securities that can be easily converted into cash, generally within one year or less. Some of the key financial securities traded here include Treasury bills, certificates of deposit, and commercial paper. 

Money markets are known to be safe investments and offer moderate returns compared to other markets. That is why traders and institutional investors use money market funds and accounts to hold their capital temporarily.

4. Derivatives Markets

They include trading financial instruments like options, futures, swaps, and forward contracts whose value is estimated from the underlying assets, which may include stocks, commodities, currencies, or indexes.

Derivatives are risk management tools used by investors to consider the future price movements of underlying assets. Compared to other financial markets, they are highly complex and advanced and hence demand excellent skills and risk management. The Chicago Board Options Exchange and the New York Mercantile Exchange are among the largest derivative markets.

5. Foreign Exchange Markets

The foreign exchange or Forex markets deal with buying, selling, hedging, and speculating on the exchange rates of various currencies. They are a global hub that allows individuals, businesses, and financial institutions to trade between currency pairs at pre-approved exchange rates. 

The forex market is allowing international trade and investment by empowering participants to convert one currency into another. Due to its global nature and constant currency exchange demand, the forex market enables trading 24 hours a day, five days a week. 

Besides being decentralised in nature, there are no central exchanges or clearinghouses. Instead, a network of banks, brokers, and other financial institutions operate the forex trading.

6. Cryptocurrency Markets

Cryptocurrency markets are a comparatively new platform for trading digital assets like Bitcoin and Ethereum. This market is totally subject to currency price fluctuations and volatility.

Digital tokens are built on blockchain technology and traded globally via online crypto exchanges (digital wallets). Traders use these centralised or decentralised digital wallets to exchange one cryptocurrency for another and convert them into dollars or euros.

Usually, the centralised exchanges are considered high-risk digital wallets and are susceptible to hacks or fraudulent activities. 

In decentralised exchanges, digital assets are traded directly peer-to-peer without requiring any exchange authority to carry forward the transaction.

7. Over-the-Counter Markets

Over-the-counter markets are decentralised financial markets where trading is done electronically. There are no brokers or intermediaries for trading in these markets. OTC markets involve the trading of certain stocks, especially from entities that are small or not too reliable and also don’t meet the standards of official exchanges. 

A few derivatives markets occupy an important part of the financial markets and are solely traded in OTC markets. Unlike many other financial markets, OTC markets lack proper regulation and transparency.

Examples of Financial Markets

Following are different examples of financial markets:

1. Stock Exchanges

Stock exchanges are either physical or virtual trading spots. Following are the examples:

• Bombay Stock Exchange (BSE)

BSE is Asia’s oldest and first stock exchange, formed in 1875 and located in Mumbai’s Dalal Street. It offers trading in equities and derivatives financial instruments, including futures and options. Initially, it started as a floor trading system (physical), but it has now shifted completely to online trading since 1995. 

It offers a trading platform to more than 6,000 companies and uses SENSEX as a performance benchmark index to monitor the top 30 companies. A few major companies listed on BSE are Tata Consultancy Services Ltd., Reliance Industries LTD., HDFC Bank Ltd., Hindustan Unilever Ltd., and more. On July 29, 2024, TCS stock closed at INR 4380.20.

• National Stock Exchange (NSE)

NSE is the first stock exchange to introduce digital trading in India. Its National Exchange for Automated Trading (NEAT) platform provides a completely screen-based automated trading system. NSE uses NIFTY 50 as a benchmark index to monitor the performance of 50 stocks. 

The index includes 50 variable stocks from almost 12 sectors of the Indian economy. A few top companies listed under the NSE are TCS Ltd., Infosys, Bharti Airtel, State Bank of India (SBI), and more. On July 29, 2024, Bharti Airtel’s stock closed at INR 1481.35.

2. Bond Markets

Bond markets sell different types of bonds like corporate bonds, government bonds, municipal bonds and more.

• Treasury Bonds

Bond markets sell Treasury Bonds (T-bonds) directly issued by the Government of India and other state governments. These bonds serve as a fund-raising instrument for the government to borrow money from the public. The money is used for funding different developmental projects and other government expenditures.

• Treasury Bills (T-Bills)

Treasury bills are short-term financial debt instruments that allow investors to reserve their short-term capital while minimising their market risk. It is issued by the Government of India in three tenors as 91 days, 182 days and 364 days T-Bills, respectively.

The RBI auctions the T-Bills at regular intervals and issues at a discounted face value for individuals, firms, banks, institutions, and others.

• Corporate Bonds

The bond markets also sell corporate bonds, which are debt securities issued by any corporation. Organisations issue these bonds to raise capital for the purpose of business growth, bill payments, improve capital and more. For example:

• IBM Corporate Bond

IBM issues bonds to raise capital for business operations and offers an interest payment to each investor.

Wrapping Up

Financial markets are an integral part of the economy. They lead to capital formation, provide liquidity, determine prices, and offer several risk management tools. For example, companies use stocks and bonds to raise capital. Similarly, hedgers leverage the derivatives markets to manage risks. 

With no financial markets, efficient capital allocation, trade, investments and growth opportunities will gradually decline. 

Understanding the financial market’s roles and types will empower investors to make reliable investment decisions and contribute to economic growth and stability.

FAQs

1. What are the factors that influence financial markets?

Several factors influence the financial markets. Some of them are geopolitical events, economic indicators, investor sentiments, and government policies. Also, the supply and demand for certain financial products can trigger their market prices and performance.

2. What are some of the probable risks of financial markets that should be considered while investing?

Some of the probable risks of financial markets you must consider while investing are liquidity risk, credit risk, operational risk and market risk. 

3. What are the basics of financial markets?

The basics of financial markets are:

• Understanding ways to trade financial assets
• Knowing the market participants
• The regulatory frameworks
• The function of supply and demand in price determination