In general terms financial market is a mechanism of delivering savings from the households, governments, and corporations to the users of these funds. Financial markets and financial assets exist in an economy because the savings of various individuals and institutions during a period of time differ from their investment in real assets. By real assets, we mean things such as houses, buildings, equipments, inventories, and durable goods. If savings equaled investment in real assets for all economic units in an economy over all periods of time, there would be no external financing, no financial assets, and no money and no financial markets. In this case each economic unit would be self sufficient. A financial asset is created only when the investment of an economic unit in real assets exceeds its savings, and it finances this excess by borrowing or issuing equity securities. Of course, another economic unit must be willing to lend. This as a whole, savings-surplus economic units provide funds to savings deficit units. This exchange of funds is evidenced by pieces of paper representing a financial asset to the holder and a financial liability to the issuer.
The purpose of financial markets in an economy is to allocate savings efficiently during a period of time to parties who use funds for investment in real assets or for consumption. If those parties that saved were the same as those that engaged in capital formation the economy can prosper without financial markets. In modern economies, however, the economic units most responsible for capital formation—-non financial corporations—- use more than their total savings for investing in real assets. Household, on the other hand, have total savings in excess of total investment. The more diverse the pattern of desired savings and investment among economic units the greater the need for efficient financial markets to distribute savings to ultimate users. The investor in real assets and ultimate saver should be brought together at the least possible cost and inconvenience.
Efficient financial markets are essential to ensure adequate capital formation and economic growth in an economy. With financial intermediaries in an economy, the flow of savings from savers to users of funds can be indirect. Financial intermediaries include institutions such as commercial banks, life insurance companies and pension and profit sharing funds. These intermediates come between ultimate borrowers and lenders by transforming direct claims into indirect ones.
Financial intermediary transforms the funds in such a way as to make them more attractive. On one hand, the indirect security issued to ultimate lenders is more attractive than is a direct or primary security. In particular, these indirect claims are well suited to the small saver. On the other hand, the ultimate borrower is able to sell its primary securities to financial intermediary on more attractive terms than it could if the securities were sold directly to ultimate lenders.
Financial intermediaries provide a variety of services and economies that make them quite attractive.
• Transaction costs and costs associated with locating potential borrowers and savers are lowered
• The risk of unreliable information is reduced.
• Due to the pool of large of amount savings and investment opportunity it provides a flexible and divisible forum to both saver and borrower.
• By investing in different securities and an intermediary actually spreads the risk.
• Intermediary provides expert services to both saver and borrower.
Some times intermediation process becomes cumbersome and there is a reversion towards direct loans and security issues. This process is called disintermediation. In other words when financial intermediations no longer makes the market efficient than the process of disintermediation occurs.
Components of Financial Markets
There are two components of financial markets
Money market refers to a mechanism where short term securities mainly with maturity period of one year are traded. A large number of buyers and sellers run the market with securities relatively short term in nature and of small denominations. Trading in the money markets involves Treasury bills, commercial paper, bankers’ acceptances, certificates of deposit, government funds, and short term mortgage- and asset-backed securities. It provides liquidity to the firms.
Capital market is a place where sale and purchase of shares and bonds take place aiming to invest or lend and borrow funds for the longer term use usually more than one year. A large number of investors provide funds to a large number of companies, corporations, and firms willing to raise funds. The capital market includes stock market (equity securities) and bond market (debt securities).