Financial Markets

A financial market is a market for creation and exchange of financial assets. If you buy or sell financial assets, you will participate in financial markets in some way or the other.

Functions of financial Markets:

Financial markets play a pivotal role in allocating resources in an economy by performing three important functions:

1. Financials markets facilitate price discovery. The continual interaction among numerous buyers and sellers who throng financial markets helps in establishing the prices of financial assets. Well organized financial markets seem to be remarkably efficient in price discovery. That is why financial economists say if you want to know what the value of financial asset is simply at its price in the financial market.
2. Financial markets provide liquidity to financial assets. Investors can readily sell their assets through the mechanism of financial markets. In the absence of financial markets which provide such liquidity, the motivation of investors to hold financial assets will be considerably diminished. Thanks to negotiability and transferability of securities through the financial markets, it is possible for companies (and other entities) to raise long term funds from investors with short term and medium term horizons. While one investor is substituted by another when a security is transacted, the company is assured of long term availability of funds.
3. Financial markets considerably reduce the cost of transacting. The two major costs associated with transacting are search costs and information cost. Search costs comprise explicit costs as the expenses incurred on advertising when one wants to buy or sell an asset and implicit and implicit costs such as the effort and time one has to put to locate a customer. Information costs refer to costs incurred in evaluating the investment, merits of financial assets.

Classification of financial markets:

There are different ways of classifying financial markets. One way is to classify financial markets by the type of financial claim. The debt market is the financial market for fixed claims (debt instruments) and the equity market is the financial market for residual claims (equity instruments).

A second way is to classify financial markets by the maturity of claims. The market for short term financial claims is referred to as the money market and the market for long term financial claims is called the capital market. Traditionally the cut off between short term and long term financial has been one year – though this dividing line is arbitrary, it is widely accepted. Since short term financial claims are almost invariably debt claims, the money market is the market for short term debt instruments. The capital market is the market for long term debt instruments and equity instruments.

A third way to classifying financial markets is based on whether the claims represent new issues or outstanding issues. The market where issuers sell new claims is referred to as the primary market and the market where investors trade outstanding securities is called the secondary market.

A fourth way to classify financial markets is by the timing of delivery. A cash or spot market is one where the delivery occurs immediately and a forward or futures market is in where the delivery occurs at a pre determined time in future.

A fifth to classify financial markets is by the nature of its organizational structure. An exchange traded market is characterized by a centralized organization with standardized procedures. An over the counter market is a decentralized market with customized procedures.

Classification of Financial markets:

Nature of Claim>
Debt market
Equity market

Maturity of Claim>
Money Market
Capital Market

Seasoning of Claim>
Primary Market
Secondary Market

Timing of Delivery>
Cash or Spot Market
Forward or futures Market

Organizational structure>
Exchange Traded Market
Over the counter Market