Financial markets play a pivotal role in allocating resources in an economy by performing three important functions:
- Financial markets facilitate price discovery: the continual interaction among numerous buyers and sellers who throng financial markets helps in establishing the prices of financial assets. The value of a financial asset can be obtained just by looking at its price in the financial market.
- Financial markets provide liquidity to financial assets: Investors can readily sell their financial assets through the mechanism of financial markets. Companies can raise long term funds from investors by negotiation and transferability of securities through financial markets
- Financial markets considerably reduce the cost of transacting. The major costs associates with transacting are search costs and information costs. Search costs includes explicit costs such as the expenses incurred on advertising when one wants to buy or sell an asset and implicit costs such a s the effort and time one has to put in to locate a customer. Information costs refer to costs incurred in evaluating the investment merits of financial assets.
- Borrowing and Lending: Financial markets permit the transfer of funds (purchasing power) from one agent to another for either investment or consumption purposes.
- Price Determination: Financial markets provide vehicles by which prices are set both for newly issued financial assets and for the existing stock of financial assets.
- Information Aggregation and Coordination: Financial markets act as collectors and aggregators of information about financial asset values and the flow of funds from lenders to borrowers.
- Risk Sharing: Financial markets allow a transfer of risk from those who undertake investments to those who provide funds for those investments.
- Liquidity: Financial markets provide the holders of financial assets with a chance to resell or liquidate these assets.
- Efficiency: Financial markets reduce transaction costs and information costs. In attempting to characterize the way financial markets operate, one must consider both the various types of financial institutions that participate in such markets and the various ways in which these markets are structured.