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Advanced financial markets are the foundation for economic growth. When functioning effectively, it enables the economy to efficiently maximize financial capital to its best use.
A financial market is where companies raise money for their capital investment. Thus, firms can raise funds at low costs when markets function effectively.
On the other hand, households accumulate wealth by investing in financial markets. For example, you might buy stocks for dividends and capital gains. Or, you might buy corporate bonds hoping for coupons and capital gains.
Investing becomes a way to get a return on our money and, therefore, more productive than keeping it under the pillow.
Long story short, financial markets unite those who have excess funds and those who need money. And when functioning effectively, markets facilitate us to use money at its highest use – investors earn returns, and companies invest in capital goods.
The reasons why financial markets are vital
Now, let’s discuss why financial markets are vital to the economy for the household, business, and government sectors. The four reasons are:
- Allows financial capital to be allocated to its highest use
- Facilitate liquidity for transactions
- Build wealth in the economy
- Facilitate increasing capital formation
- Determine fair prices for financial assets
We will discuss the reasons above in the section below. Meanwhile, other reasons to explain why financial markets are important are:
- Providing funds for those in need, for example, companies for capital investment and the government for infrastructure spending
- Facilitating us to manage risk, for example, through derivative contracts such as options
- Channels for monetary policy to be transmitted to the economy
Allows financial capital to be allocated to its highest use
In the previous example, we maximized our money by investing it in financial assets. As an investor, you maximize it by putting it in stocks or bonds to get returns. So, it’s more productive than just putting it under the pillow.
Once the money changes hands to the company, it is also used for productive purposes. For example, companies use it to purchase capital goods such as machinery. Or they use it to build new factories.
Investment in new machinery and factories contributed to increasing output. Thus, the company can generate more revenue than it costs to raise funds. In addition, investment also creates more income and jobs for households.
Meanwhile, the government may collect debt to finance infrastructure by issuing bonds. Infrastructure spending is vital to the economy. For example, the construction of roads and transportation routes lowers logistics costs. Meanwhile, education infrastructure is critical to increasing people’s access to education services to build quality human resources.
Facilitate liquidity for transactions
Financial markets make it easy for us to trade our financial assets. Securities products give us returns, and it is easy to find counterparties when we want to sell them. Thus, a liquid market allows us to sell our financial assets quickly without losing value.
On the contrary, we experience difficulties when the market is not liquid. In addition, we also assume risks when selling financial assets. Since there are no buyers for our first offer, we may have to lower our prices to attract some buyers. As a result, we suffer losses by selling at a lower price than we would like.
Build future wealth
The financial market is a place for us to get a return on our money. For example, you get a coupon when you buy a bond. And at maturity, your principal is returned. Before maturity, you also have the potential to get capital gains when the price rises.
Investors in financial markets are not only retail. But they also come from institutions. Companies and governments can also be investors. For example, companies place their cash in stocks or bonds and record it in an available-for-trading account. Likewise, governments or their subordinate organizations, such as Sovereign Wealth Funds (SWFs), invest in other countries government bonds, which allows them to build wealth.
Finally, we can move money from the present to the future by investing in financial markets. So, through investment, we can prepare funds for future needs such as retirement, children’s education, emergencies, or financial deterioration due to recession.
Facilitate increasing capital formation
Financial markets facilitate companies to raise funds for capital investment. When obtaining funds at a low cost, companies increase investment because it is more profitable.
Increased investment encourages the economy to increase the increase in accumulated capital. As a result, the economy has an increased productive capacity, enabling it to produce more output.
Determining a fair price for financial assets
Fair price is essential in decision-making. For example, if you buy stock, you need to see the fair price before spending money. On the other hand, if you don’t know the fair price, you may be buying the stock too expensive.
The opposite condition also applies to companies. They should know at what fair price they should sell their shares to the public. Without a fair price available, they may sell at a low price, causing them to raise less funds than they otherwise would.
Financial markets allow us to determine fair prices through interactions between buyers and sellers. Supply and demand work to determine a fair price, the best price for both buyers and sellers. This price reduces asymmetry, which is detrimental to one of the transacting parties.
Types of financial markets
Financial markets vary in their types, depending on how we classify them. Examples are the capital market and the money market. The capital market is then divided into the stock and bond markets.
In addition to these two are the forex, commodity, and real estate markets. The derivatives market is also a financial market.
Then, based on who the sellers are, we differentiate financial markets into the following two types:
- Primary market where securities are sold first to investors. Funds flow from the buyer to the publisher. For example, you order company shares at the initial public offering.
- Secondary market where transactions occur between investors (traders). For example, you buy shares after listing on the stock exchange.
Based on when transactions are completed and assets delivered, financial markets are divided into two: the spot market and the futures market.
- Spot market is for immediate delivery. For example, in the forex market, it takes two business days later to settle from the transaction entry date.
- Futures market is for delivery at a later date. For example, we buy a futures contract on July 1 for delivery 30 days ahead. The seller will deliver the underlying asset in 30 days from July 1.
Financial markets can also be classified into two types based on how long the traded instrument matures. They are:
- Money market is for trading short-term financial instruments – maturities of one year or less – such as paper commercials and certificates of deposit.
- Capital market is for trading long-term instruments, including the stock and bond markets.
Then, we also classify the market based on the type of financial assets traded into the traditional and alternative investment markets.
- Traditional investment markets trade conventional asset classes such as stocks and bonds.
- Alternative investment market trades asset classes such as commodities, real estate securities, and securitized debt.
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