What are the functions of financial markets?

financial markets

The financial market is defined as the place where it is possible to sell or buy financial instruments, be they stocks, bonds, derivatives, units of funds, etc. Nowadays, financial markets are no longer physical places but virtual platforms, which are also called trading venues. Here the purchase or sale proposals are entered, which are entered into the system electronically.

Financial market functions

Financial markets can perform one or more of the following functions:

1) The transfer of resources over time

2) Allocation of resources between alternative investments

3) risk-sharing

4) Aggregation and transmission of information.

As we will see, the first three functions can be performed alternately by both intermediaries' finances. The best examples are banks and financial markets (for example, from the market bond). Instead, the fourth function - the aggregation and transmission of information is typically carried out only by markets and not by intermediaries.

Transfer of resources over time

As explained in the previous paragraph, typically, the loan agreements allow the surplus units to transfer resources to deficit units. In doing so, they allow units in deficit to move resources from the future to the present. While the surplus units do the opposite, transferring resources from the present to the future.

For example, the consumer credit market allows families who want to spend more of their current income to borrow from families who wish to save. This Thus, it allows consumers to uncouple the temporal profile of consumption from fluctuations of income. More technically, we can say that financial markets allow for reallocation intertemporal consumption. Remember, as predicted by life cycle theory and that of permanent income, consumers want to avoid sudden changes in use in response to changes in income. 

But businesses may also need to transfer resources over time. Typically, they may need to make investments whose cost exceeds their current resources-profits undistributed and reserves. The credit market allows companies to make these investments by borrowing resources from households or even from other businesses. In both cases, the transfer of resources over time can be carried out by a bank, in which the return guarantee is assumed. It is required to reimburse the deposits even if the insolvency of its debtors and typically transforms its maturity typically banks take to a short-term loan, and employ those resources on longer maturities. But also the market bond and the stock market perform this function. As they allow businesses to issue securities with which they raise capital to finance their investments and to the State of finance your own deficit, i.e., the difference between tax revenue and expenditure. 

And these markets allow families to use their savings by purchasing securities issued by companies and by the State. In the case of bonds, it is done in exchange for the promise of a coupon flow and the repayment of capital. In the case of shares, it is based on the expectation of a flow of dividends. There is obviously an essential difference between the way markets and banks do this intertemporal transfer function. In the case of bond and equity markets, the risk relating to the return on the amounts is invested. For example, the one deriving from any insolvency of the debtor is entirely borne by the investor. In contrast, when the banks interpose between investors and users of the funds, they assume this risk on themselves.

Allocation of resources between projects

Within each period, it is necessary to choose between which alternative uses to allocate resources financially available. Another function of the capital markets is to "decide" which uses to use resources. For example, consider a bank that has received funding applications from several entrepreneurs whose projects differ in expected profitability and riskiness. To evaluate the solvency of the various entrepreneurs, the banker will have to evaluate both the expected profitability of the projects and their riskiness and will decide to finance only projects that are above a certain threshold of solvency. In addition, the bankers will not want to apply the same to the entrepreneurs. They will finance the interest rate. To the more risky ones, he will apply a higher rate to be compensated for the higher risk of insolvency. Likewise, these entrepreneurs can turn to the bond market or the market stock to finance their projects. 

There will be projects so unprofitable or so risky that the market will refuse to finance them. It happens, for example, from time to time that a company decides to cancel the public offer of sale (OPV) of newly issued shares. Or the subscription of a bond loan because he realizes that the demand for these securities would be insufficient. More often than not, it happens that it is the price of the securities issued to balance the demand of the investors and the company's offer. Because the bonds and shares issued to finance projects more profitable and/or less risky, they will be more requested by investors. They will be issued to a higher price, allowing their entrepreneurs to collect more resources than others, or to pay a lower cost of capital for every euro of funding raised.

So in both cases - that of the bank or that of the market - the lenders operate as a selection mechanism (screening) of projects. They decide whether to finance them and at what price finance them (or, equivalently, what cost of capital to request). The effectiveness of banks' markets as a selection mechanism depends on the distribution of information between financiers and funded entities. Typically, entrepreneurs have better information about project investment plans they intend to implement. They also make decisions in implementing the project important for its success, which, however, escape the control of their financiers. 

In selecting projects to be financed, both banks and markets face problems deriving from these information asymmetries with the financed subjects, and they do it using very different mechanisms. For example, banks can do this by establishing long-term relationships with customers, due to which they manage to acquire in-depth knowledge of the credit risk of each customer and can monitor his business, thus reducing the risk that behaves unfairly. These banking relationships can be exclusive. Especially in German-speaking countries, the company often borrows from a single bank (Hausbank). 

Markets of the securities cannot leverage the duration or exclusivity of the financing relationships that often they are established between bank and customer. But markets also have mechanisms to acquire information on the quality of the entities financed. For example, those who invest in equities can rely on information collected and disseminated by financial analysts on corporate financial statements and their future prospects. And those who invest in bonds can use the ratings of the issuing firms, which are the estimate of their solvency by the rating agencies.

That finance is a selection mechanism is true even when those who ask for funding do not. It is an enterprise, but a consumer or a sovereign state, even among consumers who request financing for the purchase of a car or a house. The credit market makes a choice, evaluating their solvency is based on a series of parameters (income, type of occupation, previous defaults, etc.) and by financing only the best risks. Likewise, some states are judged by credit rating agencies to be more reliable than others, based on parameters macroeconomic, political, etc. Therefore manage to issue government bonds at better prices (i.e., promising lower interest rates) than those with worse ratings.

Risk sharing

Once banks and markets have decided to finance a certain set of projects, the society has to share the risk that these projects entail. But the banks and the markets they also perform this function, because they allow you to divide the risk between different investors (risk-sharing). Further, it allows each investor to diversify the risk of its portfolio (risk pooling).

The banks implement the risk-sharing but above all by the securities markets. Banks there they implement by financing only part of a project or a company's projects and letting that other banks provide the rest of the financing ("multi-credit"). This way, each bank bears only part of the overall risk. Markets bring risk-sharing to the extreme since they allow dividing it among a multitude of shareholders or bondholders (and potentially among all savers). This greater risk parceling depends on two reasons: first, generally, bonds and shares can also be held in "packages" very small. They are also accessible to small savers; second, if they are listed and traded on the market, stocks and bonds are much more liquid than a bank loan in the meaning that it is much easier for their owner to obtain the corresponding market value. The sharing of risk allows each lender to bear less risk. To request a lower return for each euro of financing, which from a funded entity is equivalent to obtaining a lower cost of capital? 

Aggregation and transmission of information

The prices of shares, bonds, and other financial instruments reflect at all times information from a multitude of investors, both professional than non-professional (Families). This information concerns both the performance of the economy as a whole. For example, the future trend of interest rates and aggregate profits of companies which the future trend of the variables relating to a single issuer. The prospects of the product market have the effectiveness of the executives of the issuer of a certain security bond or equity. This information is often different and not infrequently contradictory, as investors often observe different signals or interpret the same signals differently, as they use different models to interpret them.

A function of market prices is to reflect this different information.

We can summarize them in a single number, which is the market price of a certain financial instrument. We can imagine the market price as an "average" of the "votes" that investors assign to the issuing entity, which can be a business or a sovereign state. How is this average formed? Through the balance between supply and demand: the investors who have a more favorable evaluation of the security will try to buy large quantities.

In this way, they will tend to push the price upwards; those with more unfavorable ratings will decide to sell it and tend to reduce the price. The price will tend to rise or fall depending on whether the former prevails over the latter. So in the formation of this "media," obviously, the "votes" that come from the major investors will weigh more heavily. They are professional investors who buy or sell large quantities of securities. However, the market price is not limited to aggregating investor information in such a way to reflect them continuously. It is also a public signal that broadcasts such information to all economic operators and allows them to take this into account in their decisions.

For example, the market price of a company's shares is a reference for the company executives to determine if and how much the company should invest in real capital. It can also guide the company's shareholders in deciding whether to reward an executive with generous remuneration or, on the contrary, fire him and replace him with another manager. At this point, it should be clear why, unlike the three functions discussed in the paragraphs above, the aggregation and transmission of information can only be carried out by the markets financial, and not even by intermediated finance. 

This fourth function requires that it exists a meeting point for a multitude of investors with potentially different information:

- The market 

- And the issuance of a public signal

- The market price 

- Capable of summarizing promptly, send this information and forward it to everyone. 

Financial markets manage to perform this task precisely because they generate and spread a public signal, which in turn requires a certain degree of transparency in their functioning. Instead, intermediated finance (for example, credit) is typically opaque. The intermediaries tend to keep a lot of information confidential relevant to the loan relationship (for examplefinancial markets, each bank has jealously own customer credit risk assessment).

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Jun 26, 2020

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