Commerce · Ch 4 — Introduction to Financial Markets
Meaning and Functions of Financial Markets
Meaning and Functions of Financial Markets
Every economy has two kinds of economic units at any given time — surplus units (households and institutions that save more than they currently spend) and deficit units (businesses and governments that need more funds than they currently have, to invest in projects, expand operations, or meet public spending). Left to themselves, a saver in one part of the economy and a business needing funds in another part would rarely find each other directly, on matching terms, at the right time. A financial market is the mechanism that solves exactly this problem.
A financial market may be defined as a market, or an institutional arrangement, where financial assets (also called financial instruments or securities) — such as shares, debentures, bonds, treasury bills and deposits — are created, issued, bought and sold, bringing together those who have surplus funds (savers/investors) and those who need funds (borrowers/issuers). In simple terms, a financial market is the channel through which savings in the economy are transformed into investment.
The flow of funds through a financial market runs as follows:
| Stage | Flow |
|---|---|
| 1. Savers/Investors (households, institutions) | Supply surplus funds into the financial market |
| 2. Financial Market (with regulators and intermediaries) | Channels those funds to those who need them |
| 3. Borrowers/Issuers (businesses, government) | Receive funds to invest/spend |
| 4. Return flow | Borrowers/Issuers pay interest, dividend, or repayment back to Savers/Investors through the same market |
Functions of a financial market:
- Mobilisation of savings — a financial market collects the scattered, small savings of millions of households and institutions and channels them towards productive use, rather than letting them remain idle.
- Facilitates capital formation — by connecting savers with businesses that need funds for new plant, machinery, and expansion, financial markets enable the capital formation on which industrial and economic growth depends.
- Price discovery — the continuous interaction of buyers and demanding a return and sellers of financial assets willing to supply funds determines the price (rate of return, interest rate, or share price) that a financial asset should command at any point in time; this is a genuine market-driven discovery process, not an arbitrarily fixed number.
- Provides liquidity — a financial market, especially its secondary segment, gives an investor the ability to convert a financial asset back into cash quickly by selling it to another investor, without having to wait for the asset's own maturity. This liquidity is precisely what makes investors willing to lock funds into long-term securities in the first place.
- Reduces the cost of transactions — a financial market provides ready information about traded securities (prices, volumes, the standing of issuers) and standardised trading mechanisms, so that a buyer and a seller do not have to individually search for each other and separately negotiate every term, cutting the time and cost of a transaction considerably.
- Ensures allocative efficiency of resources — because funds in a financial market are typically channelled towards the borrower/project offering the best expected return for a given level of risk, financial markets help direct the economy's scarce savings towards their most productive uses, rather than towards whichever borrower happens to ask first.
These same core principles of mobilising savings, enabling capital formation and directing funds efficiently apply across every Indian commerce syllabus that teaches financial markets — the treatment and examples here are TN's own, built for this unit.