Functions of Financial Markets

7. Functions of Financial Markets

Taken together, the money market and the capital market perform a set of functions that are essential to how an economy actually converts scattered individual savings into productive investment:

1. Mobilisation of savings — a financial market provides individuals and institutions with a safe, organised channel through which their savings can be gathered together and directed towards those who need funds, instead of lying idle.
2. Facilitates capital formation — by channelling mobilised savings into productive long-term investment (through the capital market) and meeting short-term working-capital needs (through the money market), financial markets directly support a business's ability to set up, run and expand production, which in turn drives the economy's growth.
3. Price discovery — through the continuous interaction of buyers and sellers, particularly in the secondary market, a financial market helps establish a fair price for a financial instrument (a share's market price, a bond's yield) that genuinely reflects the available information about the issuer and prevailing demand and supply.
4. Provides liquidity — a financial market, especially its secondary segment, allows an investor to convert a financial instrument back into cash relatively quickly by selling it to another investor, without having to wait for the instrument's own maturity date.
5. Reduces the cost and time of transactions — by bringing a large number of buyers and sellers together in one organised place or system, a financial market reduces the cost, effort and time an individual borrower or lender would otherwise spend searching for a counterparty on their own.
6. Ensures a continuous flow and allocation of funds — a well-functioning financial market keeps funds flowing continuously from surplus units to deficit units, and, through the price mechanism, tends to channel funds towards the borrowers/projects that can put them to the most productive use.
7. Provides information — the prices and yields quoted in a financial market are themselves a running source of information — about a company's perceived financial health, or about prevailing interest-rate conditions — that borrowers, lenders and policy-makers alike use in their own decisions.