Concept of financial markets

The essentials

A financial market is a market for the creation and exchange of financial assets such as shares, debentures, bonds and bills. It links savers (mostly households) with investors (mostly businesses and governments) and helps allocate scarce funds to their most productive uses. This process is called allocative function. Funds can flow through banks (financial intermediaries) or directly through financial markets.

Key points

• Functions of financial markets: mobilisation of savings and channelising them into the most productive uses; facilitating price discovery (the price of a financial asset is set by demand and supply); providing liquidity to financial assets (they can be easily converted into cash); and reducing the cost of transactions (by providing information about securities and a place to trade).
• Classification by maturity: the money market deals in short-term funds and instruments with a maturity of up to one year; the capital market deals in medium-term and long-term funds.
• The capital market is further divided into the primary market (new issues) and the secondary market (trading in existing securities).

Exam tips

• Price discovery means that prices of securities are set through the interaction of buyers and sellers, not by a single authority.
• Liquidity means that investors can sell their securities quickly when they need cash.

Common mistakes

• Saying financial markets deal only in shares. They include bonds, debentures, bills and other instruments.
• Confusing the money market (short-term) with the capital market (long-term).