THE ROLE OF FINANCIAL MARKETS
Investors trade financial assets in a financial market. The more prevalent term utilized for the trading of financial instruments is that they are “exchanged.” Financial markets give the accompanying three economic purposes: (1) price discovery, (2) liquidity, and (3) reduced transaction costs.
Price discovery implies that the associations of purchasers and sellers in a financial market govern the price of the asset. Comparably, they govern the required rate of return that members in a financial market asks keeping in mind the end goal to purchase a financial instrument. Financial markets flags as to how the funds accessible from the individuals who need to loan or invest funds are allotted among those requiring funds. This is on the grounds that the intention in those looking for funds relies upon the required rate of return that investor’s request.
Second, financial markets offer a medium to investors to offer a financial instrument and in this manner offer investor’s liquidity. Liquidity is the existence of purchasers and dealers prepared to exchange. This is an engaging element when conditions emerge that either compel or spur an investor to offer a financial instrument.
Without liquidity, an investor would be constrained to clutch a financial instrument until either (1) conditions emerge that take into consideration the transfer of the financial instrument, or (2) the guarantor is legally committed to pay it off. For a debt instrument, that is the point at which it matures, however for an equity instrument that does not matures —yet rather, is a perpetual security—it is until the point that the organization is either intentionally or unwillingly liquidated. Every financial markets give some type of liquidity. In any case, the level of liquidity is one of the components that portray diverse financial markets.
The third economic capacity of a financial market is that it diminishes the cost of execution when parties need to exchange a money financial instrument. We can categorize the expenses related with execution into two kinds: search costs and information costs.
Search costs falls into two classifications: explicit and implicit. Explicit costs incorporate costs to publicize one’s expectation to offer or buy a financial instrument. Implicit costs incorporate the estimation of time spent in finding a counterparty—that is, a purchaser for a merchant or a dealer for a purchaser—to the exchange. The existence of some type of financial market decreases search costs.
Information costs will be related to surveying a financial instrument’s investment traits. In a price-efficient market, costs mirrors the total information gathered by all market contestants.