Role of Financial Markets

Investors exchange financial instruments in financial markets. A more popular term used for the exchange of financial instruments is trading. Financial markets operate on three main economic functions.

Price search
Liquidity
Lower transaction costs

Finding the price means that the financial market for buyers and sellers in the financial market determines the cost of trade property. Equivalently, they determine the necessary returns to the participants in the financial market to buy financial instruments. There are indications of the financial markets how the funds available from those who want to be loaned or invested. Because the intention of finding funds depends on the investor the return required.

Second, financial markets provide a platform for investors to sell financial instruments, thus providing liquidity to investors. Liquidity is an attractive feature that forces or motivates an investor to sell a financial instrument when a situation arises where the presence of buyers and sellers are ready to trade. Without liquidity an investor is forced to hold a financial instrument either until a situation arises that permits the disposal of the financial instrument or until the issuer is contractually obligated to repay it. For a debt instrument when it matures but for an equity instrument which does not mature, the company is not liquidated voluntarily or involuntarily as long as there is a perpetual security. All financial markets provide some form of liquidity. Also the degree of liquidity is a factor that characterizes different financial markets.

A third aspect of financial markets is that it lowers the transaction cost when parties want to trade a financial instrument. In general we can classify transaction related costs into two types namely search costs and information costs.

Discovery costs fall into two major categories.

Clear costs
Inherent costs

Conspicuous costs include costs incurred in advertising one's intention to sell or buy a financial instrument. Implicit costs include the value of time spent searching for a counterparty. (eg. for seller-to-buyer or buyer-to-seller transactions) The presence of some form of organized financial market reduces search costs.

Information costs are costs associated with evaluating the investment properties of a financial instrument. In an efficient market, prices reflect the aggregate information gathered by all market participants.

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