Financial markets and institutions play an imperative role in the growth of an economy. A prosperous economy requires a strong financial system that drives it through the financial environment. Financial markets are involved with the channeling of funds from one economic player to the other. Economic players include those who have surplus funds and those who have a shortage in funds and the exchange of these funds is facilitated by the financial markets. On the other hand, financial institutions are intermediary firms that collect funds from lenders and channel them through to the borrowers through formal structures. Financial intermediaries, brokers, investment banks, and dealers provide financial products and services that cannot be obtained more efficiently if transactions are done directly in securities markets. Financial markets facilitate the efficient flow of savings and investment in the economy that helps in the accumulation of capital and the process, the production of goods and services is enhanced. The economy is significantly boosted in the end when well developed financial markets and institutions are combined with the diverse array of instruments and products that favor the financial environment for lenders and borrowers (Fabozzi, Modigliani, Jones, & Ferri, 2002).
Financial markets like those that are involved with stocks, instruments like banks CDs and institutions like insurance companies all provide opportunities for investors to specialize in specific markets, and they can diversify risks as well. Additionally, large financial markets that are more active in trading activities provide more liquidity for the participants in that market than thinkers markets which have limited securities and participants. This limits trading opportunities hence slowing the rate of economic growth of any country. It is also important to note that when a country has financial markets that are involved with lots of trading activity, many financial assets are liquid, and some may have secondary markets that can facilitate or help in the transfer of the available financial assets at a low cost.
Economic growth is facilitated by efficient financial markets and institutions which lower search and transaction costs. When a large array of financial products that have different pricing structures and varying risks are available, participants of the financial market can access the financial products that meet their needs and demands. According to Fabozzi, Modigliani, Jones, & Ferri (2002), a well developed financial system enables businesses, individuals, and governments to discover the financial institutions and markets that can provide funds and the borrower will know the cost of borrowing. In the process, investors can make comparisons on the cost of financing and the expected return on investment hence they can make investment choices that best suits their needs When lenders and borrowers are satisfied with the financial environment, they can take part in trading activities, and other transactions effectively and the economy gains direct credit.
The importance of well-developed financial markets and institutions cannot be underestimated. In developing countries, for instance, it is very difficult or more costly to raise capital, and this can lower the return on investments or savings because of limited financial markets and institutions in such countries. It is also difficult to hold a diversified portfolio in such small markets because they have a limited selection of financial assets or investment products. Additionally, thin financial markets that have few trading activity and few financial alternatives may be more difficult to find the correct financial product or service as well as risk profile that meets the needs of lenders and borrowers. In such economies, it can be difficult for any economic growth to take place because they lack well-developed financial markets and institutions that can facilitate growth (Brigham, & Houston, 2011).
There are two forms of capital markets from where investors can deal with securities. They include primary market and secondary market. Primary markets are involved with the trading of securities that have been newly issued. Such securities are issued by companies, corporations, and governments when they need to raise capital whereby they target investors can purchase the stocks or bonds. Therefore, money that is earned from the selling of these securities goes directly to the company that issues them (Brigham, & Houston, 2011). The initial public offering is the typical method of issuing securities in the primary market where the company that offers the securities hires an underwriting firm that reviews the offering and creates an ideal outlining and other details that are necessary for the issuing of securities. It is important to note that companies issuing securities through the primary market do not target small investors who are not able to purchase a high volume of securities at a very short time that is necessary to meet the financial requirements of the issuing company. This is the reason why investors who have the financial power to purchase large volumes of securities are always targeted. On the other hand, secondary market deals with the securities that have already been sold in the primary market. Small investors are in a position to trade the securities because they are no longer excluded by the IPO because they represent a small amount of money. At this point, it is the investors who purchased securities in the primary market who trade them hence the money that is earned from the sale of securities does not go to the issuing company in the primary market but rather to the investor who sells the securities according to Brigham, & Houston (2011). Additionally, the volume of securities that are sold on a daily basis varies due to the fluctuations in security demand.
Money and capital markets are the two most commonly used components of a financial market. The main difference between money markets and capital markets is the fact that money markets are used on a short-term basis while capital markets are used for long-term assets (Brigham, & Houston, 2011). In capital markets, companies are involved in the selling of stocks and bonds so that they can earn money from the investors who purchase securities, and the money is used for improving the company, purchasing assets and meeting other financial needs of the issuing company. Additionally, capital markets offer higher risk investments, but the returns are always high compared to money markets. On the other hand, money markets are involved with lending and borrowing on a short term basis where banks, for instance, can borrow or lend between each other and everything that is borrowed usually returned or paid back within a period of thirteen months. Unlike capital markets, money markets offer safer assets, and the returns are slow but steady. Capital market returns directly correlate to the level of risk although it is not always the case.
Fabozzi, F. J., Modigliani, F., Jones, F. J., & Ferri, M. G. (2002). Foundations of financial markets and institutions.
Brigham, E., & Houston, J. (2011). Fundamentals of financial management. Cengage Learning.
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