Financial Markets: Functions, Types, Difference

  • Post last modified:12/02/2022
  • Reading time:24 mins read

What is Financial Markets?

Financial Market refers to a marketplace, where the creation and trading of financial assets, such as shares, debentures, bonds, derivatives, currencies, etc. take place. It plays a crucial role in allocating limited resources, in the country‘s economy. It acts as an intermediary between the savers and investors by mobilising funds between them.


Functions of Financial Markets

Financial markets play a pivotal role in allocating resources in an economy by performing three important functions:

  1. Price Discovery
  2. Liquidity
  3. Low Transaction Cost

Price Discovery

Financial markets facilitate price discovery. The continual interaction among numerous buyers and sellers who throng financial markets helps in establishing the prices of financial assets. Well-organised financial markets seem to be remarkably efficient in price discovery.

That is why financial economists say: “If you want to know what the value of a financial asset is, simply look at its price in the financial markets.

Liquidity

Financial markets provide liquidity to financial assets. Investors can readily sell their financial assets through the mechanism of financial markets. In the absence of financial markets which provide such liquidity, the motivation of investors to hold financial assets will be considerably diminished.

Thanks to the negotiability and transferability of securities through the financial markets, it is possible for companies (and other entities) to raise long-term funds from investors with short-term and medium-term horizons. While one investor is substituted by another when security is transacted, the company is assured of long-term availability of funds.

Low Transaction Cost

Financial markets considerably reduce the cost of transacting. The two major costs associated with transacting are search costs and information costs. Search costs comprise explicit costs such as the expenses incurred on advertising when one wants to buy or sell an asset and implicit costs such as the effort and time one has to put in to locate a customer. Information costs refer to costs incurred in evaluating the investment merits of financial assets.


Nature of Financial Market

A financial market is as vital to the economy as blood is to the body. The nature of financial markets is mentioned below:

  1. It acts as a link between the investors and borrowers.

  2. These markets are readily available at anytime for both the investors and the borrowers.

  3. Financial markets initiate buying and selling of marketable commodities.

  4. The government controls the operations of a financial market in the country by imposing different rules and regulations.

  5. These markets require financial intermediaries such as a bank, non-banking financial companies, stock exchanges, mutual fund companies, insurance companies, brokers, etc. to function.

  6. Financial markets provide an opportunity of putting in their funds into various securities or schemes for short or long- term investing benefits.

Classification of Financial Market

These are the classification of financial market by different aspects:

  1. By Nature of Claim
  2. By Maturity of Claim
  3. By Timing of Delivery
  4. By Organizational Structure

By Nature of Claim

  1. Debt Market
  2. Equity Market

Debt Market

Debt Market: The market where fixed claims or debt instruments, such as debentures or bonds are bought and sold between investors.

Equity Market

Equity Market: The equity market is a market wherein the investors deal in equity instruments. It is the market for residual claims.

By Maturity of Claim

  1. Money Market
  2. Capital Market

Money Market

The market where monetary assets such as commercial paper, certificate of deposits, treasury bills, etc. which mature within a year, are traded is called money market. It is the market for short-term funds. No such market exists physically; the transactions are performed over a virtual network, i.e. fax, internet or phone.

Capital Market

The market where medium- and long-term financial assets are traded in the capital market. It is divided into two types:

  1. Primary Market: A financial market, wherein the company listed on an exchange, for the first time, issues new security or already listed company brings the fresh issue.

  2. Secondary Market: Alternately known as the Stock market, a secondary market is an organised marketplace, wherein already issued securities are traded between investors, such as individuals, merchant bankers, stockbrokers and mutual funds.

By Timing of Delivery

  1. Cash Market
  2. Futures Market

Cash Market

Cash Market: The market where the transaction between buyers and sellers are settled in real-time.

Futures Market

Futures Market: Futures market is one where the delivery or settlement of commodities takes place at a future specified date.

By Organizational Structure

  1. Exchange-Traded Market
  2. Over-the-Counter Market

Exchange-Traded Market

A financial market, which has a centralised organisation with the standardised procedure.

Over-the-Counter Market

An OTC is characterised by a decentralised organisation, having customised procedures.


Types of Financial Markets

Types of financial markets are categorized into two major segments:

  1. Money Market
  2. Capital Market

Money Market

The money market is a market for short-term funds, which deals in financial assets whose period of maturity is up to one year. It should be noted that the money market does not deal in cash or money as such but simply provides a market for credit instruments such as bills of exchange, promissory notes, commercial paper, treasury bills, etc.

These financial instruments are the close substitute for money. These instruments help the business units, other organisations and the Government to borrow the funds to meet their short-term requirement.

Money market does not imply to any specific marketplace. Rather it refers to the whole networks of financial institutions dealing in short-term funds, which provides an outlet to lenders and a source of supply for such funds to borrowers. Most of the money market transactions are taken place on telephone, fax or Internet.

The Indian money market consists of the Reserve Bank of India, Commercial banks, Cooperative banks, and other specialised financial institutions. The Reserve Bank of India is the leader of the money market in India. Some Non-Banking Financial Companies (NBFCs) and financial institutions like LIC, GIC, UTI, etc. also operate in the Indian money market.

Money Market Instruments

Following are some of the important money market instruments or securities:

  1. Call Money
  2. Treasury Bill
  3. Commercial Paper
  4. Certificate of Deposit
  5. Trade Bill

Call Money

Call money is mainly used by the banks to meet their temporary requirement of cash. They borrow and lend money from each other normally on a daily basis. It is repayable on demand and its maturity period varies between one day to a fortnight.

The rate of interest paid-on-call money loan is known as the call rate.

Treasury Bill

A treasury bill is a promissory note issued by the RBI to meet the short-term requirement of funds. Treasury bills are highly liquid instruments, which means, at any time the holder of treasury bills can transfer or get them discounted from RBI.

These bills are normally issued at a price less than their face value, and redeemed at face value. So the difference between the issue price and the face value of the treasury bill represents the interest on the investment. These bills are secured instruments and are issued for a period of not exceeding 364 days. Banks, Financial institutions and corporations normally play a major role in the Treasury bill market.

Commercial Paper

Commercial paper (CP) is a popular instrument for financing the working capital requirements of companies. The CP is an unsecured instrument issued in the form of a promissory note. This instrument was introduced in 1990 to enable corporate borrowers to raise short-term funds.

It can be issued for periods ranging from 15 days to one year. Commercial papers are transferable by endorsement and delivery. The highly reputed companies (Blue Chip companies) are the major player of the commercial paper market.

Certificate of Deposit

Certificate of Deposit (CDs) are short-term instruments issued by Commercial Banks and Special Financial Institutions (SFIs), which are freely transferable from one party to another. The maturity period of CDs ranges from 91 days to one year. These can be issued to individuals, co-operatives and companies.

Trade Bill

Normally the traders buy goods from the wholesalers or manufacturers on credit. The sellers get payment after the end of the credit period. But if any seller does not want to wait or is in immediate need of money he/she can draw a bill of exchange in favour of the buyer. When the buyer accepts the bill it becomes a negotiable instrument and is termed a bill of exchange or trade bill.

This trade bill can now be discounted with a bank before its maturity. On maturity, the bank gets the payment from the drawee i.e., the buyer of goods. When trade bills are accepted by Commercial Banks it is known as Commercial Bills. So trade bill is an instrument, which enables the drawer of the bill to get funds for short period to meet the working capital needs.


Capital Market

A capital Market may be defined as a market dealing in medium and long-term funds. It is an institutional arrangement for borrowing medium and long-term funds and which provides facilities for marketing and trading of securities.

So it constitutes all long-term borrowings from banks and financial institutions, borrowings from foreign markets and raising of capital by issuing various securities such as shares debentures, bonds, etc. In the present chapter let us discuss the market for the trading of securities.

The market where securities are traded is known as the Securities market. It consists of two different segments namely primary and secondary markets.

The primary market deals with a new or fresh issue of securities and is, therefore, also known as a new issue market; whereas the secondary market provides a place for purchase and sale of existing securities and is often termed as the stock market or stock exchange.

Types of Capital Market

Types of capital market can be categorized into two segments:

  1. Primary Market
  2. Secondary Market

Primary Market

The Primary Market consists of arrangements, which facilitate the procurement of long-term funds by companies by making a fresh issues of shares and debentures. You know that companies make fresh issues of shares and/or debentures at their formation stage and, if necessary, subsequently for the expansion of business.

It is usually done through private placement to friends, relatives and financial institutions or by making public issues. In any case, the companies have to follow a well-established legal procedure and involve a number of intermediaries such as underwriters, brokers, etc. who form an integral part of the primary market.

You must have learnt about many initial public offers (IPOs) made recently by a number of public sector undertakings such as ONGC, GAIL, NTPC and the private sector companies like Tata Consultancy Services (TCS), Biocon, Jet-Airways and so on.

Secondary Market

The secondary market known as the stock market or stock exchange plays an equally important role in mobilising long-term funds by providing the necessary liquidity to holdings in shares and debentures. It provides a place where these securities can be encashed without any difficulty and delay.

It is an organised market where shares and debentures are traded regularly with a high degree of transparency and security. In fact, an active secondary market facilitates the growth of the primary market as the investors in the primary market are assured of a continuous market for liquidity of their holdings.

The major players in the primary market are merchant bankers, mutual funds, financial institutions, and individual investors; and in the secondary market, you have all these and the stockbrokers who are members of the stock exchange who facilitate the trading. After having a brief idea about the primary market and secondary market let see the difference between them.


Difference Between Capital Market and Money Market

Some important points of difference between capital market and money market are given below:

  1. Participants
  2. Instruments
  3. Investment Outlay
  4. Duration
  5. Liquidity
  6. Safety

Participants

The participants in the capital market are financial institutions, banks, corporate entities, foreign investors and ordinary retail investors from members of the public. Participation in the money market is by and large undertaken by institutional participants such as the RBI, banks, financial institutions and finance companies. Individual investors although permitted to transact in the secondary money market, do not normally do so.

Instruments

The main instruments traded in the capital market are – equity shares, debentures, bonds, preference shares etc. The main instruments traded in the money market are short term debt instruments such as T-bills, trade bills reports, commercial paper and certificates of deposit.

Investment Outlay

Investment in the capital market i.e. securities does not necessarily require a huge financial outlay. The value of units of securities is generally low i.e. Rs 10, Rs 100 and so is the case with a minimum trading lot of shares which is kept small i.e. 5, 50, 100 or so.

This helps individuals with small savings to subscribe to these securities. In the money market, transactions entail huge sums of money as the instruments are quite expensive.

Duration

The capital market deals in medium and long term securities such as equity shares and debentures. Money market instruments have a maximum tenure of one year, and may even be issued for a single day.

Liquidity

Capital market securities are considered liquid investments because they are marketable on the stock exchanges. However, a share may not be actively traded, i.e. it may not easily find a buyer. Money market instruments, on the other hand, enjoy a higher degree of liquidity as there is a formal arrangement for this.

The Discount Finance House of India (DFHI) has been established for the specific objective of providing a ready market for money market instruments.

Safety

Capital market instruments are riskier both with respect to returns and principal repayment. Issuing companies may fail to perform as per projections and promoters may defraud investors. But the money market is generally much safer with a minimum risk of default.

This is due to the shorter duration of investing and also to the financial soundness of the issuers, which primarily are the government, banks and highly rated companies.

Expected Return

Investment in capital markets generally yields a higher return for investors than the money markets. The possibility of earnings is higher if the securities are held for a longer duration.

First, there is the scope of earning capital gains in equity shares. Second, in the long run, the prosperity of a company is shared by shareholders by way of high dividends and bonus issues.


Leave a Reply