Role of Financial Markets

Financial markets comprise institutions such as banks, insurance companies and stock exchanges that provide a range of financial services to individuals, businesses and governments.

The main services provided by financial institutions are as follows:

To facilitate saving – Both individuals and businesses save part of their income. For households, the reason for saving may be long term, such as putting money into a pension or life assurance policy, or it may be short term, such as saving for a holiday. Businesses may save some of their profits to provide a safety net if business takes a downward turn, or to build up enough cash to buy new plant and equipment. Savings may be put into bank accounts where they earn interest, or may be used to purchase shares on the stock market. This is riskier, as shares can fall in value, but may earn a higher return in the long run in the form of dividend payments and a capital gain if the shares rise in value.

To lend to businesses, individuals and the government – Banks make most of their profits by lending out the savings that are deposited with them at a higher rate of interest than they pay to savers. Households may borrow to buy a house (on a mortgage) or to buy a car. Small and large businesses may borrow to finance investment.

The government borrows long term from banks and other financial institutions by selling gilt edged securities, which are repaid on a fixed date in a number of years’ time. This is used to pay for spending on assets such as hospitals, roads or schools, that will be productive over many years. Short term borrowing, to cover temporary gaps between tax revenue and government spending on public services is done by selling Treasury bills. These are usually for 3 or 6 months duration. Sales of gilt edged securities and Treasury bills are conducted by the Bank of England on behalf of the government.

_To facilitate the exchange of goods and services _– Banks make it easy for individuals and firms to make payments to each other for goods and services, including paying workers’ wages. Central banks, such as the Bank of England underpin the payments system by printing notes and coins, but cash payments are now a small proportion of the total. Bank customers can make payments by transferring money into someone else’s account, or by using a debit or credit card. Banks and bureaux de changes also exchange currencies, making it possible to pay for goods and services abroad.

To provide forward markets in currencies and commodities – A forward market enables a trader who wants to buy or sell a currency or a commodity at a certain time in the future to fix a price at the present time. For instance, suppose a British firm imports American cars that cost $20,000 each. If the exchange rate today (called the spot market rate) is £1=$2, and he is able to sell the cars for £12,000, he will make a profit of £2000 per car. But he may need to sell the cars before he can pay the American exporter. He may be given 3 months to pay. If he waits 3 months and buys dollars on the spot market, there is a risk that the exchange rate may have changed and could reduce, or wipe out his profit. For instance if the spot market rate falls to £1=$1.50, he would have to pay £13,333 per car.

He can ___hedge ___this risk by buying his currency on the forward market. A bank might offer to sell dollars at a rate of £1 = $1.90 in 3 months time. He will then still make a profit (but a little less) by selling the cars for £12000. The bank will hope that the spot rate is still close to £1=$2 in three months. It can then buy the dollars at that price and sell them to the car importer at the higher price (ie fewer dollars per £).

Producers, such as farmers can also hedge risks by selling their produce on the forward market. They can get a guaranteed price for their crop, reducing uncertainty and risk. The forward market trader (typically an investment bank) then hopes it can sell the produce at a higher price than it has guaranteed to the farmer).

The forward market does not eliminate all risk; the car importer for instance would do better to buy on the spot market if the £ holds its value or goes up against the dollar. Also, the forward market only operates for a matter of a few months ahead; traders are generally not willing to risk guaranteeing a price further into the future.

To provide a market for equities _– _Equities ___are simply shares in companies. Selling shares is one of the main ways in which companies raise capital for investment. The owners of shares receive a share of the profits (called ___dividends) and may also make a capital gain if the shares rise in value.

Shares are bought and sold on the world’s stock markets. Banks are willing to buy or sell shares at quoted prices, so that investors know how much their shares are worth and know that they can sell them at any time. Stock markets are virtually ‘perfect markets’, resulting in a single market price for a particular company’s shares.

Stock markets provide both a primary market and a___ secondary market for shares. The primary market is when the shares are sold for the first time by the company that wants to sell them to raise capital. This is called a ___share flotation. The secondary market allows shareholders to sell their shares and /or buy other shares. This creates ___liquidity ___in the market; investors know that they can sell shares quickly and at a known price. Without his liquidity far fewer people would want to hold shares, and it would be harder for firms to raise capital.

Identify and explain the five main functions of financial markets.: Your answer should include: Saving / Lending / Mortgages / Gilt-edged Securities / Treasury bills / Exchange of goods / Exchange of services / Spot market / Forward market / Hedge / Equities / Liquidity / Primary market / Secondary market