What is the Purpose of Financial Markets?

Part 3 What is the Purpose of Financial Markets?
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A question that many people have asked, and this includes me – is what exactly is the function or purpose of financial markets? It is a very good question that we will answer here.

The purpose of financial markets is to facilitate transactions between buyers and sellers at a fair price which reflects the inherent risks and as such promotes the efficient allocation of capital (puts capital to use in an economy).

The purpose of financial markets can be broken down into three broad categories:

  • Transactional. This is the facilitation of trade through the creation of marketplaces. This brings buyers and sellers together and creates liquidity.
  • Price Discovery. This is the mechanism by which a market determines the fair value of an asset.
  • Capital Allocation. The movement of excess capital from savers to borrowers which allows capital to be put to effective use to grow the economy.

Table of Contents

Understanding The Financial Markets

The financial markets is a large and seemingly complex subject for anyone coming into financial trading for the first time.

Nothard Trading’s Trading Basics series has been put together to help the normal retail trader get an overview of the topic and demystify the key terms. In this unit we will explore the key functions of the financial markets.

Transactional Purpose Of Financial Markets

The first purpose is almost self explanatory in the simple definition of what a market is – which is any place or platform that brings together buyers and sellers.

When you look at it from this point of view, this first purpose of financial markets is purely transactional – it is there to allow the transactions in that market to take place.

It is to allow the transactions to take place in the market.

Example Of Transactional Purpose

No market would exist without demand. This demand is the underlying purpose for that market. So for example – you are online and purchase a product that is priced in US Dollars and you are paying in British Pounds. From your point of view you simply click to buy and you get charged in your local currency.

In reality, for that transaction to occur, your payment provider would need to undertake a transaction in the forex market in order for the vendor to get paid.

Without the forex market, your payment provider would only be able to complete transactions with the amount of US Dollars they had on reserve and if they didn’t have any then you would just have to wait! Obviously that is not going to happen, everyone wants an instant transaction.

With the amount of global trade that happens on a daily basis, it is not hard to understand why the forex market is the largest market by daily volume.

This simple transactional function is the basic purpose of most financial markets. As we learnt in unit 2 of the Trading Basics series – Types Of Financial Markets, there are a lot of markets out there and this function is being reproduced in all sorts of ways, wherever and whenever a buyer and seller are coming together.

Further examples of the transactional purpose of markets:

  • All other straight asset swaps
  • Savings accounts: you put your money in a savings account, you get interest
  • Borrowing: the opposite side of savings: you borrow, you pay interest
  • Issuing equity, for example in the primary and secondary markets
  • Buying and trading equity (stock markets)
  • Managing risk, futures and insurance markets

Risk Management As A Market Function

I just want to expand on the concept of managing risk through financial markets as this is actually a very important function of the financial markets.

Within the risk management function I will explain two concepts – Hedging and Futures Markets.

Note: risk management as a market function is different to risk management strategies when placing trades. For risk management in trading see unit 12 of the Trading Basics Series: Trading And Risk.

What is Hedging?

Hedging is a way of protecting your trading portfolio or a particular trade or position from a change in price that would have a negative effect on it. It is a technique in financial trading that is in effect the same thing as buying insurance.

Hedging Example

Let’s look back at the example from above where we are buying a product in US Dollars and paying in British Pounds. Imagine this time that we are not just buying a single product for home use but we are a business that imports stock from the US to sell in Britain.

Currency Risk

Now a clear business risk will exist based on the movement in price in the USD/GBP market. If USD goes up in value, it will cost us more for our stock. If we can’t pass that on to our customers then the direct result of that will be that we will make less profit.

One way to avoid that is to hedge our currency risk. This can be done by placing a trade in the forex markets to buy USD.

If the dollar rises, the gain from that trade will offset the additional cost we pay for our stock.

 If the dollar falls then we lose money on the hedging trade but our stock will cost less and offset that loss.

In theory a perfect hedge is one that exactly balances the risk in our portfolio. However, like insurance it is not free. If you purchase car insurance and someone scratches your car, you are covered and if not you have peace of mind. Either way you don’t get your insurance premium back.

Risk Depends On Time Frame

Like all types of risk, the shorter the time frame is, the lower the cost of covering that risk will be. This is simply because it is easier to predict a few days or a couple of months ahead than it is to predict several months and years ahead.

Also, it is a basic rule that the longer you hold a position the more it costs you. If you are holding a direct asset you are paying the opportunity cost of money and if you are holding a leveraged position you are paying the transactional costs of the market such as carry costs and fees.

It is a basic rule that the longer you hold a position the more it costs you.

Futures Markets

The futures market can be seen or used as another form of hedging. Futures contracts are trades that are settled at a specific date in the future. The futures markets are most commonly associated with commodities and this is where these markets evolved, most specifically with farming – and with good reason.

Futures Market is another form of hedging but one that looks at a specific date in the future. These markets are most associated with commodities.

Futures Market Providing Stability and Hedging Risk

Imagine you are a farmer growing wheat – you prepare the soil, deweed it, fertilise it, buy and plant the seeds, grow the crop, keep it protected from pests, water it and so on.

There is a lot of work required over a long period of TIME to grow food. And before the farmer actually plants a single seed they have no idea what price they are going to get for their product when it is finally harvested and sold to the grain dealer.

For the farmer, there are two clear and quantifiable risks. The first is whether or not they will have a successful crop (weather, pests, etc) and the second is not knowing what price they will receive.

Obviously, if everything goes well and the market is in the farmers favour at harvest time, then there will be a good reward at the end of the harvest. But, if not, that farmer, and that business could be faced with a very difficult situation.

The first risk can be offset with the insurance markets but the second, although seemingly less dramatic can be just as bad and may even discourage the effort in the first place as there may be no guarantee of a profit and the purpose of putting any capital to work is the expectation of a profit.

Farmed goods is where some of the first futures markets evolved for this very reason. Farmers sold their harvest at a fixed price in the present for delivery in the future.

Both parties gained from this arrangement – the farmers had reassurance of the price they would get (and in some cases an initial part payment) and the grain dealers could fix their costs ahead of time.

This market function helps to encourage risk taking and investment in the future.

Compared to the original agricultural markets, futures markets have evolved and expanded a great deal over time, especially with derivative products, but the principle is the same in that you can manage risk to a fixed date in the future.

What Is Price Discovery?

Price discovery is a mechanism of the markets that, through constant buying and selling of goods (at volume), determines the fair value of an asset. This is a key mechanism for price stability in an economy.

Have you ever heard someone say that a product is only worth what someone is willing to pay for it? This is the underlying principle of price discovery, supply and demand. There needs to be a seller and a buyer willing to purchase, at that price.

Well of course that makes sense, I might want to sell you $1 for $1.50 but I doubt anyone would be willing to make that trade. In comparison if I were to sell $1 for $0.80c then I would very quickly run out of dollars to sell!

In fact if I had enough dollars not to run out straight away and I placed these dollars on an open market – the process of price discovery would kick in straight away.

The first people lucky enough to get it at $0.80c would be very happy but before long someone else is going to be willing to pay me $0.81c. Why? Well because they want to get ahead of the people offering $0.80c – $0.19c profit on the dollar is still a good return.

This would continue (very quickly) in an upward trend till my dollar would be trading at parity with every other dollar in the world.

Market Volume Aids Price Discovery

Every day there are literally trillions of dollars worth of assets traded on the financial markets. What this means is that there is a lot of opportunity to discover the price of an asset.

As soon as something is listed on a market, and the bigger the market is, the more efficient the price discovery will be. Even if a few people are willing to sell something very cheap or to pay over the odds for a product, they may cause a short drop or spike in the price but it would very quickly move back to the consensus price.

The bigger the market is, the more efficient the price discovery will be.

Market Liquidity

Sometimes people refer to volume as liquidity, but liquidity is more than just about the sheer size of a market. Liquidity has two elements. First, it is the ability of the market to facilitate transactions – specifically about having buyers and sellers available to trade an asset at any given time.

Secondly, it is a property of the assets themselves. A liquid asset is one that can readily be converted into a tradable unit (normally cash).

Why Is Price Discovery Important?

Why is this important? Well, it allows us to know the value of things and it will discourage movements in price based on bad information.

For example, you would be pretty upset if every time you went shopping you paid a different price for your staple foods due to random changes in the market caused by panic, fear or greed.

Generally prices are stable, even though these things happen as the rational players will bring the price back in line. The markets discourage poor pricing that does not meet the markets needs with a potential loss and good pricing with a profit. This is obviously a very good motivator!

Price stability is a key output of price discovery in the markets.

Price discovery is not the same as valuation. Price discovery is a market mechanism and valuation is the process of applying analysis to determine an asset’s value.

Applying market analysis is one of the core jobs of a financial trader. An overview of Fundamental Analysis and Technical Analysis is provided in units 7 and unit 8 of the Trading Basics series (linked).

Those with the best information and analysis are the ones that will get ahead of the price and will be rewarded by the market when price discovery moves in their direction as the rest of the market catches up.

Allocation of Capital

Another definition of a market is any place or platform that brings together savers and borrowers. This purpose of financial markets is vital for the functioning of an economy.

Every day, entrepreneurs around the world are starting businesses and existing businesses are looking to invest and expand. Consumers are taking out mortgages or loans to invest in other projects.

In order for this to happen, there needs to be a market where savers can deposit their money and borrowers can take out loans. This process is what allows the economy to grow by allocating the spare capital of savers to those looking to make use of that capital for investment and growth.

Efficient Allocation Of Capital

Now, when people talk about this market function you will often hear them referring to it in a specific way – ‘The Efficient Allocation of Capital’. What this means is that we not only expect the market to allow this transfer of capital but also to do it in a way that creates the most value.

Market Functions Are Complementary

Having learnt about the transactional, risk and pricing functions of the markets we can see how this can be the case.

Savers will demand a return on their money and market makers will require a return to facilitate the transaction. As such the cost of borrowing will reflect the risk and perceived future returns on that investment.

These mechanisms should mean that capital is only allocated in such a way that it creates a net economic benefit for all participants in the market chain – otherwise known as the profit motive.

This does not mean that the market is perfect, of course it isn’t. Businesses still go bust and there will be bad loans that are not repaid but on the whole the market mechanisms will reflect that risk.

More Trading Basics

There is loads more to learn and we will uncover more terms in the rest of the Trading Basics blog series. Read our previous or next unit. 

Justina Nothard

Justina Nothard

Hi, I’m Justina Nothard, a retail investor trading Stock Index Futures.

I understand how hard it can be for the ordinary trader to learn the basics and find useful tools and practical information.

This is why I decided to create Nothard Trading to help you take control of your trading.

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