Functions of Financial Market

Functions of Financial Market

Financial markets play a pivotal role in allocating resources in an economy by performing three important functions:
1. 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. The value of a financial asset can be obtained just by looking at its price in the financial market.
2. Financial markets provide liquidity to financial assets: Investors can readily sell their financial assets through the mechanism of financial markets. Companies can raise long term funds from investors by negotiation and transferability of securities through financial markets
3. Financial markets considerably reduce the cost of transacting. The major costs associate with transacting are search costs and information costs. Search costs includes explicit costs such as the expenses incurred on advertising when one wants to buy or sell an asset and implicit costs such a s 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.

Classification of Financial Market

There are different ways of classifying financial markets. They are as follows: The debt market is the financial market for fixed claims(debt instrument) and equity market is the financial market for residual claims(equity instruments) Money market is the market for short term financial claims. Capital market is the market for long term financial claims. Since short term financial claims are almost invariably debt claims, the money market is the market for short term debt instruments and the capital market is the market for long term debt instruments and equity instruments.
Third way to classify financial markets is based on whether the claim represents new issues or outstanding issues. The market where issuers sell new claims is referred to as the primary market and the market where investors trade outstanding securities is called the secondary market.
A cash or spot market is one where the delivery occurs immediately and a forward or futures market is one where the delivery occurs at a pre-determined time in future. An exchange- raded market is characterized by a centralized organization with standardized procedures. An over the counter market is a decentralized market with customized procedures.

Methods of Floatation

Initial issues are those floated by new companies for the first time, while further issues are subsequent issues floated by the existing companies.
Issues can be classified as those given for cash, for exchange of technical know-how, exchange of shares of another company or exchange for any other services rendered by the agencies or promoters.
The placement of the issues may be through (i) prospectus (ii) offer of sale (iii) private placement (iv) rights issue
i. Offer through prospectus: Offer through prospectus involves inviting subscription from the public through issue of prospectus. The price at which the securities are offered for sale is at the face value of the share in the case of new companies and may be at a premium or discount in the case of old companies.
The prospectus is a document, which is a notice, or circular or advertisement inviting offers for subscription or purchase of any shares or debentures from the public. The prospectus should contain authentic data such as name of the company, address, activities, board of directors, location of industry, authorized, subscribed and paid up capital, dates of opening and closing of the subscription list, names of brokers and underwriters etc. and should be delivered to the Registrar of Companies for registration. The draft of the prospectus should be approved by board , solicitors, lending financial institutions and the stock exchanges in which they are to be listed.
ii. Offer of sale: This method consists of outright sale by the company instead of offering shares to the public to through intermediaries such as issuing houses or share brokers. The company sells shares en bloc at an agreed price to brokers or merchant bankers who in turn resell them to the investing public. Offer of sale of shares takes place in the case of existing shareholders purchasing en bloc and then reselling them to the public. Similarly, foreign collaborators or promoters may sell their shares to the Indian public through offer of sale which may be either through brokers or through prospectus.
iii. Private Placement: Private placement is defined as sale by the issuing house or broker to his own clients of securities previously purchased by him. The issuing houses or financial intermediaries buy them outright with the intention of placing them with their clients afterwards. The brokers would make their profit in the process of reselling to the public. This method of private placement is used to a limited extent in India but is very popular abroad.
Before the issues are placed in the market by the promoters, they sell to their friends and well wishers as the Govt. guidelines require a minimum contribution from the promoters and their friends. Private placement is also made by bargaining with financial institutions for their share of contribution.
Private placement in India is mostly of equity or equity related instruments of unlisted companies and debt instruments of listed companies.
Appeal of private placement: The phenomenal growth of private placement of debt may be attributed to the following reasons.
1. Accessibility: Private placement market can accommodate issues of smaller size whereas the public issues market does not permit an issue below a certain minimum size.
2. Flexibility: There is greater flexibility in working out the terms of issue. e.g. When a non-convertible debenture issue is privately placed, a discount may be given to institutional investors to make the issue attractive. There may be more latitude to renegotiate the terms of the issue and even roll over the debt.
3. Speed: A private placement requires lesser time , perhaps a month or two, as the elaborate procedure followed in a public issue is largely bypassed.
4. Lower issue costs: The issue cost for a private placement is substantially less as a public issue entails several statutory and non- statutory expenses associated with underwriting, brokerage, printing, mailing, announcements, promotion and so on. whose costs are quite high.
Institutional investors, before participating in a private placement, need to look into a number of factors like the net worth of the company, the interest cover, the level of profit before tax, the asset cover, the debt equity ratio, the dividend record, the percentage of unsecured deposits/borrowings, the price history of the company’s stock, and the existence of carried forward loss.
iv. Rights Issue: is an offer with a preemption right to the shareholder of existing companies to contribute to the share capital or its debt capital in the form of debentures. An Existing company can issue rights to augment its equity base, if necessary. These are offered to the existing shareholders in a particular proportion to their existing share ownership. The rights are themselves transferable and saleable in the market.