Financial markets take many different forms and operate in diverse ways. But all of them, whether highly organized, like the London Stock Exchange, or highly informal like the money changers on the street corners of many African capital, server the same basic functions.
The Basic Functions are:
The value of an ounce of gold or a share of stock is no more, and no less, then what someone is willing to pay to own it. Markets provide price discovery, a way to determine the relative values of different items, based upon the prices at which individuals are willing to buy and sell them.
Market prices offer the best way to determine the value of a firm or of the firm’s assets or property. This is important not only to those buying and selling businesses, but also to regulators.
An insurer, for example, may appear strong if it values the securities it owns at the prices it paid for them years ago, but the relevant question for judging its solvency is what prices those
securities could be sold for if it needed cash to pay claims today.
In countries with poorly developed financial markets, commodities and currencies may trade at very different prices in different locations. As traders in financial markets attempts to profit form these divergences, prices move towards a uniform level, making the entire economy more efficient.
Firms often require funds to build new facilities, replace machinery or expand their business in other ways. Shares, bonds and other types of financial instruments make this possible. Increasingly, the financial markets are also the source of capital for individuals who wish to buy homes or cars, or even to make credit card purchased.
As well as long term capital, the financial markets provide the grease that makes many commercial transactions possible. This includes such things as arranging payment for the sale of a product abroad, and providing working capital so that a firm can pay employees if payments from customers run late.