B&E | A Layman's Understanding of Financial Markets

B&E | A Layman's Understanding of Financial Markets

By Rahul Guhathakurta

B&E | A Layman's Understanding of Financial Markets

Image Attribute: Stock market ticker / Creative Commons

In a rudimentary economy, there are no financial markets. In such an economy, each person has to be financially self-sufficient. No one can invest in the means of production without financing it out of his or her own saving; and no one can save without a simultaneous act of real investment. 

In every possible sense, they very opportunity to invest is dependent upon the individual's ability to save. Likewise, the desire to save is constrained by the individual's opportunities to invest. Individual who want to invest more than they can possibly save are forced to cut back on their investment.  And, those who want to save more that their opportunities allow are forced to cut back on savings.  As a result, very little of either gets done. Financial markets make it possible for acts of saving and investment to be separated: these markets make it possible for some members of the society to save, while others may assume the responsibility for real investment operations.  The separation of the acts of saving and investment serves to increase both savings and investment, and hence the wealth and growth of the economy. Individuals who want to save but not to invest can do so by lending in financial markets. Others who want to invest but not save can do so by borrowing in financial markets. Thus, financial markets increase the availability of capital by tapping the savings potential of non-investing individuals. So, a major function of such markets is to provide a link between savings and investment thereby facilitating the creation of new wealth. 

Each person may feel free to make saving and investment decisions but they are not really as free as they think. The different individual decisions of participation in the market must be balanced. If everyone decided to invest more than they saved, then everyone need to borrow, but no one could, because there would be lenders in the overall equation. Fortunately, the balancing process is facilitated through the movement of interest rates towards an equilibrium. The interest-rate price of lending and borrowing transactions adjust rapidly so that those who want to borrow can find willing lenders and vice-versa. If everyone wanted to borrow, the interest rate would quickly rise to such a high level that enough participants would change their minds and decide to lend instead. 

The development of markets to bring to those who want to save and lend together with those who want to borrow and invest is an important step towards financial development. However, direct face-to-face dealing between ultimate net savers and ultimate net investors is often not practical. "Securities brokers" are needed when face-to-face transaction turns out to be too costly. "Financial intermediaries" are needed to resolve differences between the needs of savers and needs of those who invest. Even if saver-lenders and borrowers-investors can agree on an interest rate, they will conclude their transaction only if they can further agree on all other terms such as maturity, collateral, method of redemption, etc. Such agreement can be exceedingly difficult. Most savers prefers to keep their savings liquid by lending short-term. Investment, on the other hand, is usually long-term; it is usually financed through long-term borrowing. Obviously, a single market connecting such lenders with such borrowers cannot work to mutual advantage. This, then, suggests the development of differentiated markets. One for short-term lending and one for long-term borrowing. This problem is solved by the development of different types of financial intermediaries.The presence of many various financial intermediaries in an economy indicates that the economy is in an advanced stage of financial development. 

Financial markets can be classified as "open" and "negotiated" markets. When transactions are not standardized, as in primitive society, every transaction involving credit has to be personally negotiated. However, the appearance of large borrowers who could break down their borrowings into small but homogeneous units creates the potential atmosphere for open markets. An open market is one in which the unit of transactions is well known and does not need to be negotiated every time a transaction is carried out. These kind of securities can be offered for bidding to many buyers. When the unit of transaction is very similar, even if not identical, an open market readily develops. High-grade corporate bonds are not all alike, but an open market in corporate bonds in general can be said to exist. 

Thus, an open market system is very beneficial for capital formation. When a large corporation needs millions of dollars to finance a plant construction and capital asset purchase, it can offer small-denomination securities in the open market to tap the savings of tens of thousands of relatively small investors. 

The opportunity for an ultimate borrower to secure credit by selling securities in the open market exists only in highly developed financial economies. An open market must be open to all qualified participants. The number of buyers and sellers must be large enough that interest rates are determined by impersonally by the forces of supply and demand.  

Negotiated markers, by contrast, include all the transactions that takes place between a single lender and a single borrower, or among a small number of parties. Between them the terms of a loan are personally bargained. These terms include the all-agreed interest rate. The open market is open only to large borrowers with unknown credit standing. The rest of us would better by negotiating for credit. Though, the lending side of the open market is less discriminating.

Let's accept this fact, financial markets and allied institutions are vital to the economic well-being and future growth of a free market oriented economy. Moreover, this particular sector, along with services sector as a whole, has been one of the most rapidly growing component of the global economy, creating challenging businesses and career opportunities for the future. For all of these reasons, an understanding of the lending and borrowing activities, the portfolio behavior, the management policies and the regulatory environment is highly essential.

About the Author:

Rahul Guhathakurta is the founder of IndraStra Global, a strategic analysis and information services provider to the corporate, start-ups and various other entities. He regularly tweets at @rahulogy and can be reached through his Linkedin profile.

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