2. What are Financial Markets?

Financial market refers to a marketplace for buying and selling different types of securities. What do you do if you want to borrow money? You go to a bank. Similarly, if you want to invest your money and buy a security such as a stock, bond, real esatate or a precious metal, you visit a securities market. The most common type of financial markets that you may have come accross in you life are stock markets (such as the Pakistan Stock Exchange) and Forex markets – a place to trade currencies.

2.1. What is a Security?

A security is a certificate that lets you own an asset or part of it without physically holding onto it. Suppose Ahsan lends Rs. 500 to his friend so that he can buy a new car. In return, Ahsan receives a certificate that claims that he would own 1% of his friend’s car. This certificate is a security and the underlying asset is his friend’s car.

 

In general, securities have some monetary value and they can usually be bought and sold in a market. Securities that can be easily traded in a market are called “marketable” or “liquid” securities while those that can’t be traded are termed “non-marketable.” In the example stated above, the security that lets you own 1% of your friend’s car can’t be traded elsewhere and thus, is non-marketable. This means that you can’t go to a bazaar in your neighborhood, sell this security to another individual and get your money back.

The most common types of marketable securities are stocks and bonds.

2.2. The role of Financial Markets

  • Financial markets are responsible for directing funds from savers and investors toward governments, instituitions and individuals in need of capital.
  • Financial markets can lower search costs. It’s better if you know the exact location of the market selling Toyota cars compared to a situation where you have to search every showroom in the country to find your preferred model.
  • Existence of such markets reduces information and transaction costs. Consider a situation where you have to knock every neighbor’s door and ask if they have spare money to lend. The cost of visitng all these houses is high. Even if you find an interested party, that lender would charge you more because he knows no one else in the neighborhood is willing to lend you money. Therefore, a well-functioning marketplace will attract multiple lenders and borrowers and therefore reduce costs by quoting the best price that matches demand and supply of money.
  • In an efficient financial market, individuals and instituitions can compare products offered by different financial instituitions and thus, select the best product that meets their needs.
  • Facilititate production of goods and services in Pakistan.

2.3. Key Players

  • Corporations demand funds to buy real assets such as machinery, inventory or equipment for expansion and growth of their businesses.
  • Households supply funds by purchasing different securities i.e. financial assets. The funds received by purchase of these financial assets are utilized by corporations to buy real assets.
  • Government of Pakistan can be a borrower or a lender depending upon the revenue and spending needs of the country.

Financial intermediaries are responsible for facilitating the transaction between investors (security buyers) and corporations (security issuers). An example of financial intermediary is a bank. Suppose a company wants to borrow money in order to buy land for building a new factory. He goes to a bank and asks for money. An individual who has excess cash and wants to lend it also goes to the same bank. The bank takes the money from the individual and supplies it to the company. Of course, without a bank neither the individual would be able to know that a firm is in need of money nor would the company know that an individual is looking to invest his extra cash.