Before proceeding, it is important to explain what financial markets are. The triumvirate of markets, instruments and institutions offers potential investors the opportunity to invest their money in areas that they hope will bring about orderly change.
These can be very different, and it is this diversity that enables them to develop strategies that work for individuals. Together, all three contribute to economic growth, and the bigger they are, the better for their host country.
America provides a prime example of this, with its financial system widely considered to be excellence, its markets transacting myriad daily transactions, and its financial services industry large and well developed. With this in mind, it is not surprising that with an economy that accounts for around 24.5% of the world’s gross product, it is the richest country in the world.
Why are Financial Institutions Important?
Financial markets play a fundamental role in the accumulation of capital and the production of goods and services, which makes them very important for businesses. The two are not easy to explain. Let’s start with the loan price and the return on investment.
Both act as signals to producers and consumers, helping to channel funds from savers to consumers, businesses, governments and businesses and for investors who want to raise capital. It does this by matching those who are willing to pay the highest price or interest rate with those who are able to lend, and this is not just happening at the national level.
Financial markets also facilitate the flow of capital between countries. This relationship exists because effective financial markets direct the flow of capital in the form of savings and investments in such a way as to facilitate its accumulation and promote the production of goods and services. This allows both borrowers and lenders to find a partner who suits their needs as much as they want, which benefits investors as well as individuals, businesses and governments in need of funding because when is easy to determine how much for the borrower, investors can evaluate the financing price and weigh it against the expected return.
The result is that they can make the best investment decision and thus reap their rewards in the financial market. Against this background, one could say that the financial markets thereby channel lending to the entire economy of a country and thus stimulate the production of goods and services.
Types of Financial Markets for Running a Healthy Economy
Money markets involve buying and selling very short-term debt instruments. The main players are commercial banks. The most important instruments for acquiring short-term finance are bank loans or overdrafts or commercial or treasury bills. Banks traditionally lend one another when funds are tight, and the Bank of England acts as the lender of last resort in the money markets.
Capital markets involve buying and selling long-term debt securities, including stocks and shares of the private sector, public sector bonds. The primary capital market comprises the initial sale and purchase of stocks and bonds and the secondary capital market comprises the resale of these securities.
Stocks and bonds are bought, held, or sold in the hope of speculative gain or to avoid speculative losses. The securities can also be sold to regain liquidity. Previously issued bonds can be bought back by the banks on behalf of the government to increase the liquidity of the economy through quantitative easing.
The mortgage market involves the granting of long-term loans to purchase a property. They can be traded on the used mortgage market. Like the stock market, the secondary mortgage market enables original lenders, banks, and mortgage companies to regain lost liquidity. The new owner of the mortgage debt is entitled to the mortgage repayments.
Insurance involves the transfer of risk from one party, the insured, to another party, the insurer, for a fee known as a premium. Insurance markets are often divided into general insurance and life insurance, but the principles are the same, that is, risk transfer from one party to another.
Since premiums are collected regularly, but claims are rarely or far into the future, insurance companies usually have very large funds that are invested in order to generate investment income. This means that insurance companies are major players in other financial markets such as the equity, bond and derivatives markets.
Liquidity is also the most important service that helps the healthy financial market economy. Hence, there are financial intermediaries who provide liquidity to the people who need it. There are different types of liquidity such as market liquidity versus funding liquidity.
The ability to instantly exchange goods or services for cash. This is because people accept cash without worrying too much about value and risk. In a country like India, digital transactions are only made by 50% of the population because rural areas are still undeveloped and no internet connections are available.
The Bottom Line
Apple started out in a garage in California. Even though it had some great ideas, Steve Jobs needed money to make it a reality. In 1977 he persuaded a lone investor to loan the company $250,000 and five years later, he raised more than $100 million from the financial markets by selling shares in the company. Apple is now worth hundreds of billions of dollars and employs more than 100,000 people. Hence, financial markets, if they work well, can improve the country’s situation.
Hope this article helped you understand why financial markets are so important for running a smooth and healthy economy!