Question

What do financial markets do? Why are financial markets important to a society? How do financial markets accomplish what they do? What are asymmetric information problems and why would this problem in financial markets matter to society?

Answer 1

What do financial markets do?

A financial market is a market in which people trade financial securities and derivatives at low transaction costs. Securities include stocks and bonds, and precious metals.

The term "market" means exchanges, organizations that facilitate the trade in financial securities, e.g., a stock exchange or commodity exchange. This may be a physical location (such as the NYSE, LSE, JSE, BSE) or an electronic system (such as NASDAQ).

Why are financial markets important to society?

1. Financial Market Index like S&P500 (for USA), NIFTY & SENSEX (for India) tell us on a whole where Society is moving and Our Quality of life. (Barometer for Society)

• Nifty and Sensex are not only the barometer for the stock market but also the Barometer of our whole Indian Economy. It is a Barometer for our consumption.

• Say none of you have invested in stocks but all of you have reliance Jio connection. You pay a monthly rental to Reliance Jio, which increases its revenue, which increases its profits. If revenue and profit of Reliance jio goes higher then share price of reliance will go higher, if share price will go higher than Sensex and nifty will go higher as it is a part of Sensex and nifty.

• It means even if you don’t invest in stock, but if you have more jio connection, if you buy more cars from tata motors or bikes from Bajaj, if you buy more houses taking loan from HDFC. It means your consumption power is going up, which in turn means Sensex and nifty going up. It shows the quality of our life in India. So, we need to be happy when nifty goes up.
• That’s the reason why the Government is so obsessed with stock markets.

(Reliance Jio is a Mobile Phone Connection Company Just like AT&T, Verizon in USA

And Please Interchange Nifty/Sensex with your countries Stock Market Index like S&P500 in case of USA)

2. Borrowing and Lending: Financial markets permit the transfer of funds (purchasing power) from one agent to another for either investment or consumption purposes.
3. Liquidity: Financial markets provide the holders of financial assets with a chance to resell or liquidate these assets.
4. Efficiency: Financial markets reduce transaction costs and information costs.

How do financial markets accomplish what they do?

1. financial markets accomplish through various Institutions like Banks, Mutual Funds, Brokerage Firms etc. which help in pooling many Investors to Financial Market.
2. Financial Market ensures correct pricing of the product through the forces of Demand and Supply.
3. Financial Markets also provides a better risk/return trade off:

{To understand this, we need to understand the types of Risk:

Total Risk = Systematic Risk + Unsystematic Risk.

1. Systematic Risk:

It is the risk due to macro-economic factors. It is the total market risk. It is diversifiable. It is risk due to the Economy i.e. Markets Risk to Individual Companies.

2. Unsystematic Risk:

It is the risk due to micro economic factors. It is the Individual Business risk. It is Undiversifiable. It contains Financial and Business Risk.

As Per Capital Market Theory (CMT) and Modern Portfolio Theory(MPT):

we need to Invest is as many stocks as we can to Kill the Systematic Risk.

CMT crux is that we need to Invest in Market Portfolio (all stocks of NYSE) to attain the highest Sharpe Ratio (i.e. the best Risk and Return Trade off)

Both this theory strongly suggest that Systematic Risk can be eliminated (and brought to minimum) via Diversification BUT Unsystematic Risk cannot be Eliminated.

So even if we Invest In all stocks of NYSE there will be Total Risk will reduce as Systematic risk gets diversified.

(SELF NOTE: DONOT FORM PART OF THE ANSWER

The above answer is given from Portfolio Managers Point of View who Invest in Market.

BUT

From An Individual Business Point of View:

Systematic Risk cannot be Eliminated as Macro Economic Factors are not in its Hands to control.

Unsystematic Risk can be Eliminated as Micro Economic Factors like Finance Risk, is in its Hands to control.) }

What are asymmetric information problems and why would this problem in financial markets matter to society?

Asymmetric information means that one party has more or better information than the other when making decisions and transactions. These happens due to Insider Information leading to Insider Trading.

The imperfect information causes an imbalance of power. Accurate information is essential for sound economic decisions. When a market experiences an imbalance it can lead to market failure.

The integrity of the markets will be damaged and investors will be discouraged from partaking in them. Insiders with nonpublic information will be able to avoid losses and benefit from gains, effectively eliminating the inherent risk that investors without the undisclosed information take on by investing in the markets. If those investors in the dark begin(the one who don’t have Asymmetric information) to withdraw from the markets, there would be no other investors for those partaking in insider trading to sell to or buy from, and insider trading would effectively eliminate itself.

In Short Asymmetric information will eliminate the Financial Market and With No Financial Market, there will be a huge crisis to society for Lending and Borrowing the Money i.e. STOPING MONEY FLOW.

Which will crash the Economy and Society.

Hope you find the Answer Helpful. Thank you.