Question

Financial markets are linked to the economy. Define financial markets.

Answer 1

A financial market is a market where financial instruments are exchanged or traded. Financial markets provide the following three major economic functions:

1. Price discovery: It means that the price of a financial asset is determined through the interaction and transactions between the buyers and sellers of financial instruments in a financial market. In addition to the price of a financial instrument, and its yield or interest rate is also determined in the financial market.
2. Liquidity: It means that the financial market provides an opportunity for investors to sell a financial instrument at its fair market value at any time.
3. Reduction of Transaction Costs: Financial markets reduce transaction costs by providing a common platform for the buyers and sellers of financial instruments where the participants are charged and/or bear the costs of trading a financial instrument.

There are several types of financial markets including

1. Money Market: It is the market for short-term debt securities with a maturity of one year or less such as commercial papers.
2. Capital Market: It is the market where debts or securities with long-term maturity are traded.
3. Primary Market: It is the market where newly issued shares of firms are traded.
4. Secondary Market: It is the market where the sale and purchase of shares that have already been issued by the firms take place among investors.

Financial markets are important for the functioning of the economy as both the firms and government borrow money from the financial markets for investment purposes. Moreover, the demand and supply interaction in the financial markets have an impact on the interest rate that affects the aggregate demand in the economy.