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0 FINANCIAL MARKETS

1.1 INTRODUCTION OF FINANCIAL MARKETS

A financial market is a general term describe any marketplace where buyers and sellers joining in
the trade of assets like equities, bonds, currencies and derivatives. Financial market usually defined
by having transparent pricing, basic rules on trading, costs and fees, and market power determining
the prices of securities.

Financial market may be found in almost every nation in the world. Some are very small, with
only several participants, while other like New York Stock Exchange (NYSE) and forex market
trading trillions of dollars every day.

Investor have access to a huge amount of financial market and exchange represent various financial
products. A few these markets are permanently open to private investor while the rest remain
exclusive domain of major international banks and financial professionals.

1.2 ROLE OF FINANCIAL MARKETS

Financial markets are markets in which financial instruments are exchanged or traded. Financial
markets provide three major economic roles such as price discovery, liquidity and reduction of
transaction costs.

1.2.1 PRICE DISCOVERY

The role of price discovery means that the transaction between buyers and sellers of financial
instruments in the financial markets determine the price of traded assets. At the same time the
required return on investment of funds is determined by the participants in the financial markets.
The motivation for seeking funds depending on the required return that investors demand. It is the
function of financial markets indicate how the funds are from people who want to lend or invest
funds will be allocated between those who need funds and raise funds by issuing financial
instruments.

1.2.2 LIQUIDITY

The role of the liquidity provided an opportunity for investors to sell financial instruments, as it is
referred to as a measure of the ability to sell assets at fair market value at any time. Without
liquidity, investors will be forced to hold the financial instrument until the situation arises to sell
or the issuer is contractually obliged to pay it. Debt instrument is liquidated when it matures, and
equity instrument is until the company is either voluntarily or involuntarily liquidated. All financial
markets provide some form of liquidity. However, financial markets have different characteristics
of liquidity.

1.2.3 REDUCTION OF TRANSACTION COSTS

The role of reduction of transaction costs is when financial market participants is charged and bear
the cost of trading a financial instruments. In a market economy the economic rationale for the
existence of institutions and instruments is related to transaction costs, with the surviving
institutions and instruments are those that have lowest transaction costs. The main properties
determining the cost of the transaction is asset specificity, uncertainty and frequency of occurrence.

Specificity of assets is related to the way transactions are organized and implemented. It is lower
when an assets can easily be put to alternative uses, can be used for different tasks without
significant cost.

Uncertainty are also related to the transaction costs, which has external resources when events
change beyond the control of the contracting parties, and depends to opportunistic behavior of the
contracting parties. If a change in the existing external event is confirmed, then it is possible to
make adjustments to the original contract, taking into account the problems caused by external
uncertainties. In this case it is possible to control transaction costs. However, when the conditions
that are not easily seen, the opportunity to create incentives for the parties to revise the initial
contract and cause a problem of moral hazard. The higher the uncertainty, the more opportunistic
behavior can be observed, and transaction costs are higher may be exist.

Frequency of occurrence plays an important role in determining if transactions have taken place
in the market or within the firm. It can reduce transaction costs when they are implemented on the
market. Instead, transactions often require a detailed contract and must take place in the firm to
reduce costs.

1.3 IMPORTANCE OF FINANCIAL MARKETS

Financial markets play a critical role in the accumulation of capital and the production of goods
and services. The price of credit and returns on investment provide signals to producers and
consumers—financial market participants. Those signals help direct funds (from savers, mainly
households and businesses) to the consumers, businesses, governments, and investors that would
like to borrow money by connecting those who value the funds most highly (i.e., are willing to pay
a higher price, or interest rate), to willing lenders. In a similar way, the existence of robust financial
markets and institutions also facilitates the international flow of funds between countries.

In addition, efficient financial markets and institutions tend to lower search and transactions costs
in the economy. By providing a large array of financial products, with varying risk and pricing
structures as well as maturity, a well-developed financial system offers products to participants
that provide borrowers and lenders with a close match for their needs. Individuals, businesses, and
governments in need of funds can easily discover which financial institutions or which financial
markets may provide funding and what the cost will be for the borrower. This allows investors to
compare the cost of financing to their expected return on investment, thus making the investment
choice that best suits their needs. In this way, financial markets direct the allocation of credit
throughout the economy—and facilitate the production of goods and services.