The Many Roles Of Financial Markets

What role do financial markets play in the modern world? What is the response to ciritics who claim they are unproductive and driven by idle speculators? In this second introductory article Narayan Naik explains the economic functions of markets go beyond more allocation of capital the need for which was vividly highlighted by the failure of Soviet and other experiments in central planning. They include choice in the timing of consumption, the management of risk, separation of ownership from day-to-day managerial control and aggregated information about company performance which can be useful to both outsiders and insiders alike.

On the next page Laurent Germain develops this last point in his discussion of the efficient markets hypothesis (EMH), the controversial contention that all available information is reflected in prices.

 

He argues that the extent to which this is true depends on the nature of the information: information contained in past prices; all public information, including that contained in past prices; or all public and private information.

The growth of financial markets has been one of the outstanding developments of the past 15 years or so. That period has seen a change in the composition of financial markets. The share of banks in total recorded financial assets has tended to fall while that of securities markets and even more that of financial derivatives futures, options and swaps has greatly increased. These developments have been most advanced in the United States and United Kingdom but the removal of restrictions is leading to a similar expansion of financial market transactions in other countries, notably France, Germany and, most recently, Japan.

The role of banks in the economic system has long been understood but that of securities markets has been criticised on the grounds that they are driven by speculation regarded as unproductive and consume too many real resources.

It is essential, however, to recognise the varied economic roles that financial markets play it is clear, for example, that the absence of financial markets was one of the critical weaknesses of the Soviet bloc.

That financial markets, in the form of both banking and securities markets, are necessary for the effective allocation of real capital hardly needs saying, especially in the light of the Soviet experience and the failure by governments in other countries to plan production.

But the economic functions of financial markets go beyond this and include: the provision of choice in the timing of consumption the management of risk the role of corporate management and the provision of information.

Choice of consumption

Financial markets and instruments enable individuals to choose more effectively between current and future consumption. Borrowing enables them to consume more while lending, in the widest sense, enables them to exchange consumption today for more tomorrow. A market interest rate establishes the economic price of this exchange.

For individuals as a whole, however, the provision of a higher level of consumption tomorrow, with given technology, can only come from the additional output generated by physical investment.

So a choice of timing in consumption patterns is linked to the role of capital markets in providing producers with resources in excess of those generated out of their own income. In the process both borrowers and lenders are made better off.

Financial markets also allow efficient risk-sharing among investors. As we will see later in this series, there are two types of risks: those which can be diversified away and those which cannot.

Diversifiable risk can be eliminated by holding assets on which the returns are not perfectly correlated with each other. Financial markets, therefore, enable investors to eliminate diversifiable risk. Furthermore, the operations of derivatives markets in particular enable individuals to choose which non-diversifiable risks they are willing to bear and which they lay off.

Non-diversifiable risk, by definition, cannot be eliminated merely by holding a spread of assets. But forward, futures and options markets allow the transfer of non-diversifiable risk from more risk-averse to less risk-averse individuals and from those who cannot manage risk to those who can. Thus, financial markets make efficient risk sharing among investors possible.

Financial markets offer an array of financial instruments with very different risk-return relationships. These make it easier for individuals and organisations to choose a degree of risk which corresponds more closely to their risk-tolerance levels. For example, investors who are extremely risk-averse may invest a large part of their wealth in risk-free securities (such as government bonds), more risk-tolerant investors may select risky stocks while investors with intermediate risk preferences may choose a combination of bonds and stocks.

In some cases risk-matching may take place in financial markets. For example, the user of copper loses if copper prices rise whereas the producer gains and conversely. A forward purchase of copper by the former at an agreed price and a forward sale by the latter can enable them both to hedge

their price risk. However, if there is not an equal and opposite supply of hedging, the gap has to be filled by speculators. So, paradoxically, it is speculation that makes possible a wider range of risk reduction. Moreover, if speculators are more skilled at judging the right or, in the language of economics, the equilibrium, price than other traders, the effect of their transactions in moving prices towards this level enhances the role of markets in resource allocation.

The role of management

Financial markets enable the separation of ownership from day-to-day managerial control a practical necessity for running large organisations.

Many corporations have hundreds of thousands of shareholders with very different tastes, wealth, risk tolerances and personal investment opportunities. Yet, as the American economist Irving Fisher showed in 1930, they can all agree on one thing managers should continue to invest in real assets until the marginal return on the investment equals the rate of return on investments of a similar degree of risk available in capital markets.

Since shareholders are unanimous about the investment criteria, they can safely delegate the operations of an enterprise to a professional manager.

Managers do not need to know anything about the preferences of their shareholders nor do they need to consult their own tastes. They need to follow only one objective, to invest in projects that yield a higher return compared with that offered by investments of equal risk in capital markets (the opportunity cost of capital).

Put differently, the managers objective becomes that of investing in projects that in present value terms cost less than the benefits they bring in, that is, investing in positive net present value projects. This objective maximises the market value of each stockholders stake in the company and is therefore in the best interest of all shareholders.

The maximisation of net present value in competitive markets also implies the maximisation of return over cost in terms of the use of real resources and, therefore achieves a social optimum in the widest sense.

Financial markets and information

The stock market aggregates the diverse opinions of market participants and conveys how much the equity of a company is worth under its current management.

Suppose the shares of company A are trading at a given price and that company B can use the assets of company A more efficiently under its own management. Then company B may acquire company A. If there were no stock market to value performance it would have been very difficult for company B to discover that the assets of company A were not being put to the best use.

Thus, by providing information on performance a well-functioning stock market leads to the more efficient use of assets and enables poor management to be disciplined through a market for corporate control. When an organisation announces a plan, such as a new project or a company takeover, the stock price may respond in a positive or a negative way. Thus the organisations management can see what market participants collectively think of its proposed plan.

If the stock price reaction is negative, management may decide to re-examine its own calculations and reconsider its plan. Thus the stock market helps management by providing a second opinion about its policy. Moreover, because stock prices reflect the value of the assets under current management, they give an indication of how well the management is performing and therefore help to evaluate its performance. There is considerable evidence to suggest financial markets act as efficient aggregators of information (see box above for the definition of different degrees of market efficiency) and help the efficient allocation of all resources via information conveyed through market prices.

Consider the case of a farmer who has land that can be used to grow wheat, corn or oatmeal. He is reasonably certain about how much it will cost him to grow any of these crops and how much output his land will yield.

However, there is considerable uncertainty about the price his crop will fetch after harvesting. This uncertainty depends not only on the weather but also on the demand and supply conditions after harvesting.

However, the farmer can look at the futures prices of wheat, corn and oatmeal and, knowing his cost structure, decide which is the most profitable crop for him. He can also use the futures markets to assure himself a guaranteed price for the crop. In this way financial markets provide signals as to the socially most desired and economically most efficient use of the farmers land.

Commercial banks clearly play important economic roles as well. In addition to bringing borrowers and lenders together, they also act as monitors of companies.

If finance is provided entirely through the diverse ownership of stockholders, no single investor has an incentive to incur the cost of monitoring management and ensure it is acting in stockholders best interest. Such monitoring only needs to be done by one party duplication might not result in better monitoring and would waste resources.

Stockholders cannot profitably combine to hire a monitor because of a free rider problem each would want others to bear the costs of monitoring. When a bank lends to a corporation, it has an incentive to be the single monitor.Further, by holding a large portfolio of loans to companies, the bank can guarantee it is undertaking the monitoring and thus overcome the free rider problem.