The Role Of Financial Markets

Financial markets play many important economic roles. They enable individuals to achieve a better balance between current and future consumption. For example, entrepreneurs with good investment projects may be in need of financing while individuals wanting to provide for their retirement may be looking for avenues in which to invest their savings. Financial markets bring the borrowers in contact with the lenders and in the process make both better off. Financial markets also allow efficient risk sharing among investors. As we will see later, risks are of two types: diversifiable and non-diversifiable. Diversifiable risk can be eliminated by holding assets the returns of which are not perfectly correlated. Financial markets not only help investors in diversifying some of the risk, but also offer a wide array of financial instruments with very different risk-return relationships. This enables individuals to choose the risk profile of their investments according to their risk-tolerance levels. Investors who are extremely risk averse, for example, may choose to invest a large fraction of their wealth in risk-free securities (such as gilts), whereas more risk-tolerant investors may elect to invest in speculative stocks.

 

Furthermore, the presence of derivatives markets means that individuals can choose which non-diversifiable risks they want to bear and which they want to lay off via the futures or options markets. A non-diversifiable risk, by definition, cannot be eliminated through diversification. However, the presence of futures and options markets allows the transfer of risk from more risk-averse to less risk-averse individuals and from those who cannot manage risk to those who can. Thus, financial markets enable efficient risk sharing among investors.

Financial markets also make possible the separation of ownership and management that is 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 Irving Fisher showed in 1930, they can all agree on one thing they should continue to invest in real assets as long as the marginal return on the investment equals the rate of return on similar investments in capital markets. Since shareholders are unanimous about the investment criterion, they can delegate the operations of an enterprise to a professional management team. Managers do not need to know anything about the preferences of their shareholders; neither do they need to consult their own tastes. Managers need to follow only one objective: to invest in projects that yield a higher return compared with that offered by equivalent investments in capital markets (the opportunity cost of capital). Put another way, the managers objective becomes that of investing in projects that in present value terms cost less than the benefits they bring in, i.e. investing in positive net present value projects. This objective maximises the market value of each stockholders stake in the concern and therefore turns out to be in the best interest of all the shareholders.

The separation of ownership and management is a fundamental condition for the successful operation of a capitalist economy. It means that individuals can decide how much to consume now and how much to invest for the future. Once they have decided how much to invest, by using the wide array of financial instruments available in capital markets, they can choose the time pattern of consumption plan and the risk characteristic of the consumption plans that suit them.

The managers of large private corporations, on the other hand, can borrow money from capital markets to buy real assets. The real assets may be tangible, such as machinery, factories and offices, or they may be intangible, such as technical expertise, trademarks and patents. When the managers maximise net present value they make everyone better off. Thus, well functioning financial markets ensure that individual maximisation leads to a socially optimal outcome.

Financial markets lead to the efficient allocation of 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. There is, though, considerable uncertainty about the price his crop will fetch after harvesting. This price uncertainty depends not only on factors such as weather conditions but also on the levels of demand and supply that may prevail in future

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 a guaranteed price for the crop and then go ahead with planting the crop. In this way financial markets ensure that the land is put to its most efficient use.

The stock market aggregates diverse opinions of market participants and conveys how much the equity of a company is worth under current management. Suppose the shares of Company A are trading at a given price and suppose that another organisation, Company B, can use the assets of Company A more efficiently. Then Company B may decide to acquire Company A. If it does so, the assets of Company A will be put to more efficient and productive use under the management of Company B. If there were no stock market, then it might be difficult for Company B to notice that the assets of Company A were not being put to best use. Even if Company B noticed this, it might not be possible to acquire Company A and thereby transfer the assets. Thus, the presence of a well functioning stock market leads to the more efficient utilisation of assets and enables poor management to be disciplined through a market for corporate control.

When a company announces a plan of future actions, such as starting a new project or the takeover of another company, the stock price may respond in a positive or a negative way. The management of the company can observe the stock price reaction and learn what the market participants collectively think of its proposed plan. If the stock price reaction is negative, the management may wish to re-examine its own calculations and reconsider its decision. Thus, the stock market helps management to get a second opinion about its investment decisions. Moreover, since stock prices reflect the value of the assets under current management, the market provides a measure of how well management is doing its job and therefore helps the process of evaluating managerial performance.

Banks play important economic roles as well. In addition to bringing borrowers and lenders together, banks also act as monitors of companies. If finance is provided entirely through the diverse ownership of shareholders, no one alone has an incentive to spend resources to monitor the management and ensure that it is acting in the best interest of those shareholders. Monitoring is best carried out by only one party since duplication may not result in improved monitoring and would waste resources. But shareholders cannot combine to hire somebody to monitor because of a free rider problem; each would want others to bear the costs of monitoring the monitor. When a bank lends to a corporation, it has an incentive to be the single monitor.

To summarise, well functioning financial markets bring borrowers and lenders together, improve risk sharing, lead to the efficient allocation of resources, provide information to market participants, allow separation of ownership and management and help the monitoring of management. Together they improve the quality of investment decisions and the welfare of all market participants.

Signpost

Finance

Finance, it can be argued, is the very centre of business and therefore of management. It is certainly an area of which any general manager must have a very secure grasp. For that reason it is given considerable coverage in Mastering Management. The Finance Module begins with four sections looking at the finance function within a company, financial markets and investment decisions, risk and return, and the efficiency of markets. The module will be completed over eight subsequent parts: planned to be Parts 2, 4, 5, 6, 9, 13, 15 and 17. The topics scheduled to be covered include: discounted cash flow and other criteria for assessing the viability of projects; cost of capital; choice of capital structure; the changing nature of finance; dividend policy; options and derivatives; warrants and convertibles; interest rates and currency swaps; financial regulations and bank capital requirements; managerial remuneration and company performance.

Summary

Financial markets serve a number of useful purposes. These include bringing borrowers and lenders together; sharing risk between investors; separating ownership and management; achieving a better balance for individuals between current and future consumption; efficiently allocating resources, effectively utilising assets, and helping the process of evaluating managerial performance through the signals contained in market prices.