Role of Stock Markets in an Economy

Financial market is one of the components of financial system. Financial market facilitates the efficient allocation of financial resources of the economy so as to achieve socially desirable and economically productive purposes. Existence of an efficient financial market is a pre requisite for promoting savings, investments and consequent economic growth.

Financial markets are extremely important to the general health of an economy. The main function of financial system, viz. capital formation takes place practically in financial markets. Financial institutions work as financial intermediaries and establish link between suppliers and users of funds in financial market. Financial products, including the supply of credit, mortgages, company shares and insurance, are bought and sold in primary and secondary financial markets. Financial products and securities are first issued into primary financial markets, which is where all financial products originate and where contracts are first drawn up. Secondary markets exist to enable buyers and sellers to resell their products and contracts to a third party.

Among all investment options available, capital market is considered the most challenging as well as the most rewarding. Capital market is a market for securities (equity and debt), where companies (and government) raise long term funds from the public investors and where investors can subsequently trade among themselves in these securities.

Basically stock market performs two functions:

  1. To facilitate resource raising from the community for financing corporate sector and government for various activities; and
  2. To provide an organised market place for the investors to freely buy and sell securities.

The stock exchange is an organized market, in which supply and demand for securities are brought together. A differentiation is made between the cash and forward markets. Equities and bonds are traded on the cash markets. They offer investors the opportunity to take part in the economic progress of corporations. Risks that arise from price fluctuations in the cash markets are hedged in the options and futures markets through trading in options and futures contracts – so-called derivative financial products.

The stock market fulfills a central function in the economy, bringing together savers and investors (providers of capital) on the one hand with companies and the state (borrowers) on the other. Without this “mediator”, the capital providers and borrowers would have to negotiate directly, which would generate heavy search and information costs. Whereas companies and the state often require large sums of long-term capital, most of the savers and investors want to provide small amounts for relatively shorter time periods. The stock market makes possible an optimal and efficient reconcilement of interests between these groups. Savers and investors can buy and sell securities on the exchange at any time, without directly affecting the companies. For this reason, the stock market is also known as a circulating market (secondary market). It is also an issuers’ market in which new issues can be placed (primary market).

Central functions and responsibilities of a stock market are:

  • Making available cost-effective trading platforms.
  • Bundling of liquidity by concentrating supply and demand.
  • Guaranteeing the fungibility, or interchangeability, as well as the identical structuring of a particular category of security.
  • Ensuring the greatest possible transparency for investors.
  • Providing information on prices and volume.

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