A core objective of a financial system is to allow individuals, firms, and others to exchange money and risk with each other, and move it across time and location.
The core functions of a financial system include:
- Bringing together market participants so that they can invest their savings, raise loans, raise equity capital, manage their risks, purchase/sell assets and earn profit by trading on available information.
- Determining and communicating the prevailing rates of return and cost of capital; and
- Facilitating the efficient allocation of capital.
- Bringing together counterparties.
Entities invest in stocks, bonds, certificates of deposit, real estate, etc. because they are interested in moving money from today to some future date (for retirement in case of individuals or capital expenditure in case of companies). Investing excess money is better than just letting it stay idle as long as the rate of return offered by the investment is commensurate with the inherent risk.
Individuals, companies, and governments raise loans from a bank or by issuing notes or bonds which they repay using their future earnings. Borrowers must convince lenders of their creditworthiness by offering collateral, an equity position or providing credit rating, etc. The government facilitates the borrowing function by creating bankruptcy codes and courts.
Companies raise money by issuing common stock to investors which entitles them to share in the profits of the money. Investment banks undertake new equity issues on behalf of companies, analysts value them, and regulators ensure the availability of reliable accounting information. The financial system provides liquidity and information (about stock value) which enables investors to trade their shares with each other.
Values of stocks, bonds, currencies, commodities, etc. depend on a lot of variables. Financial markets offer hedging instruments such as forward contracts, futures contracts, options, insurance contract, etc. which allow different market participants to hedge their risks. For example, a maize farmer might be worried about the price it would be able to fetch when its crop is ripe. Similarly, a food processing company might want to eliminate the risk of any adverse movement in the price of maize. The financial system allows these two entities to settle a price today for delivery in the future thereby eliminating risk faced by both.
Spot exchange of assets
One of the functions of money is that it is a medium of exchange. The financial system allows individuals and entities to exchange their assets (commodities, real estate, etc.) to money and use that money to buy more assets. The existence of liquid financial markets facilitates the exchange function of money.
The financial system allows entities who have superior insight into intrinsic values of different financial instruments to use their insight to realize excess returns, a return higher than the return that corresponds to the risk of the investment. They do this by buying undervalued assets and selling overvalued assets and hope that the market gravitates towards the intrinsic value.
Determination of equilibrium interest rate
A financial market receives supply of money principally from investors and lenders which is demanded by borrowers and companies issuing capital. The interplay of this demand and supply for money dynamically sets the equilibrium interest rate, which is the price of money, the rate at which supply equals demand. When the equilibrium rate is too high, more people save and few borrow, and the rate comes down and vice versa. The actual return on an individual financial instrument is a function of the equilibrium rate, characteristics of the instruments and its risks.
Efficient capital allocation
Since investors and other providers of capital are risk-averse, they want to get the best bang for their buck. In attempting to maximize their return per unit of risk, they only invest in such projects which they believe would be most profitable. This mechanism enables projects with good prospects to get scarce capital and poor projects are left off.