Solved: A financial system consists of both financial institutions and financial markets. Financial markets bring

A financial system consists of both financial institutions and financial markets. Financial markets bring the “key players” together and their funds. For this discussion, choose one of the functions of the financial markets and discuss how financial institutions play a role in this process.

Expert Answer

The market where different types of financial instruments are exchanged and traded are known as financial market. The following three major functions are performed by the financial markets:-

1) Price discovery

2) Liquidity

3) Reduction of transaction costs

1) Price discovery:- Price discovery function of financial markets facilitates the determination of price of the traded financial assets through a transaction which is performed between the buyers and sellers of financial instruments in a financial market.

2) Liquidity:- With the help of liquidity function of financial markets, an opportunity if provided to the investors to sell a financial instrument as it signifies the measurement of the ability to sell any financial assets at its fair market value at anytime.

3) Reduction of transaction costs:- When some kind of charges are levied to the participants of a financial market and/or bear they bear the cost of trading a financial instrument, it is termed as Reduction of transaction costs

Role of Financial Institutions:- Financial institutions can be defined as special financial entities which have the function of efficient allocation of funds in those situations when the prevailing situation in the market is difficult for the investors or lenders to deal directly with those who are willing to borrow the funds in financial markets. Financial institutions include depository institutions, insurance companies, regulated investment companies, investment banks, pension funds.

Creating more favorable transaction opportunities than it can be realized by lenders/investors and borrowers dealing directly with each other in the financial market is the main function of these institutions.

The major functions of these institutions are:-

  • Receiving funds from the lenders
  • Providing these funds to those who want these funds for their uses.
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