Financial Market

A financial market is an arena in which prices form to enable the exchange of financial assets to be executed. Given the advent of electronic trading systems, financial markets can now be structured in many ways. Historically, they were physical meeting places in which traders came into face-to-face contact with one another, and trading occurred on the basis of prices being “cried out” on the market floor. Today, many financial markets have lost this intensely human dimension. Instead, prices are displayed across a network of computer screens, and assets are bought and sold at the click of a mouse attached to a computer keyboard. In such instances, the market place has become increasingly virtual, as physical proximity between traders is no longer necessary for trade in assets to commence.

Despite this change in the physical configuration of financial marketplaces, the rationale for establishing financial markets remains much as it ever was. Financial markets exist as a means of redistributing risk from the more risk-averse to the less risk-averse. Some risk is attached to holding all financial assets because the value of those assets can depreciate or appreciate. The more risk-averse the asset-holders, the more that they will seek to use financial markets to find an intermediary who is willing to accept that risk on their behalf. This, of course, will not be a costless exercise. An intermediary's willingness to accept a proportion of the risk embodied in an asset will have to be rewarded through the payment of a fee.

This, for instance, is the principle through which money is raised on the capital market to provide the resources for investment in new productive capacity. An investor with cash reserves may choose to invest that cash in an asset that has a minimal risk attached to it—say, an interest-bearing bank account, which is an extremely safe asset because the bank has almost a zero default risk. Alternatively, those investors may choose to make their cash available to entrepreneurs via the capital market. Entrepreneurs will approach the capital market to raise additional resources when they have insufficient cash reserves of their own to fund their activities, and they will seek investors to [Page 311]accept some of the risk inherent in their entrepreneurial activities. Investors who make their cash available in such a way will clearly require recompense—that is, a fee—for the additional risks that they are taking, and this recompense takes the form of higher returns than would be available from less-risky investments. The entrepreneur must pay a return in excess of the prevailing rate of interest that the investor would earn from a simple bank account.

Financial markets, then, match the risk-averse with the less risk-averse and savers with borrowers. A smoothly functioning market environment will, in theory, exhibit a symmetrical distribution of risk-aversion around the mean, and it will be populated by an equal number of savers and borrowers. In practice, though, the situation is rather more complicated because of the dominance of the speculative motive for holding assets. Following the liberalization of trade in financial assets from the 1970s onward, financial markets have increasingly become an arena of speculation.

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