Understanding Types and Functions of Financial Markets
Financial markets are platforms that facilitate the buying and selling of financial instruments. They can be classified into several types:
- Capital Markets: These include the stock and bond markets where long-term securities are issued and traded. They enable companies to raise capital for expansion.
- Money Markets: These deal with short-term borrowing and lending, typically with maturities of one year or less. Instruments include treasury bills and commercial paper.
- Foreign Exchange Markets: These facilitate the trading of currencies, allowing businesses and individuals to exchange one currency for another.
- Derivatives Markets: These involve financial contracts whose value is derived from underlying assets, such as options and futures.
- Commodities Markets: These involve trading in physical goods like gold, oil, and agricultural products.
Functions of financial markets include:
- Price Discovery: Financial markets determine the price of securities based on supply and demand.
- Liquidity: They provide liquidity by enabling assets to be bought and sold quickly without significant price changes.
- Risk Management: Markets allow participants to hedge against risks through derivatives and other financial instruments.
- Capital Formation: They facilitate the allocation of resources to productive uses, promoting economic growth.
- Information Dissemination: Financial markets provide information about the economy, financial conditions, and the performance of companies, aiding investors in decision-making.
Key points to remember
- Types: Capital, Money, Foreign Exchange, Derivatives, Commodities markets.
- Functions include price discovery, liquidity, and risk management.
- Financial markets aid in capital formation and information dissemination.
- Liquidity allows quick buying/selling without major price changes.
- Risk management through derivatives helps mitigate financial risks.
Worked example
Example of Capital Market Function
Scenario: ABC Ltd is looking to raise KES 10 million for expansion. It decides to issue shares in the capital market.
- Issuance: ABC Ltd issues 1 million shares at KES 10 each.
- Transaction: Investors buy the shares, providing ABC Ltd with the required capital.
Journal Entries:
| Date | Particulars | KES | |------------|-------------------------------|----------| | 2026-01-01 | Cash | 10,000,000 | | | Share Capital | |
| Date | Particulars | KES | |------------|-------------------------------|----------| | 2026-01-01 | Share Capital | 10,000,000 | | | Cash | |
Balance: Cash increases by KES 10 million, and Share Capital also increases by KES 10 million, maintaining balance.