Economic Functions of Financial Markets

The two primary economic functions of financial assets were already dis- cussed. Financial markets provide three additional economic functions.
First, the interactions of buyers and sellers in a financial market determine the price of the traded asset; or, equivalently, the required return on a financial asset is determined. The inducement for firms to acquire funds depends on the required return that investors demand, and this feature of financial markets signals how the funds in the economy should be allocated among financial assets. It is called the price discovery process. Whether these signals are correct is an issue that we discuss when we examine the question of the efficiency of financial markets.
Second, financial markets provide a mechanism for an investor to sell a financial asset. This feature offers liquidity in financial markets, an attractive characteristic when circumstances either force or motivate an investor to sell. In the absence of liquidity, the owner must hold a debt instrument until it matures and an equity instrument until the company either voluntarily or involuntarily liquidates. Although all financial markets provide some form of liquidity, the degree of liquidity is one of the factors that differentiates various markets.
The third economic function of a financial market reduces the search and information costs of transacting. Search costs represent explicit costs, such as the money spent to advertise the desire to sell or purchase a financial asset, and implicit costs, such as the value of time spent in locating a counterparty. The presence of some form of organized financial market reduces search costs. Information costs are incurred in assessing the investment merits of a financial asset, that is, the amount and the likelihood of the cash flow expected to be generated. In an efficient market, prices reflect the aggregate information collected by all market participants.