A business is a part of an economic system that consists of two main sectors – households that save funds and business firms which invest these funds. A financial market helps to link the savers and the investors by mobilizing funds between them. In doing so it performs what is known as an allocative function. It allocates or directs funds available for investment into their most productive investment opportunity. When the allocative function is performed well, two consequences follow:
There are two major alternative mechanisms through which allocation of funds can be done: via banks or via financial markets. Households can deposit their surplus funds with banks, who in turn could lend these funds to business firms. Alternately, households can buy the shares and debentures offered by a business using financial markets. The process by which the allocation of funds is done is called financial intermediation. Banks and financial markets are competing intermediaries in the financial system, and give households a choice of where they want to place their savings.
Every economy has two basic sectors when it comes to funds – savings and investment. Savings is what we refer to when individual households save money. And investment is the capital that industries require to start and run their businesses.
Now the economy must provide a link between savings and investments. One obvious way to convert savings into investment is via banks. Alternatively, savings can be turned into investments through financial markets. Households will use their savings to buy financial instruments and commodities such as shares, stocks, debentures etc. This is the whole concept of the financial market.
This way a financial market serves an allocative function and mobilize idle funds to be put to more productive use. When the allocation of funds is done well, there are some added benefits, such as;