Chapter 15
INVESTORS AND MARKETS : The financial markets


The job of a financial system is to bring together those economic agents with surplus funds and those with funding needs:

  • either through the indirect finance model, wherein banks and other financial institutions perform the function of intermediation; or
  • through the direct finance model, wherein the role of financial institutions is limited to that of a broker.

But a financial system also provides a variety of payment means, and it facilitates transactions because:

  • the funds of many investors are pooled to finance large projects; and
  • the equity capital of companies is subdivided into small units, enabling investors to diversify their portfolios.

A financial system also distributes financial resources across time and space, and between different sectors. It provides tools for managing risk, disseminates information at low cost, facilitates decentralised decision-making, and offers mechanisms for reducing conflict between the parties to a contract.

Financial markets are becoming more important every day, a phenomenon that goes hand-in-hand with their globalisation. The modern economy is no longer a credit-based economy, where bank loans are the predominant form of finance. Today it is rather a capital market economy, wherein companies solicit funding directly from investors via the issuance of shares and bonds.

Alongside their traditional lending function, banks have adapted to the new system by developing advisory services to facilitate corporate access to the financial markets, be they equity markets or bond markets.

Conceptually, markets are efficient when security prices always reflect all relevant available information. It has been demonstrated that the more liquid a market is, the more readily available information is, the lower transaction costs are and the more individuals act rationally, the more efficient the market is. The last of these factors probably constitutes the biggest hindrance to market efficiency because human beings cannot be reduced to a series of equations. Irrational human behaviour gives rise to mimicry and other anomalies, leading to speculative excesses that specialists in behavioural finance are still trying to comprehend and explain.

A financial market brings together three types of players:

  • hedgers, who refuse to assume risk and instead wish to protect themselves from it;
  • speculators, who assume varying degrees of risk; and
  • arbitrageurs, who exploit market disequilibria and, in so doing, eliminate these discrepancies and therefore ensure market liquidity and efficiency.

The existence of these three types of players is necessary in a market to ensure that the corporates will be in a position to find financing and hedging products that they need at normal prices.