Role of Financial Markets  | Capital &  Risk Allocation | Agency Problem | Essential of Investments
Channel: Farhat Lectures. The # 1 CPA & Accounting Courses
Date: 07/06/2020

In this video, I discuss role of financial markets. Financial markets play a vital role in facilitating the smooth operation of capitalist economies by allocating resources and creating liquidity for businesses and entrepreneurs. The role of financial markets not only help investors in diversifying some of the risk, but also offer a wide array of financial instruments with very different risk.

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Stock prices reflect investors’ collective assessment of a firm’s current performance and future prospects. When the market is more optimistic about the firm, its share price will rise. That higher price makes it easier for the firm to raise capital and therefore encourages investment. In this manner, stock prices play a major role in the allocation of capital in market economies, directing capital to the firms and applications with the greatest perceived potential.

Do capital markets actually channel resources to the most efficient use? At times, they appear to fail miserably. Companies or whole industries can be “hot” for a period of time (think about the dot-com bubble that peaked and then collapsed in 2000), attract a large flow of investor capital, and then fail after only a few years. The process seems highly wasteful.

But we need to be careful about our standard of efficiency. No one knows with certainty which ventures will succeed and which will fail. It is therefore unreasonable to expect that markets will never make mistakes. The stock market encourages allocation of capital to those firms that appear at the time to have the best prospects. Many smart, well-trained, and well-paid professionals analyze the prospects of firms whose shares trade on the stock market. Stock prices reflect their collective judgment.

You may well be skeptical about resource allocation through markets. But if you are, then take a moment to think about the alternatives. Would a central planner make fewer mistakes? Would you prefer that Congress make these decisions? To paraphrase Winston Churchill’s comment about democracy, markets may be the worst way to allocate capital except for all the others that have been tried.

Virtually all real assets involve some risk. When Toyota builds its auto plants, for example, it cannot know for sure what cash flows those plants will generate. Financial markets and the diverse financial instruments traded in those markets allow investors with the greatest taste for risk to bear that risk, while other, less risk-tolerant individuals can, to a greater extent, stay on the sidelines. For example, if Toyota raises the funds to build its auto plant by selling both stocks and bonds to the public, the more optimistic or risk-tolerant investors can buy shares of stock in Toyota, while the more conservative ones can buy Toyota bonds. Because the bonds promise to provide a fixed payment, the stockholders bear most of the business risk but reap potentially higher rewards. Thus, capital markets allow the risk that is inherent to all investments to be borne by the investors most willing to bear it.

This allocation of risk also benefits the firms that need to raise capital to finance their investments. When investors are able to select security types with the risk-return characteristics that best suit their preferences, each security can be sold for the best possible price. This facilitates the process of building the economy’s stock of real assets.