Question

1.) Explain what it means for financial markets to serve as a capital allocation mechanism.

2.) Explain what it means for financial markets to serve as a risk allocation mechanism.

3.) What is the point of secondary market trading?

Answer 1

(1): Financial markets serve as a capital allocation mechanism by enabling the distribution of financial resources to different sectors in such a manner that efficiency is increased and overall profit levels are maximized. Financial markets enables capital allocation by ensuring that a marketplace exists for trading in instruments like equities, bonds, currencies, bullion and derivatives. Financial markets helps to ensure the flow of funds and resources through different entities in a smooth and systematic manner. Thus financial markets can be said to serve as a capital allocation mechanism.

(2): Risk allocation mechanism is a capability driven mechanism and individual entities are not capable of always having this mechanism on their own. They rely on different institutions of financial markets like banks, non-banking finance companies, primary capital markets and secondary capital markets to manage and allocate their risks in an optimal manner. Financial markets not only support and enable linear risk allocation but also make use of dynamic strategies to replicate options. Thus non-linear risk allocation can be done by financial markets in a proper manner. Financial market allocates total financial risk among various investors in such a manner that the individual investor’s standalone risk becomes insignificant.

(3): Secondary market is the market in which securities are traded after a company has sold its equities (stocks) and debt (bonds) by offering it in the primary market. This is the market in which investors buy and sell securities that is already owned by them. The point of secondary market trading is to optimize the balance of liquidity and risk. Different investors have different liquidity requirement and different risk appetite and the secondary market enables investors to buy or sell securities as per their requirement for liquidity and as per their risk appetite and risk profile.