The role of financial markets

What financial markets do

Financial markets are where savers, borrowers, investors and traders meet. Banks, stock exchanges, bond markets and currency markets are all part of them. Their roles named in the specification are:

• Facilitating saving: households and firms can save safely and earn interest or a return.
• Lending to businesses and individuals: savings are channelled to borrowers who want to invest (a firm building a factory) or consume (a family buying a house with a mortgage).
• Facilitating the exchange of goods and services: payment systems (cards, transfers) and foreign currency let buyers pay sellers, including across borders.
• Forward markets in currencies and commodities: a firm can agree today a price for currency or a commodity (wheat, oil, copper) to be delivered in future. This reduces risk from price changes.
• A market for equities: firms raise finance by selling shares (equities) on a stock market; investors can buy and sell existing shares easily.

Why they matter for the economy

By moving funds from savers to borrowers, financial markets raise investment, which increases capital goods and shifts the PPF outwards. Forward markets let importers and exporters plan, encouraging trade and specialisation.

But they can also fail: lenders may not know how risky borrowers are (asymmetric information), banks may take excessive risks if they expect to be rescued (moral hazard), and asset prices can form bubbles. These appear in topic 1.3.5.

Forward market example

A coffee importer must pay a foreign supplier 1,000,000 units of foreign currency in three months. If the currency rises in value, the importer pays more in its home currency. Buying the currency forward at today's agreed rate fixes the cost now, so the importer knows its costs and can set prices with confidence. The price of certainty: if the currency had fallen instead, the importer misses that gain.

Worked example

Explain how a stock market helps a growing firm.

1. The firm can sell new shares (equities) to investors.
2. This raises finance without borrowing or paying interest.
3. The finance pays for investment such as new machinery, raising capacity.
4. Investors are willing to buy because they can sell the shares easily later.

Answer: It lets the firm raise equity finance for investment, because investors can buy and later resell shares easily.

Check yourself

1. A chocolate maker agrees today to buy cocoa in six months at a fixed price. Which part of financial markets is it using?
   • A forward market in commodities
   • The equity market
   • A savings account
   • A payment card system
   Show answer

   A forward market in commodities. A forward contract fixes a future price today, reducing risk.

2. A firm raises finance by selling shares to the public. Which role of financial markets is this?
   • Facilitating the exchange of goods and services
   • Forward markets in currencies
   • Providing a market for equities
   • Lending to individuals
   Show answer

   Providing a market for equities. Shares are equities; the stock market is the market for them.

3. A bank uses deposits from savers to give a mortgage to a household. This shows financial markets
   • channelling saving into lending
   • providing a forward market
   • issuing equities
   • acting as a unit of account
   Show answer

   channelling saving into lending. Financial intermediaries move funds from savers to borrowers.

4. How can well-functioning financial markets help economic growth?
   • They remove scarcity
   • They guarantee that asset prices never fall
   • They replace the need for money
   • They channel savings into investment in capital goods
   Show answer

   They channel savings into investment in capital goods. More investment raises productive capacity and shifts the PPF outwards.

5. Explain why an exporter might use a forward market in currencies.
   Show answer

   The exporter will receive foreign currency in future and its value could fall. A forward contract fixes the exchange rate now, which reduces risk and uncertainty so the firm knows its revenue and can plan.. Say what is fixed and why that helps the firm.

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Sources

• Pearson Edexcel International Advanced Subsidiary/Advanced Level in Economics specification (2018)

Last updated 8 November 2026. Spotted a mistake? Tell us.