Functions of Stock Market: A Comprehensive Guide

Functions of Stock Market: A Comprehensive Guide

A stock market plays a very important role in the economy by offering an organized platform where investors can easily buy and sell shares of publicly listed companies online. Beyond acting as a marketplace, the stock market has several functions that expedite capital formation, investor wealth generation and economic growth. Here, in this article, we shall explore the functions of stock market and why they are equally significant for business, traders, investors as well as for the economy. 

What is a Stock Exchange?

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A stock exchange is an organized marketplace where investors and traders can buy and sell financial instruments, such as shares of stock and bonds through electronic trading platforms. They are the most important component of stock market where companies raise capital by selling their shares of stock. A company's entry into a stock exchange begins with an IPO, where it shares are open to the public for buying. Once listed, these shares can be bought and sold on the exchange. 

Some well-known stock exchanges across the world are BSE – Bombay Stock Exchange, NSE – National Stock Exchange, NASDAQ, NYSE - New York Stock Exchange (NYSE), JPX - Tokyo Stock Exchange, LSE -London Stock Exchange and SSE - Shanghai Stock Exchange.

What are the Functions of a Stock Market?

1. Capital Formation and Fundraising

In a stock market companies list their stocks on the exchanges through Initial Public Offerings (IPOs). The aim is to raise funds by issuing shares to institutions as well as retail investors. While, investors aim to earn returns, the company utilizes the funds for their company expenses and business expansion. Not just new companies, even already established listed companies too can raise additional funds through Follow-On Public Offerings (FPOs).
One of the most important functions of the market, capital formation and fund raising not only help companies to grow and expand without any debts, but also play a crucial role in boosting their financial health and also strengthening the overall economy.

2. Liquidity and Marketability of Investments

In a stock market, traders and investors can easily buy and sell shares (even large quantities of a security) without causing large price movements. The narrow bid-ask spread, continuous trading hours and easy market accessibility allows investors and traders to easily enter and exit positions during the trading days. 
One of the most important functions of the market, it is liquidity that gives both, traders and investors’ the confidence to when needed they can easily convert their investments into cash.

3. Price Discovery and Valuation

 Price discovery is an important function for both, investors as well as listed companies. The reason being, it provides insights into a company’s financial health, growth prospects, and perceived value. It ensures that the price of a security is fair for both buyers and sellers. Price discovery helps in determining a stock's resistance and support lines – helping traders find trades that they feel are fair and efficient

Price discovery is a process in the market that helps fix the price of a trading instrument based on the supply and demand as it involves both the buyer and seller agreeing on the trade. On the other hand, valuation is the rate at which the financial instrument was last traded.

4. Wealth Creation for Investors

The stock market allows all types of investors to create and generate wealth. It provides a platform where traders and investors can invest any amount in listed companies especially fundamentally strong companies, and reap benefits over time. Several of the listed companies are also known to pay dividends (a percentage of their profits) to their shareholders.

With capital appreciation as well as dividends, the stock market plays an important role when it comes to contributing significantly to investors’ personal wealth generation.

5. Economic Indicator and Market Sentiment

The performance of the stock market is often seen as a barometer/gauge for the economy’s health. The two important and major indices SENSEX and NIFTY50 signal the economic outlook as the markets tend to react to interest rate changes, government policies, inflation data, as well as geopolitical events.

So, when the market is bullish and doing well, it indicates that the economy is growing and the companies are doing well. This results in more buying, more borrowing, more spending, more hiring and even more investing.
By gauging market indices and trends, investors, and economists can estimate economic stability, making it an important instrument for economic forecasting.

6. Facilitates Corporate Governance and Accountability

When an investor becomes a stockholder in a company, they are vested with the voting rights in any corporate decision. This, facilities not just accountability but also good corporate governance and transparency in listed companies. Regulatory body Security Exchange Board of India - SEBI not just regulates the companies listed on the stock exchanges but also ensures that they adhere to the norms mandated by them. 

By adhering to rules and norms mandated by regulatory bodies, the listed companies ensure transparency, which helps in gaining investor’s confidence and also in fostering sustainable business practices.

7. Risk Management and Hedging Opportunities

Not just equities, the stock market also offers several risk management instruments to its investors, like derivatives, to hedge against market volatility. Investors can trade in ‘derivatives’ and safeguard their portfolios from risk such as price fluctuations during uncertain times. Institutional investors often use F&O to stay protected against any potential price volatility or market downturns.

This significant feature of the stock market not only bestows investors with opportunities to protect their investments, but also ensures that market fluctuations do not excessively or disproportionately affect their portfolios.

8. Promotes Investment Culture

The stock market is the platform that allows traders and investors to multiply their income and earnings legally, just by investing. This motivates them to invest, and park their funds into different financial instruments in the stock market. Both, Stock exchanges as well as financial advisors endorse ‘investing’ as a long-term wealth creation strategy for all. In addition, it also allows investors to diversify their portfolios across sectors, and asset types, which further brings a sense of stability as well as balanced investment approach.

By supporting investment culture, the stock market plays an important role in helping individual investors to achieve their long-term financial goals.

How Do Stock Markets Work?

Stock markets, as we know, is an assemblage of buyers and sellers that facilitate the selling and buying of stocks through primary as well as secondary market:

Primary market: Companies sell new shares to investors through initial public offerings (IPOs) to raise capital. 

Secondary market: Investors buy and sell existing shares among themselves, with the company no longer directly involved. 

Stock exchanges: Provide the infrastructure for trading, such as the NSE and BSE. They track the flow of orders for each stock and relay this information to all participants. 

Computer systems: Match buy and sell orders almost instantaneously. 

Market participants: Include investors, traders, market makers, and brokers. 

The price of a stock is determined by the supply and demand for that stock. When demand is high, buyers bid up the prices of the stocks. When there are more sellers than buyers, prices go down.

In Summary

The stock market is very important part of any country’s financial system as well as its economy as it mobilizes funds into the core sectors of the economy. It is the market that eliminates deficiency of capitals in various sectors as it allows companies to raise capital and boosts their growth. Besides, the capital raised through stock markets drives job creation, and technological advancement, thereby playing a crucial part in a country’s overall economic development.