Stock exchange or securities market is a place where trading in securities takes place. Read this article to learn the meaning, features and functions of stock exchanges and understand the importance of stock exchanges and methods of trading on stock exchanges. After taking this lesson, learner will be able to explain the meaning and importance of stock exchange and state the economic functions of stock exchanges.
What is a Stock Exchange?
We know that companies can raise capital by issuing shares or debentures known as corporate securities and governments also issue bonds and instruments known as government securities to raise funds from the public. Investors hold securities either to earn income by way of interest or dividend or to gain capital appreciation due to increase in the price of the security over time. But investors cannot sell them without finding a buyer for the same. Similarly, people with accumulated savings or the institutions having surplus funds may also like to invest their funds in various securities and they also cannot do that without finding a seller.
Stock exchange is an organization which facilitates this process of buying and selling existing securities by providing a medium for buyers and sellers to interact with each other. As there could be a large number of buyers and sellers who want to trade in a particular security, stock exchanges facilitates arriving at trading price based on supply and demand by providing a medium. They help both buyers and sellers arrive at a mutually satisfactory price.
Definition of Stock Exchange:
The word “Stock Exchange” is made from two words 'Stock' and Exchange. Stock means part or fraction of the capital of a company, and Exchange means a transferring the ownership; representing a market for purchasing and selling. Thus, we can describe the stock exchange as a market or a place where different types of securities are bought and sold. Securities traded on a stock exchange include shares issued by companies, unit trusts, derivatives, pooled investment products and bonds. As the stock exchange deals in all types of securities, it is known as 'securities market' or 'securities exchange' also. A stock exchange is a secondary market of securities because the trading happens only for the securities that have already been issues to the public and now being allowed to be traded on the floor of a stock exchange after getting listed with the stock exchange. The initial offering of stocks and bonds to investors is by definition done in the primary market and subsequent trading is done in the secondary market.
The Securities Contracts (Regulation) Act, 1956 has defined stock exchange as an “association, organization or body of individuals, whether incorporated or not, established for the purpose of assisting, regulating and controlling business of buying, selling and dealing in Securities.”
According to Pyle, “security exchanges are market places where securities that have been listed thereon may be bought and sold for either investment or speculation”.
K.L. Garg has described the stock exchange as “an association of persons engaged in the buying and selling of stocks, bonds and shares for the public on commission and guided by certain rules and conditions.”
Features of Stock Exchanges:
Based on the above discussion and definitions, given below are the main characteristics of any stock exchange:
Organized Market: Stock exchange is an organized market of securities (shares, debentures, bonds, etc.) where the securities are bought and sold on the floor of a stock exchange. All transactions are regulated by the rules and bye-laws of the concerned stock exchange.
Formation & Membership: A stock exchange is generally registered as an association or a society or a company. The membership of the stock exchange is restricted to a certain number, and new members are admitted only when there are vacancies. Every member has to pay the prescribed membership fee.
Only Members Can Trade: Stock exchange is only open to the members of exchange also known as brokers. Brokers act as an agent of the buyers and sellers of shares, debentures and bonds. In a stock exchange, transactions take place between members or their authorized agents on behalf of the investors.
Listed Securities: To be able to trade a security on a certain stock exchange, it must be listed on the respective stock exchange as per the guidelines issued by the exchange. The stock exchanges do not allow trading in each and every company's securities. Companies which want their securities to be traded on the floor of a stock exchange have to fulfill certain conditions. The stock exchange satisfies itself about the genuineness and soundness of the company to protect the investors from being cheated. Exchanges maintain records at a central location of such securities but now the trade is increasingly moving from physical places to electronic networks enabling speed and reducing cost.
Functions of Stock Exchanges:
Stock exchange is one of the most important financial intermediaries and plays a very important role in the capital formation and economic development of the country. Given below are some important functions of stock exchanges from economic point of view:
Marketability of Securities: The stock exchange provides for easy marketability of securities as securities can be bought and sold conveniently on the floor of the stock exchange. The Stock Exchange provide companies with the facility to raise capital for expansion through selling shares to the investing public and on the other hand provides investors with a platform to trade these shares.
Price Determination & Continuity: Since transactions take place regularly on a stock exchange there is continuity in the dealings. Supply and demand in stock markets are driven by various factors and this balance of supply and demand affects the price of stocks. These prices gets duly recorded and reported in the newspapers for the benefit of investing public. Besides, stock exchanges have defined rules and regulations to moderate price fluctuations to ensure continuity in buying and selling.
Mobilizing Surplus Savings: Stock exchange is an integral part of the capital market of a country. When people draw their savings and invest in shares (through an IPO or the issuance of new company shares of an already listed company), this leads mobilization of funds to help companies finance their organizations. They facilitate the process by which the savings from all parts of country gets channelized as investment into industrial and commercial undertakings financing their capital requirements. This promotes business activity resulting in stronger economic growth and higher productivity levels of firms.
Barometer of the Economy: The share prices fluctuate on stock exchanges as a result of underlying market forces. The intensity of buying and selling of securities and the corresponding rise or fall in the prices of securities reflects the investors' assessment of the economic and business conditions. Share prices tend to rise or remain stable when companies and the economy show signs of stability and growth whereas they might fall sharply at the time of an economic recession, stagnation, depression, or financial crisis. Change in security prices are known to be highly sensitive to changing economic, social and political conditions and hence act as a barometer of economic and business conditions.
Mobility of Capital: Investing in other businesses require huge capital outlay whereas investing in shares is open to both the large and small stock investors. Stock exchanges furnish an open and continuous market for small investors and their savings that are invested in securities are converted into cash for reinvestment in other securities. Thus, stock exchanges provide mobility to capital and facilitate sound investment. Savings are encouraged when people come to invest in stock exchange.
Profit Sharing & Resource Allocation: As a result of stock market transactions, funds flow from the less profitable to more profitable enterprises. All type of stock investors whether they are individuals, professional stock investors, institutional investors earn capital gains through dividends and stock price increases. This enables them to share in the wealth of profitable businesses. Industries which have potentials of growth are able to attract the savings of people towards their ventures relatively more than those which have no such prospects. Thus, financial resources of the economy are allocated on a reasonable basis. Unprofitable and troubled businesses may result in capital losses for shareholders.
Speculation: The stock exchanges are also fashionable places for speculation and bring equilibrium in the prices of securities which are bought and sold by speculators. In a financial context, the terms "speculation" and "investment" are actually quite inter-related because "investment" means the act of placing money in a financial vehicle with the intent of producing returns over a period of time. Speculators generally buy securities in anticipation of rise in the prices. As a result of their buying, prices do not decline as low as might have been the case without their buying and vice versa hence regulating excessive price fluctuations.
Liquidity: This is the most important function provided by the stock exchanges. The capital investments are generally long term and if shareholder wants their investment back, in a physical scenario, it will result in winding up the company and selling its assets to discharge the money. Investors usually prefer liquidity of their investment. The stock markets facilitate and provide that assurance to investors. These are markets which facilitate buying and selling of securities assuring liquidity of investments which goes to serve the investor's need.
Corporate Governance: As stock exchanges facilitate ownership of companies to be help by a wide and varied scope of owners, companies generally tend to improve management standards and efficiency to satisfy the demands of these shareholders. To safeguard the interest of investors more stringent rules are imposed by public stock exchanges and the government on public corporations when compare to privately owned enterprises. Every stock exchange defined its own rules and regulations for the control of operations of the exchange. Only members are allowed to deal in securities and make transactions. As the members have to transact their business strictly according to the rules, the investors' interests are safeguarded against dishonesty or malpractices. Traded public companies tend to have better management records than privately held companies.
Click here for Related Downloads