The stock exchange is a pivotal institution in the capital market that marshals resources for economic activities. It absorbs savings and provides liquidity for investments, helps reduce investment risks, offers transparency for investments and encourages entrepreneurship. Economic development requires commitment to long-term investment. The stock exchange provides long-term capital for major sectors of the economy including businesses and the government. Stock exchange indexes are often used as an indicator of economic health.
At any stage of development, various sectors of the economy need long-term capital to grow. For example, the business sector needs capital to invest in new production facilities or revamping existing plants. Likewise, governments need funds for infrastructure investments. These types of investments require long-term capital commitment and are provided by a properly functioning stock exchange.
Without the existence of a liquid stock exchange, investors are reluctant to tie up their money in long-term investments. A liquid stock exchange helped the industrial revolution; without it savers would have been unwilling to commit to long-term projects that were necessary in the early phase of the industrial revolution. Liquidity gives the investors in publicly-traded shares the peace of mind that they can sell their shares whenever they want to exit their investments. At the same time, investors in privately-held shares need to wait until their investments generate returns.
Transparency and Value Creation
A properly functioning stock exchange encourages investment and helps create value for investors. To make sound decisions, investors require reliable information about investment opportunities and their quality. A functioning stock exchange generates and disseminates information about publicly-traded companies. Stock prices reflect the company's performance and available information. Additionally, long-term investments require investors to relinquish direct control over their money. In this situation, investors need guarantees that the managers of the investments sincerely work to create value for investors. A developed stock exchange helps this in two ways. Firstly, compensating managers based on stock performance or in company shares aligns the interests of managers with investors. Secondly, in a liquid stock exchange, the opportunity for others to take over a company gives the management an incentive to maximize value for investors. In other words, other agents will take over the enterprise and turn it around for better value creation if the managers do not perform well.
A liquid stock exchange provides an opportunity for investors to diversify their financial investments across different economic activities and spread their risks. Additionally, they have limited liability in their investments and have no obligations to continue investing in failing ventures. Existence of risk reduction mechanisms can spur more investments.
Financiers of start-up companies can transform their privately-held shares into tradeable securities through the normal mechanism of a stock exchange. This helps them exit and liquidate their investments in previous ventures and reinvest in new opportunities. The existence of an exit mechanism encourages investment in a venture at an early stage.
Video of the Day
- Duncan Smith/Photodisc/Getty Images