Financial System

Financial System and Allocation of Capital

It can be argued, that the diversification – the process of helping reduce risk by investing in several different types of funds or securities – works in hand with the capital allocation. As earlier indicated, the financial markets succeed optimum diversification, which in turn results in an optimum allocation of capital.

In a paper (Wurgler J. 2000) it is stated “Economists have long argued that financial markets can improve the allocation of capital across an economy’s investment opportunities”.

Considering the previously mentioned characteristics of the financial markets we can appreciate that theoretically these institutions can direct the surplus units’ capital to the ‘best’ investment opportunities because of the following:

  • Their expertise is the major factor that enables the institution to identify, for instance: a company’s value, its operating performance and consequently, its ability to respond to its obligations and, thus, to lend funds to trustworthy and low risk deficit units.
  • It is also the financial institutions expertise that enables them to diversify the yield through allocation of funds into different projects with different risk profiles. The combination of different investments helps them to manage the variability of returns, commonly referred as “market risk”.

Moreover, as stated in an article (Investors group financial services 2005), “Different types of assets do well during different phases of market cycles”. Thus, it is again the specialization of the financial markets that enables them to recognize the cycle’s phase and allocate accordingly the capital at hand through a balanced portfolio.

The financial markets optimum allocation of recourses is subject to the following preceding conditions:

  • Full information.

Everybody has the same information (even though they can not predict the future perfectly). In other words, the concept of the efficient market as defined in their book (Lumby and Jones 1999) exists, when, for example, in the stock market the market price of a company’s shares rapidly and correctly reflects all relevant information as it becomes available.

  • Known preferences and maximizing behaviour on the part of borrowers and lenders.

Although, as stated by Professor James,[1] in practice, different people have different information and this makes them interact in a ‘sophisticated’ rational way, which is not necessarily rational in the strict “utility-maximizing” sense that is standard in economics and finance. This in turn could lead to a different evaluation of risk.

  • Absence of externalities.

It is assumed that there are no significant differences between private and social marginal costs and returns.

[1] Dow James: Professor of Finance - London Business School.

Manolis Anastopoulos – Assignment: Foundations of Financial Analysis                                      

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