Characteristics of a Well-functioning Financial System

A well-functioning financial system has complete markets with effective financial intermediaries and financial instruments allowing:

• Investors to move money from the present to the future at a fair rate of return;
• Borrowers to easily obtain capital;
• Hedgers to offset risks; and
• Traders to easily exchange currencies and commodities.

Well-functioning financial systems are characterized by financial instruments that help people solve financial problems, liquid markets with low trading costs (operationally efficient), timely financial disclosures resulting in market prices that reflect available information (informationally efficient), and therefore prices that move primarily with changes in fundamental value instead of liquidity demands. Well-functioning markets ultimately lead to efficient allocations, which use resources where they are most valuable.

Question

Which of the following is least likely a characteristic of a well-functioning financial system?

1. Instruments that solve financial problems.
2. Market prices that always equal fundamental value.
3. Markets where assets can be easily traded at low cost.

Solution

The correct answer is B.

Informational efficiency in well-functioning financial systems should allow investors to estimate fundamental values and cause price changes to correlate with changes in fundamental value. However, fundamental value estimates in well-functioning financial systems will not necessarily always match actual fundamental value.