What are Capital Markets?
A capital market is a place that allows the trading of funding instruments such as shares, debentures, debt instruments, bonds, ETFs, etc. It is a source for raising funds for individuals, firms, and governments.
The securities exchanged here would typically be a long-term investmentLong-term InvestmentLong Term Investments are financial instruments such as stocks, bonds, cash, or real estate assets that a company intends to hold for more than 365 days in order to maximize profits and are reported on the asset side of the balance sheet under the heading non-current assets. with over a year lock-in period. On the other hand, short-term investmentsShort-term InvestmentsShort term investments are those financial instruments which can be easily converted into cash in the next three to twelve months and are classified as current assets on the balance sheet. Most companies opt for such investments and park excess cash due to liquidity and solvency reasons. are usually found in the money marketMoney MarketThe money market is a financial market wherein short-term assets and open-ended funds are traded between institutions and traders..
Table of Contents
- A capital market provides individuals and firms with an avenue to raise funds for their needs and wants. It is of two types – primary marketPrimary MarketThe primary market is where debt-based, equity-based or any other asset-based securities are created, underwritten and sold off to investors. It is a part of the capital market where new securities are created and directly purchased by the issuer. and secondary marketSecondary MarketA secondary market is a platform where investors can easily buy or sell securities once issued by the original issuer, be it a bank, corporation, or government entity. Also referred to as an aftermarket, it allows investors to trade securities freely without interference from those who issue them..
- The market plays a crucial role in economic development. It mobilizes savings from individuals, banks, financial institutionsFinancial InstitutionsFinancial institutions refer to those organizations which provide business services and products related to financial or monetary transactions to their clients. Some of these are banks, NBFCs, investment companies, brokerage firms, insurance companies and trust corporations. , real estate, and gold, thus diverting savings from unproductive channels to productive areas.
- Commercial banksCommercial BanksA commercial bank refers to a financial institution that provides various financial solutions to the individual customers or small business clients. It facilitates bank deposits, locker service, loans, checking accounts, and different financial products like savings accounts, bank overdrafts, and certificates of deposits., financial institutions, individual investors, insurance companies, business corporations, and retirement funds are the major suppliers of funds in the market.
- There are usually long-term investments here, such as shares, shares, debt, government securities, debentures, bonds, etc. Stock exchangesStock ExchangesStock exchange refers to a market that facilitates the buying and selling of listed securities such as public company stocks, exchange-traded funds, debt instruments, options, etc., as per the standard regulations and guidelines—for instance, NYSE and NASDAQ. operate the market predominantly.
How Does a Capital Market Work?
A capital market assists an economy by providing a platform to gain funds for business operations, development activities, or wealth enhancement. The functioning of a capital market follows the theory of the circular flow of money.
For example, a firm needs money for business operationsBusiness OperationsBusiness operations refer to all those activities that the employees undertake within an organizational setup daily to produce goods and services for accomplishing the company's goals like profit generation. and usually borrows it from households or individuals. In the capital market, the money from individual investors or households is invested in a firm’s shares or bonds. In return, investors gain profits as well as goods and services.
The market comprises suppliers and buyers of finance, along with trading instruments and mechanisms. There are also regulatory bodies. Stock exchanges, equity marketsEquity MarketAn equity market is a platform that enables the companies to issue their securities to the investors; it also facilitates the further exchange of these stocks between the buyers and sellers. It comprises various stock exchanges like New York Stock Exchange (NYSE)., debt markets, options markets, etc., are some capital market examples.
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Types of Capital Market
#1 – Primary Market
The primary market is for trading freshly issued securities, i.e., first-time trading. It enables an initial public offering. It is also known as the new issues market.
Here, companies raise funds with the help of preferential allotment, rights issueRights IssueThe term "right issue of shares" refers to the offering of shares to all existing Equity or Preference shareholders of the Company in proportion to their current shareholding in the Company., electronic IPOs, or the pre-selected issue of securities or private placementPrivate PlacementPrivate placement of shares refers to the sale of shares of the company to the investors and institutions selected by the company, which generally includes banks, mutual fund companies, wealthy individual investors, insurance companies.. Usually, like an investment bank, the intermediary attaches an initial price to the shares. Once the sale materializes, firms take their shares to the stock exchange to facilitate trading between different investors.
#2 – Secondary Market
The trading of old securities occurs in the secondary market, which occurs after transacting in the primary market. Both stock markets and over-the-counter trades come under the secondary market. We also call this market the stock market or aftermarket.
Examples of secondary markets are the London Stock Exchange, the New York Stock Exchange, NASDAQ, etc.
Elements of a Capital Market
- Individual investors, commercial banks, financial institutions, insurance companies, business corporations, and retirement funds are some significant suppliers of funds in the market.
- Investors offer money intending to make capital gains when their investment grows with time. In addition, they enjoy perks like dividendsDividendsDividends refer to the portion of business earnings paid to the shareholders as gratitude for investing in the company’s equity., interests, and ownership rights.
- Companies, entrepreneurs, governments, etc., are fund-seekers. For instance, the government issues debt instrumentsDebt InstrumentsDebt instruments provide finance for the company's growth, investments, and future planning and agree to repay the same within the stipulated time. Long-term instruments include debentures, bonds, GDRs from foreign investors. Short-term instruments include working capital loans, short-term loans. and deposits to fund the economy and development projects.
- Usually, long-term investments such as shares, debt, government securities, debenturesDebenturesDebentures refer to long-term debt instruments issued by a government or corporation to meet its financial requirements. In return, investors are compensated with an interest income for being a creditor to the issuer., bondsBondsBonds refer to the debt instruments issued by governments or corporations to acquire investors’ funds for a certain period., etc., are traded here. In addition, there are also hybrid securitiesHybrid SecuritiesHybrid securities are the combined characteristics of two or more types of securities, usually both debt and equity components. These securities allow companies and banks to borrow money from investors and facilitate a different mechanism from the bonds or stock offering. such as convertible debentures and preference shares..
- Stock exchanges operate the market predominantly. Other intermediaries include investment banks, venture capitalists, and brokers.
- Regulatory bodies have the authority to monitor and eliminate any illegal activities in the capital market. For instance, the Securities and Exchange Commission overlooks the stock exchange operations.
- The capital market and money market are not the same. Securities exchanged in the former would typically be a long-term investment with over a year lock-in period. Short-term investments trade in the money markets and include aA certificate of deposit (CD) is an investment instrument mostly issued by banks, requiring investors to lock in funds for a fixed term to earn high returns. CDs essentially require investors to set aside their savings and leave them untouched for a fixed period. certificate of depositsCertificate Of DepositsA certificate of deposit (CD) is an investment instrument mostly issued by banks, requiring investors to lock in funds for a fixed term to earn high returns. CDs essentially require investors to set aside their savings and leave them untouched for a fixed period., bills of exchangeBills Of ExchangeBills of exchange are negotiable instruments that contain an order to pay a certain amount to a particular person within a stipulated period of time. The bill of exchange is issued by the creditor to the debtor when the debtor owes money for goods or services., promissory notesPromissory NotesA promissory note is defined as a debt instrument in which the issuer of the note promises to pay a specified amount to a party on a particular date., etc.
Functions of Capital Market
- It mobilizes parties’ savings from cash and other forms to financial markets. It bridges the gap between people who supply capital and people in need of money.
- Any initiative requires cash to materialize. Financial markets are central to national and economic development as they provide rich sources of funds. For example, the World Bank collaborates with global capital markets to mobilize funds to achieve its goals, such as poverty elimination.
- The International Bank for Reconstruction and Development (IBRD) has assisted over 70 countries by raising nearly $ 1 trillion since the first bond in 1947. Likewise, a report suggested that the European Union companies need to turn to this market to manage their pandemic balance sheet as banks alone will not suffice.
- For the participants, the exchange instruments possess liquidityLiquidityLiquidity is the ease of converting assets or securities into cash., i.e., they can be converted into cash and cash equivalentsCash And Cash EquivalentsCash and Cash Equivalents are assets that are short-term and highly liquid investments that can be readily converted into cash and have a low risk of price fluctuation. Cash and paper money, US Treasury bills, undeposited receipts, and Money Market funds are its examples. They are normally found as a line item on the top of the balance sheet asset. .
- Also, the trading of securities becomes easier for investors and companies. It helps minimize transaction and information costs.
- With higher risks, investors can gain more profits. However, there are many products for those with a low-risk appetite. In addition, there are some tax benefits obtained from investing in the stock market.
- Usually, the market securities can work as collateral for getting loans from banks and financial institutions.
- Investments in shares and mutual fundsMutual FundsA mutual fund is a professionally managed investment product in which a pool of money from a group of investors is invested across assets such as equities, bonds, etc are deemed risky as the investment is highly volatile due to market fluctuations. Therefore, there is a massive chance of losing money to market risksMarket RisksMarket risk is the risk that an investor faces due to the decrease in the market value of a financial product that affects the whole market and is not limited to a particular economic commodity. It is often called systematic risk..
- Market fluctuations risk one’s investments and hinder a fixed incomeFixed IncomeFixed Income refers to those investments that pay fixed interests and dividends to the investors until maturity. Government and corporate bonds are examples of fixed income investments.. Those who are investing their hard-earned savings, such as retired employees and senior citizens, will prefer the safety of their funds to high earningsEarningsEarnings are usually defined as the net income of the company obtained after reducing the cost of sales, operating expenses, interest, and taxes from all the sales revenue for a specific time period. In the case of an individual, it comprises wages or salaries or other payments..
- With the wide range of investment alternatives present in the market, an investor may not make a fruitful choice without professional advice.
- Trading of securities may involve a brokerage feeBrokerage FeeA brokerage fee refers to the remuneration or commission a broker obtains for providing services and executing transactions based on client requirements. It is usually charged as a percentage of the transaction amount., commission, etc., increasing the cost of transactions.
Most markets are not perfectly efficient. The capital market is no exception, but to some extent, the prices of securities reflect that they have incorporated the current information in the market.
A capital market is where individuals and firms borrow funds using shares, bonds, debentures, debt instruments, etc. The most common example is a stock exchange such as NASDAQ, trading shares from different companies amongst investors.
They are of two types –
• Primary market – deals with fresh stocks.
• Secondary market – trading with old securities.
This article has been a guide to the capital market and its meaning. Here we discuss its functions, types of capital markets, and advantages and disadvantages. You can learn more about financing from the following articles –