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 investment with a lock-in period of over a year. 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 market where institutions and traders trade short-term and open-ended funds. It enables borrowers to readily meet finance requirements through any financial asset that can be readily converted into money, providing an organization with a high level of liquidity and transferability..
- 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 market.
- 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 marketEquity 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 market, options market, etc., are some capital market examples.
Types of Capital Market
#1 – Primary Market
The primary market is a market for trading freshly issued securities, i.e., first time trading. It is also known as the new issues market. It enables initial public offering.
Usually, the intermediary, like an investment bank, 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. Here, companies raise funds with the help of preferential allotment, rights issue, 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..
#2 – Secondary Market
The trading of old securities occurs in the secondary market, which takes place after transacting in the primary market first. We also call this market the stock market or aftermarket. Both stock markets and over-the-counter trades come under the secondary market.
Examples of secondary markets are the London Stock Exchange, the New York Stock Exchange, NASDAQ, etc.
Elements of a Capital Market
- Individual investors, commercial bank, financial institutions, insurance companies, business corporations, and retirement funds are some significant suppliers of funds in the market.
- Investors offer money with the goal to make capital gains when their investment grows with time. In addition, they enjoy perks like dividendDividendDividend is that portion of profit which is distributed to the shareholders of the company as the reward for their investment in the company and its distribution amount is decided by the board of the company and thereafter approved by the shareholders of the company., 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, debentures, bondsBondsA bond is financial instrument that denotes the debt owed by the issuer to the bondholder. Issuer is liable to pay the coupon (an interest) on the same. These are also negotiable and the interest can be paid monthly, quarterly, half-yearly or even annually whichever is agreed mutually., 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 a lock-in period of over a year. Short-term investments trade in the money markets and include certificate of depositsCertificate Of DepositsCertificate of deposit (CD) is a money market instrument issued by a bank to raise funds from the secondary money market. It is issued for a specific period for a fixed amount of money with a fixed rate of interest. It is an arrangement between the depositor of money and the bank., 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 a negotiable instrument that represents the debtor's or the writer's (the maker's) written consent to pay a promised sum to the creditor (the payee) on a specified date., etc.
Functions of Capital Market
- It mobilizes the savings of parties from cash and other forms to financial markets. Thereby, 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 ravaged balance sheet as banks alone will not suffice.
- For the participants, the instruments of exchange possess liquidityLiquidityLiquidity shows the ease of converting the assets or the securities of the company into the cash. Liquidity is the ability of the firm to pay off the current liabilities with the current assets it possesses., 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 attained 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 an investment fund that investors professionally manage by pooling money from multiple investors to initiate investment in securities individually held to provide greater diversification, long term gains and lower level of risks. 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 fee, 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 and 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 the capital market along with advantages and disadvantages. You can learn more about financing from the following articles –