Definition: A capital market is a place where medium to long-term securities are traded. These securities include company shares and different forms of the private sector and government debt. Capital markets, among others, aim to boost transactional efficiencies by creating an avenue for holders and seekers of capital to transact.
The capital market enables companies, governments/nations to carry out expenditures above their current incomes. It also allows individuals, firms (including retail and institutional investors) and countries to lend.
Content: Capital Market
Examples of Capital Markets
Capital markets may include stock markets, bond markets, and derivatives markets. In a broader sense, it can also include currency or foreign exchange markets. These markets are usually located in big cities and major financial centres such as New York, Tokyo, London, Shanghai, Singapore, Toronto, and Hong Kong.
Capital Market Features
Capital market act as an integral part of the economy by ensuring the mobility of funds from the lenders to the borrowers. It possesses the following characteristics:
Both Public and Private Sector Participants: Capital markets provide an avenue for both governments and private investors to exchange funds for various purposes.
Facilitates the Trading of Various Securities: The capital market makes it possible to trade various securities such as the ones mentioned above.
Concerned with only Medium and Long-Term Investments: Funds accessed in capital markets are usually for medium or long-term tenures.
Presence of Third Parties or Intermediaries: Different kinds of intermediaries are active players in the capital market. These include underwriters, brokers, dealers, etc. These intermediaries are crucial for day-to-day operations in the capital market, where they help to facilitate several transactions.
Channelizes Funds: Capital markets have free-market policies and acts as a necessary component of every democratic economy that serves as a mediator between lenders and borrower.
Availability of Huge Resources: Because of the numbers and capacity of its participants, capital markets are sources of huge amounts of developmental and business investment resources.
Adheres to Government Rules and Regulations: Though capital markets are designed to work according to free-market economics, they are still under significant government oversight. They are monitored and controlled by government rules and regulations.
Capital Market Types
Primary and secondary markets together form the capital market. With the digital revolution and increased use of computers, most contemporary primary and secondary markets now operate as computer-based electronic platforms.
A primary market is a place where securities are created. It is thus a market for new securities. These new securities are referred to as primary offerings or initial public offerings (IPOs). The primary market is, therefore, mostly for firms going public for the first time. Issuing companies play an active part in the primary market, called the new issues market.
This is a market for the trading of existing or already-issued securities. It is popularly referred to as the stock market. Unlike the primary market, issuing companies have no role in the secondary market. Examples include the London stock exchange and the New York stock exchange.
Capital Market Instruments
The four widely traded capital market instruments are discussed below:
Equities or Common Stocks
Equities are securities that can only be made available by business firms. They are accessible at both primary and secondary markets. When you invest in equities, you automatically become a permanent shareholder and part-owner in the firm you invested in. This remains the case for as long as you maintain ownership of the stock. As part-owner, you are granted certain rights like voting and occupy positions in the company.
Unlike debts whose interests are scheduled to be paid, dividends due to equity holders have no guarantee of being declared. Hence, equities are considered high-risk instruments and are therefore capable of yielding higher returns. However, since they are regarded as firm owners, equity holders are accorded the least preference should their company be liquidated.
Debt instruments are valuable means of raising funds by governments and companies all over the world. Like equities, they are also available in the primary and secondary markets. The debt is sealed by a trust deed, a contract agreement between the lender and the borrower. The agreement schedules the duration of the debt as well as when interest payments are to be made.
Debt instruments (especially those issued by governments) are considered risk-free, which implies lower returns than other capital market instruments. Lenders receive top preference if the company they lent to is liquidated.
Corporate organizations issue preference shares. Unlike equities, holders of preference shares have no voting power. Their dividend yields are similar to coupon yields from bonds. In the case of liquidation, investors holding preference shares are prioritized only after bondholders.
Instruments in this category are referred to as derivatives because they are derived from other securities (called underlying assets). Among them are asset-backed securities (ABS), options, futures, swaps, etc. They are often peculiar to economies with developed financial and capital markets.
Capital Market Functions/Importance
The capital market is considered to be the heart of a country’s economic system for the following reasons:
- An important source of capital formation
- Allocation of funds from a surplus (lenders) to deficit (borrowers) units
- Facilitates and stimulates investments and infrastructural development
- Promotes economic growth and gross domestic product
- Helps in medium to long-term planning
- Encourages trading in securities
- Helps relatively small companies to expand
- Provides employment and career development opportunities
- Helps to develop the financial system
- Promotes public and private sector co-operation
- Discourages money laundering and capital flight
- Reduces transaction and information cost
- Promotes efficient allocation of resources
- Encourages deficit financing by government
- Provides income investment and commercial banks, insurance companies, mutual funds, investment trust
- Part of education curriculum
- A source of information/data for researchers and scholars
- An indication of a country’s level of development
Comparing Capital and Money Markets
Unlike capital markets that raise medium and long-term funds, money markets are sources of short-term finance such as loans with as short as a 24-hour repayment schedule. While capital market instruments have maturities of at least one year, money market instruments usually mature less than a year. Both the capital market and money market are components of the broader financial market.
When a company sources short-term funds from the money market, such funds are usually used as operating expenses, e.g., payment of staff salaries. But a firm that seeks long-term funds from the capital market most likely intends to use it for income yielding investments such as the acquisition of new production equipment and machinery or construction of new plants. Such capital market investments may require a long time before generating enough income for the loan to be paid back hence their long-term nature.