The capital market includes the securities market and the bond market. It serves as a pathway for organisations with surplus funds to transfer those funds to those needing capital to grow their businesses.
What are Capital Markets?
Also known as the securities market, the capital market is where the funds from the investors are made available to the government and companies for developing their projects.
Funding instruments traded in the capital markets include debentures, shares, bonds, debt instruments, ETFs, etc. The securities exchanged here are typically long-term investments.
The capital market includes the securities market and the bond market. Keep reading to learn the different types of capital market, their functions and the various instruments traded here.
What are the Functions of the Capital Market?
Capital market instruments are the best medium for organisational finance and provide various modes of investment to investors building capital.
The primary functions of the capital market are:
- Facilitating the movement of capital to productive areas to augment the national income
- Acting as the link between savers and investors
- Boosting economic growth
- Mobilising savings for financing long-term investments
- Facilitating the trading of securities
- Reducing the information and transaction cost
- Offering hedging against market risks via derivative trading
- Improving the effectiveness of capital allocation
- Facilitating transaction settlement
- Providing continuous availability of funds to the government and companies
What are the Types of Capital Market?
The primary market is a new issue dealing with new securities issues. Trading financial instruments are done here for the first time, also called IPO or Initial Public Offer.
The functions of the primary market are as follows:
- Origination refers to the examination, assessment and process of new project proposals in the primary market. Origination begins before an issue is brought forward in the market with the help of commercial banks.
- Underwriting – The success of the new issues guaranteeing a minimum subscription is ensured by underwriting firms. The underwriters purchase the problems when they remain unsold.
- Distribution – The dealers and brokers typically handle the job of distributing the issue because they are in direct contact with the investors.
The secondary market, also known as the stock market, is where trading occurs for existing securities. The securities are bought and sold here by the investors.
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The primary functions of the secondary market are:
- The security value is regularly informed, and investors are offered liquidity for their assets.
- Provides a marketplace where securities are traded.
What are the Instruments Traded in the Capital Market?
In the capital market, five types of instruments are traded. They are explained below.
Equities refer to the money invested in an organization by purchasing shares in the stock market.
- Equity Shares: Equity shares are part ownership where the shareholders are fractional owners and initiate the maximum entrepreneurial liability related to a trading concern. Equity shareholders reserve the right to vote. However, holders of this instrument rank bottom on the scale of preference in the event of company liquidation because they are considered owners of the enterprise.
- Preference Shares: Preference shares are issued by corporate bodies, and on the scale of preference, the investors rank second when the company goes under. These shares are often treated as debt instruments as they do not confer voting rights to the holders. They also have a dividend payment structured like a coupon or interest paid for bond issues.
Debt securities are financial assets entitling the owners to a stream of interest payments. Borrowers must repay the principal borrowed and are classified into bonds and debentures.
- Bonds: Bonds are fixed-income instruments primarily issued by the state and center governments, municipalities, and organisations for financing infrastructural development and other projects. It is referred to as a loaning capital market instrument, and the bond issuer is the borrower. Typically, bonds carry a fixed lock-in period, and on the maturity date, bond issuers must repay the principal amount to the bondholders.
- Debentures: Debentures are unsecured investment options and not backed by any collateral. The lending is based on mutual trust. Investors act as potential creditors of the issuing company or institution.
Derivatives are capital market financial instruments. Their values are determined by underlying assets like stocks, currency, stock indexes and bonds. The most common types of derivative instruments are:
- Forward: It is a contract between two parties in which the exchange occurs at the end of the contract at a specific price.
- Future: It is a derivative transaction involving the exchange of derivatives on a determined future date at a predetermined price.
- Options: It is an agreement between two parties. Here, the buyer has to right to buy or sell a specific number of derivatives at an exact price for a particular period.
- Interest Rate Swap: An agreement between two parties involving swapping interest rates. Both parties must agree to pay each other interest rates on their loans in different options, currencies, and swaps.
Exchange-traded funds are a pool of financial resources from many investors. These are utilized to purchase different capital market instruments like debt securities (derivatives and bonds), shares, etc.
Most ETFs are registered with the SEBI (Securities and Exchange Board of India). Therefore, it is an appealing option for investors with limited knowledge of the stock market.
In the stock market, ETFs with features of mutual funds and shares are traded as shares produced through blocks. They are listed on stock exchanges, and investors can purchase and sell them according to their requirements during the equity trading.
Foreign Exchange Instruments
Foreign exchange instruments are represented on the foreign market. It primarily consists of derivatives and currency agreements.
They can be broken into three categories – outright forwards, spot, and currency swaps.
How Does a Capital Market Work?
Capital markets assist an economy by offering a platform to gain funds for development activities, business operations, or wealth enhancement. The theory of the circular flow of money impacts the functioning of a capital market.
For instance, a company needs money for business operations and typically borrows it from individuals or households. In the capital market, the money from households or individual investors is invested in a company’s bonds or shares. As a result, investors gain profits and goods and services.
The market comprises suppliers, finance buyers, mechanisms, and trading instruments. There are also regulatory bodies. Some capital market examples are options markets, debt markets, equity markets, stock exchanges, etc.
What is the difference between the money market and the capital market?
Money markets are used for short-term borrowing of assets held for less than a year or a year. On the other hand, capital markets are used for long-term securities that indirectly or directly impact the capital.
Capital markets include the debt market and the equity market.
How to learn about the capital market?
You can learn about the capital market on the Yubi platform or in online courses.
What are the two main types of capital markets?
The two primary types of capital markets are primary and secondary markets.
What is the difference between the primary and secondary markets?
The primary market is where private organisations go public by making their shares available for trading to the public. On the other hand, the secondary market is where investors trade the shares.
How are bonds different from debentures?
The issuer’s collateral or asset backs bonds, but debentures are not backed by collateral or physical assets.
Are capital markets efficient?
Similar to most markets, the capital market is not perfectly efficient. However, the prices of securities reflect they have incorporated the present information available in the market.
What is a capital market, and are there examples?
Capital markets are where firms and individuals borrow funds using bonds, shares, debentures, debt instruments, etc. NASDAQ is the most common example, and it is a stock exchange where shares are traded from different firms amongst investors.