Capital Market is where different financial instruments are traded between various entities. On one side, some entities have much more capital than they require, and on the other side, some entities need capital for various purposes.
Capital markets are used to sell equities (stocks) and debt securities.
What Are Capital Markets?
Capital markets are where savings and investments are channeled between suppliers and those in need. Suppliers are people or institutions with capital to lend or invest, typically including banks and investors. Businesses, governments, and individuals seek capital in this market. Capital markets are composed of primary and secondary markets.
The most common capital markets are the stock and bond markets. They seek to improve transactional efficiencies by bringing suppliers together with those seeking capital and providing a place to exchange securities.
Understanding Capital Markets
The term capital market is a broad term used to describe the in-person and digital spaces in which various entities trade different financial instruments. These venues may include the stock market, the bond market, and the currency and foreign exchange markets. Most markets are concentrated in major financial centers such as New York, London, Singapore, and Hong Kong.
Capital markets are composed of the suppliers and users of funds. Suppliers include households and institutions like pension and retirement funds, life insurance companies, charitable foundations, and non-financial companies that generate excess cash. The users of the funds distributed on capital markets include:
- Home and motor vehicle purchasers.
- Non-financial companies.
- Governments finance infrastructure investment and operating expenses.
Capital markets primarily sell financial products such as equities and debt securities. Equities are stocks, which are ownership shares in a company. Debt securities, such as bonds, are interest-bearing IOUs.
Types of Capital Market
These markets are divided into two different categories:
Primary Market-
The primary market is the market for new shares or securities. A primary market is one in which a company issues new securities in exchange for cash from an investor (buyer). It deals with the trade of new issues of stocks and other securities sold to investors.
Secondary Market-
Secondary market deals with the exchange of prevailing or previously-issued securities among investors. Once new securities have been sold in the primary market, an efficient manner must exist for their resale. Secondary markets give investors the means to resell/ trade existing securities. Another important division in the capital market is based on the nature of security sold or bought, i.e., stock market and bond market.
Instruments traded in the Capital Market
Capital market instruments ensure a seamless flow of funds in an economy. They transfer surplus funds from investors to those in need of capital for expansion and therefore help the economy’s balanced growth by promoting investments and savings.
The capital market has two parts—primary and secondary markets. Companies issue securities for the first time through the IPO on primary markets. At the same time, the trade of already issued securities happens on the secondary market. Capital market instruments are bought and sold in exchange for monetary value.
There are several instruments traded in the capital market. The common ones are as follows:
1) Stocks
Stock is a capital market instrument issued by companies to raise capital. It is also known as equity share. Investment in company stocks gives you ownership and voting rights in the company. The partial ownership in the company extends until you sell the shares in the secondary market or the company liquidates. Also, you become a partner in the company’s profits and losses, and the returns are offered as dividends. The increase in the share value depends on the organization’s performance which impacts the investor’s return. Considered a high-risk instrument, equity has generated higher returns than other instruments in the capital market in the past.
2) Preference shares
Preference shares get preference in the case of dividend payments or liquidation payouts. It means the company has to pay dividends or payouts to preference shareholders before equity shareholders. However, preference shareholders do not enjoy voting rights in the company. Preference shares are typically not traded in the secondary market like equity shares. The types of preference shares include:
- Redeemable: The issuing organization can redeem the preference shares by choosing buyback later.
- Irredeemable: A company can redeem the irredeemable shares only when it liquidates.
- Convertible: An investor can convert these preference shares into equity after a specific time.
According to the Companies Act 2013, Indian companies cannot issue irredeemable preference shares. Instead, they can issue redeemable shares that must be redeemed within 20 years of their issue.
3) Debt
Governments and companies issue debt instruments to finance capital-intensive projects. Issued on primary or secondary markets, debt is a form of borrowing with no ownership rights in the organization. The debt instruments usually have limited tenure, after which the issuing entity has to return the principal amount. The interest payments are made annually, semi-annually, quarterly or monthly. Debt instruments include municipal, government, and corporate bonds/debentures. Debt investments are considered less risky than equity. However, the default risk may be higher if the financial health of the issuing company is not good. So, you must invest in debt instruments after analyzing the financial status of the issuing organization.
4) Derivatives
Derivatives are capital market instruments that derive their value from an underlying asset. The underlying assets can be bonds, stocks, metals, commodities, currency, etc. The trade of these instruments is based more on speculation. However, these can be used for hedging and arbitrage purposes as well. Thus, considered more volatile and riskier than equity, derivatives are suitable for experienced investors in the financial market. Derivatives are traded on the secondary market, and the common ones in India are:
- Future contracts
- Options contract
5) Exchange-traded funds (ETFs)
ETFs are capital market instruments where many investors pool their resources to invest in bonds, equity or gold. Having features of both shares and mutual funds, most ETFs are registered with the Securities and Exchange Board of India (SEBI). Like mutual funds, ETFs are beneficial for investors looking to invest in an index, a basket of stocks or a commodity.
6) Foreign exchange instruments
Foreign exchange instruments are traded on the foreign market. They consist of derivatives and currency agreements. The currency agreements are further categorized into:
- Currency futures
- Currency swaps
- Currency options
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