Meaning of Capital Market
Capital market is a financial market for long-term securities that includes both debt and equity. Companies and governments can raise long-term funds (more than a year) through this market. The capital market connects the surplus units with the deficit units. It means that the funds are channelized from those who have excess capital to those who need it.
Funds are raised by issuing capital market instruments like stocks and bonds. These instruments have a higher risk than money market instruments. However, at the same time, these instruments generate higher returns. These markets are strictly regulated in order to avoid any fraudulent practices. The Securities and Exchange Commission (SEC) regulates the capital or securities market in the USA.
- Meaning of Capital Market
- Functions of Capital Market
- Types of Capital Market
Functions of Capital Market
The capital market plays an important role in the development of an economy. Let us discuss the functions of these markets for a deeper insight.
The capital market acts as a link between savers and entrepreneurial borrowers. It transfers money from savers (households) to entrepreneurial borrowers (companies who need capital). This way, these markets mobilize savings in an economy and divert them into productive investment. Productive usage of funds paves the way for economic growth and prosperity.
Formation of Capital
Capital formation is the process of increasing the stock of real capital. It includes creating capital goods like factories, machinery, tools, equipment, etc. These capital goods are utilized for the production of other goods. Savings are mobilized through the capital market to various sectors, such as the agricultural sector, industrial sector, etc., in an optimal manner. Optimal allocation increases the rate of capital formation in an economy.
Rapid Economic Growth
The allocation of capital is done optimally for better utilization of scarce resources. Improvement in capital goods increases the efficiency of labor. Superior and technologically advanced capital goods increase overall productivity. This increased productivity enhances economic growth.
Benefits to Investors
In the capital market, investors are provided with an avenue for long-term investments. Most importantly, investors are offered a wide variety of instruments like bonds, mutual funds, insurance policies, equities, etc. This enables investors to diversify and channelize their savings into the most profitable avenues. To protect investors from any unscrupulous activities, these markets are strictly regulated.
Variety of Services
The capital market provides a wide array of services. Services such as underwriting, export finance, consultancy, merchant banking, credit rating, etc., are offered to investors.
Liquidity of Funds
In this market, funds are available for long-term investments. Because of organized stock and other exchanges, both security sellers and buyers are readily available. This makes the capital market a liquid market as funds are available continuously.
Types of Capital Market
Capital Markets are classified into two major markets: Primary Market and Secondary Market.
The market in which securities are issued for the very first time to the investors is known as the Primary Market or the New Issue Market. The main role of the primary market is capital formation.
A company raises capital by issuing securities such as shares or bonds in the primary market. The investors who invest in the new issue of the company become the shareholders of the company. In the primary market, the transactions directly occur between the company and the investors. The money invested by the investors in the primary market directly goes to the company.
A company can raise funds from the primary market through various methods like Public Issue, Private Placement, Right Issue, etc.
Public issue or Initial Public Offering is the process of issuing shares to the public for the first time.
A private placement is the offering of shares to a few selected investors. These selected investors could be mutual funds, venture capital, banks, insurance companies, etc.
Rights Issue or Rights Offer is a way through which a listed company raises capital by offering shares to the existing shareholders. For example, XYZ company comes out with a 1:2 right issue. This means that XYZ shareholders can buy an extra share for every 2 shares they have. Usually, the stocks issued in the form of the right issues are lower priced than the prevailing market price of the share.
Trading of previously issued securities takes place in the secondary market. An Investor can directly buy a share from the seller. The secondary market has a huge volume and magnitude of transactions that affect the primary market.
The secondary market includes both stock exchanges and the over-the-counter market. Some of the popular stock exchanges are the London Stock Exchange (LSE), New York Stock Exchange (NYSE), Bombay Stock Exchange (BSE), etc.
There are two types of a secondary markets. They are the Over-the-Counter market and Dealer Market.
Over the Counter market
Over-the-counter or Off-exchange trading is a form of decentralized trading of securities. Trading of securities takes place directly between the parties. The buyers and sellers openly announce the prices at which they are willing to sell or buy securities. It is less transparent than exchanges.
In the dealer market, the buyers and sellers do not gather in a commonplace physically. The brokers and the dealers act as an intermediary between the buyers and the sellers. A lot of dealers exist in this market. Therefore, due to competition, dealers offer the best price to the investors.
- Debt Market: Meaning, Issuers, Instruments, Advantages, Disadvantages, and More
- Marketable Securities – Meaning, Types, Importance And More
- Equity Market: Meaning, Types, Participants, Procedure, and More
- Factors Affecting Cost of Capital
- Financial Securities
- Financial Intermediaries – Meaning, Functions And Importance