Capital Markets

What are Capital Markets?

Capital markets are the exchange system platform that transfers capital from investors who want to employ their excess capital to businesses that require the capital to finance various projects or investments.

Types of Capital Markets

Capital markets primarily feature two types of securities: equity securities and debt securities. Both are forms of investments that provide investors with different returns and risks and provide users with capital with different obligations.

1. Equity Securities

Equity securities are traded on the stock market and are essentially ownership shares of a business or venture. When you own equity securities of a company, you essentially own a portion of that company and are entitled to any future earnings that the company brings in.

However, the money that you invest in equity securities is not required to be paid back to you by the business.

2. Debt Securities

Debt securities are traded on the bond market and are IOUs that can come in the form of bonds or notes. They essentially represent the borrowing of money that will be paid back at a later date with interest.

Interest is the required compensation that entices lenders to lend their money. The borrowers will take the money today, use it to finance their operations, and pay back the money in addition to a prescribed rate of interest at a later date.

The securities can be bought and sold on two types of markets:

• The primary market is when a company directly issues the securities in exchange for capital.
• The secondary market is when the security holders trade with other investors in a transaction that is separate from the issuing company.

Other Financial Markets

Capital markets specifically relate to equity and debt securities, as these two asset classes allow issuers to raise capital. Capital markets are a subset of the broader financial markets, which feature trading of other securities as well, including:

• Foreign exchange (forex)
• Commodities
• Derivatives

Functions of a Capital Market

Capital markets serve various essential functions within the financial ecosystem.

Allocation of Capital

One of the primary functions of capital markets is the efficient allocation of capital. Investors channel their savings into productive investments, enabling businesses to finance new projects, research initiatives, and operational expansions. This allocation process fosters economic development by directing resources toward ventures with the highest potential returns.

Risk Management

Capital markets offer diverse financial instruments, such as derivatives, which facilitate risk management for investors and businesses. Through options, futures, and swaps, market participants can hedge against adverse price movements, mitigate volatility, and safeguard their investments. By managing risks effectively, capital markets enhance market stability and investor confidence.

Price Discovery

Capital markets serve as platforms for price discovery, where the forces of supply and demand interact to determine asset prices. Through continuous trading and information dissemination, markets reflect investors’ collective expectations, assessments of intrinsic value, and macroeconomic factors. Accurate price discovery ensures that assets are fairly valued, fostering efficient resource allocation.

Facilitation of Economic Growth

By connecting investors with capital-seeking entities, capital markets play a pivotal role in fostering economic growth and innovation. Businesses utilize capital to fund research, develop new technologies, and expand operations, driving productivity gains and job creation. Moreover, access to capital enables entrepreneurs to pursue entrepreneurial endeavors, spurring entrepreneurial activity and fostering a dynamic business environment.

Liquidity Provision

Capital markets enhance liquidity by enabling investors to buy and sell securities freely. Liquid markets ensure that investors can exit positions quickly and at fair prices, promoting market efficiency and reducing transaction costs. Additionally, liquidity facilitates capital formation by attracting investors who seek readily tradable assets, thereby deepening market participation and fostering investor confidence.

Capital Market Transactions

As mentioned earlier, transactions can take place in two types of markets. Both the primary market and the secondary market host such transactions.

As a company matures from a start-up to a larger company, it will usually require capital to finance the expansion of its operations. It will raise the required capital either through equity markets — on a stock exchange — or through debt markets.

The transactions are facilitated by investment bankers, lawyers, and accountants who ensure that the ownership transfer is legally executed and that enough investors are willing to invest their capital into the company.

After the money’s been invested, and securities are issued in exchange, investors can decide to sell their securities on the secondary market to other investors.

The transactions are facilitated either through a centralized exchange — such as the New York Stock Exchange (NYSE) — or facilitated over-the-counter (OTC), which is a decentralized way of trading securities without a central exchange or broker.

Private Capital Markets

The information above refers to public capital markets, which receive more media coverage and attention. Publicly traded securities can be traded by anyone, and there is full disclosure of a public company’s operations. However, there is also a large private market where securities are held privately.

There is less attention and information on private companies, making it difficult to invest in them, especially for smaller investors. In the private markets, there is less liquidity, meaning that it is more difficult to buy and sell securities.

It leads to longer time horizons for investors; in public markets, you can sell a security in a matter of seconds, but in private markets, it can take much longer to find a buyer.

Investors are compensated for the lack of liquidity and lack of information. There are usually much greater returns from private capital markets. From the company’s perspective, it can raise capital without the scrutiny and regulation that comes with being publicly listed.

Capital and Financial Market Products

There are many different capital and financial market products, some of which we referred to earlier:

• Equity securities
• Commodities
• Debt securities
• Foreign exchange
• Derivatives

Each of the above is traded in different markets and exchanges. Some of these are centralized, such as equity securities, foreign exchange, and some derivative securities.

Others are decentralized and traded between market participants without an exchange or a broker, such as debt securities, commodities, and other derivatives.

Derivatives can get complicated, but they represent a huge market as well. They are versatile and can be structured and created to tailor features such as risk and return for other securities.

Capital markets are a staple of the global economy. They provide an arena in which investors looking to invest saved funds in return for compensation. They can funnel their capital towards people and businesses who need the capital now in order to expand. This is the crux of how a capitalist, market-based economy grows.

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Related Readings

Thank you for reading CFI’s guide on Capital Markets. To keep learning and developing your knowledge of financial analysis, we highly recommend the additional resources below:

• Alternative Investment Market (AIM)
• London Stock Exchange (LSE)
• Over-the-Counter (OTC)
• Types of Markets – Dealers, Brokers, Exchanges
• See all capital markets resources
• See all equities resources

Frequently Asked Questions

What are the differences between capital markets and financial markets?

Capital markets represent a subset of financial markets that specifically deal with the buying and selling of equity and debt securities.

Financial markets, on the other hand, encompass a broader range of activities, including commodity markets, derivatives markets, and foreign exchange markets. While capital markets tend to focus on long-term instruments, financial markets encompass both short-term and long-term instruments.

What are the best-known capital markets?

The world’s best-known capital markets are often synonymous with major financial centers where significant trading activity occurs, extensive liquidity prevails, and prominent companies are listed. Here are some of the most renowned capital markets:

• New York Stock Exchange (NYSE): As the largest stock exchange globally by market capitalization, the NYSE is synonymous with Wall Street and is home to numerous blue-chip companies. It’s known for its stringent listing requirements and iconic trading floor.
• NASDAQ: This electronic stock exchange is renowned for its technology-focused listings, including many prominent tech giants like Apple, Amazon, and Microsoft. NASDAQ is known for its electronic trading platform and innovative market structure.
• London Stock Exchange (LSE): The LSE is one of the oldest stock exchanges globally and serves as the primary exchange for European equities. It’s known for its diverse listings, including multinational corporations and financial institutions.
• Tokyo Stock Exchange (TSE): As the largest stock exchange in Japan, the TSE plays a crucial role in Asia-Pacific markets. It’s known for its robust regulatory framework and significant trading volumes in Japanese equities.
• Hong Kong Stock Exchange (HKEX): HKEX is a major hub for trading Chinese and international securities. It’s known for its strategic location bridging East and West markets and its role as a gateway to Mainland China’s capital markets.
• Shanghai Stock Exchange (SSE): As one of China’s primary stock exchanges, the SSE is instrumental in China’s domestic capital market development. It’s known for its role in facilitating capital formation for Chinese companies.
• Euronext: Euronext operates multiple stock exchanges across Europe, including Amsterdam, Brussels, Dublin, Lisbon, Milan, and Paris. It’s known for its diverse listings and pan-European market presence.
• Frankfurt Stock Exchange (FWB): As Germany’s primary stock exchange, FWB is a key player in European capital markets. It’s known for its role in trading German equities and its integration into global financial markets.

These exchanges represent just a fraction of the capital markets worldwide, but they stand out due to their size, liquidity, regulatory frameworks, and global prominence. Investors and businesses alike often turn to these markets for capital raising, trading opportunities, and benchmarking against global indices.