What is Capital Market?

If you are a novice at investing, this article on capital market basics is a must-read. The capital market functions as a critical link between savers and investors with entities that need funds like companies, government, and individuals. The existence of a capital market is essential for an economy to function, why? We will discuss in detail in the article below.

Capital Market Meaning

A capital market is a market for the trading of long-term investments. In other words, it is a marketplace for investments that have a lock-in period greater than a year, or their maturity period is at least more than one year.

The capital market involves the sale and purchase of both equity and debt instruments, including equity shares, debentures, preference shares, secured premium notes, and zero-coupon bonds. It also caters to all forms of lending and borrowing financial transactions.

Let’s learn more about capital markets and explore its functionality. A capital market helps in the mobilisation of savings for financing long-term investments. It also aids in the trading of securities. Also, a capital market reduces transaction and information costs by encouraging the ownership of a broad spectrum of productive financial assets. It facilitates the quick valuation of shares and debentures.

One of the primary functions of a capital market is providing insurance against market volatility and price risk through derivative trading. One of the best things about the capital market is also that it offers a wide range of investment instruments to investors, thereby fostering the creation of capital in the economy.

Security transactions in a capital market are undertaken by participants including both individual entities as well as business institutions. As part of capital market basics, let’s cover the types of capital markets. The capital markets are mainly of two types-Primary and Secondary capital markets.

How Does the Capital Market Work?

Investors purchase and sell financial instruments on the capital market, like stocks and bonds, to raise capital for companies. It operates through stock exchanges and over-the-counter markets.

When a company or government needs money, it issues securities to investors. Investors buy these securities, providing the issuer with capital. In return, investors receive ownership in the company (stocks) or a promise of repayment with interest (bonds).

Securities are traded between investors through brokers on exchanges, where prices are determined by supply and demand. Companies use the capital raised to fund projects, grow their businesses, or for financing operational activities.

Types of Capital Market

Primary capital market

In this type of capital market, companies, governments, and public-sector institutions can raise funds through issued bonds. The primary capital market consists of corporations that raise money through the selling of new stocks through an initial public offering (IPO).

Therefore, in a primary capital market, investors directly purchase shares from a company. Primary markets are characterised by the trade of new issues of stocks and other securities. Apart from IPOs, rights issues, private placement shares, and e-IPOs are also issued in the primary market.

When a company wants to raise capital from the market, it turns to its existing investors. Current shareholders are given an opportunity or privilege to sign up for more shares from the company, usually at a preferential rate. It is an efficient and quick method to raise funds from the market. Some other companies avoid the IPO route because of high incidental costs by placing company shares to selected individual investors. However, these activities also take place in the primary market.

Primary market assists in capital formation, where secondary market is responsible for adding liquidity to the market. Together they constitute and ensure functioning of the capital market.

Read In detail about Primary Market

Secondary capital market

In the secondary capital markets, financial and investment instruments such as stocks, shares, and bonds, among others, are purchased and sold by customers. In a secondary capital market, the chief feature is the exchange and trade of existing or previously-issued securities. Stock exchanges such as the National Stock Exchange (NSE) and the Bombay Stock Exchange (BSE) are examples of secondary capital markets.

Accelerated capital formation, mobilisation of savings, generating long-term capital, the advancement of industrial and economic growth, dynamic channelling of funds, and well-boosted generation of foreign capital are some of the many advantages of capital markets. The existence of the capital market encourages people to invest in productive investment channels, in turn, stimulating industrial and economic development.

Beyond the above classifications, a broad sense of capital market includes a market for any type of financial asset. In a further segregation the capital market includes the following sub-categories.

Read In detail about Secondary Market

Corporate finance market

A market where capital funds are available to non-financial companies. Instruments traded in the corporate finance market are bonds (public and private) and equities (common and preferred).

Financial services

It is a marketplace restricted to specific players like investment banks, private equity firms, and venture capital firms.

Public market

The public market is open for general investors, brokers, stock exchanges – regulated by a governing body.

Elements of a Capital Market

• Sources of funds: Individual investors, financial institutions, insurance companies, businesses, commercial banks, and retirement funds provide capital to the market.
• Investor objectives: Investors aim to grow their capital, earn dividends, receive interest, and enjoy ownership rights over time.
• Fund-seekers: Companies, entrepreneurs, and governments seek funds to finance operations, projects, or development. Governments, for example, issue bonds to raise money for economic growth.
• Long-term investments: The market primarily deals with long-term instruments such as stocks, bonds, debentures, and government securities. Hybrid securities like convertible debentures and preference shares are also available.
• Market intermediaries: Stock exchanges are the primary operators, supported by brokerage firms, investment banks, and venture capitalists.
• Regulatory oversight: Regulatory bodies, like the Securities and Exchange Commission, monitor market activities and ensure operations are legal and transparent.

Functions of Capital Market

• Capital allocation: It efficiently allocates capital to companies and governments that need funding for projects and growth.
• Price determination: Through trading on exchanges, it utilises supply and demand to determine securities prices.
• Facilitating liquidity: Investors can buy and sell securities easily, which provides liquidity and allows them to access their investments when needed.
• Risk management: Investors can diversify their portfolios by investing in different securities, reducing risk.
• Promoting economic growth: By providing funding to companies and governments, the capital market fuels economic growth and development.

Examples of Capital Market Instruments 

• Bombay Stock Exchange (BSE) is one of Asia’s oldest stock exchanges, offering trading in stocks, derivatives, and mutual funds with thousands of listed companies.
• National Stock Exchange (NSE), India’s largest stock exchange, is recognised for its NIFTY 50 index, which tracks the top 50 companies.
• The primary market enables companies to raise funds through Initial Public Offerings (IPOs) and Follow-on Public Offerings (FPOs).
• The secondary market facilitates the trading of existing shares, such as those of Reliance Industries and Infosys, on BSE and NSE.
• Corporate bonds are issued by companies like Tata Motors and Reliance Industries to raise funds and can be traded later.
• Government securities, including Treasury Bills and long-term bonds, are issued to finance the government’s budgetary needs.
• Futures and options contracts, based on assets like stocks or indices, are available on NSE for indices such as NIFTY 50.
• Commodity derivatives, including futures contracts for gold, silver, and agricultural products, are traded on platforms like MCX and NCDEX.
• Mutual funds pool investor money to build diversified portfolios of stocks, bonds, and other assets, with leading fund houses like HDFC and ICICI Prudential.
• Foreign Portfolio Investments (FPI) bring liquidity to the Indian market by allowing foreign investors to trade in stocks, bonds, and derivatives.
• Alternative Investment Funds (AIFs), such as venture capital and private equity, cater to high-net-worth individuals and institutions.
• SEBI regulates stock exchanges and mutual funds to protect investors, while RBI manages government securities and foreign exchange markets.

How To Invest in Capital Markets?

• Research: Understand the basics of investing, different types of securities, and the risk-return tradeoff.
• Set investment goals: Determine your financial goals, risk tolerance, and investment timeframe.
• Open an investment account: Choose a brokerage firm and open an investment account to buy and sell securities.
• Diversify: Distribute your money among multiple asset types (stocks, bonds, etc.) to reduce risk.
• Monitor and rebalance: Examine your portfolio frequently and make adjustments as needed to stay aligned with your investment goals.
• Stay informed: Stay informed on economic and market developments to make informed investment decisions.

Conclusion

The capital market plays a vital role in connecting investors with businesses and governments seeking funds. It offers a wide range of instruments like stocks and bonds, making it easier to achieve financial goals while supporting economic growth. Understanding how it works helps you make informed decisions and unlock its potential for long-term wealth creation.

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