What Is a Capital Market?
A capital market is a financial system that matches investors who have money or savings with those who want to borrow funds.
In addition, capital markets include other types of securities, including currencies and commodities such as gold and oil.
Capital markets benefit the economy by encouraging the efficient allocation of risk among participants in a competitive environment.
The term “financial markets” may actually be more accurate than “capital markets.” Securities are sold not just by companies but also by governments and others.
Understanding How Capital Markets Work
Capital markets play a crucial role in society, providing companies with the money to grow, mature businesses with new capital for expansion, and private citizens with opportunities to invest in financial instruments.
Companies typically raise capital by issuing stock or bonds through an investment bank, which then makes these securities available for purchase by investors on a public exchange like the New York Stock Exchange (NYSE) or over-the-counter.
The role of capital markets is to match savers and borrowers. Lenders that have extra funds can put them to work in investments that will provide a return that is larger than the interest they would earn from a savings account.
Individuals, corporations, and governments all borrow money for various reasons – purchasing equipment or funding new projects, expanding production capacity, entering new markets, reducing financial risk, etc.
Conversely, lenders receive interest on their loaned capital or dividends from shares of stock.
Capital markets allow these transactions to take place on a large scale by bringing together those who have money to lend with those who need it.
Types of Capital Markets
In a stock market, investors buy or sell shares of publicly traded companies.
Investors buy shares because they hope the company will succeed and the stock price will rise, increasing the market value of their investment.
Companies list shares on exchanges so they can raise capital to fund expansion or projects. They also do so to give investors an opportunity to buy or sell securities with relative ease through brokers who are members of that exchange.
In a bond market, lenders provide funds to borrowers by buying their bonds for cash or by purchasing them via a broker with the understanding that they will be repaid with interest at a later date along with the original loan amount.
Individuals use bond markets when looking for safe investments that pay more than money in savings accounts or CDs.
In a commodity market, investors buy commodities such as gold, oil, and wheat to gain value through future price appreciation.
Commodities are raw materials that can be bought and sold via futures contracts or options on futures contracts.
Foreign Exchange (Forex) Markets
The forex market enables companies to purchase foreign currencies at specified prices for the purpose of making international purchases or sales, transferring funds across international borders, hedging exchange rate risk on investments in foreign countries, etc.
Currency values fluctuate relative to one another, providing players in this market with opportunities to make money buying low and selling high.
Primary vs Secondary Capital Markets
A primary market is one in which securities are first offered to the public through an initial public offering (IPO).
Companies that want more capital than they can raise from private individuals often go public and sell shares of their stock on a stock exchange, such as the NYSE. The company gets cash and buyers get stocks or bonds in a promising company.
After its IPO, a stock may also be traded over-the-counter on what is called secondary markets. Customers on these exchanges buy and sell stocks among themselves rather than trade them directly with the issuing company or other investors/members of the exchange.
The SEC regulates both primary and secondary markets.
Capital markets are key to a healthy economy because they allow an efficient allocation of capital and provide liquidity. Liquidity refers to the ability of a market maker or investor to easily buy or sell a security without moving the price significantly, as well as the ease with which the security can be converted into cash.
When capital markets function well, they drive economic growth and development.
About the Author
True Tamplin, BSc, CEPF®
True Tamplin is a published author, public speaker, CEO of UpDigital, and founder of Finance Strategists.
True is a Certified Educator in Personal Finance (CEPF®), contributes to his financial education site, Finance Strategists, and has spoken to various financial communities such as the CFA Institute, as well as university students like his Alma mater, Biola University, where he received a bachelor of science in business and data analytics.