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.

It is a market for trading securities, which can include stocks and bonds. These high-risk investments pay a return to investors as interest or dividends.

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.

The relative availability of capital drives interest rates up or down, depending on the demand for borrowing.

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

Stock 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.

Bond Markets

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.

Commodity Markets

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.

Final Thoughts

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.

Capital markets can be affected by the state of the economy at large, but they continue to operate 24 hours a day, 5 days a week.
The New York Stock Exchange (NYSE) facilitates trade between buyers and sellers who exchange stocks listed on it. The NYSE also operates as a self-regulatory organization for both brokers who trade on its exchanges and listed companies that have an obligation to disclose certain information to their shareholders.
Initial public offering (IPO) is the first time shares of stock in a company are offered to the public, either directly or through dealers who sell them on commission. An IPO usually offers investors an opportunity to buy shares at a discount from current market prices. The issuing company typically receives cash upfront because it does not have to wait for all the funds raised by the IPO to be disbursed before starting operations. The money can be used immediately, which strengthens its position within the capital structure and affects its risk level.
Capital markets work very similarly around the world because most use central banking systems which operate on similar principles. However, some emerging economies have less developed capital markets due to unstable governments and/or high corruption rates that inhibit transparency and trust between buyers and sellers.
A derivative is a financial security with a value that is reliant upon or derived from an underlying asset or group of assets. This underlying asset could be an index, commodity, interest rate, currency, etc. As opposed to capital markets which focus on helping companies raise funds for operations and expansion by trading equity (stock) securities or debt (bond) securities with investors, derivatives are traded among traders. These instruments allow them to hedge risk or gain exposure to assets they may not have access to any other way. Specific types of derivatives include options, futures contracts & swaps.
True Tamplin, BSc, CEPF®

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.

To learn more about True, visit his personal website, view his author profile on Amazon, his interview on CBS, or check out his speaker profile on the CFA Institute website.