Capital Market and Instruments

09/10/2022 0 By indiafreenotes

Capital market refers to facilities and institutional arrangements through which Medium and long-term funds (for a period of minimum 365 days and above), both debt and equity are raised and invested. It provides all with a series of channels through which savings of the community are made available for industrial and commercial enterprises and for the public in general. The capital market consists of development banks, commercial banks and stock exchanges.

A capital market assists an economy by providing a platform to gain funds for business operations, development activities, or wealth enhancement. The functioning of a capital market follows the theory of the circular flow of money.

For example, a firm needs money for business operations and usually borrows it from households or individuals. In the capital market, the money from individual investors or households is invested in a firm’s shares or bonds. In return, investors gain profits as well as goods and services.

The market comprises suppliers and buyers of finance, along with trading instruments and mechanisms. There are also regulatory bodies. Stock exchanges, equity markets, debt markets, options markets, etc., are some capital market examples.

Primary Market

The primary market is for trading freshly issued securities, i.e., first-time trading. It enables an initial public offering. It is also known as the new issues market.

Here, companies raise funds with the help of preferential allotment, rights issue , electronic IPOs, or the pre-selected issue of securities or private placement. Usually, like an investment bank, the intermediary attaches an initial price to the shares. Once the sale materializes, firms take their shares to the stock exchange to facilitate trading between different investors.

Secondary Market

The trading of old securities occurs in the secondary market, which occurs after transacting in the primary market. Both stock markets and over-the-counter trades come under the secondary market. We also call this market the stock market or aftermarket.

Examples of secondary markets are the London Stock Exchange, the New York Stock Exchange, NASDAQ, etc.

Elements of a Capital Market

  • Individual investors, commercial banks, financial institutions, insurance companies, business corporations, and retirement funds are some significant suppliers of funds in the market.
  • Investors offer money intending to make capital gains when their investment grows with time. In addition, they enjoy perks like dividends, interests, and ownership rights.
  • Companies, entrepreneurs, governments, etc., are fund-seekers. For instance, the government issues debt instruments and deposits to fund the economy and development projects.
  • Usually, long-term investments such as shares, debt, government securities, debentures, bonds, etc., are traded here. In addition, there are also hybrid securities such as convertible debentures and preference shares.
  • Stock exchanges operate the market predominantly. Other intermediaries include investment banks, venture capitalists, and brokers.
  • Regulatory bodies have the authority to monitor and eliminate any illegal activities in the capital market. For instance, the Securities and Exchange Commission overlooks the stock exchange operations.
  • The capital market and money market are not the same. Securities exchanged in the former would typically be a long-term investment with over a year lock-in period. Short-term investments trade in the money markets and include a certificate of deposits, bills of exchange, promissory notes, etc.

Functions of Capital Market

  • It mobilizes parties’ savings from cash and other forms to financial markets. It bridges the gap between people who supply capital and people in need of money.
  • Any initiative requires cash to materialize. Financial markets are central to national and economic development as they provide rich sources of funds. For example, the World Bank collaborates with global capital markets to mobilize funds to achieve its goals, such as poverty elimination.
  • The International Bank for Reconstruction and Development (IBRD) has assisted over 70 countries by raising nearly $ 1 trillion since the first bond in 1947. Likewise, a report suggested that the European Union companies need to turn to this market to manage their pandemic balance sheet as banks alone will not suffice.
  • For the participants, the exchange instruments possess liquidity, i.e., they can be converted into cash and cash equivalents.
  • Also, the trading of securities becomes easier for investors and companies. It helps minimize transaction and information costs.
  • With higher risks, investors can gain more profits. However, there are many products for those with a low-risk appetite. In addition, there are some tax benefits obtained from investing in the stock market.
  • Usually, the market securities can work as collateral for getting loans from banks and financial institutions.
  1. Equities:

Equity securities refer to the part of ownership that is held by shareholders in a company.

In simple words, it refers to an investment in the company’s equity stock for becoming a shareholder of the organization.

The main difference between equity holders and debt holders is that the former does not get regular payment, but they can profit from capital gains by selling the stocks.

Also, the equity holders get ownership rights and they become one of the owners of the company.

When the company faces bankruptcy, then the equity holders can only share the residual interest that remains after debt holders have been paid.

Companies also regularly give dividends to their shareholders as a part of earned profits coming from their core business operations.

  1. Debt Securities:

Debt Securities can be classified into bonds and debentures:

  • Bonds:

Bonds are fixed-income instruments that are primarily issued by the centre and state governments, municipalities, and even companies for financing infrastructural development or other types of projects.

It can be referred to as a loaning capital market instrument, where the issuer of the bond is known as the borrower.

Bonds generally carry a fixed lock-in period. Thus, the bond issuers have to repay the principal amount on the maturity date to the bondholders.

  • Debentures:

Debentures are unsecured investment options unlike bonds and they are not backed by any collateral.

The lending is based on mutual trust and, herein, investors act as potential creditors of an issuing institution or company.

  1. Derivatives:

Derivative instruments are capital market financial instruments whose values are determined from the underlying assets, such as currency, bonds, stocks, and stock indexes.

The four most common types of derivative instruments are forwards, futures, options and interest rate swaps:

  • Forward: A forward is a contract between two parties in which the exchange occurs at the end of the contract at a particular price.
  • Future: A future is a derivative transaction that involves the exchange of derivatives on a determined future date at a predetermined price.
  • Options: An option is an agreement between two parties in which the buyer has the right to purchase or sell a particular number of derivatives at a particular price for a particular period of time.
  • Interest Rate Swap: An interest rate swap is an agreement between two parties which involves the swapping of interest rates where both parties agree to pay each other interest rates on their loans in different currencies, options, and swaps.
  1. Exchange Traded Funds:

Exchange-traded funds are a pool of the financial resources of many investors which are used to buy different capital market instruments such as shares, debt securities such as bonds and derivatives.

Most ETFs are registered with the Securities and Exchange Board of India (SEBI) which makes it an appealing option for investors with a limited expert having limited knowledge of the stock market.

ETFs having features of both shares as well as mutual funds are generally traded in the stock market in the form of shares produced through blocks.

 ETF funds are listed on stock exchanges and can be bought and sold as per requirement during the equity trading time.

  1. Foreign Exchange Instruments:

Foreign exchange instruments are financial instruments represented on the foreign market. It mainly consists of currency agreements and derivatives.

Based on currency agreements, they can be broken into three categories i.e spot, outright forwards and currency swap.