What’s it: The capital market is where long-term instruments are traded. Examples include New York Stock Exchange, NASDAQ Stock Market, Shanghai Stock Exchange, Hong Kong Stock Exchange, Tokyo Stock Exchange, Euronext, and London Stock Exchange.
The capital market includes the bond market and the stock market. Through this market, companies raise funds to finance their capital investments. Likewise, the government usually takes on debt by issuing bonds in the capital market.
Businesses raise funds to finance their capital investments. Meanwhile, the government raised funds to finance the deficit.
Various parties invest in the capital market to obtain returns such as coupons, dividends, and capital gains. They may be individuals (we call them retail investors). Others are institutional investors such as insurance companies, pension funds, hedge funds, and investment management firms.
Why is the capital market important?
Conceptually, the capital market facilitates money/funds in the economy to be allocated at its highest use. You, as an investor, get the highest return for the money you allocate. Investing reduces opportunity costs when you hold cash. Your money is more productive because it can generate returns than when you have it or put it under your pillow.
Meanwhile, companies acquire funds for their most productive use. They use it to invest in growing the business. Thus, they can generate more profits in the future.
Likewise, the government uses debt to cover deficits. Governments usually run deficits to stimulate the economy to grow, such as spending on infrastructure, health, and education. These expenditures are essential to the economy because they contribute to an increase in potential output, which in turn will lead to more tax revenues.
The second reason the capital market is important is to increase transaction efficiency. The market is an alternative to borrowing from a bank. In addition, transparency and significant demand-supply potential contribute to reducing information asymmetry.
Likewise, investors and instrument issuers do not need to conduct searches, enter into legal agreements, and complete fund transfers. As a result, capital markets facilitate low transaction costs to generate returns (investors) or to raise funds (companies).
The difference between capital markets, money markets, and financial markets
The capital market is a subset of the financial market. Specifically, it only trades long-term financial instruments.
Meanwhile, financial markets traded other asset instruments. The derivatives market, commodity market, and forex market are examples. The money market is another example.
The money market only facilitates short-term funding needs such as working capital. Instruments in the money market include treasury bills, commercial paper, and banker’s acceptances. Other instruments are certificates of deposit, repurchase agreements, and money orders.
Companies, for example, collect funds from the money market for working capital. They use it for operational costs and to fulfill liquidity, such as paying suppliers or employees.
Meanwhile, the company collects funds from the capital market for long-term investments such as buying machines or building factories. They expect the investment to generate economic returns for more than one year.
What are the two types of capital markets?
The capital market includes the primary market and the secondary market. The primary market is where transactions take place between issuers and investors. Meanwhile, secondary market transactions occur between investors, except when buying back or redemption.
Then, we divide the capital market into two based on the instruments traded:
- Equity market
- Debt market
The equity market trades stocks. It represents an ownership interest in the company. So, when you buy stock in a company, you are the shareholder.
When investing in stock, you can potentially get two returns on your money: dividends and capital gains. Yes, it is potential because the company may not decide to distribute dividends.
The dividend can be a stock dividend or a cash dividend. Meanwhile, capital gains are profits when you can sell shares at a higher price than the purchase price.
Companies raise funds by selling shares to the public because it offers several advantages. First, companies do not need to pay money regularly, like interest in bonds.
Second, it does not contribute to increasing financial leverage because equity does not represent financial obligations.
Third, equity offers financial flexibility in the future. Companies can take on debt to increase capital without fear of being limited by financial leverage.
Conversely, when taking on debt, leverage increases. Thus, its current leverage level limits the company’s ability to add new debt.
To be precise, the capital market only trades debt instruments with maturities of more than one year. So, we must exclude some debt securities such as bills and commercial paper (commercial paper). Both are traded in the money market.
So, the capital market only includes instruments such as bonds. Bonds represent a financial obligation for which the company will pay interest (called the coupon) and, at maturity, the principal.
Paying coupons regularly and principal at maturity is a common feature. Some bonds may not have maturity. We call them perpetual bonds; they pay fixed interest in perpetuity without being redeemed.
Meanwhile, another feature is zero-coupon bonds. As the name suggests, issuers do not pay coupons regularly. Instead, they will only pay the principal when it is due.
So, when you invest in zero-coupon bonds, you will only get capital gains. Issuers discount it heavily when selling it to investors to entice them to buy.
Companies issue debt securities to raise funds and achieve optimal capital structure. The capital structure is optimal when the cost of capital is minimized. Achieving it is essential to maximizing company value.
However, issuing bonds increases financial leverage because the bonds represent a financial obligation. The company’s capacity to increase debt is limited by high financial leverage.
Financial distress is the negative impact if the debt is too large. Interest expenses pile up and must be paid, even when the company is not generating income.
How does the capital market work?
The capital market does not trade goods or services. Instead, it transacts proofs or certificates representing ownership (equity) or financial obligations (bonds). And now, both are mostly paperless.
Transactions in the capital market occur in the primary and secondary markets. In the primary market, transactions take place between instrument issuers and investors. It is the market where the instrument is first sold to the market.
The instrument issuer may be a company. Or, they are the government. They represent the demand side. Companies issue stocks or corporate bonds to fund long-term investments.
Meanwhile, the government issued bonds to cover the budget deficit. The government will take on debt since tax revenues are insufficient to cover expenditures. And issuing bonds is the most common way to do this.
Investors in the primary market represent the supply side. They can come from retail investors and institutional investors. So, they may be individuals, companies, or other organizations such as foundations. Institutional investors include pension funds, insurance, investment management companies, etc.
Organizations under the government, such as the Sovereign Wealth Fund (SWF), usually also take part as investors, especially in the bond market. Likewise, central banks trade government bonds for open market operations, not for profit.
In the primary market, investors buy directly from issuers. And it is a one-time transaction. Then, after buying, the investor might trade it back into the secondary market for a profit.
In the secondary market, transactions are no longer between investors and issuers. Instead, it is between investors and other investors. Thus, demand and supply occur between them and no longer involve the issuer, except in share repurchase transactions or bond redemption.
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