FM 7 – Capital Market

TOPIC NO. 1 – INTRODUCTION TO CAPITAL MARKETS

What are Capital Markets?

Capital markets are the exchange system platform that transfers capital from investors who
want to employ their excess capital to businesses that require the capital to finance various
projects or investments.

Capital markets are where savings and investments are channeled between suppliers and
those in need. Suppliers are people or institutions with capital to lend or invest and
typically include banks and investors. Those who seek capital in this market are
businesses, governments, and individuals. Capital markets are composed of primary and
secondary markets. The most common capital markets are the stock market and the bond
market. They seek to improve transactional efficiencies by bringing suppliers together with
those seeking capital and providing a place where they can exchange securities.

KEY TAKEAWAYS

 Capital markets refer to the venues where funds are exchanged between suppliers
and those who seek capital for their own use.
 Suppliers in capital markets are typically banks and investors while those who seek
capital are businesses, governments, and individuals.
 Capital markets are used to sell different financial instruments, including equities
and debt securities.
 These markets are divided into two categories: primary and secondary markets.
 The best-known capital markets include the stock market and the bond markets.
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Understanding Capital Markets

The term capital market is a broad one that is used to describe the in-person and digital
spaces in which various entities trade different types of financial instruments. These
venues may include the stock market, the bond market, and the currency and foreign
exchange (forex) markets. Most markets are concentrated in major financial centers such
as New York, London, Singapore, and Hong Kong.

Capital markets are composed of the suppliers and users of funds. Suppliers include
households (through the savings accounts they hold with banks) as well as institutions like
pension and retirement funds, life insurance companies, charitable foundations, and non-
financial companies that generate excess cash. The users of the funds distributed on
capital markets include home and motor vehicle purchasers, non-financial companies, and
governments financing infrastructure investment and operating expenses.

Capital markets are used primarily to sell financial products such as equities and debt
securities. Equities are stocks, which are ownership shares in a company. Debt securities,
such as bonds, are interest-bearing IOUs.

These markets are divided into two different categories:

 Primary markets where new equity stock and bond issues are sold to investors
 Secondary markets, which trade existing securities

Capital markets are a crucial part of a functioning modern economy because they move
money from the people who have it to those who need it for productive use.

Primary vs. Secondary Markets

Primary Market

When a company publicly sells new stocks or bonds for the first time, such as in an initial
public offering (IPO), it does so in the primary capital market. This market is sometimes
called the new issues market. When investors purchase securities on the primary capital
market, the company that offers the securities hires an underwriting firm to review it and
create a prospectus outlining the price and other details of the securities to be issued.

All issues on the primary market are subject to strict regulation. Companies must file
statements with the Securities and Exchange Commission (SEC) and other securities
agencies and must wait until their filings are approved before they can go public. 1

Small investors are often unable to buy securities on the primary market because the
company and its investment bankers want to sell all of the available securities in a short
period of time to meet the required volume, and they must focus on marketing the sale to
large investors who can buy more securities at once. Marketing the sale to investors can
often include a roadshow or dog and pony show, in which investment bankers and the
company's leadership travel to meet with potential investors and convince them of the
value of the security being issued.
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Secondary Market

The secondary market includes venues overseen by a regulatory body like the SEC where
these previously issued securities are traded between investors. Issuing companies do not
have a part in the secondary market. The New York Stock Exchange and Nasdaq are
examples of secondary markets.

The secondary market has two different categories: the auction and the dealer markets.
The auction market is home to the open outcry system where buyers and sellers
congregate in one location and announce the prices at which they are willing to buy and
sell their securities. The NYSE is one such example. In dealer markets, though, people
trade through electronic networks. Most small investors trade through dealer markets.

Are Capital Markets the Same as Financial Markets?

While there is a great deal of overlap at times, there are some fundamental distinctions
between these two terms. Financial markets encompass a broad range of venues where
people and organizations exchange assets, securities, and contracts with one another, and
are often secondary markets. Capital markets, on the other hand, are used primarily to
raise funding, usually for a firm, to be used in operations, or for growth.

What Is a Primary vs. Secondary Market?

New capital is raised via stocks and bonds that are issued and sold to investors in
the primary capital market, while traders and investors subsequently buy and sell those
securities among one another on the secondary capital market but where no new capital is
received by the firm.

Which Markets Do Firms Use to Raise Capital?

Companies that raise equity capital can seek private placements via angel or venture
capital investors but are able to raise the largest amount through an initial public offering
when shares list publicly on the stock market for the first time. Debt capital can be raised
through bank loans or via securities issued in the bond market.

The Bottom Line

Capital markets are a very important part of the financial industry. They bring together
suppliers of capital and those who seek it for their own purposes. This may include
governments that want to fund infrastructure projects, businesses that want to expand, and
even individuals who want to buy a home. They are divided into two different categories:
the primary market where companies list new issues for the first time and the secondary
market, which allows investors to purchase already-issued securities. The key benefit to
these markets is that they allow money to move from those who have it to those who need
it for their own purposes.
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What Are Financial Markets?

Financial markets refer broadly to any marketplace where securities trading
occurs, including the stock market, bond market, forex market, and derivatives
market. Financial markets are vital to the smooth operation of capitalist
economies.

KEY TAKEAWAYS

 Financial markets refer broadly to any marketplace where the trading of

securities occurs.
 There are many kinds of financial markets, including (but not limited to)
forex, money, stock, and bond markets.
 These markets may include assets or securities that are either listed on
regulated exchanges or trade over-the-counter (OTC).
 Financial markets trade in all types of securities and are critical to the
smooth operation of a capitalist society.
 When financial markets fail, economic disruption, including recession and
rising unemployment, can result.

Understanding the Financial Markets

Financial markets play a vital role in facilitating the smooth operation of capitalist
economies by allocating resources and creating liquidity for businesses and entrepreneurs.
The markets make it easy for buyers and sellers to trade their financial holdings. Financial
markets create securities products that provide a return for those with excess
funds (investors/lenders) and make these funds available to those needing additional
money (borrowers).
The stock market is just one type of financial market. Financial markets are created when
people buy and sell financial instruments, including equities, bonds, currencies, and
derivatives. Financial markets rely heavily on informational transparency to ensure that the
markets set prices that are efficient and appropriate.
Some financial markets are small with little activity, and others, like the New York Stock
Exchange (NYSE), trade trillions of dollars in securities daily. The equities (stock) market is
a financial market that enables investors to buy and sell shares of publicly traded
companies. The primary stock market is where new issues of stocks are sold. Any
subsequent trading of stocks occurs in the secondary market, where investors buy and sell
securities they already own.

Types of Financial Markets

There are several different types of markets. Each one focuses on the types and classes of
instruments available on it.
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a. Stock Markets

Perhaps the most ubiquitous of financial markets are stock markets. These are venues
where companies list their shares, which are bought and sold by traders and investors.
Stock markets, or equities markets, are used by companies to raise capital and by investors
to search for returns.
Stocks may be traded on listed exchanges, such as the New York Stock Exchange
(NYSE), Nasdaq, or the over-the-counter (OTC) market. Most stock trading is done via
regulated exchanges, which plays an important economic role because it is another way for
money to flow through the economy.
Typical participants in a stock market include (both retail and institutional) investors,
traders, market makers (MMs), and specialists who maintain liquidity and provide two-sided
markets. Brokers are third parties that facilitate trades between buyers and sellers but who
do not take an actual position in a stock.
b. Over-the-Counter Markets

An over-the-counter (OTC) market is a decentralized market—meaning it does not have

physical locations, and trading is conducted electronically—in which market participants
trade securities directly (meaning without a broker). While OTC markets may handle trading
in certain stocks (e.g., smaller or riskier companies that do not meet the listing criteria of
exchanges), most stock trading is done via exchanges. Certain derivatives markets,
however, are exclusively OTC, making up an essential segment of the financial markets.
Broadly speaking, OTC markets and the transactions that occur in them are far less
regulated, less liquid, and more opaque.
c. Bond Markets

A bond is a security in which an investor loans money for a defined period at a pre-
established interest rate. You may think of a bond as an agreement between the lender and
borrower containing the loan's details and its payments. Bonds are issued by corporations
as well as by municipalities, states, and sovereign governments to finance projects and
operations. For example, the bond market sells securities such as notes and bills issued by
the United States Treasury. The bond market is also called the debt, credit, or fixed-income
market.
d. Money Markets

Typically, the money markets trade in products with highly liquid short-term maturities (less
than one year) and are characterized by a high degree of safety and a relatively lower
interest return than other markets.
At the wholesale level, the money markets involve large-volume trades between institutions
and traders. At the retail level, they include money market mutual funds bought by individual
investors and money market accounts opened by bank customers. Individuals may also
invest in the money markets by purchasing short-term certificates of deposit
(CDs), municipal notes, or U.S. Treasury bills, among other examples.
e. Derivatives Markets
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A derivative is a contract between two or more parties whose value is based on an agreed-
upon underlying financial asset (like a security) or set of assets (like an index). Rather than
trading stocks directly, a derivatives market trades in futures and options contracts and
other advanced financial products that derive their value from underlying instruments like
bonds, commodities, currencies, interest rates, market indexes, and stocks.
Futures markets are where futures contracts are listed and traded. Unlike forwards, which
trade OTC, futures markets utilize standardized contract specifications, are well-regulated,
and use clearinghouses to settle and confirm trades. Options markets, such as the Chicago
Board Options Exchange (Cboe), similarly list and regulate options contracts. Both futures
and options exchanges may list contracts on various asset classes, such as equities, fixed-
income securities, commodities, and so on.
f. Forex Market

The forex (foreign exchange) market is where participants can buy, sell, hedge, and
speculate on the exchange rates between currency pairs. The forex market is the most
liquid market in the world, as cash is the most liquid of assets. The currency market handles
more than $7.5 trillion in daily transactions, more than the futures and equity markets
combined.1
As with the OTC markets, the forex market is also decentralized and consists of a global
network of computers and brokers worldwide. The forex market is made up of banks,
commercial companies, central banks, investment management firms, hedge funds, and
retail forex brokers and investors.
g. Commodities Markets

Commodities markets are venues where producers and consumers meet to exchange
physical commodities such as agricultural products (e.g., corn, livestock, soybeans), energy
products (oil, gas, carbon credits), precious metals (gold, silver, platinum), or "soft"
commodities (such as cotton, coffee, and sugar). These are known as spot
commodity markets, where physical goods are exchanged for money.
However, the bulk of trading in these commodities takes place on derivatives markets that
utilize spot commodities as the underlying assets. Forwards, futures, and options on
commodities are exchanged both OTC and on listed exchanges around the world, such as
the Chicago Mercantile Exchange (CME) and the Intercontinental Exchange (ICE).
h. Cryptocurrency Markets

Thousands of cryptocurrency tokens are available and traded globally across a patchwork
of independent online crypto exchanges. These exchanges host digital wallets for traders to
swap one cryptocurrency for another or for fiat monies such as dollars or euros.
Because most crypto exchanges are centralized platforms, users are susceptible to hacks
or fraudulent activity. Decentralized exchanges are also available that operate without any
central authority. These exchanges allow direct peer-to-peer (P2P) trading without an actual
exchange authority to facilitate the transactions. Futures and options trading are also
available on major cryptocurrencies.
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The Bottom Line

Financial markets provide liquidity, capital, and participation that are essential for economic
growth and stability. Without financial markets, capital could not be allocated efficiently, and
economic activity such as commerce and trade, investments, and growth opportunities
would be greatly diminished.
Many players make markets an essential part of the economy—firms use stock and bond
markets to raise capital from investors. Speculators look to various asset classes to make
directional bets on future prices. At the same time, hedgers use derivatives markets to
mitigate various risks, and arbitrageurs seek to take advantage of mispricings or anomalies
observed across various markets. Brokers often act as mediators that bring buyers and
sellers together, earning a commission or fee for their services.