The capital market, also known as the securities market, is a marketplace where investors' cash are made available to businesses and governments for project development.
Similarly, if a firm needs money to grow its operations, it can issue shares in the stock market, which investors can purchase.
The bond market and the securities market are both part of the capital market.
It acts as a pathway for surplus funds to be moved to organizations that require financing for their operations. These funds are being invested in a variety of profitable sectors by the companies.
In this blog, we'll go through the functions of the capital market and the five types of instruments that are exchanged there.
What are the Functions of the Capital Market?
The capital market is the finest source of funding for businesses since it provides a variety of investment options for all investors, allowing them to build capital.
The main functions of the capital market are:
- The capital market serves as a conduit between savers and investors.
- It aids in the movement of capital to more productive locations in order to increase national GDP.
- It contributes to the expansion of the economy.
- It aids in the mobilization of savings for long-term investment finance.
- It makes it easier to trade securities.
- It lowers the cost of transactions and information.
- It aids in the valuation of financial instruments in a timely manner.
- It provides market risk hedging through derivative trading.
- It aids in the settling of transactions.
- It enhances the efficiency with which capital is allocated.
- It ensures that finances are available to businesses and the government at all times.
What Are The Types Of Capital Market?
The Primary Market and the Secondary Market are the two types of capital markets
1. Primary Market
The primary market is a new issue market where new securities are primarily issued. It is a location where financial instruments are traded for the first time, commonly known as an Initial Public Offering (IPO).
Functions Of Primary Market
Let us now look at the primary market's key functions:
- Origination: In the primary market, origination refers to the examination, evaluation, and process of new project ideas.
- Underwriting: Underwriting firms guarantee the success of new issues by requiring a minimum subscription. When an issue remains unsold, the underwriters purchase it.
- Distribution: Generally, the duty of distribution is provided to brokers and dealers who have direct contact with investors in order to ensure the success of the issue.
2. Secondary Market
The secondary market is a type of capital market where trading takes place for existing securities. It is called the stock market, and it is where investors buy and sell securities
Functions Of The Secondary Market
Let's take a look at the secondary market's key functions:
- It informs the public on a regular basis about the value of security.
- It provides investors with liquidity for their investments.
- It entails continuous trading.
- It acts as a marketplace for the trading of securities.
Capital Market Instruments
Capital market instruments can be simply defined as the instruments used for trading in the different types of capital market.
What Are The Instruments Traded In The Capital Market?
The five types of instruments traded in the capital market are listed and explained below:
The portion of a company's ownership held by shareholders is referred to as equity securities. In simple terms, it refers to a financial investment in the company's equity stock in order to become a shareholder.
The key difference between equity and debt holders is that equity holders do not get regular payments, but they can profit from capital gains by selling their holdings.
In addition, equity holders receive ownership rights and become one of the company's owners.
When a business declares bankruptcy, equity holders can only share the remaining interest after debt holders have been paid. Companies also pay dividends to their shareholders on a regular basis as a result of earned earnings from their core business operations.
2. Debt Securities
Bonds and debentures are two types of debt securities. They will be briefly explained below
Bonds are fixed-income securities issued by the federal government, state governments, municipalities, and even private corporations to fund infrastructure development and other initiatives.
It's a loaning capital market instrument, with the bond's issuer serving as the borrower. Bonds, in general, have a set lock-in duration. As a result, bond issuers must return bondholders the principal amount on the maturity date.
Debentures, unlike bonds, are unsecured investment options with no collateral backing. Investors operate as potential creditors of an issuing institution or business, and the lending is based on mutual trust.
Derivative instruments are capital market financial instruments with underlying assets such as currency, bonds, stocks, and stock indexes that determine their value.
Types Of Derivatives Instruments
The four types of derivative instruments are forwards, futures, options and interest rate swaps. Each of these four types of derivatives instruments will be explained below:
- Forward: A forward is a contract between two parties in which the exchange occurs at a specific price at the end of the contract.
- Future: A future is a derivative transaction in which derivatives are exchanged at a predetermined price at a future date.
- Options: An option is a contract between two parties in which the buyer has the right to buy or sell a specific number of derivatives at a specific price for a specific period of time.
- Interest Rate Swap: An interest rate swap is a contract between two parties in which both parties agree to pay each other interest rates on their loans in different currencies, options, and swaps.
4. Exchange-Traded Funds
Exchange-traded funds are a collection of numerous investors' financial resources that are pooled to buy various capital market instruments such as stocks, bonds, and derivatives.
Most ETFs are registered with the Securities and Exchange Commission (SEC), making them an enticing alternative for investors with a limited understanding of the stock market.
ETFs with characteristics of both shares and mutual funds are commonly traded in the stock market as shares produced through blocks. ETF funds are traded on stock exchanges and can be purchased and sold as needed during stock market hours.
5. Foreign Exchange Instruments
Financial instruments traded on the foreign exchange market are known as foreign exchange instruments. Currency agreements and derivatives make up the majority of it. They can be divided into three groups based on currency agreements: spot, outright forwards, and currency swap.
The capital market encompasses all five types of instruments. They are traded in a variety of ways because each one is unique and has distinguishing characteristics. As a result, it's critical to comprehend the different types of capital market instruments so that you can invest in them in accordance with your financial objectives.