Capital markets, more commonly known as financial markets, connect people and entities, either corporate or governmental, who have money (or “capital”) with people and businesses who need it. There are many types of capital markets, including stock markets, bond markets and commodity markets. Securities are bought and sold on these markets by investors.How Does A Capital Market Work?
A capital market is a place for buying and selling financial products such as stocks, bonds and currency. These markets connect people who have capital and want a profit with corporations and governments that need money from these investors. For example, the stock market, which is one kind of capital market, helps companies that need investors find individuals and institutions with money to invest. The bond market helps institutions looking to borrow money find investors who can extend those loans in exchange for a stream of interest payments.What Kinds of Capital Markets Are There?
Capital markets can come in many different forms and sizes. Stock markets such as the New York Stock Exchange, the NASDAQ or the London Stock Exchange are all examples of capital markets that deal in equities. The Chicago Mercantile Exchange is a capital market dealing in commodities. The most common types of capital markets are:
In a primary market, investors buy financial products directly from the institutions which create them (such as the companies issuing the stocks or the institutions issuing the bonds). All of the capital that moves in a primary market goes to the individual or institution seeking that money.
For example, on a primary bond market the buyer who purchases a bond gets it directly from the institution looking for that loan. On a primary stock market, investors buy shares directly from the company that’s looking for an investment. Companies and other institutions only receive capitalization from the primary market.
It is rare for individuals to participate in primary markets by nature of their sheer size. Most primary market sales involve multi-million-dollar transactions, putting them well beyond the reach of the average investor. Primary markets are, instead, mostly populated by institutions such as banks, investment funds and other large-scale investors.
Most individual investors will participate in secondary markets. On a secondary market, investors buy and sell financial products among themselves. The money that changes hands does not go to the institution seeking capital, but rather is exchanged among investors.
For example, most trades on the stock exchange are considered a secondary market. Here, an individual will own shares of a stock and will sell those shares to another individual. The underlying company neither participates in the transaction nor receives any of the money.Benefits of Secondary Markets
Secondary markets are generally the largest capital markets both by trading volume and by value. Most stock and bond trading that happens, for example, occurs on the secondary market. The only exception is when shares are sold as part of a public offering (when a company creates, issues and sells shares of ownership).
Even though none of the money exchanged on the secondary market directly capitalizes corporations that issue stock or entities that issue bonds, they still derive benefits from secondary market activity. These markets increase liquidity and promote sales on the primary market. When investors buy assets on the primary market, they rarely do so intending to hold those assets for long periods of time. The ability to sell assets on the secondary market for a profit makes it more likely that investors will buy those assets on the primary market, and that they will spend more for them.
Corporations also benefit from secondary markets because changes in the value of securities traded on secondary markets can affect the ability of those entities to borrow money. The higher the share price the greater a corporation’s ability to borrow money (and vice versa). Further, corporations often buy their own shares on the secondary market, which boosts their share price, to lower their cost of capital. That directly affects the ability of corporations to launch capital projects, like building a factory or launching a product line.
Secondary markets also allow for market corrections through their sheer volume of trading. Traders will identify weak business models over time, particularly as information becomes available that might not have been available during a primary market sale. This lets future investors know how to approach a company when it issues new assets on the primary market.
The broader economy benefits from rising share prices because it boosts consumer confidence, which spurs spending. This is sometimes known as the wealth effect.The Bottom Line
Capital markets, also known as financial markets, enable trading of stocks, bonds, currencies and commodities. They come in two varieties, primary and secondary. The former facilitate trades between entities that create securities and buyers, typically large or institutional buyers; the latter facilitate trades among investors, not the entities that created the securities.Capital Market Tips
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