How Do Capital Markets Work?
The financial term for investment funding is “capital.” It should come as no surprise then, that capital markets are places where investors and those seeking funds come together. Specifically, investors fund companies and municipalities via the purchase of equity securities (stocks) and debt securities (bonds).
Capital markets exist to create a free exchange of wealth. They allow investors to leverage the wealth-generating capabilities of larger entities for personal enrichment. Likewise, companies and municipalities can dictate their own capital-raising terms. Capital markets are effectively the basis for free-market economies. Here’s a look at how these markets work and what they’re used for.
What Are Capital Markets?
As mentioned above, capital markets facilitate the transfer of funds between those with capital and those who need it. This can happen through the buying and selling of financial instruments. For example…
- Stock markets involve the buying and selling of stocks, representing company equity.
- Bond markets involve the buying and selling of bonds, which are debt securities.
- Forex (foreign exchange) markets involve currency trade, facilitating international business for companies.
There are other, smaller capital markets. Stocks, bonds and forex represent are most accessible and most prolific markets for investors. Anyone can come to these markets and participate. How people participate in capital markets depends on the exchange of capital. This occurs in primary and secondary markets.
- Primary markets involve a direct transaction. A venture capital firm is an example of an entity that operates through a primary market.
- Secondary markets involve transactions made through a broker. This is how most people participate.
No matter the financial product or the amount of capital involved, capital markets function in the same way. Buyers bring capital to the table; sellers offer incentive to earn that investment. With billions in stocks and bonds traded daily – and trillions in forex – this is how the free market functions.
Some people confuse capital markets with financial markets, but the two aren’t interchangeable. Capital markets, like money markets and commodity markets, are a type of financial market. “Financial market” is the broad term for the markets that govern the broader financial economy.
Types of Securities
The biggest decision an investor needs to make is determining which type of security is most appealing to them. This depends on risk tolerance and the amount of capital they’re willing to invest.
- Debt securities tend to be fixed-income assets like bonds. These are promissory notes from the issuer to the investor. Investors make money by reaping the total amount paid into the security, plus interest payments.
- Equity securities leverage the earning power of the seller. By owning part of the success of a company, investors benefit from increasing share prices. Equity securities have unlimited growth potential. But they also have unlimited downside.
- Hybrid securities combine the traits of debt and equity securities. These include preferred stocks and convertible bonds. They offer flexibility to both the investor and the issuer, depending on the terms and stipulations.
- Derivative securities aren’t fungible securities. Instead, they’re investments based on the value of fungible securities like stocks and bonds. Derivatives aren’t part of capital markets – they belong to a separate market that is based on capital markets.
There’s an increasing and proportionate risk–reward scale in the above securities. Debt securities are safe and generally assured. Conversely, derivative securities are speculative and volatile. Debt offers minimal return on investment; derivative prospects offer major return on investment.
How to Buy, Sell and Trade Securities
The beauty of capital markets is that they’re open. Anyone can invest in them, provided they have the capital. Primary markets are typically open to only those with significant buying power. Secondary markets generally require only a brokerage account. In either case, the scenario is the same: the market exists to exchange capital for financial products that generate wealth.
Buying in secondary markets offers liquidity to buyers. Since they’re not transacting directly with a company, there’s a middle ground. This middle ground is where securities trade between investors. When you log on to your brokerage account to buy or sell stocks or bonds, you’re transacting with other investors in the secondary market.
For those pursuing wealth through primary markets, there are more incentives – but also more barriers. Capital investments are more expensive, but they can result in accessible hybrid securities. As always, there’s also proportional risk and reward.
Key Capital Market Terms to Know
While each market has its own lingo, there are some broad terms investors need to learn as they participate in capital markets.
- Institution: An entity that pools large sums of money to leverage more buying power
- Primary market: Offers direct interaction with the issuer of financial products
- Retail: Everyday investors who purchase securities through a brokerage
- Secondary market: The intermediary exchange between direct sellers and direct buyers
- Securities: Financial products that can represent debt or equity and are tied to an entity.
There are many, many more capital market terms to get to know. The more involved investors become in certain markets, the more they’ll become familiar with them.
The Basic Functions of Capital Markets
Capital markets have many functions. Their primary function is to bridge the gap between companies that need money and investors who have it. This flow of capital allows economies to keep growing and expanding.
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Within each type of capital market, there are even more functions. Individuals grow their wealth and save for retirement through investment in capital markets. Companies can also finance growth by issuing new debt. At all times, the purpose of these markets remains the same: to promote capital liquidity.