What is Capital Market?
A capital market is a place where investors can buy and sell medium-term and long-term securities. All organisations, institutions and instruments that supply long-term and medium-term financing are included in the capital market. However, it does not include tools and institutions that provide short-term finances up to one year. Capital markets connect buyers and sellers of stocks, bonds, currencies and other financial assets.
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The availability of savings, the correct organisation of its constituent units and the entrepreneurial qualities of its people are all factors in the development of a good capital market in a country. The stock market and the bond market are both part of the capital market.
Features of Capital Market
Some of the most important features of capital market are as follows:
- Link between savers and investment opportunities: The capital market acts as a link between savings and investment opportunities in which they can be invested. The capital market channelises the money from savers to risk-taking borrowers.
- Long-term investment deals: Long-term and medium-term funds are available in the capital market. Capital markets channelise the savings for more than a year.
- Utilises intermediaries: Intermediaries, such as stockbrokers, underwriters to an issue, depository’s participants (such as NSDL and CDSL), are provided a platform through capital market. These intermediaries serve as the working organs of the capital market and are critical components of the capital market.
- Capital formation determinant: The activities of the capital market determine the rate of capital formation in an economy. The capital market provides appealing opportunities to those with excess funds, causing them to invest more and more in the capital market and encourages them to save more for profitable avenues.
- Government regulations and rules: The capital market is free to operate but it is regulated by SEBI and is governed by government policies.
Structure of Capital Market in India
In the capital market, borrowers want money and lenders provide money. The capital market is divided into three segments:
- Government securities market or gilt-edged market regulated by the Reserve Bank of India (RBI)
- Corporate debt market
- Equity market
Let us now study about the components of the Indian capital market.
Government securities market
This market is also known as the gilt-edged market. It mainly deals in government and semi-government bonds. Government securities are certificates or debt obligations issued by the government. These types of securities pay a fixed rate of interest.
Industrial securities market
The industrial securities market deals with the shares and debentures issued by both old and new businesses. This market is further subdivided into two parts: the primary market (called new issues market) and the secondary market (called old issues market).
Development Financial Institutions (DFIs)
These institutions were established primarily to provide medium and long-term financial assistance to the private sector. Industrial Finance Company of India (IFCI), Industrial Investment Bank of India (IIBI), EXIM Bank, SFC, UTI, etc. are among them.
Financial intermediaries
A financial intermediary is an organisation that acts as a link between the investors and the borrowers in order to meet the financial goals of both parties. For example, merchant banks, mutual funds, leasing companies, venture capital firms, etc.
Primary and Secondary Markets
The market that offers a conduit for the issuing of new securities by issuers (Government entities or corporates) to obtain cash is hence known as the Primary Market. The securities (financial instruments) may be issued in many forms, such as stock, debt, etc., at face value, at a discount or premium or both. They could be sold on the local market or the global market.
After a company has sold its offering in the primary market, its securities are traded in the secondary market or on the stock exchanges. Secondary market includes the Bombay Stock Exchange (BSE), the National Stock Exchange (NSE), New York Stock Exchange (NYSE), the London Stock Exchange, Nasdaq, etc. Because small investors are restricted from participating in IPOs, they have a much better chance of trading securities on the secondary market. Anyone who is willing to pay the asking price per share can buy securities in the secondary market.
In the secondary market, the brokers typically purchase securities on behalf of the investors. Prices in the secondary market fluctuate with demand as opposed to the primary market where prices are set before an IPO is issued. Investors have to pay a commission to the broker in order to complete the transaction.
After the IPO is sold out, the sale and purchase of securities takes place without any intervention of the issuing company except in the case of a company stock buyback. The volume of securities traded varies from day to day due to fluctuations in supply and demand. It also has a significant impact on the price.
Individual investors, for example, have been able to purchase Apple stock on the secondary market since the company’s initial public offering (IPO) on December 12, 1980 because Apple no longer participates in the issuance of its stock, investors will essentially deal with one another when trading shares in the company. There are two types of secondary markets: auction markets and dealer markets.
In the open outcry system, buyers and sellers gather at one location and announce the prices at which they are willing to buy and sell their securities. This system is used in the auction market. One such example is the New York Stock Exchange. People trade in dealer markets, on the other hand, via electronic networks. The majority of small investors transact through dealer markets.
Capital Market Instruments
The important instruments used in capital markets are:
Equities
Equity securities refer to the portion of a company’s ownership that is held by the shareholders. In simple terms, it is an investment in a company’s equity stock that allows an investor to become a shareholder. Equity holders do not receive regular payments, but they can make profits from capital gains by selling their stocks. The equity holders gain ownership rights and become co-owners of the business.
When a company declares bankruptcy, equity holders are allowed to receive remaining interest after debt holders have been paid. Companies distribute regular dividends to shareholders as a portion of their earnings from core business operations.
Debt instruments
Bonds and debentures are the two types of debt securities.
- Bonds: Bonds are fixed-income securities issued mainly by government entities, municipalities or companies to fund various development projects such as for development of infrastructure. It is a capital market instrument that lends money with the bond’s issuer acting as the borrower. Bonds typically have a pre-determined lock-in period. As a result, bond issuers must repay bondholders, the principal amount on the maturity date.
- Debentures: Debentures are similar to bonds but these are unsecured investment options. These securities are not backed by any collateral. In such cases, the lending is based on mutual trust as investors act as potential creditors for the company or institution that issues the securities.
Derivatives
Derivatives are capital market financial instruments, the value of which is based on the underlying assets such as currency, bonds, stocks, commodities or stock indices. Forwards, futures, options and interest rate swaps are the four most prevalent types of derivative instruments.
Exchange-Traded Funds (ETFs)
ETFs are collection of money from a number of investors that are pooled together to buy a variety of capital market instruments such as stocks, bonds and derivatives. As most ETFs are registered with the Securities and Exchange Board of India (SEBI), they are a good option for people who are new to the stock market.
ETFs that combine the characteristics of stocks and mutual funds are typically traded on the stock exchange in the form of blocks of shares. ETF funds are traded on stock exchanges and can be bought and sold whenever you need them during normal business hours.
Foreign currency instruments
Foreign exchange instruments are financial instruments that are traded in the international market. It is primarily made up of currency agreements and derivatives. Currency agreements are classified into three types: spot, outright forwards and currency swaps.
Types of Equity Security
As studied earlier, a financial instrument that represents a company’s ownership share is known as an equity security. The holder of the instrument is also entitled to a portion of the issuing organisation’s earnings. Various types of equity securities are as follows:
Common stock
The type of equity that represents a company’s initial investment is known as common shares or common stock. The shareholders receive certain rights to the company’s assets as a result of this equity. The par value of the common stock is recorded, which is the stock’s face value. The total common stock capital is calculated by multiplying the number of outstanding shares by the par value of the stock. To be clear, common stockholders have greater control over the company and its management.
Preferred stock
Preferred stock, also known as preferred shares, is a type of stock that pays a fixed dividend to its shareholders. If the company is wound up, the preferred stockholders will receive all of the money owed to them before the common stockholders. If dividends were suspended due to a problem for preferred shareholders, they are paid first when the company is about to close down.
In fact, the company can change the features of preferred stock to make agreements more appealing to potential investors. There may be provisions for call and convertibility, for example. However, these shares do not grant any rights to the company’s operations or management. Shareholders do not have any voting rights, either. The only advantage is that they will receive dividends regardless of company’s performance.
Contributed surplus
The additional paid-in capital equity, also known as contributed surplus capital equity, collects the additional amount that investors pay for shares above their par value. This account is typically larger than the others and it fluctuates as the company makes gains and losses from stock sales.
Retained earnings
Retained earnings equity account reflects the company’s earnings minus dividend payments to shareholders. Simply put, retained earnings are the portion of a company’s net income that is not distributed as dividends. This can be put towards investments or can be saved for the future.
Treasury stock
Some companies choose to buy back their shareholders’ shares. The repurchased shares are classified as treasury stock when this is done. The amount paid to buy back shares from investors is referred to as a company’s treasury equity. This equity account usually has a negative balance and is used to deduct total equity from the accounts.
Types of Debt
Debt securities are a type of financial asset which provide a steady stream of interest payments to the debt holders. In case of debt securities, the borrower must repay the borrowed principal. The creditworthiness of the borrower determines the interest rate on a debt security.
There are two broad types of debt, namely secured and unsecured. Let us discuss about them in detail as follows:
Secured debt
When a borrower requests a loan, the lender must consider whether the debt will be repaid. Secured debt reduces the risk for lenders as secured debt is backed by an asset or collateral which acts as a loan security. There are two forms of collateral, i.e., cash or property.
It can also be used if borrowers do not make their payments on time. Failure to repay a secured debt can have serious consequences. For example, payments that are not made on time may be reported to credit bureaus. An unpaid debt may also be sent to collections.
Unsecured debt
There is no need for collateral when a debt is unsecured. For example, student loans, credit cards and personal loans. If you do not have any collateral, your credit will certainly play a larger role in determining whether or not you qualify for unsecured debt. Before approving unsecured loans, lenders consider credit reports to evaluate borrowers’ creditworthiness.
