What Are Capital Markets and How Do They Work?

What Are Capital Markets?

Capital markets are channels where savings and investments are channeled between suppliers and those in need. Suppliers include banks and investors, while those who seek capital are businesses, governments, and individuals. The most common capital markets are the stock market and the bond market. They aim to improve transactional efficiencies by connecting suppliers with those seeking capital and facilitating the exchange of securities.

Key Takeaways

• Capital markets are venues where funds are exchanged between suppliers and those who seek capital.
• Suppliers in capital markets are banks and investors, while those who seek capital are businesses, governments, and individuals.
• Capital markets sell various financial instruments, such as equities and debt securities.
• These markets are divided into primary and secondary markets.
• The well-known capital markets include the stock market and the bond market.

Understanding Capital Markets

Capital markets encompass in-person and digital spaces where entities trade different financial instruments. These venues, including the stock market, bond market, and forex markets, are primarily located in major financial centers. Capital markets consist of capital suppliers and users. Suppliers include households, pension funds, insurance companies, foundations, and non-financial companies with excess cash. Users of capital include home and vehicle purchasers, non-financial companies, and governments financing infrastructure investments and expenses.

Capital markets primarily sell equities (ownership shares in a company) and debt securities (such as interest-bearing bonds). These markets are categorized as primary markets (where new stock and bond issues are sold) and secondary markets (where existing securities are traded).

Capital markets play a crucial role in moving money from suppliers to those who need it for productive use.

Primary vs. Secondary Markets

Primary Market

A company publicly sells new stocks or bonds for the first time in the primary capital market, often through an initial public offering (IPO). The issuing company hires an underwriting firm to review the securities and create a prospectus outlining their price and other details. All issues in the primary market must adhere to strict regulations, including filing statements with the SEC. Small investors are often unable to participate due to the focus on large investors. Marketing the sale to investors may include roadshows where investment bankers and company leaders meet potential investors.

Secondary Market

The secondary market is overseen by regulatory bodies like the SEC and involves trading previously issued securities among investors. The issuing company does not have a direct part in the secondary market. Examples of secondary markets include the New York Stock Exchange and Nasdaq. The secondary market can be categorized as an auction market (with open outcry trading) or a dealer market (where people trade through electronic networks).

Are Capital Markets the Same as Financial Markets?

While there may be some overlap, there are fundamental distinctions between these two terms. Financial markets encompass various venues where people and organizations exchange assets, securities, and contracts, and can include secondary markets. Capital markets, however, primarily facilitate the raising and allocation of funding for firms.

What Is a Primary vs. Secondary Market?

New capital is raised through stocks and bonds issued in the primary market, while the secondary market involves the buying and selling of already-issued securities among traders and investors.

Which Markets Do Firms Use to Raise Capital?

Companies can raise equity capital through private placements or initial public offerings on the stock market. Debt capital can be raised through bank loans or bond market securities.

The Bottom Line

Capital markets play a vital role in facilitating the flow of capital. They bring together capital suppliers and those who need it, including governments, businesses, and individuals. Capital markets are divided into primary and secondary markets, allowing companies to list new issues and investors to trade existing securities. The main benefit of these markets is enabling the transfer of funds to support various purposes.