Capital market instruments are financial securities used by entities to raise long-term funds. They include stocks, bonds, and derivatives. They play critical roles in resource allocation, risk management, and price discovery and help businesses and investors hedge against various risks. Their performance often reflects economic health, with price trends serving as key economic indicators.
Capital market instruments are integral to the functioning of financial markets, impacting both the global economy and individual investment strategies.
What are Capital Markets?
Capital markets are financial markets where long-term debt or equity-backed securities are bought and sold. These markets are crucial for the functioning of a modern economy because they facilitate raising capital, trading securities, and investing funds with longer time horizons.
They include:
- Stock Markets - where shares of public companies are traded.
- Bond Markets - where debt instruments such as government, corporate, and municipal bonds are traded.
Capital markets differ from money markets, which deal with short-term funds and securities with maturities of less than one year.
What are the Types of Capital Markets?
Capital markets are categorized based on the types of securities traded and the nature of the securities themselves.
They can be broadly divided into two main types:
Primary Market
In the primary market, new securities are issued and sold for the first time. Companies, governments, and other entities use the primary market to raise new capital by issuing new stocks (in initial public offerings, or IPOs) and bonds. The funds raised from sales in the primary market go directly to the issuer, minus any fees paid to the underwriters and other parties involved in the issuance process.
Secondary Market
After securities are issued in the primary market, investors trade them in the secondary market. This market does not directly provide capital to the issuer; instead, it offers liquidity, allowing investors to buy and sell them among themselves. The secondary market is crucial for price discovery and investors looking to exit investments or reallocate portfolios without impacting the issuing entity.
Both markets play critical roles in the financial system by providing avenues for raising capital and enabling investment and trading in various financial instruments. They are supported by a network of exchanges, brokers, and other intermediaries that facilitate the smooth functioning of trading activities.
Why are Capital Markets Important?
Capital markets provide essential funding for many different types of companies, facilitate innovation, and help maintain economic stability.
Capital markets are important because they:
- Mobilize savings for productive investments, driving economic development.
- Ensure resources are directed to the most valuable projects, boosting competitiveness.
- Offer financial instruments for hedging against risks, promoting financial stability.
- Facilitate transparent pricing of securities, aiding informed investment decisions.
- Enforce regulatory standards and investor scrutiny, improving business practices.
- Reflect broader economic conditions, serving as a crucial gauge of market sentiment and health.
What are Capital Market Instruments?
Capital market instruments are financial securities used to raise long-term funds. They typically have a maturity of more than one year and are essential for the functioning of the financial markets. They include a wide range of securities, each serving different financial needs and investment strategies.
Examples of Capital Market Instruments
Capital market instruments are essential for the functioning of capital markets. They enable investors to grow and diversify while providing companies and governments with the necessary funding. Here are some examples.
Equity Instruments
Equity instruments are financial securities that represent ownership in a company, typically in the form of stocks.
Common stocks: Common stocks represent shares of ownership in a company. Holders of common stock usually have voting rights, which they can exercise in corporate decisions, typically through voting on company directors and other important matters at shareholder meetings. Common stockholders are last in line when it comes to claims on a company's assets in the event of liquidation, following bondholders and preferred shareholders.
Preferred stocks: Preferred shareholders typically do not have voting rights but have a higher claim on assets and earnings than common stockholders. For example, dividends to preferred shareholders must be paid before any dividends can be declared on common stocks. In bankruptcy, preferred stockholders are paid off before common stockholders but after debt holders.
Convertible securities: Convertible securities, like convertible bonds or convertible preferred stock, combine features of both debt and equity. A convertible bond, for instance, functions like a regular bond by offering fixed interest payments, but it also gives the holder the option to convert it into a predetermined number of shares of the issuing company’s common stock at certain times during its life, typically at the discretion of the holder.
Debt Instruments
Debt instruments are financial securities issued by entities like corporations or governments that represent a loan made by an investor to the issuer. The issuer is obligated to repay the principal along with interest at a specified date. Examples of debt instruments include:
Bonds: Long-term debt securities issued by corporations, governments, or other entities that pay periodic interest and return the principal at maturity. Types include corporate bonds, government bonds, and municipal bonds.
Debentures: Unsecured bonds that rely on the creditworthiness and reputation of the issuer, rather than collateral, to appeal to investors.
Mortgage-Backed Securities (MBS): Financial instruments created by pooling various mortgage loans and selling their cash flows to investors. These securities are secured by the principal and interest payments from the underlying home loans, providing regular income to investors.
Derivative Instruments
Derivative instruments are financial securities whose value is derived from the performance of underlying assets or rates and are primarily used for hedging risks or speculating on future price movements.
Options: Contracts that give the holder the right, but not the obligation, to buy or sell an asset at a set price before a certain date.
Futures: Agreements to buy or sell an asset at a future date at a price.
Swaps: Contracts to exchange cash flows or other financial instruments between two parties to hedge against risk or speculate.
