Capital markets, where long-term financial securities exchange hands, are as fascinating as complex. They're a crossroads for companies, governments, and individuals looking to raise funds or invest. This article explores different types of capital markets and their segments, like bond and stock markets. We'll spotlight capital market instruments, the vital tools facilitating these exchanges. Don't miss out on this journey to the heart of the financial system - where money takes on a life of its own!
What is the capital market?
The capital market is the market where corporations and governments issue financial assets such as bonds and shares to meet their medium to long-term financial needs.
Difference between money market and capital market
It is opposite to the money market which provides short-term financing. Let’s see a more detailed comparison of the capital and money markets:
Money market (Short-dated financial assets) | Capital market (Long-dated or undated financial assets) | |
Private sector raising finance | Commercial bills | New issues of shares and corporate bonds. |
Central government raising finance | Treasury bills | New issues of government bonds (or gilts in the UK). |
Table 1. Comparison of money market and capital market - StudySmarter.
While the money market is associated with short-dated financial assets, the capital market issues and trades long-dated or undated securities.
In the money market, there are bills issued by an investment bank or the Central Bank known as Commercial bills and Treasury bills. These are short-term loans that expire within a year. On the other hand, the capital market is made up of shares, corporate bonds, and government bonds that last for a year or more.
Fig. 1 - New York Stock Exchange is an example of a capital market
Types of capital markets
In understanding the financial ecosystem, it's essential to distinguish between the two main types of capital markets:
primary market
and secondary market.
These markets play crucial roles in capital allocation, helping fuel economic growth and development.
Primary Market
The primary capital market, also known as the new issues market, is where securities are created. In this market, companies issue new shares of stocks and bonds to the public for the first time, such as during an Initial Public Offering (IPO). For instance, when a company like Uber decided to go public in 2019, it sold its shares on the primary market, raising capital to fund its operations.
The primary market (new-issues market) is where securities are issued and traded in public for the first time.
Secondary Market
On the other hand, the secondary market is where investors trade securities previously issued in the primary market. Essentially, the secondary market provides a platform for the buyers and sellers of existing securities to interact and make transactions. Take the New York Stock Exchange for example, where shares of publicly traded companies like Apple, Microsoft, or Tesla are bought and sold every day – this is part of the secondary market.
The secondary market (second-hand market) is where investors trade securities first issued on the primary market.
Stock exchanges are secondary markets. Some of the world’s oldest and most reputable stock exchanges include the New York Stock Exchange (NYSE) and the NASDAQ in the US and the London Stock Exchange (LSE) in the UK.
Instruments of capital market
Capital markets teem with diverse financial instruments, each having its own role and significance. When businesses and governments need to raise capital, they issue securities that investors can purchase. There are three main instruments in the capital market:
- equities (stocks, shares),
- bonds, and
- derivatives
Equities
Equities, often referred to as stocks or shares, represent an ownership stake in a company. Investing in equities gives investors a claim on part of the company's earnings and assets. For example, if you own a share of a company like Apple, you effectively own a tiny fraction of that business.
Equity or shares are undated financial assets issued by a firm to acquire funding.
There are five main types of shares, including:
Ordinary shares
These are the most popular type of shares because they shareholders a voting right. While ordinary shareholders have the highest potential financial gains, they are the last to pay if the company is to go bankrupt.
Non-voting ordinary shares
These are ordinary shares that don’t give the holder a voting right.
Preference shares
Preference shares carry no voting right though their holders can receive preferential treatment when it comes to dividends. Preference shareholders often receive a fixed dividend.
Cumulative preference shares
Cumulative preference shares allow the holders to receive the dividend cumulatively. This means that if a dividend is not paid this year, it will be paid in successive years as long as the company still makes profits.
Redeemable shares
Redeemable shares are sold on the agreement that the company can buy them back at a later date. Companies can’t issue redeemable shares alone, they must also issue other non-redeemable types of shares.
Bonds
Bonds, on the other hand, are debt securities. Governments and corporations issue bonds to borrow money from investors for a specified period. You're essentially lending money to the issuer when you purchase a bond. For instance, buying a US government bond is akin to lending money to the US government. The issuer promises to repay the bond's face value upon maturity and often makes periodic interest payments.
Bonds are loans the government or companies issued to fund their future spending or investment.
The two main types of bonds are corporate bonds and government bonds. In addition, there are foreign bonds and municipal bonds.
Corporate bonds
Corporate bonds are debt securities issued by a company to raise capital for their financial needs. They can be largely classified into investment-grade bonds and junk bonds. Investment-grade bonds are issued by large and influential corporations whereas junk bonds come from startups or financially struggling firms. The latter involves more risks but offers a more attractive interest rate than the former.
Government bonds
Government bonds are known in the UK as gilts. These are bonds with a fixed rate of returns issued by the government to cover its spending or pay for debts. It’s generally safer to invest in government bonds than other securities, though they are not risk-free due to interest rates, inflation, or liquidity issues.
Foreign bonds
Foreign bonds are issued by foreign corporations who want to obtain capital in the host country’s currency. For example, a US firm issuing a foreign bond in the UK capital market will obtain its funding in the British pound sterling. Foreign bonds allow businesses to raise the capital they would not otherwise be able to raise in their home market. However, there’s a risk of currency fluctuations which means the company may have to repay more than it has borrowed.
Municipal bonds
Municipal bonds are considered high-quality debt as they are issued by a state, a local government (not central government), or a nonprofit entity to fund public services. In the UK, the UK Municipal Bonds Agency (UK MBA) allows local authorities to source funding from sources other than the Central Government at a lower cost.1
Derivatives
Derivatives, another type of financial instrument, derive their value from underlying assets like stocks, bonds, commodities, currencies, interest rates, or market indexes. Options, futures, and swaps are common types of derivatives. They serve as tools for hedging risk or speculating on future price movements.
Thus, the array of instruments available in capital markets caters to the varying needs and risk appetites of investors while providing avenues for entities to raise funds. These financial instruments collectively facilitate the flow of capital, stimulating economic progress.
Segments of capital market
The capital market isn't just a monolithic entity, but rather, it's divided into various segments, each serving a different purpose. The key segments of the capital market include
- the stock market,
- bond market,
- and derivatives market.
Stock Market
The stock market is perhaps the most recognized segment of the capital market. Here, shares or equity securities representing ownership in a company are bought and sold.
Consider Amazon, for instance. When you buy Amazon's shares, you become a shareholder, owning a small piece of the company.
Fig. 2 - Stock exchange prices
Bond Market
The bond market, also known as the debt or fixed-income market, is where debt securities are traded. Governments, municipalities, and corporations raise capital in this market by issuing bonds.
For example, if the U.S. government needs to fund infrastructure projects, it might issue Treasury bonds that investors can buy. In return, the government agrees to pay the bondholders the principal plus interest by a specific date.
Derivatives Market
The derivatives market is where financial instruments such as futures, options, and swaps are traded. These instruments derive their value from underlying assets like stocks, bonds, commodities, currencies, interest rates, or even market indexes.
For example, a wheat farmer might use futures contracts to lock in a price for their crop months before it's harvested, providing some protection against price swings in the commodity markets.
Bond calculation
In this section, we will learn about bond yield and how it correlates with bond prices.
Bond yield is the long-run interest rate earned by bondholders (people who purchase a bond).
There are two ways to calculate bond yield:
- Current yield
- Yield to maturity
Current yield
The current yield is the return the investor can expect when holding their investment for one year.
To calculate it, we divide the coupon by the bond’s market price.
\(\text{Current yield}=\frac{\text{Annual coupon payment}}{\text{Current market price}}\)
- The annual coupon payment is the guaranteed annual interest payment a bondholder can expect to receive from the bond issuer.
- The bond market price is the price that is regulated by the supply and demand on the stock exchange. It is to be distinguished from the bond's issue price at which the bond can be redeemed at the maturity date.
Yield to maturity
Yield to Maturity (YTM) is the interest rate that makes the present values of all cash flows until maturity is equal to the price of the initial investment.
To calculate YTM, you need to consider the time value of money: the concept that a sum of money is worth more now than in the future.
Here’s the formula:
\(Bond\ price = Coupon \times \frac{1 - (1 + YTM)^{-n}}{YTM} + \frac{Face\ value}{(1 + YTM)^n}\)
- n: Number of periods till maturity.
Knowing the bond’s current market price, face value, time to maturity, and coupon payment, you can determine the rate of return YTM by applying a trial-and-error process until the present values of all future cash flows equal the bond price.2 A quicker way is to use an online calculator.
The inverse relationship between bond prices and interest rates
Let’s consider the case of a government bond to understand how bond prices and bond yields (long-term interest rates) are related.
Government bonds are long-term loans issued by the government at a fixed interest rate.
The price at which a bond is sold for the first time is called the issue price. This is also the maturity price that the bond issuer must pay the bondholder at the maturity date. When the bond is traded on a stock exchange, it will assume a second-hand price which is regulated by the supply and demand of the market.
Bond maturity is the time from the bond’s issue date to when the bond issuer must repay the original value of the bond to the investor.
Up till maturity, bond issuers are subjected to pay the investor a coupon payment.
Coupon is the annual interest rate on a bond, calculated as the percentage of the bond's face value (current yield).
Here’s an example with bond yield calculations:
Suppose a government bond is issued at the maturity price of £100. The annual interest payment is £10.
We can calculate the coupon payment or current yield of the bond at:
\(Yield = \frac{Annual\ coupon\ payment}{Bond's\ issue\ price} = \frac{£10}{£100} = 10\%\)
Now, if the bond is sold on the secondary market at the price of £200, the bond yield will drop to:
\(Yield = \frac{Annual\ coupon\ payment}{Gilt's\ current\ market\ price} = \frac{£10}{£200} = 5\%\)
Consider another situation where the bond price drops to £50. The bond yield will increase to:
\(Yield = \frac{Annual\ coupon\ payment}{Gilt's\ current\ market\ price} = \frac{£10}{£50} = 20\%\)
As you can see in the above examples, there is an inverse relationship between the bond price and the long-run interest rate (yield). When the long-term interest rate increases, the bond price will drop. Alternatively, a decline in the bond price will result in an increase in the bond yield.
Functions of the capital market
Finally, let’s study the functions of the capital market.
Raise capital
The capital market allows firms or the government to raise capital quickly for future financial needs. Firms can raise capital by issuing shares (equity), corporate bonds, or borrowing from a bank. As for the government, a common way to obtain funding is to issue government bonds. In the UK, government bonds are referred to as gilt-edged securities or gilts.
Common ways for firms to raise capital:
- Issuing shares: companies can raise capital by selling ordinary shares. Ordinary shareholders retain part of the company’s ownership and thus gain certain rights to the business such as a voting right. They also receive dividends provided that the business is doing well financially and does not decide to reinvest the profit.
- Bank loans: banks can lend money to a business at a fixed interest rate over a period of time. This interest rate is also known as the cost of borrowing which allows the business to calculate monthly payments and plan future cash flows.
- Issuing bonds: a third option for companies to raise capital is issuing bonds. Bonds are preferable to bank loans as businesses tend to pay bondholders less than the interests they pay the banks. Also, unlike stocks, bonds don’t give investors a share of the company's profit.
Connect buyers and sellers of securities
The capital market can link those with extra cash (buyers of a bond or equity) with those in need of capital (sellers of a bond or equity) to cover their financial needs. As a result, capital is put to more productive use. Instead of sitting idle, it is allocated to cover business expenses or investments while collecting interests for the investors.
Facilitate economic growth
The capital market allows businesses and governments to raise capital quickly for expansion and growth. For example, a business can acquire funding from the public to explore new markets and sell to more customers. This not only increases its income but also contributes to the overall economic growth.
Inter-temporal consumption smoothing
Inter-temporal consumption smoothing is the smoothing of consumption over your lifetime, which occurs in practice.
In theory, though, the level of consumption should follow the level of income: in other words, consumption should increase as one earns more.
People’s income is usually depicted in a hump shape. It starts low in the beginning, rises and peaks in middle age, and decreases during retirement. This means you should consume less when you are young, consume more in middle age, and spend only a little amount when you retire. However, in reality, people like to smooth their consumption throughout a lifetime. They borrow money while they are young, pay off debts and save money in the middle of their lives, and spend their savings in retirement. One way to smooth your consumption efficiently (saving more money) is to invest in bonds and stocks.3
By storing wealth in bonds and stock, you can shift your purchasing power from one period to another. For example, if you spend all the money you earn today, there’ll be no extra cash for later use. On the other hand, purchasing shares of a company or holding them for a period of time will help you save money while earning an accumulated interest on top of the initial investment.
Capital Market - Key takeaways
References
- Colin Marrs, Aidan Brady on the municipal bond agency, 2014.
- Jason Fernando, Yield to Maturity, Investopedia, 2021.
- Scott A. Wolla, Smoothing the Path: Balancing Debt, Income, and Saving for the Future, 2014.
