The capital market, encompassing the securities and bond markets, plays a vital role in facilitating the transfer of funds between organizations with surplus capital and those in need of financial resources for business expansion.
It serves as a financial avenue where investors engage in buying and selling various financial instruments, such as stocks and bonds, through exchanges. The capital market acts as a platform to connect those seeking investment opportunities with individuals or entities possessing capital.
With this article, we aim to explore the diverse capital market instruments, providing valuable insights for investors to make informed decisions and navigate this dynamic financial landscape.
Features of Capital Market
The capital market plays a crucial economic role by linking savers and investment opportunities. The following are the features of Capital Markets:
Investor-Investment Link
The capital market connects savers with investment opportunities. Savers invest their money in various financial instruments, while companies and governments access funds for investment and expansion.
Role of Intermediaries
Intermediaries like underwriters, brokers, and financial institutions facilitate smooth market functioning. They execute transactions, provide analysis, maintain transparency, and ensure regulatory compliance.
Influence on Capital Formation
Capital markets determine the pace of capital formation, promoting economic growth through profitable investments, increased savings, and capital accumulation.
Focus on Long-Term Investment
Capital markets primarily cater to long and medium-term investments, supporting projects with funding needs exceeding a year.
Accessible to All Entities
The capital market has no entry barriers, welcoming any suppliers or fund users. This promotes competition and provides a wide range of investment options.
Functions of Capital Market
The capital market serves key functions that drive efficient capital allocation and support economic growth:
Capital Generation
It offers a platform for entities to acquire long-term funding by issuing securities, facilitating investments, expansions, and promoting economic development.
Allocation Function
The capital market connects investors with investment opportunities, channeling savings into different modes and attracting diverse lenders to invest.
Liquidity Accouterment
Capital markets ensure the seamless buying and selling of securities, enabling investors to liquidity their investments whenever necessary.
Effective Capital Allocation
They direct capital towards companies and projects with growth potential, enhancing economic efficiency.
Compliance With Corporate Governance
Capital markets enforce standards for disclosure, promoting transparency, accountability and fostering investor confidence.
Types of Capital Market
Capital markets can be classified into two types:
- Primary Market
- Secondary Market
Primary Market
In the primary market, the focus is on trading newly issued securities. When companies decide to make their initial public offering (IPO) and become publicly traded, they offer shares to external entities outside their organization.
The primary market fulfils various functions, including:
Origination
This involves evaluating, assessing, and processing new project proposals within the primary market. Origination typically begins before bringing an issue to the market, often with the support of commercial banks.
Underwriting
Underwriting firms play a vital role in ensuring the success of new issues by guaranteeing a minimum subscription. If the shares remain unsold, the underwriters purchase them.
Distribution
The responsibility of distributing the issue usually falls on dealers and brokers who maintain direct contact with investors.
Secondary Market
The secondary market deals with securities that have been previously traded in the primary market, like Bombay Stock Exchange (BSE) and National Stock Exchange (NSE).
The basic functions of the secondary market are:
Regular Updates
The secondary market provides regular updates on the value of securities, keeping investors well-informed. This ensures transparency and enables investors to make informed decisions.
Liquidity
Investors in the secondary market benefit from liquidity for their assets, allowing them to trade their holdings quickly and easily.
Marketplace
It serves as a marketplace where investors trade securities among themselves, facilitating the exchange of ownership and enabling the discovery of prices.
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Types of Capital Market Instruments
Some of the capital market instruments are:
Stocks
Stocks, also called equity shares, are issued to raise funds and depict ownership in a company.
One gets partial ownership and voting rights as a shareholder. One’s ownership lasts until he sells the shares or the company liquidates. By purchasing stock, the shareholder shares the company’s gains and losses and is paid dividends in return.
Equity Securities
It symbolises ownership in a company and consists of common stocks, preferred stocks, and depository receipts. It entitles shareholders to a share of the company’s assets and gains.
Moreover, Common stocks are a company’s most basic form of ownership, but preferred stocks have a greater claim to the company’s assets and dividends.
Preference shares
Preference shares are given priority when it comes to distributing dividends or settling obligations during liquidation. It signifies that the company must fulfil its obligations by disbursing dividends or payments to preference shareholders before addressing the concerns of equity shareholders.
Preference shareholders do not possess the privilege to participate in company voting decisions. Furthermore, unlike equity shares, preference shares are generally not traded in the secondary market.
Types of preference shares
Redeemable
The issuing company can reclaim the preference shares by opting for a buyback later.
Irredeemable
A company can redeem the irredeemable shares upon liquidation.
Convertible
An investor can convert preference shares into equity after a fixed duration.
The Companies Act of 2013 prohibits Indian companies from issuing irredeemable preference shares. Instead, they can issue redeemable shares with a 20-years of redemption period.
Derivatives
Derivatives are monetary instruments whose value is derived from underlying assets, such as bonds, equities, commodities, currencies, and more. While trade of these instruments is based more on speculation, they also serve as tools for hedging and arbitrage. Due to their inherent risk and volatility, derivatives are most suitable for experienced investors in the financial market. These instruments are actively traded on the secondary market.
The common ones in India are:
- Options contract
- Future contracts
Exchange-traded funds (ETFs)
ETFs are investment instruments where investors pool their funds for bonds, equities and gold. Moreover, they are a combination of shares and mutual funds. They are registered under SEBI. Like mutual funds, investors can invest in an index, basket of stocks or a commodity in an ETF.
Debt Securities
Debt securities are investor loans to companies and governments. These securities include bonds, bills and notes.
Moreover, notes have a term between one to ten years, while bonds often have more than ten years maturities. Bills are very short-term debts of a maturity period of less than a year.
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Currency Market Instruments
Currency market instruments are short-term debt securities with less than a year of maturity period. It includes certificates of deposit, commercial paper, and Treasury bills. Moreover, conservative investors prefer currency market instruments due to their low-risk nature.
Asset-Backed Securities
A collection of assets, such as mortgages or car loans, backs asset-backed securities (ABS).
These securities are created by pooling similar assets and issuing securities backed by the cash flows generated by those assets.
Foreign Exchange (FX) instruments
The FX instruments are traded on the foreign market. They include currency agreements and derivatives.
The currency agreements are further categorised into:
- Currency futures
- Currency options
- Currency swaps
Real Estate Investment Trusts (REITs)
REITs are financial instruments that hold and manage assets that generate returns from real estate. Investors can invest in real estate through REITs without purchasing and maintaining the properties themselves. And earn returns through rental income and capital growth.
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Conclusion
Capital market instruments facilitate the transfer of funds and connect investors with investment opportunities. It provides diverse financial instruments, such as stocks, bonds, derivatives, and ETFs, catering to different risk preferences and investment objectives.
The capital market functions to allocate capital efficiently, generate wealth, and support economic growth. It operates under government regulations to ensure fairness and market integrity.
Moreover, understanding different capital market instruments is also important to frame informed decisions. As a potential investor, you must also analyse your financial objectives and risk tolerance before placing an investment.
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Capital Market Instruments: FAQs
What are Capital Market Instruments?
Capital market instruments are securities like stocks, bonds, and derivatives that are traded to raise capital and manage risks.
How does the Capital Market work?
The capital market is a medium that facilitates the transfer of funds from individuals with surplus income to businesses needing capital.
What are the examples of capital markets?
Examples of capital markets are BSE, NSE, NASDAQ and NYSE.
What is the capital market and its types?
The capital market serves as a platform for exchanging savings and investments between capital providers and seekers through various financial instruments. It encompasses the primary market and secondary market.
Who controls the capital market in India?
The Securities & Exchange Board of India, or SEBI, is the regulatory body for the capital market, although private placements currently remain unregulated.
