A capital market is an exchange where shares, bonds, debentures, debt securities, and ETFs can be traded. It’s a way to raise money for regular people, businesses, and governments. Short-term, high-quality debt securities with an average maturity of one year or less are available for lending, and borrowing on the regulated exchange market known as the money market. To meet their short-term cash flow demands, it enables governments, banks, and other important institutions to sell short-term securities. Individual investors may also make modest, low-risk investments in the money markets.
Types of Capital Market Instruments
The efficient transfer of medium- to long-term funds from the surplus to the deficit unit is the responsibility of the financial market segment known as the capital market. To transfer money, documents (or certificates) called “instruments” are employed as proof of investments. There are primarily two types of instruments:
Debt Instruments
Companies or governments can raise money for capital-intensive projects by using a debt instrument. You can buy it on the primary market or the secondary market. The borrower-creditor relationship in this type of instrument ownership does not necessarily indicate ownership in the borrower’s company. According to the trust deed, the contract has a set lifespan, and interest is paid at predetermined intervals (contract agreement). As a result, at the end of the contract period, the invested funds are returned along with interest, which is paid either quarterly, semi-annually, or annually.
$12.2 trillion in fixed income was issued in 2020, an increase of 48.1% over the previous year. The highest rise in issuance was in mortgage-backed securities, increasing 96.2% to $4.0 trillion. Treasury securities increased by 32.7% to $3.9 trillion while corporate bonds increased by 60.4% to $2.3 trillion.
The term “sovereign bond” refers to an instrument issued by the federal government; the term “state bond” refers to an instrument issued by a state or local government; and the term “debenture,” “industrial loan,” or “corporate bond” refers to an instrument issued by a corporate body (company).
Equities or Common Stock
This instrument, which can also be bought on the primary or secondary markets, can only be issued by enterprises. Unless it is sold on the secondary market to another investor, an investment in this kind of business gives the investor ownership of the company for the duration of the contract.
Consequently, the investor has particular benefits and rights (such as the ability to vote and hold positions in the company). The owner of loans may be entitled to the interest that must be paid, whereas the owner of equities may earn dividends that are or may not be reported.
Due to the significant risk involved in this instrument, the return is higher (when successful). The United States issued stock, including common shares, worth $390.0 billion in 2020, a 71.0% increase from the prior year. The volume of initial public offerings (IPOs) climbed from $48.8 billion in 2019 to $85.3 billion in 2020, a 74.7% rise. The amount of follow-on, or secondary, issuance in 2020 increased by 77.8% to $258.5 billion.
Two further types of products are also available on the capital market. They are They are preference shares and derivatives.
Preference Shares
In the case of a company’s insolvency, holders of this instrument, which corporate entities issue, are granted second preference (after bondholders). In that authorized share capital and paid-up capital are calculated independently from equity capital and added to it to determine the total, the instrument is similar to equity in this regard. Preference shares can also be viewed as a sort of debt instrument due to the lack of voting privileges for holders and the dividend payment structure that is comparable to the interest (coupon) paid on bonds.
Both convertible and irredeemable preference shares are available. The original amount repaid to the investor is converted to equity upon the maturity of the instrument, even though dividends (interest) had already been paid in this case.
Only when a contract is irredeemable but non-convertible, where it will always be renewed at maturity, may the holder sell his ownership on the secondary market. The instrument won’t also be converted into equity.
When redeemable, the principal is returned after a defined period. In this case, it is strictly regarded as a debt instrument. Interest may be cumulative, variable, or fixed, depending on the provisions of the Trust Deed.
Derivatives
The financial instruments that are derived from the underlying assets are derivatives. They are securities. Because anything that affects the underlying asset must also influence the derivative, the underlying assets dictate the derivative’s price, risk, and function. An asset, an index, or an event could make up the derivative. In the majority of industrialized economies, derivatives are frequently used.
Futures, options, swaps, rights, exchange-traded funds, asset-backed securities (ABS), mortgage-backed securities (MBS), asset-backed securities (MBS), and commodities are examples of derivatives. The most popular derivative in Nigeria allows a security’s owner to increase his holdings by a predetermined ratio. This is known as rights. An agreement known as a trust deed outlines the
Are Capital Market Instruments Different from Money Market Instruments?
The money market and the capital market are the two most significant components of the financial market, which have many diverse sections. In the money market, only short-term liquid financial assets are traded. On the capital market, however, only long-term securities are exchanged.
The capital market is vital to a country’s economic growth because it provides a platform for raising money. The money market also has a wide range of useful characteristics. This article describes the differences between the money market and the capital market.
Bottom Line
The capital market, to sum it all up, is a venue where businesses can raise money from outside investors. Capital markets can be divided into two categories: main markets and secondary markets. The latter involves trading of previously existing securities, whereas the former deals with fresh securities. Capital markets are defined concerning the security traded in these markets, which are categorized as the bond market and the stock market. In the modern era, there is a proliferation of different secondary markets like the NYSE, BSE, NSE, etc.
References
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- Osei, K. A. (1997). Analysis of factors affecting the development of an emerging capital market: The case of the Ghana stock market.
- Prameswari, O. (2022). Capital Market Instruments. Available at SSRN 4161358.
- Fabozzi, F. J. (2015). Capital markets: institutions, instruments, and risk management. MIT Press.
- Culp, C. L. (2002). The ART of risk management: alternative risk transfer, capital structure, and the convergence of insurance and capital markets (Vol. 142). John Wiley & Sons.
- Obstfeld, M., & Taylor, A. M. (2003). Globalization and capital markets. In Globalization in historical perspective (pp. 121-188). University of Chicago Press.
- Fabozzi, F. J., & Drake, P. P. (2009). Finance: capital markets, financial management, and investment management (Vol. 178). John Wiley & Sons.
- Smith, R. C., & Walter, I. (2006). Governing the modern corporation: Capital markets, corporate control, and economic performance. Oxford University Press.
- De la Torre, A., & Schmukler, S. (2006). Emerging capital markets and globalization: the Latin American experience. World Bank Publications.
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