What are Capital Markets?

Capital markets are the places where people buy and sell investments. The main investments traded are stocks, bonds, and derivatives. There are two types of capital markets: primary markets and secondary markets.

Primary Markets

Primary markets are where new investments are sold for the first time. When a company wants to raise money, they can sell new stocks or bonds in the primary market. This is called an initial public offering (IPO) for stocks. The company gets the money from the sale.

Companies work with investment banks to organize the IPO. The investment banks help decide the initial price of the shares and find buyers. They market the new stocks to potential investors like pension funds, mutual funds, and wealthy individuals.

Governments can also raise money in primary markets by issuing new bonds. They sell the bonds to investors and use the money for projects or to pay off other debts.

Secondary Markets

Secondary markets are where people buy and sell investments that have already been issued in the primary market. The New York Stock Exchange (NYSE) and NASDAQ are examples of secondary markets for stocks in the United States. The London Stock Exchange is the main secondary market in the United Kingdom.

In secondary markets, the original company or government that issued the investment does not receive any money from the sales. Instead, the money goes to the investor who sold the stock or bond.

Secondary markets are important because they give investors a way to sell their investments and get their money back. This liquidity makes investors more willing to buy stocks and bonds in the first place.

Stocks

Stocks represent ownership in a company. When you buy a stock, you become a shareholder and own a small piece of the company.

There are two main types of stocks: common stock and preferred stock. Common stock gives shareholders voting rights at shareholder meetings. Preferred stock does not have voting rights, but shareholders usually receive guaranteed dividends.

Stock prices change based on supply and demand in the market. If more people want to buy a stock than sell it, the price goes up. Stock prices can also be affected by company news, economic reports, and global events.

Investors can make money from stocks in two ways:

1. If the stock price increases and they sell the stock for more than they bought it for.
2. If the company pays dividends to shareholders out of its profits.

Of course, stock prices can also go down. Shareholders can lose money if they have to sell their shares for less than they bought them for.

Bonds

Bonds are like loans that investors make to companies or governments. When you buy a bond, you lend money to the issuer for a set period of time. In return, the issuer promises to pay you interest and to return your principal when the bond matures.

Bonds are considered less risky than stocks because bondholders are paid before shareholders if the company goes bankrupt. Government bonds are generally considered very safe since governments can raise taxes or print money to pay them off.

Bond prices change based on interest rates in the economy. When interest rates rise, bond prices fall (and vice versa). This is because new bonds will pay higher interest, so older bonds with lower rates are less valuable.

Investors can make money from bonds in two ways:

1. Receiving interest payments from the issuer over time.
2. Selling the bond for more than they paid if interest rates have fallen (bond prices have risen).

The risk with bonds is that the issuer could default and not make the promised payments. Highly-rated bonds have a lower risk of default.

Derivatives

Derivatives are investments that derive their value from an underlying asset. The underlying could be a stock, bond, commodity, currency, interest rate, or market index.

Common types of derivatives include:

1. Options: Contracts that give the buyer the right (but not obligation) to buy or sell an asset at a specific price by a certain date.
2. Futures: Contracts that obligate the buyer to buy an asset (or seller to sell an asset) at a specific price on a certain date in the future.
3. Swaps: Contracts where two parties agree to exchange cash flows. For example, exchanging a fixed interest rate for a floating rate.

Derivatives are often used for hedging or speculation. Hedging is when companies or investors use derivatives to protect against price movements. Speculation is when traders try to profit from predicting price movements.

Derivatives can be very complex and risky. They played a major role in the 2008 Global Financial Crisis. Many derivatives trade over-the-counter (OTC), which means they aren’t traded on exchanges and there is less regulation and transparency.

Capital Markets Regulation

Capital markets are regulated to protect investors, ensure fair competition, and promote stability. In the United States, major regulators include:

1. Securities and Exchange Commission (SEC): Oversees securities markets.
2. Commodity Futures Trading Commission (CFTC): Regulates derivatives markets.
3. Financial Industry Regulatory Authority (FINRA): A self-regulatory organization that oversees brokers.

Key regulations include requiring companies to disclose financial information, prohibiting insider trading, and overseeing the fairness of market trading. Regulators also set capital requirements for financial institutions to ensure they have enough resources to weather losses.

Internationally, regulators coordinate through organizations like the International Organization of Securities Commissions (IOSCO) to set global standards. However, regulation ultimately happens at the national level and varies by country.

The Role of Capital Markets

Capital markets play a crucial role in the economy by channeling savings to productive uses. They provide companies with access to capital to fund operations, make investments, and grow their businesses. This capital fuels economic growth and job creation.

For investors, capital markets offer opportunities to grow wealth over time. By allocating capital to the most promising companies and projects, markets (in theory) ensure that resources are used efficiently.

However, capital markets can also contribute to inequality as the wealthy are more likely to own stocks and benefit from rising prices. Regulation aims to balance efficiency with fairness and stability.

Capital markets have also become increasingly globalized. Companies can raise money from investors worldwide, and investors can access opportunities outside their home countries. However, this interconnectedness also means that shocks can spread quickly across borders.

Technology is also transforming capital markets. Online brokerages have made investing more accessible. High-frequency trading firms use algorithms to trade in milliseconds. Blockchain technology could change how records are kept and trades settled.

Looking ahead, the challenge will be ensuring that capital markets continue to serve their core purposes of allocating resources productively, providing good investment options for a broad range of people, and supporting overall economic health. Wise oversight that keeps up with a changing world will be essential. With the right balance, capital markets can continue to be a vital engine for growth and shared prosperity.