Capital Markets

Capital markets are vital components of the financial ecosystem, serving as platforms where organizations can raise funds by issuing securities. These markets are divided into primary and secondary segments; the primary market is where new securities are created and sold, while the secondary market involves the trading of existing securities among investors. The stock market, a significant part of capital markets, allows public companies to sell shares to investors, who can benefit from the company's growth. Conversely, the bond market deals with debt securities, providing a mechanism for governments and corporations to borrow funds.

The operation of capital markets influences not only individual investment opportunities but also broader economic stability and growth. Investors utilize various analytical approaches, such as fundamental and technical analysis, to assess the potential value of securities. Additionally, the Capital Asset Pricing Model (CAPM) assists in determining the expected return on investments based on their inherent risk. With the globalization of capital markets, there is an increasing interest in opportunities within emerging markets, where companies are often seeking to improve corporate governance to attract investment. The health of capital markets is crucial, as fluctuations can have profound impacts on employment, economic security, and societal stability.

Published in: 2021

By: Gould, Marie

Subject Terms

Capital Markets

Abstract

This article focuses on capital markets and introduces the concepts of stock and bond markets. Capital markets consist of primary and secondary markets, and are considered a critical factor in American capitalism. There is an exploration of the Capital Asset Pricing Model, which compares individual assets and market returns based upon their respective risk and return trade-offs. In closing, there is a discussion of the impact of global capital markets.

The success of the financial market is important to citizens worldwide. "We live in a world that is shaped by financial markets and we are profoundly affected by their operation. Our employment prospects, our financial security, our pensions, the stability of the political systems and nature of the society we live in are all greatly influenced by the operations of these markets" (Fenton-O'Creevy, Nicholson, Soane, & Willman, 2005, p. 1-2). If the market is not healthy, there is potential for crises.

Financial markets can be defined in two ways. The term can refer to organizations that facilitate the trade of financial products, or it can refer to the interaction between buyers and sellers to trade financial products. Many who study the field of finance will use both definitions, but economics scholars tend to use the second meaning. Financial markets can be both domestic and international.

"Financial market" can be seen as an economic term because it highlights how individuals buy and sell financial securities, commodities, and other items at low transaction costs and prices that reflect efficient markets. The overall objective of the process is to gather all of the sellers and put them in one place so that they can meet and interact with potential buyers. The goal is to create a process that will make it easy for the two groups to conduct business.

When looking at the concept of "financial markets" from a finance perspective, one could view financial markets as a way to facilitate the process of raising capital, transferring risk, and conducting international trade. The overall objective is to provide an opportunity for those who desire capital to interact with those who have capital. In most cases, a borrower will issue a receipt to the lender as a promise of repayment. These receipts are called securities and can be bought or sold. Lenders expect to be compensated for lending the money. Their compensation tends to be in the form of interest or dividends.

Types of Financial Markets. There are different categories of financial markets, and some of them are:

Capital markets—Capital markets consist of primary and secondary markets and are considered a critical factor in American capitalism. New securities are bought and sold in the primary market, and investors sell their securities in the secondary markets. Companies rely on these markets to raise the funds needed to purchase the equipment required to run the business, conduct research and development, and assist in securing other items needed for the operations of the company.
Stock markets—In order to raise a large amount of cash at one time, public corporations will sell shares of ownership to investors. Investors gain profits when the corporations increase their earnings. Many view the Dow Jones Industrial Average as the stock market, but it is only one of many components. Two other components are the Dow Jones Transportation Average and the Dow Jones Utilities Average. Stocks are traded on world exchanges such as the New York Stock Exchange and NASDAQ.
Bond markets—Bonds are the opposite of stocks. Usually, when stocks go up, bonds go down. The different types of bonds include treasury bonds, corporate bonds, and municipal bonds. Mortgage interest rates are affected by bonds.

Financial Market Analysis. When one is analyzing the financial market, he or she has the option of using one of two approaches. Fundamental and technical analyses are two types of analysis, but they have different approaches in terms of whether or not to trade or invest in financial markets. Overall, the process focuses on how to select markets and tools in order to trade or invest and time when it is appropriate to open and close trades or investments in order to maximize returns.

Technical Analysis. According to Investorwords.com (2018), technical analysis is defined as:

A method of evaluating securities by relying on the assumption that market data, such as charts of price, volume, and open interest, can help predict future (usually short-term) market trends. Unlike fundamental analysis, the intrinsic value of the security is not considered. Technical analysts believe that they can accurately predict the future price of a stock by looking at its historical prices and other trading variables. Technical analysis assumes that market psychology influences trading in a way that enables predicting when a stock will rise or fall.

Fundamental Analysis. According to Investopedia.com (2018), fundamental analysis is defined as:

A method of evaluating a security in an attempt to measure its intrinsic value, by examining related economic, financial and other qualitative and quantitative factors. Fundamental analysts study anything that can affect the security's value, including macroeconomic factors such as the overall economy and industry conditions, and microeconomic factors such as financial conditions and company management. The end goal of fundamental analysis is to produce a quantitative value that an investor can compare with a security's current price, thus indicating whether the security is undervalued or overvalued. Read more: Fundamental Analysis https://www.investopedia.com/terms/f/fundamentalanalysis.asp#ixzz55ao4awJE Follow us: Investopedia on Facebook

Specific Uses of Each Approach. Which is better? Both types of analysts have been successful in the designated fields. The "right" answer depends on what the investor is interested in. For example a long-term investor looking for strong companies, growth, and income potential may be interested in the fundamental approach. However, long-term investors who diversify, or spread their investments across multiple organizations in order to minimize risk, or short-term investors waiting for a change in sentiment, may not be overly concerned about a company's current status. These types of investors would probably support the technical approach. Given the strengths of both approaches, many investors tend to find benefits from each type of analysis. Technical analysts can provide information on the broad market and its trends (macro level), whereas, fundamental analysts can assist an investor in determining whether or not an issue has the basics in order to meet the investor's needs (micro level). In order to get a glimpse of the "big picture," it may be beneficial to take the best from both approaches.

Application

Capital Asset Pricing Model (CAPM). In order to select investments for a portfolio, modern portfolio theory will use the capital asset pricing model. The capital asset pricing model (CAPM) is utilized to calculate a theoretical price for a potential investment, and illustrates a direct relationship between the returns of the shares and the stock market returns over time. The model compares individual assets and market returns based upon their respective risk and return trade-offs. It can be used to:

Establish the worth of a company's shares;
Determine the worth of a company's equity, which accounts for the risk inherent in the company's investments.

There will always be some type of risk associated with an investment portfolio. The degree of risk can fluctuate between industries as well as between companies. A portfolio's risk is divided into two categories—systematic and unsystematic risk. Systematic risk refers to investments that are naturally riskier than others, and unsystematic risk refers to when the amount of risk can be minimized through diversification of the investments.

Table 1 provides some characteristics of the fundamental and technical approaches to financial analysis.

The CAPM model operates on a set of assumptions such as:

Due to the risk adverse nature of investors, the model illustrates one period, at the end of which the investor desires to maximize their return (wealth).
Investors perceive a level playing field in terms of opportunities available to them through investment and returns.
Asset returns can be assumed to distribute along a normal distribution curve.
Risk free assets are available at a risk free rate and can be borrowed or lent out by investors in unlimited amounts.
Assets are available in a defined amount; the quantities of assets remain a part of the one period model.
Pricing of assets occurs in a perfectly competitive market where they are perfectly divisible.
Information within asset markets is free and readily available to all investors.
Taxes, regulations, and restrictions do not exist on short selling ("CAPM," 2008).

In addition, the CAPM model includes the following propositions:

"Investors in shares require a return in excess of the risk free rate, to compensate for the systematic risk;
Investors should not require a premium for unsystematic risk because it can be diversified away by holding a wide portfolio of investments;
Since systematic risk varies between companies, investors will require a higher return from shares in those companies where the systematic risk is greater" ("Session 9," n.d.).

The same propositions can be applied to capital investment by companies:

"Companies expect a return on a project to exceed the risk free rate so that they can be compensated for the systematic risk;
Unsystematic risk can be diversified away, which implies that a premium for unsystematic risk is not required;
Companies should strive for a bigger return on projects when the systematic risk is greater" ("Session 9," n.d.).

Viewpoint

Global Capital Markets. Litvack (2006) has been quoted as saying that "emerging market companies still lag behind in corporate governance. However, their success in developing businesses outside their home countries and their need to tap global capital markets is forcing them to devote more attention to their rules" (p. 158). Given the growth of the emerging markets, many investors will be attracted to worldwide opportunities. Venture capitalists are particularly attracted to this type of investment. Some venture capitalists specialize in assisting companies when they have reached a point where financing is necessary to expand the business into emerging markets.

Venture Capital. Venture capital is usually available for a product or idea that may be risky but has a high potential of yielding above-average profits. Funds are invested in ventures that have not been discovered. The money may come fro individuals, government sponsored Small Business Investment Corporations (SBICs), insurance companies, and corporations. It is more difficult to obtain financing from venture capitalists. A company must provide a formal proposal such as a business plan so that the venture capitalist may conduct a thorough evaluation of the company's records. Venture capitalists only approve a small percentage of the proposals that they receive.

Funding may be invested throughout the company's life cycle, with funding being provided at both the beginning and later stages of growth. Venture capitalists may invest at different stages. Some firms may invest before the idea has been fully developed while others may provide funding during the early stages of the company's life. At other times, as mentioned above, venture capitalists aid an existing business in expanding into emerging markets.

Venture Capitalists & Company Input. As a result of the high stakes involved with the amount of money being invested and the risk factor, emerging market companies are being challenged to respond to the concerns and questions from their stakeholders, such as venture capitalists. There have been requests to respond to issues such as "weak and unaccountable board of directors, inadequate internal controls, widespread corruption, and opaque ownership structures and transactions" (Litvack, 2006, p. 158). According to Litvack (2006), companies can address these issues by dealing with the following issues:

The Role of the Board

Many boards are selected based on their ability to champion the position of the current leadership of an organization. Therefore, boards tend not to be a separate entity of the organization. In order to resolve this issue, it may be in the organization's best interest to hold annual elections for board members.

The Audit Committee

Many emerging market corporations have complex ownership structures, which results in many intertwined transactions. These types of activities must be closely monitored in order to avoid the perception of inappropriate and unethical transactions taking place. There needs to be a check and balance process in place. Therefore, it is crucial that each board of directors entity has an audit committee to validate that the organization is operating ethically.

Corruption

It is believed that corruption is rampant in emerging market corporations. Therefore, there has to be an attempt to clean up this image. In order to combat corruption, corporations have enacted stricter anti-bribery laws, become tougher when enforcing national and international anti-bribery laws, and required sound corporate governance and business ethics.

The Laws of the Market

Shareholders become concerned when the local laws and enforcement do not move quickly in order to eliminate corruption. However, laws such as the Foreign Corrupt Practices Act and the Sarbanes-Oxley Act force organizations to be in compliance and allow them to secure funding.

Corporate Political Influence

It has been suggested that corporate influence and shareholder money has been used to shape public policy, especially in the United States. However, the F&C Asset Management has published a standard of good practice that is designed to keep emerging market companies in compliance. One of the recommendations is that donations to individual political candidates and parties should be avoided. Even when this cannot be validated, following these practices encourages organizations to disclose the information and seek shareholder approval before making a donation.

Conclusion

Capital markets consist of primary and secondary markets and are considered a critical factor in American capitalism. The primary market consists of newly created securities, while the secondary market consists of securities that are being sold by investors. Companies rely on these markets to raise the funds needed to purchase the equipment required to run the business, conduct research and development, and assist in securing other items needed for the operations of the company.

The capital asset pricing model (CAPM) is utilized to calculate a theoretical price for a potential investment, and illustrates a direct relationship between the returns of the shares and the stock market returns over time. The model compares individual assets and market returns based upon their respective risk and return trade-offs. It can be used to establish the worth of a company's shares and determine the worth of a company's equity, which accounts for the risk inherent in the company's investments.

Litvack (2006) has been quoted as saying that "emerging market companies still lag behind in corporate governance. However, their success in developing businesses outside their home countries and their need to tap global capital markets is forcing them to devote more attention to their rules" (p. 158). Given the growth of the emerging markets, many investors will be attracted to worldwide opportunities.

Terms & Concepts

Bond Markets: Whether from the original seller or on an exchange, it is the market for all types of bonds.

Capital Markets: Marketplace in which organizations raise funds to conduct business through the selling of securities and debt.

Capital Asset Pricing Model (CAPM): A model used in finance to determine a theoretically appropriate required rate of return (and thus the price if expected cash flows can be estimated) of an asset, if that asset is to be added to an already well-diversified portfolio, given that asset's non-diversifiable risk ("Capital asset pricing model," 2009).

Financial Markets: A market for the exchange of capital and credit, including the money markets and the capital markets ("Financial markets," 2009).

Fundamental Analysis: A method in which to evaluate a security by attempting to measure its intrinsic value by examining related economic, financial, and other qualitative and quantitative factors ("Fundamental analysis," 2009).

Market Capitalization: Represents the aggregate value of a company or stock. It is obtained by multiplying the number of shares outstanding by their current price per share ("Market capitalization," 2009).

Stock Markets: The organized trading of stock; both exchanges and over-the-counter sales occur.

Stock Index: Consists of a listing of market prices for a particular group of stocks, such as the S&P 500 and the NASDAQ Composite Index.

Technical Analysis: A method in which to evaluate securities by relying on the assumption that market data (i.e. charts of price, volume, and open interest) may assist in predicting future (usually short-term) market trends ("Technical analysis," 2009).

Venture Capitalists: A term used for an investor who provides capital to either start-up ventures or small companies that wish to expand but do not have access to public funding ("Venture capitalists," 2009).

Bibliography

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Capital Markets

On this Page

Subject Terms

Capital Markets

Abstract

Application

Viewpoint

Conclusion

Terms & Concepts

Bibliography

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