Investing Answers Building and Protecting Your Wealth through Education Publisher of The Next Banks That Could Fail
Investing Answers Building and Protecting Your Wealth through Education Publisher of The Next Banks That Could Fail

Capital Markets

What it is:

The capital markets are a source of financing for companies around the world. The most famous of the capital markets are the stock market and bond market. 

How it works (Example):

Companies utilize capital markets to raise money for projects by issuing stock IPOs, bonds and short-term money market securities. Individual investors wish to earn interest or dividends on their savings can meet companies looking to raise funds by issuing securities.

To illustrate how a corporate bond moves through capital markets, suppose AB Co. needs to raise $1000. AB Co. offers a 10-year bond on the bond market with a par value of $1000. The bond is purchased by someone wishing to earn interest on the $1000 that they have available. AB Co. receives the $1000 in cash and the investor receives a bond and the promise of repayment plus interest. Should the bondholder later decide he no longer wants the bond, he can sell it to another investor in the marketplace.

To illustrate using stocks, suppose AB Co. decided to raise more funds by issuing ten new shares of stock for $100 per share. AB Co. offers these shares in the market and someone purchases all ten for $1000 total. This time, the investor obtains stock certificates giving him partial ownership of the company. AB Co. gets the $1000 in funds they wanted to raise. As in the example above, should this investor wish to no longer hold these stocks, he can sell them to another investor in the stock market for the current market price. Should the company have extra cash, it could buy the stock back as well.

Why it Matters:

Capital markets serve two purposes. Firstly, they bring together investors holding capital and companies seeking capital through equity and debt instruments. Secondly, and almost more importantly, they provide a secondary market where holders of these securities can exchange them with one another at market prices. Without the liquidity created by a secondary market, investors would be less inclined to purchase equity and debt instruments for fear of being unable to unload them in the future.