Capital Markets Explained

By Colin Dodds · August 01, 2023 · 7 minute read

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Capital Markets Explained

Capital markets are markets for capital, where businesses and other organizations can find financial resources to help them grow. The capital markets are also where financial securities like stocks and bonds are generated, which is critical for investors of all stripes to understand.

The capital markets play a key role in the economy, and there are also a wide variety of them. Again, this can all be critical for investors to understand, especially if they’re in the early stages of building their portfolios.

What Are Capital Markets?

As mentioned, capital markets refer to entities that offer funding to businesses, organizations and other entities that need capital. Capital market instruments are financial securities, including stocks and bonds. Most capital markets are located in the world’s financial centers, such as London, New York, Singapore and Hong Kong.

The entities that supply the capital consist of financial institutions, corporate treasurers, commercial banks, pension plans, life insurance companies, charitable foundations, and other asset managers. The entities that go to the capital markets to acquire capital include companies, nations, states, municipalities, banks, among others.

💡 Quick Tip: Before opening an investment account, know your investment objectives, time horizon, and risk tolerance. These fundamentals will help keep your strategy on track and with the aim of meeting your goals.

What Are the Types of Capital Markets?

There are a wide range of capital markets. The most common capital markets are stock markets, where investors exchange capital for equity stakes in a given company, and the bond market, where investors exchange capital for a right to agreed-upon debt repayments from a company, a state, or another entity.

Stock markets are probably the most well-known of the capital markets. They are capital markets because it’s where companies go to acquire the capital they need to grow, and where investors go to find opportunities for their capital to grow. Companies acquire capital in the stock markets through an initial public offering (IPO) when they sell fractional ownership stakes in themselves to investors.

Recommended: A Brief History of the Stock Market

Bond markets, on the other hand, are not as popular or as well understood by the general public. For one thing, the bond market doesn’t have a central exchange. Instead, they sell over the counter. And most of the people who trade in this OTC market are professional traders, such as pension funds, investment banks, hedge funds, and asset managers.

The bond market is a capital market because it is where companies, states, and other entities go to raise money by offering their debt in the form of a bond. In a bond issuance, investors pay for the right to receive repayment, along with the interest rate offered in the bond.

Stock and bond markets are one way to divide up the capital markets. But there are other so-called hybrid securities such as preferred stocks, convertible bonds, convertible preference shares and other sophisticated securities that companies sell to raise capital. And they also trade in the capital markets.

Primary Market vs. Secondary Market

Capital markets are also commonly divided into primary and secondary markets. The primary markets are where the entities who need capital sell stakes in themselves in the form of a stock IPO, or take on debt by selling bonds directly to investors. It is where issuers sell “new” securities, and where investors buy them.

The other side of the capital markets are the secondary markets. This is where investors buy and sell the stocks and bonds that have already been issued.

Recommended: Bonds vs Stocks: Key Differences for Investors

While the New York Stock Exchange and the Nasdaq are different stock exchanges where companies hold their IPOs, they are much better known to investors because of their roles as the secondary markets where investors buy and sell shares of companies. The issuers of stocks typically only play a role in the secondary markets when they conduct a share buyback.

Capital Markets vs. Financial Markets vs. Money Markets

While capital markets overlap with financial markets, the two are not synonymous.

Financial markets are a broader category that includes any venue in which people and institutions trade any financial asset, including securities, currencies, derivatives, commodities and contracts. Capital markets specifically refer to the places where companies and other entities go to raise funding.

Capital markets are also distinct from money markets in that the money market is where investors trade short-term debt. The money markets also have a wide variety of participants, such as corporations, banks, governments and financial institutions.

In the money market, they lend and borrow for terms as short as a single night, all the way up to a year. The capital markets, on the other hand, consist of trade in longer-term stocks and bonds.

Capital Markets vs. Other Funding Sources

When a company, a state or another entity needs to raise money, they have a few options. They can borrow money from a bank, or another institution. And a private company can even sell a stake to a private equity investor, a venture capital firm, or an angel investor. Those funding mechanisms come with less scrutiny and draw less attention. So what advantages do the capital markets offer?

If a company wants to access large-scale funding from the capital markets, it can issue stocks or bonds. To issue stocks to sell to the institutions that offer funding through the capital markets, the company will have to conduct an IPO.

IPOs and Capital Markets

A company will usually consider an IPO when it has grown in size and matured as an organization. From a size perspective, one common time to consider an IPO is when a unicorn company has reached a valuation of $1 billion, though many companies go public before this point.

As a company grows, many early-stage investors, including company founders, will look to the public markets as a way to cash out their investments.

The maturity of the company is also important, as it will need to have internal procedures and dedicated professionals to take on the kind of scrutiny and regulatory compliance that the Securities and Exchange Commission (SEC) demands of publicly traded companies.

Many companies will choose to conduct an IPO to raise capital in amounts that simply aren’t available through private investors. The public capital market creates the opportunity for millions of investors to buy stakes in the company.

For many companies, the day of its IPO represents the beginning of a new stage of growth. In addition to the funds raised in an IPO, the credibility and transparency of being a publicly traded company can make it easier and less expensive to borrow money in the future.

Bond Issuance and Capital Markets

To access public funding through a bond issue, a company or another entity will start by discussing its need for capital with an investment bank. The bank will do some research to see if the borrower meets the requirements for the bond market.

If the borrower doesn’t have a rating from a bond-rating agency, the bank will help the borrower get in touch with the right rating agencies.

Once the terms of the bond are agreed upon, and the rating assigned to it, the bank sets up meetings with institutional investors. If they respond positively, then the bonds go to the investors who agreed to buy it over the course of the meetings leading up to the issuance date.

💡 Quick Tip: If you’re opening a brokerage account for the first time, consider starting with an amount of money you’re prepared to lose. Investing always includes the risk of loss, and until you’ve gained some experience, it’s probably wise to start small.

The Takeaway

The term capital markets encompasses any place where companies, countries, states or other entities go to obtain capital from investors. While the term capital markets is a familiar one, it is sometimes confused with other types of markets.

Understanding the basics of capital markets is very important for investors, as they will be interacting with numerous capital markets throughout their investing journeys. While you may not end up thinking about capital markets on a day to day basis, some background knowledge is helpful.

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Photo credit: iStock/Ivan Pantic

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