What Are Capital Markets? How They Work

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Capital markets are the markets where companies, governments and other entities raise long-term money by selling securities such as stocks and bonds, and where investors later trade those securities with one another. They connect two groups. Suppliers of funds have savings to invest. Users of funds need money to operate, expand or build.

What Are Capital Markets?

The term covers the physical and electronic venues where financial instruments are issued and traded, chiefly the stock market and the bond market. Some definitions add commodities and foreign exchange (forex) markets, although those are more often grouped under the wider heading of financial markets. Activity is concentrated in financial centers such as New York and London, and most of it now runs electronically rather than on trading floors.

How Capital Markets Work

Suppliers and users of funds

On the supply side are:

• Households, through bank deposits, retirement accounts, brokerage accounts and other savings products
• Pension and retirement funds
• Life insurance companies
• Charitable foundations and endowments
• Nonfinancial companies that generate more cash than they currently need

On the user side are nonfinancial companies funding operations or growth, governments financing infrastructure and operating budgets, and individuals buying homes or vehicles. Households often reach capital markets indirectly. A bank that makes a mortgage may package and sell those loans as securities, and a pension fund invests a worker’s contributions in stocks and bonds on that worker’s behalf.

The instruments

Capital markets mainly trade two kinds of securities:

• Equity securities (stocks). A buyer owns a slice of the company, with a claim on its residual value and any dividends. Equity carries no repayment obligation.
• Debt securities (bonds). A buyer lends money to the issuer, which promises interest payments and repayment of principal at maturity. Governments, municipalities and corporations all issue bonds.

Hybrids such as preferred stock and convertible bonds sit between the two. Derivatives like options and futures derive their value from these underlying securities and trade alongside them, but they are contracts written on securities and do not raise capital for the issuer.

Interpreting capital markets

Prices in capital markets carry information. A rising share price signals that investors value a company’s expected future earnings more highly, which is why valuation measures like the P/E ratio compare price with earnings. Bond yields show what borrowers must pay to raise debt, and indexes such as the S&P 500 summarize the value of a large group of listed companies.

Primary vs. Secondary Markets

Primary markets

A company enters the primary market when it sells new stocks or bonds to investors, as in an IPO. This is sometimes called the new issues market. The issuer usually hires an investment bank as underwriter. The underwriter helps price the securities, prepares a prospectus describing the offering and the business, and markets the deal. Marketing often includes a roadshow, in which bankers and company executives meet prospective investors to make the case for the security.

In the United States, public offerings must be registered with the Securities and Exchange Commission (SEC). The company files a registration statement and cannot sell to the public until the SEC declares it effective. The SEC reviews disclosure; it does not judge whether the investment is a good one. State securities regulators and other agencies may also be involved.

Secondary markets

Once issued, securities trade between investors on secondary markets regulated by bodies such as the SEC. The issuer is not a party to these trades; the money moves between buyer and seller. The secondary market still matters to the issuer: it gives investors a way to exit, which makes them more willing to buy new issues, and it sets a price the company can use for future offerings.

Secondary markets fall into two broad types:

• Auction markets, where buyers and sellers submit the prices at which they will trade and orders are matched. The NYSE grew out of the open outcry tradition, with traders gathered in one location calling out bids and offers.
• Dealer markets, where dealers quote prices and trade from their own inventory over electronic networks. Nasdaq began as a dealer market, and much bond trading still works this way. Most small investors trade through electronic networks.

Why Are Capital Markets Important?

Without capital markets, a growing business would depend on its own profits, bank loans or private placements with angel investors or venture capital firms. A public listing generally gives access to the largest pool of equity money and spreads risk across many holders. Capital markets also do several jobs at once:

• Allocation: money tends to flow toward issuers investors judge most likely to use it well.
• Liquidity: investors can sell securities before a company is wound up or a bond matures.
• Price discovery: continuous trading produces a market value for a company and a market rate for its debt.
• Government finance: treasury and municipal bonds fund roads, schools and budget gaps without requiring immediate tax increases.

Example of Capital Markets

Hypothetical example, for illustration only.

A software company wants $50 million to build a new data center. It hires an underwriter, files with the SEC and sells 2.5 million new shares at $20 each in an IPO. That sale is a primary-market transaction: $50 million (before underwriting fees) goes to the company, and buyers receive shares.

A month later the stock trades at $25 on an exchange. An investor who bought at $20 sells 1,000 shares to another investor for $25,000. That is a secondary-market trade. The seller gains $5,000 before costs; the company receives nothing.

At the same time, a city issues $100 million of 10-year bonds with a 4% annual coupon to fund a bridge. Bond buyers supply the $100 million in the primary market, and the city owes $4 million a year in interest plus the principal at maturity. If interest rates later rise, those bonds will trade below face value on the secondary market, because new bonds would pay more.

Limitations of Capital Markets

• Cost and complexity of issuing. Underwriting fees, legal work and ongoing disclosure obligations make public offerings expensive, which puts them out of reach for many small firms.
• Uneven access. Underwriters aim to place large volumes quickly and tend to focus on institutions that buy in size, so retail investors may receive little or no allocation in popular new issues.
• Price volatility. Secondary-market prices can swing on sentiment and news, not only on changes in a company’s underlying value. Investors can lose principal on stocks and, if they sell before maturity or the issuer defaults, on bonds.
• Regulation varies by jurisdiction. SEC rules apply in the United States. Other countries have their own regulators and disclosure standards.

Capital Markets vs. Related Terms

Capital markets vs. financial markets. Financial markets is the broader term for any venue where assets, securities and contracts are exchanged, including currencies, commodities and derivatives. Capital markets are the part focused on raising long-term funding through stocks and bonds.

Capital markets vs. money markets. Money markets handle short-term borrowing and lending, typically under one year, through instruments like Treasury bills, commercial paper and certificates of deposit. Capital markets handle longer-term funding.

Capital markets vs. stock market. The stock market is one capital market. The bond market is another, and in many countries it is the larger source of funding for governments.

FAQs

The Bottom Line

Capital markets matter to anyone with savings in a retirement account, pension or brokerage account, and to businesses and governments that need long-term funding. Knowing whether a trade happens in the primary or secondary market shows who receives the money. Public listings offer the largest pool of equity money, but issuing costs, uneven access to new issues and price volatility mean investors can lose principal and many small firms cannot use them.