Capital Market

A capital market is the market in which long-term financial instruments are issued and traded, including equities and long-term debt securities. Capital markets channel savings into long-term investment, providing firms and governments with funding and offering savers a return on their funds.

Instruments

Capital markets encompass equity markets, where shares are issued and traded, and bond markets, where long-term debt securities are issued and traded. Other instruments include hybrid securities, which combine features of debt and equity, and securitised products, which are backed by pools of assets.

The instruments differ in their risk and return characteristics, in their seniority, and in the rights they confer. Equity holders have a residual claim and typically voting rights, while debt holders have a fixed claim and priority in the event of insolvency.

Participants

Participants in capital markets include issuers, who raise funds, and investors, who provide them. Issuers include firms, governments, and other entities. Investors include institutional investors, such as pension funds, insurance companies, and mutual funds, as well as individual investors.

Intermediaries, including investment banks, brokers, and exchanges, facilitate issuance and trading. They provide services including underwriting, market making, and advice, and they operate the infrastructure through which securities are traded and settled.

Functions

Capital markets perform several functions. They allocate savings to investment, directing funds to the uses with the highest expected returns. They provide liquidity, allowing investors to sell their holdings and thereby reducing the premium they demand. They facilitate price discovery, aggregating information about the value of securities.

Capital markets also enable the diversification of risk, allowing investors to hold portfolios that spread risk across many securities. They impose discipline on firms, through the market for corporate control and through the information conveyed by security prices.

Development and Policy

The development of capital markets is influenced by legal and institutional factors, including the protection of investors, the quality of disclosure, and the efficiency of the legal system. Countries with stronger institutions tend to have deeper and more liquid markets.

Policy questions concern the regulation of markets, the protection of investors, and the promotion of market development. The design of regulation must balance the benefits of market discipline against the risks of instability, and it must adapt to the evolution of markets and of financial innovation.

Primary and Secondary Markets

The primary market is where new securities are issued and sold to investors, raising funds for the issuer. The secondary market is where existing securities are traded among investors, providing liquidity and price discovery without providing funds directly to the issuer.

The two markets are linked, since the prices determined in the secondary market affect the terms on which securities can be issued in the primary market. Liquid secondary markets reduce the cost of capital for issuers by allowing investors to sell their holdings.

Market Efficiency

The efficiency of capital markets concerns the extent to which prices reflect available information. Under the efficient market hypothesis, prices incorporate all relevant information, so that systematic excess returns are impossible.

The evidence on market efficiency is mixed. While markets appear efficient in many respects, anomalies and behavioural patterns challenge the strong form of the hypothesis. The debate informs the design of regulation and the understanding of market dynamics.

Regulation

Capital markets are regulated to protect investors, to ensure the integrity of markets, and to maintain financial stability. The regulation includes disclosure requirements, the licensing of intermediaries, and the supervision of exchanges and of trading.

The design of regulation balances the benefits of investor protection and market integrity against the costs of compliance and the risk of impeding innovation. The regulation must adapt to the evolution of markets and of financial technology.

Development

The development of capital markets depends on the legal and institutional environment, including the protection of property rights, the enforcement of contracts, and the quality of disclosure. Countries with stronger institutions tend to have deeper and more liquid markets.

The development of capital markets can support growth by improving the allocation of capital and by providing financing for investment. Policies to promote development include legal and regulatory reform, the development of market infrastructure, and the encouragement of institutional investors.

See also

• Equity Market
• Government Bond
• Investment Bank