What are capital markets?
A capital market is any organized venue where suppliers of money (investors, savers, institutions) trade financial instruments with entities that need funds (companies, governments). The most familiar capital markets are equity (stock) and debt (bond) markets. Their essential economic purpose is to transfer money from those who have surplus capital to those who can put it to productive use.
Key definitions
– Capital market: venue (physical or electronic) for issuing and trading long‑term financial instruments used to raise funding.
– Equity: a share of ownership in a company (stock).
– Debt security (bond): a contract promising repayment of principal plus interest—an interest‑bearing IOU.
– Primary market: where new securities are sold by the issuer for the first time (examples: initial public offering, bond issuance).
– Secondary market: where previously issued securities are traded between investors (examples: NYSE, Nasdaq).
– Underwriter: a financial intermediary (often an investment bank) that helps structure, price, and sell new securities on the primary market.
– Auction market: secondary‑market model where buyers and sellers compete to set transaction prices (traditional open outcry or order book).
– Dealer market: secondary‑market model where dealers post bid and ask prices and execute trades electronically on behalf of clients.
How capital markets work — step by step
1. Supply and demand meet. Households, pension funds, insurers and other savers supply capital. Companies, municipalities and governments demand capital to invest or operate.
2. New capital is raised in the primary market. An issuer hires underwriters, prepares disclosures (a prospectus), and sells new shares or bonds to investors. Regulatory approval is required before a public sale.
3. After the initial sale, securities move to the secondary market. Investors buy and sell those securities among themselves; proceeds from secondary trades go to the selling investor, not to the issuing company.
4. Market structure determines how trades match. In auction markets, buyers and sellers submit orders that are matched; in dealer markets, market makers quote prices and facilitate trades electronically.
5. Settlement, custody and regulation. Trades are settled through clearinghouses and custodians; regulatory agencies oversee disclosure, fairness and stability.
Primary vs. secondary markets — the practical difference
– Primary market = issuer receives new capital. Example activities: IPOs, follow‑on stock offerings, new bond issues. Issuers typically coordinate with investment banks and file required regulatory documents.
– Secondary market = liquidity and price discovery. Stocks and bonds already issued are bought and sold among investors. Trading here creates market prices and allows investors to enter or exit positions; it does not directly provide new funds to issuers.
Who participates?
– Suppliers of funds: retail savers, pension funds, insurance companies, mutual funds, hedge funds, corporations with excess cash.
– Users of funds: nonfinancial firms, governments, households (mortgages, auto loans funded via capital markets), project sponsors.
– Intermediaries: investment banks, brokers, dealers, exchanges, custodians, clearinghouses, regulators.
Checklist for issuers and investors
For an issuer planning to raise capital:
– Decide instrument: equity vs. debt vs. hybrid.
– Select advisors: investment banks, legal counsel, auditors.
– Prepare disclosures: audited financials and prospectus required by regulators.
– Choose market/venue and structure (public listing vs. private placement).
– Estimate costs: underwriting fees, legal/accounting, listing fees, ongoing disclosure costs.
– Consider timing, market conditions and investor demand.
For an investor looking to buy or evaluate securities:
– Confirm market type: primary (new issue) or secondary (existing security).
– Read the prospectus or offering documents for new issues.
– Check liquidity: average daily trading volume and bid‑ask spread.
– Review fees and execution method (dealer vs. auction).
– Assess issuer creditworthiness (for bonds) or fundamentals/valuation (for stocks).
– Be aware that secondary trades do not inject new funds into the company.
Small worked numeric example — company IPO proceeds
Assumptions:
– Company offers 5,000,000 new shares at $10.00 per share.
– Underwriting fee (gross spread): 6% of gross proceeds.
– Other issuance costs (legal, accounting, listing): $1,000,000.
Step 1 — Gross proceeds:
5,000,000 shares × $10.00 = $50,000,000.
Step 2 — Underwriting fee:
6% × $50,000,000 = $3,000,000.
Step 3 — Net proceeds to company (before taxes
Step 3 — Net proceeds to company (before taxes and other adjustments):
Gross proceeds − Underwriting fee − Other issuance costs
= $50,000,000 − $3,000,000 − $1,000,000
= $46,000,000.
Step 4 — Net proceeds per new share:
Net proceeds ÷ Number of new shares
= $46,000,000 ÷ 5,000,000
= $9.20 per share.
Notes and caveats (assumptions clarified)
– This example ignores taxes, any stabilization or greenshoe/overallotment option, and any post‑issuance adjustments. If the underwriter exercises a greenshoe, the total shares and/or gross proceeds can change.
– “Underwriting fee” (also called the gross spread) is the amount paid to underwriters for distributing the offering; it is deducted from gross proceeds before the company receives cash.
– Secondary shares sold by existing shareholders in the same transaction (if any) do not increase proceeds to the company; only newly issued shares provide cash to the issuer.
– Real transactions may include additional line items (escrow, escrow fees, underwriting syndicate manager fees, tax withholding, escrowed holdbacks) that affect net proceeds.
What this shows in plain terms
– From $50.0M of gross cash raised, the company keeps $46.0M after a 6% underwriting fee and $1.0M of other issuance costs — i.e., $9.20 received for each new $10.00 share sold (before taxes and other adjustments).
Reputable sources for further reading
– Investopedia — Capital Markets overview: https://www.investopedia.com/terms/c/capitalmarkets.asp
– U.S. Securities and Exchange Commission (SEC) — IPOs: The basics: https://www.sec.gov/fast-answers/answersipohtm.html
– Nasdaq — Listing process & requirements: https://www.nasdaq.com/solutions/listing
– New York Stock Exchange (NYSE) — How to list: https://www.nyse.com/listings
Educational disclaimer
This information is educational and illustrative only. It is not individualized investment advice or a recommendation to buy or sell securities. Consult a licensed financial professional for personal guidance.