The Structure and Function of Capital Markets Explained

In the world of finance, capital markets play a pivotal role by offering a platform for entities to raise funds and for investors to allocate resources efficiently. These markets are like a bustling bazaar where various financial instruments, such as stocks, bonds, and derivatives, are bought and sold. This article delves into the structure and function of capital markets, offering a comprehensive understanding of their significance while integrating key concepts like the capital asset model.

What are Capital Markets

Capital markets are marketplaces where buyers and sellers engage in the trade of financial securities, primarily for raising medium to long-term financing. These markets facilitate a country's economic growth by providing businesses and governments the means to raise capital for development projects. The two main types of capital markets are the equity market and the debt market.

Equity Markets

These include stock markets where shares of companies are issued and traded. It allows companies to raise capital by offering ownership stakes to shareholders.

Debt Markets

This involves the issuance of bonds. Here, borrowers can raise funds by issuing debt to investors—with the promise of repayment plus interest.

Structure of Capital Markets

Primary Market

The primary market is where companies issue new securities directly to investors. In this market, capital flows from investors directly to corporations. The process of issuing new stocks is primarily conducted through an Initial Public Offering (IPO). The primary market is essential for channeling savings and investments for economic activities.

Example Calculation:
When a company offers an IPO, it sets a price per share. Suppose a company issues 1 million shares at INR 100 per share. The company raises INR 100 million from the IPO.

Secondary Market

In contrast, the secondary market allows investors to buy and sell existing securities. The National Stock Exchange (NSE) and the Bombay Stock Exchange (BSE) in India are examples of secondary markets. Here, the capital flows between investors rather than from investors to companies.

Trading Systems

Capital markets utilise trading systems that can be order-driven or quote-driven. The NSE and BSE use electronic order-driven systems where trades are matched through an electronic limit order book.

Regulation

Capital markets are regulated by financial regulatory authorities like the Securities and Exchange Board of India (SEBI), which ensures transparency and fair practices.

Function of Capital Markets

Fundraising for Enterprises

Capital markets provide corporates and governments the facilities to raise funds for long-term projects. This enables economic growth and development.

Price Determination

Interactions in the market determine the prices of securities. Factors like economic conditions, political stability, and interest rates influence these market dynamics.

Liquidity

Secondary markets provide liquidity, allowing investors to convert securities to cash quickly.

Risk Management

Markets offer risk management tools like derivatives. Investors and businesses can hedge against risks related to price fluctuations.

Information Dissemination

The prices and volume of trades reflect the information available in the market, allowing investors to make informed decisions.

Understanding the Capital Asset Pricing Model (CAPM)

The capital asset model or CAPM is a popular theoretical model used to determine the expected return on an asset, considering its risk relative to the market. It introduces the concept of systematic risk, or market risk, measured by the beta coefficient (β).

The CAPM formula is:
Expected Return (E) = Risk-Free Rate (Rf) + Beta (β) × (Market Return (Rm) – Risk-Free Rate (Rf))

Where:

• Risk-Free Rate (Rf) is the return of a risk-free investment, such as a government bond
  
  

• Beta (β) is the sensitivity of the asset to market movements
  
  

• Market Return (Rm) is the expected return of the overall market
  
  

Example Calculation:
Suppose the Risk-Free Rate (Rf) is 5%, the Market Return (Rm) is 12%, and a stock has a Beta (β) of 1.2.

Expected Return (E) = 5% + 1.2 × (12% - 5%) = 5% + 8.4% = 13.4%

This means the expected return for the stock, given its market risk, is 13.4%.

Key Trends in the Indian Capital Markets

Technological Advancements

Technology plays a crucial role, with artificial intelligence and machine learning enhancing trading efficiency and accuracy. Electronic trading has transformed both primary and secondary markets, making them more accessible and efficient.

Sustainability and ESG Investing

Environmental, Social, and Governance (ESG) criteria have become important in investment decisions. More funds are flowing into companies with sustainable practices, reflecting a shift in investor preferences.

Retail Participation

There has been a surge in retail participation in the Indian capital markets, supported by increased financial literacy and internet penetration.

Conclusion

Capital markets are integral to the functioning of modern economies. They provide the much-needed capital for companies while offering investors avenues for potential growth. While navigating these markets, models like the capital asset model can aid in understanding the risk-return dynamics.

Disclaimer: Investment in the Indian stock market involves inherent risks. Prospective investors must thoroughly evaluate all potential risks and advantages, keeping in mind their risk tolerance, financial goals, and market conditions. This article is for informational purposes only and does not constitute financial advice.