Capital market is an organized market mechanism for effective and efficient transfer of money capital or financial resources from the investing class to the entrepreneur class in the private and public sectors of the economy.
Parikh states, ‘By capital market I mean the market for all financial instruments, short-term and long-term as also commercial, industrial and government papers’.
Capital market is generally understood as the market for long-term funds. The capital market provides long-term debt and equity finance for the government and corporate sector.
Objectives of Capital Market
In 1955, the then Finance Minister spoke about the objectives of the capital and securities market in the Lok Sabha in this way:
The economic services which a well regulated and efficiently run capital market can render to a country with a large private sector are considerable.
- In the first place, it is only an organized securities market (an integral part of capital market) which can provide sufficient marketability and price continuity for shares, so necessary for the needs of investors.
- Secondly, it is only such a market that can provide a reasonable measure of safety and fair dealing in the buying and selling of securities.
- Thirdly, through the interplay of demand for and supply of securities, properly organized stock exchange assists in a reasonably correct evaluation of securities in terms of their real worth.
- Lastly, through such evaluation of securities the stock exchange helps in the orderly flow and distribution of savings as between different types of competitive investments.
Importance of Capital Market
Industrial revolution made possible mass production and mass production needs massive capital which can be procured through company form of organization and company form of organization led to the development of security markets.
Hence security market or capital market is an essential prerequisite for faster industrial growth and channelizing the savings of masses who do not venture to create and manage enterprise but want to be mere investors.
On the other hand, security markets help the entrepreneurs in setting up their projects which are beyond their financial capacity. Thus security market acts as a linking pin between economically deficit units and economic surplus units. Healthy, efficient and transparent functioning of the security market is therefore imperative for industrialization and economic development.
The developing countries as well as developed countries need funds for their economic development and growth. These funds are obtained from the surplus economic units or savers. A savings surplus unit can be a business, a household, Central Govt., State Govt. or local self-government whose current savings exceed consumption during a period under consideration.
On the other hand, there are deficit economic units whose consumption or investment is more than the current income.
If the investment equals the current savings for all units in an economy, then there would be no need for any economic unit to obtain funds externally from financial markets. In a modern economy, there is a gap between the investment and consumption needs as compared to the income.
Some units save more than they invest. Others invest more than they save. The capital or financial market is needed for the flow of funds from surplus to deficit units so that savings can be properly utilized by the deficit units.
A rupee saved is of little use for a country if it is not invested promptly. Money itself produces nothing until it becomes capital i.e., it is invested in capital goods. After investment in productive areas, it enhances the national product or per capita income and raises the standard of living of the masses.
A substantial amount of savings occur in the household units which are widely scattered in rural, urban and metropolitan areas. Their investment criteria vary significantly while the major investments are taken up in the governmental, semi-governmental and corporate sector.
The flow of savings from the household sector to these sectors necessitates the mobilisation of resources. Capital market facilitates transforming funds from the surplus units to the deficit units.
The pace of an economic development is conditioned, among other things, by the rate of long-term investment and capital formation. And capital formation is conditioned by the mobilization, augmentation and channelization of investable funds.
The capital market serves a very useful purpose by pooling the capital resources of the country and making them available to the enterprising investors. Well-developed capital markets augment resources by attracting and lending funds on a global scale.
The increase in the size of the industrial units and business corporations due to technological developments, economies of scale and other factors has created a situation where in the capital at the disposal of one or few individuals is quite insufficient to meet the investment demands.
A developed capital market can solve this problem of paucity of funds. Form organized capital market can mobilize and pool together even the small and scattered savings and augment the availability of investable funds.
While the rapid growth of joint stock companies has been made possible to a large extent by the growth of capital markets, the growth of joint stock business has in its turn encouraged the development of capital markets. A developed capital market provides a number of profitable investment opportunities for the small savers.
Functions of Capital Market
The functions of financial market which comprise capital and money market involve the exchange of one financial asset for another e.g., surplus economic units exchange money into another financial asset that provides future return in the form of interest, dividend and capital appreciation. They bring savers and borrowers together by selling securities to savers and lending that money to the borrowers.
The efficiency of finance market depends upon how efficiently the flow of funds is managed in an economy. As Prof. Schimpeter in his book, “The Theory of Economic Development”, has put it, ‘without the transfer of purchasing power to him an entrepreneur cannot become an entrepreneur’.
It is equally important that financial market should induce people to become entrepreneurs and motivate individuals and institutions to save more.
Capital and money markets are the means for allocating the savings in the most desirable way so that we can achieve the desired national objectives and priorities. This facilitates in the efficient production of goods and services, thus it contributes to the society’s wellbeing and raises the standard of living of not only of borrowers but also of others in the economy.
Financial markets perform this function by transmitting the nation’s savings into best possible productive uses which in turn raises the output and employment level in a country.
The proper development and growth of finance markets play a vital role for the fast growth of the economy. For meeting the growing financial needs of a developing economy, financial ark should also grow at a faster rate.
Moreover, it should be efficient and more diversified. Van Home in r book, Financial Management and Policy has rightly said. The more varied the vehicle by which savings can flow from ultimate savers to ultimate users of funds’ the most efficient the financial markets of an economy tend to be.
Financial markets satisfy the needs of both savers and borrowers. In financial markets, there are different financial instruments which are bought and sold daily. These instruments differ in liquidity, marketability, maturity, risk, return, tax concisions etc. Investors differ in their attitudes towards risk, return and liquidity.
Moreover, investors want to have a more diversified investment portfolio. Hence the greater the diversification in financial instruments in a financial market, the greater will be the efficiency in generating and transferring the savings into investment.
The financial markets not only help in transfer of savings in new industry but also provide opportunities for financial investment so as to earn income on surplus. In other words, these markets perform both financial and nonfinancial functions.
The financial markets enable financing of not only physical capital formation but also of consumption expenditure. That is why financial markets manage the flow of funds not only between individual savers and investors but also between institutional savers and investors.
The demand for long-term funds comes from individuals, institutions, central govt., state govt., local self-govt. and private corporate sector. Funds are raised through issue of shares, debentures and bonds which constitute the new issue market.
Apart from raising funds directly from savers the deficit units obtain longterm funds from public financial institutions and investment institutions also. The supply of funds mainly comes from individuals, institutions, banks and industrial financial institutions.
The capital market plays a significant role in the financial system. Savings and investments are vital for economic development of an economy. Generally, units which save and invest are different; capital market provides a bridge by which savings of surplus units are transmitted into long-term investments by deficit units.
The pace of economic development along with other things depends upon the rate of long-term investments and capital formation in a country. The rate of capital formation depends upon the rate of savings, rate of investment and financial markets.
The capital market plays a vital role in mobilising the savings and making them available to the enterprising investors. The primary capital market helps Govt. and industrial concerns in raising funds by issuing various kinds of securities. The secondary market provides liquidity to the outstanding securities.
An active capital market through its price mechanism allocates the scarce financial resources to the most productive uses at a low cost. The system of allocation of funds works through incentives and penalties.
Usually the cost of capital is comparatively low for the large and efficient companies as their securities are subject to lesser risks. Shares of high growth companies command a premium in the market while the poor performance companies face problems in selling their securities and may have to issue securities at a discount to raise additional funds. The specified shares are more attractive than non-specified shares.
The market comprises suppliers and buyers of finance, along with trading instruments and mechanisms. There are also regulatory bodies. Stock exchanges, equity markets, debt markets, options markets, etc., are some capital market examples.
The primary market is for trading freshly issued securities, i.e., first-time trading. It enables an initial public offering. It is also known as the new issues market.
Here, companies raise funds with the help of preferential allotment, rights issue , electronic IPOs, or the pre-selected issue of securities or private placement. Usually, like an investment bank, the intermediary attaches an initial price to the shares. Once the sale materializes, firms take their shares to the stock exchange to facilitate trading between different investors.
The trading of old securities occurs in the secondary market, which occurs after transacting in the primary market. Both stock markets and over-the-counter trades come under the secondary market. We also call this market the stock market or aftermarket.
Examples of secondary markets are the London Stock Exchange, the New York Stock Exchange, NASDAQ, etc.
Elements of a Capital Market
- Individual investors, Commercial banks, financial institutions, insurance companies, business corporations, and retirement funds are some significant suppliers of funds in the market.
- Investors offer money intending to make capital gains when their investment grows with time. In addition, they enjoy perks like dividends, interests, and ownership rights.
- Companies, entrepreneurs, governments, etc., are fund-seekers. For instance, the government issues debt instruments and deposits to fund the economy and development projects.
- Usually, long-term investments such as shares, debt, government securities, debentures, bonds, etc., are traded here. In addition, there are also hybrid securities such as convertible debentures and preference shares.
- Stock exchanges operate the market predominantly. Other intermediaries include investment banks, venture capitalists, and brokers.
- Regulatory bodies have the authority to monitor and eliminate any illegal activities in the capital market. For instance, the Securities and Exchange Commission overlooks the stock exchange operations.
- The capital market and money market are not the same. Securities exchanged in the former would typically be a long-term investment with over a year lock-in period. Short-term investments trade in the money markets and include a certificate of deposits, bills of exchange, promissory notes, etc.
The capital market plays an important role immobilising saving and channel is in them into productive investments for the development of commerce and industry. As such, the capital market helps in capital formation and economic growth of the country. We discuss below the importance of capital market.
The capital market acts as an important link between savers and investors. The savers are lenders of funds while investors are borrowers of funds. The savers who do not spend all their income are called. “Surplus units” and the borrowers are known as “deficit units”. The capital market is the transmission mechanism between surplus units and deficit units. It is a conduit through which surplus units lend their surplus funds to deficit units.
Funds flow into the capital market from individuals and financial intermediaries which are absorbed by commerce, industry and government. It thus facilitates the movement of stream of capital to be used more productively and profitability to increases the national income.
Surplus units buy securities with their surplus funds and deficit units sells securities to raise the funds they need. Funds flow from lenders to borrowers either directly or indirectly through financial institutions such as banks, unit trusts, mutual funds, etc. The borrowers issue primary securities which are purchased by lenders either directly or indirectly through financial institutions.
The capital market prides incentives to savers in the form of interest or dividend and transfers funds to investors. Thus it leads to capital formation. In fact, the capital market provides a market mechanism for those who have savings and to those who need funds for productive investments. It diverts resources from wasteful and unproductive channels such as gold, jewellery, real estate, conspicuous consumption, etc. to productive investments.
A well-developed capital market comprising expert banking and non-banking intermediaries brings stability in the value of stocks and securities. It does so by providing capital to the needy at reasonable interest rates and helps in minimising speculative activities.
The capital market encourages economic growth. The various institutions which operate in the capital market give quantities and qualitative direction to the flow of funds and bring rational allocation of resources. They do so by converting financial assets into productive physical assets. This leads to the development of commerce and industry through the private and public sector, thereby inducing economic growth.
In an underdeveloped country where capital is scarce, the absence of a developed capital market is a greater hindrance to capital formation and economic growth. Even though the people are poor, yet they do not have any inducements to save. Others who save, they invest their savings in wasteful and unproductive channels, such as gold, jewellery, real estate, conspicuous consumption, etc.
Such countries can induce people to save more by establishing banking and non-banking financial institutions for the existence of a developed capital market. Such a market can go a long way in providing a link between savers and investors, thereby leading to capital formation and economic growth.