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Home > Financing Checklists > Understanding Capital Markets, Structure and Function

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Understanding Capital Markets, Structure and Function


Checklist Description

This checklist outlines capital markets, their structure, and their function.

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Definition

Capital markets provide a wide range of products and services that are related to financial investments. Capital markets include the stock market, commodities exchanges, the bond market, and just about any physical or virtual service or intermediary where debt and equity securities can be bought or sold. Their primary purpose is to raise funds and channel investors’ money to areas where there is a deficit or need for investment. They play a vital role as intermediaries between governments and companies, which use them to finance a myriad of activities.

The capital markets can be broken down into the primary market, where new stocks and bonds are issued to investors, and the secondary market, where existing stocks and bonds are traded.

In the primary market, governments, companies, or public sector organizations can obtain funding through the sale of a new stock or bonds. These are normally issued through securities dealers and banks, which underwrite the offered stocks or bonds. The issuers earn a commission, which is built into the price of the security offering.

In the secondary market, stocks and shares in publicly traded companies are bought and sold through one of the major stock exchanges, which serve as managed auctions for stock. A stock exchange, share market, or bourse is a company, corporation, or mutual organization that provides facilities for stockbrokers and traders to trade stocks and other securities. Stock exchanges also provide facilities for the issue and redemption of securities, trading in other financial instruments, and the payment of income and dividends.

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Advantages

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Disadvantages

  • In capital markets, bond prices are influenced by economic data such as employment, income growth/decline, consumer prices, and industrial prices. Any information that implies rising inflation will weaken bond prices, as inflation reduces the income from a bond.

  • Prices for shares in capital markets can be very volatile. Their value depends on a number of external factors over which the investor has no control.

  • Different shares can have different levels of liquidity, i.e. demand from buyers and sellers.

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Action Checklist

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Dos and Don’ts

Do

  • Before you buy, check how quickly you will be able to sell if necessary, and at what discount and dealing fee.

Don’t

  • Don’t, unless you are completely confident, invest in only one type of bond or security. An exchange-traded fund or an index fund might be a much safer bet.

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Further reading

Books:

  • Fabozzi, Frank J., and Franco Modigliani. Capital Markets: Institutions and Instruments. 4th ed. Upper Saddle River, NJ: Prentice Hall, 2008.
  • Maginn, John L., Donald L. Tuttle, Jerald E. Pinto, and Dennis W. McLeavey (eds). Managing Investment Portfolios: A Dynamic Process. 3rd ed. Hoboken, NJ: Wiley, 2007.
  • McInish, Thomas H. Capital Markets: A Global Perspective. Malden, MA: Blackwell Publishers, 2000.

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