Capital Markets – Some Basics

The capital market is an important constituent of the financial system. It is a market for long term funds both equity and debt and funds raised within and outside the country.

The capital market aids economic growth by mobilizing the savings of the economic sectors and directing the same towards channels of productive uses. This is facilitated through the following measures.

1) Issue of primary securities in the primary market that is, directing cash flow from the surplus sector to the deficit sectors such as the government and the corporate sector.
2) Issue of secondary securities in the primary market that is, directing cash flow from the surplus sector to financial intermediaries such as banking and non- banking financial institutions.
3) Secondary market transactions in outstanding securities which facilities liquidity. The liquidity of the stock market is an important factor affecting growth. Many profitable projects require long term finance and investment which means locking up funds for a long period. Investors do not like to relinquish control over their savings for a long time. Hence, they are reluctant to invest in long gestation projects. It is the presence of the liquid secondary market that attracts investors because it ensures a quick exit without heavy losses or costs.

Hence, the development of an efficient capital market is necessary for creating a climate conducive to investment and economic growth.

Functions of a Capital Market:

The functions of an efficient capital market are as follows:

1) Disseminate information efficiently for enabling participants to develop an informed opinion about investment, disinvestment, reinvestment, or holding a particular financial asset.
2) Enable quick valuation of financial instruments – both equity and debt.
3) Provide insurance against market risk or price risk through derivative trading and default risk through investment protection fund.
4) Enable wider participation by enhancing the width of the market by encouraging participation through networking institutions and associating individuals.
5) Provide operational efficiency through

i) simplified transaction procedure
ii) lowering settlement timings, and
iii) lowering transaction costs

6) Develop integration among
i) real sector and financial sector
ii) equity and debt instruments
iii) long term and short term funds
iv) long term and short term interest costs
v) private sector and government sector and
vi) domestic funds and external funds.
7) Direct the flow of funds into efficient channels through investment, disinvestment, and reinvestm

Primary Capital Market and Secondary Capital Market:

The capital market comprises the primary capital market and the secondary capital market

Primary market refers to the long term flow of funds from the surplus sector to the government and corporate sector (through primary issues) and to banks and non banks financial intermediaries (through secondary issues) Primary issues of the corporate sector lead to capital formation (creation of net fixed assets) and incremental change in inventories.
The nature of fund raising is as follows:

Equity issues by:

Corporates (primary issues)
Financial intermediaries (secondary issues)

Debt instruments by:

Government (primary issues)
Corporates(primary issues)
Financial intermediaries (secondary issues)

Equity issues through
Global Depository Receipts (GDR)
And American Depository Receipts

Debt instruments through:
External Commercial Borrowings
Other External Borrowings:
Foreign Direct Investments (FDI) in equity and debt form
Foreign Institutional Investments (FII) in the form of portfolio Investments
Non-resident Indian Deposits (NRI) in the form of short term and
medium term deposits

The fund raising in the primary market can be classified as follows:

i) Public issue by prospectus
ii) Private placement
iii) Rights issues

Secondary market is a market for outstanding securities. An equity instruments being an eternal fund, provides an all time market while a debt instruments with a defined maturity period, is traded at the secondary market till maturity. Unlike primary issues in the primary market which result in capital formation, the secondary market facilitates only liquidity and marketability of outstanding debt and equity instruments. The secondary market contributes to economic growth by channelizing funds into the most efficient channel through the process of disinvestment to reinvestment. Te secondary market also provides instant valuation of securities (equity and debt instruments) made possible by changes in the internal environment that is through companywide and industry wide factors. Such a valuation facilitates the measurement of the cost of capital and rate of return of economic entities at the micro level.

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