What Are Capital Markets?

Capital Markets Explained

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Capital markets are international markets where buyers and sellers go to trade assets like stocks and bonds. The biggest capital markets are the stock and bond markets, but currency and derivative markets are also popular among investors and businesses. 

Capital markets are a crucial part of a functioning and growing economy. Here’s how they work and a few examples of how businesses use them. 

Definition and Examples of Capital Markets

Capital markets are financial markets where buyers and sellers trade assets. Businesses typically use capital markets to raise new capital—funds that a business uses to grow or meet current operating expenses—by issuing assets like stocks or bonds. Investors buy those assets and, in the case of stocks, gain partial ownership in a company and the opportunity to earn returns on their investments.

Capital markets exist in primary and secondary forms. The primary market is where the security (the stock or bond) is originally issued to raise the capital. Following that issuance, the security trades on a secondary market (this is likely what you typically think of as the stock market). 

If you buy the security on the secondary market, you are still owed payments issued by the company. That means principal and interest payments on bonds and dividend payments on stocks would make their way to your account.

Here’s how Tesla (TSLA) has utilized the capital markets in recent years:

On December 8, 2020, the company filed at the Securities and Exchange Commission (SEC) that it would be raising up to $5 billion in a new stock offering. This filing came just three months after its last filing to raise capital via the stock market—that filing was for $5 billion, too.  In August 2020, it raised just over $700 million using asset-backed bonds tied to vehicles that it leases to customers.

The other commonly used capital markets are currency and derivative markets. Businesses use currency markets to hedge risks incurred by generating revenue in foreign markets and traders use it to take advantage of interest rate differences with the “carry trade”. A common derivative for both individual investors and businesses is the futures market, where businesses can lock in the price of a commodity to be delivered in the future.

How Capital Markets Work

The easiest way to understand how capital markets is know how the various types of capital markets operate.

Stock Market

Businesses that are listed on stock exchanges (secondary markets for stocks) are called public companies. As a public company, the business is required to have an investor base of a certain size and file audited financials with the SEC each quarter.  

Businesses then trade on an exchange, like the New York Stock Exchange (NYSE) or the NASDAQ. Each exchange has its own listing requirements that companies must follow to stay on the exchange.

Individual investors can set up a brokerage account to either purchase shares of businesses directly or buy into a pool of money called a fund that chooses and buys companies for them. When you buy a stock in your brokerage account, you are buying a fractional share of the business. The broker works with the exchange and other intermediaries to buy and sell stocks.  

Bond Market

The federal government raises funds by issuing treasury bonds, bills, and notes that trade on the secondary market. These bonds are considered to be safe investments because they are backed by the government’s massive tax revenue. Other bonds are often priced relative to treasuries based on how risky they are perceived to be. 

Municipal bonds, or “munis,” are the local form of treasury bonds. They are backed by the tax base of local cities, counties, or states. Like treasuries, many munis pay tax-free interest. While not considered risk-free, munis are generally thought of as one of the least risky asset classes. 

Finally, corporate bonds are used by businesses to raise funds on the open market. Businesses don’t have to be publicly traded to issue bonds, but they do have to file with the SEC to keep investors updated on their financials. 

Currency Market

Currency trading is commonly referred to as “FOREX trading.” Currencies don’t often move much so FOREX trading often includes a ton of leverage. This can lead to big returns but it can also lead to getting wiped out quickly.   

Businesses can use the currency market to make sure they don’t lose money on otherwise profitable deals because of currency fluctuations.

Derivatives Market

Futures contracts are an agreement to buy or sell a certain quantity of an asset at a future date. For example, you could agree to buy 10 pounds of gold bullion at $2,000 per ounce in six months. If the price goes over $2,000 per ounce, you make money. 

Speculators want to buy futures contracts for the huge potential gains (futures trading uses a ton of leverage just like FOREX trading). Businesses use it to hedge. If you’re a gold miner uncertain of where the gold price will be in six months, you may decide to sell the futures above to lock in a price of $2,000 per ounce now. That way, if the price drops, you still make money.

One of the most famous examples of a company using a derivatives market is Southwest hedging future oil prices. Over the years, Southwest has stayed competitive as one of the industry’s low-cost providers by selectively hedging its jet fuel costs. When other airlines suffered from high jet fuel costs, Southwest raked in millions in gains on its futures contracts. 

Key Takeaways

  • Capital markets exist to link investors with businesses in need of capital.
  • Many big businesses use the stock and bond markets to raise new capital for growth.
  • Currency and derivatives markets are mostly used by businesses to hedge future profits and investors to speculate using leverage.