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Capital Market | Definition, Features, Functions, Advantages, Disadvantages & Capital Market Instruments

Capital Market

What is Capital Market ?

Capital market means a common place where the borrowers and lenders meet to finance the requirement of long-term funding. In a broader aspect, it involves all those channels from where the savings are mobilized and the same are used in funding the industrial and government expenditure. It comprises of savings that includes both corporate as well as personal savings which are utilized for making investments in the new IPO's and other public offerings that are issued by the government authorities.
So, a capital market is a well organised market structure where the money is transferred from the lender to the borrower in lieu of certain interest or other compensatory benefits. The individual investors are the primary savers who lends the same to the entrepreneurs for circulation of money in the industry which may be either owned privately or belong to the government.

Definition of Capital Market 

According to P.K. Dhar :
"This is not a market for capital goods; rather it is a market for raising and advancing money capital for investment purposes".

According to M.Y. Khan :
"It is a market for long term funds. Its focus is on financing of fixed investments in contrast to money market which is the institutional source of working capital finance".

Functions of Capital Market 

Following are the main functions of the capital market :

1) Allocation Function : 
Many times the investors are unaware about the investment opportunities that are available to them and thus are deprived of investing. Capital market in this situation assists in channelizing the savings on behalf of the investors in different available modes. So, the present savings are attributed among the respective borrowers. The market acts a magnet where different lenders having different perspectives are invited for making their investment.

2) Liquidity Function : 
Capital market aims at bringing the lenders and the borrowers at a common platform where they can exchange their funds at mutually agreed interest rates and lending period. Thus, the liquidity is always available at the discretion of both the parties.

3) Other Functions : 
Apart from the basic function of allocating the funds and the liquidity function, capital market also important functions: serves the following

i) Indicative Function : 
In addition to showing the progress of a company, capital market is also a good indicator of the economic position of a country.

ii) Savings and Investment Function : 
The long-term debts can be easily converted into liquid funds in less time. Thereby, the lenders can redeem their funds at their own will. This helps in restoring the confidence of the lenders as they earn a good rate of interest with an assurance of liquid funds.

iii) Transfer Function : 
This market organizes the movement of the assets i.e. the tangible assets and the intangible assets in different individual units or the groups.

iv) Merger Function : 
This market facilitates merging between the willing companies and companies having a slack their management with the pioneers of the industry.

Features of Capital Market 

The various characteristics of capital market are as follows :

1) Link between Savers and Investment Opportunities : 
The capital market acts as channel between the process of saving and investment. The capital market sends money from savers to entrepreneurial borrowers.

2) Provides Long Term Investment : 
The capital market supplies the funds required for long and medium investment. The capital market does not make use of short-term savings of less than one year.

3) Utilizes Intermediaries : 
Capital market uses various intermediaries such as brokers, underwriters, depositories, etc. by which all the work of capital market is performed and it is also the important part of capital market.

4) Determinant of Capital Formation : 
The various task of the capital market decide the rate of capital formation in an economy. The capital market gives choices to the firm about utilizing excess funds to invest more in capital market which helps in increasing the saving in the profitable manner.

5) Government Rules and Regulations : 
The capital market works according to the rules and regulations framed by the government. They are free but need to work according to the government policies.

6) No Entry Barriers : 
The capital market is accessible to all the people. Any number of suppliers or users of funds can enter the market and deal with each other.

7) Absence of Transaction Cost : 
The participant does not have to pay transaction costs for buying and selling of securities.

8) No Tax Differences : 
The tax should be such that it should treat every investor in the same manner. It should not be favorable to one over other.

9) Liquidity : 
The capital market is more liquid as compared to real estate or commodity market because they have various institutions like banks, mutual funds, retail investors, hedge funds, etc. which helps the investors in easily exiting from the market as the investors can sell their investments whenever they want.

10) Variety of Instruments : 
The capital market has different type of instruments like bonds, debentures, equity stocks, futures and options. There are many more choices available according to the risk bearing capacity of the investors. The company with high leverage can increase their capital by investing in equity and the company having less leverage can raise their capital by investing in bond and debenture.

Capital Market Instruments

Following instruments are found in the capital market : 

1) Equity Shares : 
They are also termed as ordinary shares or common stock. One might understand both the terms 'shares' and 'stocks' as the same but there is some basic difference that is involved. Shares denote the small units of equal denomination constituting the share capital of the company. On the other hand, stock is the aggregate of fully paid shares of the company that is taken together. In other words, it is the collection of the shares. A stock has a value and represents as to what quantum it contains. Thus, stock can be further divided into fractions but again the denomination will be in terms of money and not in terms of number of shares.

2) Preference Shares : 
Preference shares are like a hybrid instrument as they possess the features of a bond as well as that of an equity share. Unlike bonds, the preference shareholders have right to receive dividend even if there are no profits or less profits. Also in the event of liquidation of a company, their money is paid in preference to the equity shares. And unlike equity shares, they possess the characteristic of perpetual liability. Only the rate of dividend is fixed, but it is at the discretion of the Board of Directors to pay dividend or not.

3) Sweat Equity : 
Such shares are issued by the company to their internal staff i.e., directors or employees at a discounted rate in lieu of services rendered by them to the company which have brought certain know-how or value addition.

4) Debentures : 
They constitute a type of debt payment and a substitute to the shares. Basically, they are issued by the private sector companies for raising desired funds from the general public. Under this, the money is borrowed with a promise of redemption on a certain fixed date and with the promise of periodic payment of interest. In India, Debentures are treated like bonds only but generally the bonds are issued by public sector companies.

5) Warrants : 
It is a bearer document where the buyer agrees to purchase a certain amount of equity shares at a specific price. Normally, this right to purchase can be exercised over a long period and the aim is to make the offer lucrative for the investors, so that they may subscribe for the bonds or preference shares.

6) Secured Premium Notes (SPNs) : 
SPN has the characteristics of medium and long-term notes. They are issued alongside a warrant and the redemption is done at the end of the specific periods.

7) Derivatives : 
Derivatives are the instruments whose value is determine from the underlying instruments.

New Instruments in Capital Market

The new instruments in the capital market are as follows :

1) Global Depository Receipts (GDR's) : 
GDR is the global finance method which helps the issuer to raise capital from different market present across the world. It can be traded either in public or private market that exist inside or outside US, They are mainly supplied to international financial institutions. The global depository receipts certificate is provided by the international banks which are related to worldwide distribution of capital markets.

2) Foreign Currency Convertible Bond (FCCB) : 
It is a quasi-debt instrument which is given to the investors by various kinds of corporate entity, international agency, sovereign state, etc. which are there all over the world. They are expressed in freely convertible foreign currency. The Euro convertible bonds are basically provided as the unsecured obligation to the borrowers. FCCBs show the equity linked debt security which can be easily converted into shares or depository receipts. The investors of FCCB can change it into equity by the help of fixed formula at fixed exchange rate or they can keep it as the bond.

3) Futures : 
The futures contract is an agreement done between two parties to buy or sell an asset at a certain price in the future time period. They are the special types of forward contract as they are formerly standardized exchange-traded contracts. It is not exactly same as forward contract. In future contract, the counter-party is the clearing corporation on the accurate exchange. The future is basically in cash or cash equivalent instead of physical delivery of the underlying asset. The parties involved in future contract may buy or write options on futures.

4) Options : 
The options is the financial derivative showing the contract which is sold by option writer to option holder. It does not give the obligation but the right to the buyer to call or put the security or any other financial asset at a strike price during certain period of time or at an exercise date.

5) Tracking Stocks : 
The tracking stock is the kind of common stock which "tracks" or is controlled by the financial performance of certain business unit or operating department of a company instead of whole company. Hence, the units or divisions perform well and the value of the tracking stocks may increase even though the performance of the company as the whole is not satisfactory. The vice versa of the situation can also be true.

6) Mortgage Backed Securities : 
The return of these securities depends upon the performance of the specific assets. They have maturity period of 3 to 10 years and is financed by assets like mortgages, credit card receivables, etc. There is the obligation from the loan originator and intermediary institution to provide the minimum yield of maturity.

7) Hedge Funds : 
Hedge fund is known as fund of funds which is unregistered private investment partnerships funds. They may be invested and traded in different markets, strategies and instruments which may include securities, non securities and derivatives. They are different from mutual funds as they have different regulatory requirement. Both mutual funds and hedge funds need to provide information of some periodic and standardized pricing and valuation to investors.

8) Domestic Hedge Fund : 
The domestic hedge funds are present in U.S.A. which are basically in organised form as the limited partnerships to I collect the investors which are accountable to U.S. Income Tax Act. The sponsor of the funds is basically a partner and investment advisor. The hedge funds may be of limited liability company (LLC) or business trust. These LLPs, LLCs and business trust are not taxed separately but the income is taxed at the individual level of investors. These three kinds of firms limit the investors according to their liability but LLCs provide extra advantage of limited liability for fund advisors.

9) Off-shore Hedge Fund : 
These are basically present in countries like Cayman Islands, British Virgin Islands, the Bahamas, Panama, The Netherlands Antilles or Bermuda. They are basically for the investments of U.S. tax exempt entities like pension funds, charitable trusts, foundations and endowments, as well as non U.S. residents. The U.S. tax-exempt investors invest in off-shore hedge funds as they are subject to taxation only if they invest in domestic limited partnership hedge funds.

10) Exchange Traded Funds (ETF) : 
Exchange Traded Funds has the advantages of both closed-end and open-end mutual fund. They work according to the stock market index and are traded on stock exchange like a single stock at index linked prices. The merits of these funds are that they provide variety, adaptability of holding a single share at the same time. They are newly introduced in India but are very popular in abroad.

11) Fund of Funds (FOF) : 
These investments are also known as multi-manager investments. The fund of funds has the portfolio of other investment funds instead of investing directly in shares, bonds or other securities.

Advantages of Capital Market

Following points illustrate the importance of capital market : 
  • Capital market provides direction to the company in achieving its financial targets. 
  • Amalgamations and mergers can be facilitated through the available share price.
  • The element of liquidity assists in encouraging the growth. 
  • Foreign investment is also attracted which brings about uniformity in the reporting norms. 
  • In case of insufficient availability of funds in the money market, the funds can be arranged from the capital market.
  • Interests/dividend rates, liquidity, security entails the investors to do in-depth study of the market and make the investments.

Disadvantages of Capital Market

The limitations of capital market are as follows : 
  • The capital market has the risk of losing money.
  • The capital market involves various charges which decrease profit from various investment done. 
  • The capital market has the problem of volatility as it does not remain stable for long time especially in case of the long-term investments.
  • The capital market has the risk for the people who pursue their career in capital market. The businesses in which the investment is done is liable for the working performance and also has the burden of delivering goods. If the goods are not according to the customers, it will indirectly lead to loosing the investors.

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