Which comes to your mind when you hear the word markets?
Do you picture a vendor selling goods in exchange for money?
Well, we are all familiar with this type of market. But, you will be surprised to learn that some important markets are not available in the form of stores. In fact, there is a market where buyers and sellers probably never meet in person. This market also has a huge significance on our economy. It is called the financial markets.
What is a Financial Market?
A vegetable market is a place where buyers and sellers meet to exchange vegetables for cash. Similarly, a financial market is a place where lenders and borrowers of money meet.
In our economy, you will always find a set of individuals who have surplus funds and are looking to invest. These individuals are known as investors. While there are others who are in need of money. They are known as borrowers. The role of the financial market is to bridge the gap between the two.
So, the market in which the individuals with surplus money meet the individuals who need money is called a financial market.
Watch this video to know everything about the financial market
There are two types of financial markets:
Capital Markets: Here borrowers raise funds for more than a year.
Money Markets: Here borrowers raise funds for less than a year.
In this article, let’s focus and learn everything about capital markets including:
What are capital markets?
History of capital markets in India
Basic structure of capital markets
Types of capital markets
Role of SEBI in capital markets
It is just like any other market, but the instrument being traded between the buyer and the seller is capital (money). This capital is raised for more than a year. Hence, it is also called a long term investment.
But why do we need capital markets?
Simply because capital is the core of any company. A business will not be able to produce goods if there is no capital. It will not be able to pay its employees and other liabilities without capital.
Even governments need capital to build roads, bridges and conduct other welfare activities for their citizens.
So, it’s safe to say that capital is at the core of any economy. It helps the country improve its standard of living. Hence, having a capital market is crucial.
History of Capital Markets in India
To explore the roots of capital markets, we need to go back to 1947. During the time of independence, India was an underdeveloped country. Most households were poor and had little to no savings.
Companies used to approach banks to raise capital. But with low savings rate, even banks were unable to provide huge loans.
Looking at this situation, the government had to set up financial institutions like the Industrial Development Bank of India (IDBI). Over the period of time, IDBI played the role of being the apex institution for lending loans. It also helped industries in planning and development of new projects.
After globalisation of the Indian economy in 1991, many foreign institutional investors (FII’s) from across the world started to invest in India through the securities markets. This led to its massive growth.
But in 1992, the Harshad Mehta Scam revealed the inadequacies of our capital markets. This was a turning point for Indian capital markets. It led to the formation of the Securities and Exchange Board of India (SEBI).
Mr P Chidambaram (former Finance Minister) abolished the long-term capital gains (LTCG) tax on securities and kept short-term capital gains tax at 10% in 2005. He did it to encourage retail participation in the stock markets. The Indian capital markets have seen tremendous growth in technology and the S&P BSE Sensex has surpassed 50,000 levels despite LTCG tax being reintroduced in 2018.
Let us now understand the structure of capital markets and how the capital markets work.
Basic Structure of the Capital Markets
In capital markets, there is an exchange of capital. Let’s try to relate this with cricket for better understanding.
Take a look at the picture below.
The bowler is the lender of the capital.
The batsman is the borrower.
Following are all the possible lenders and borrowers in the real world scenario.
Lenders of capital:
Retail investors (Investors like you and me)
Institutional investors (Mutual fund companies and insurance companies)
Foreign Institutional Investors (Investors from other countries who wants to invest in the Indian stock markets)
Borrowers of capital:
Entrepreneurs who wish to issue shares of the company.
Government who wants to borrow money by issuing debt.
While watching cricket we do see a person standing behind the bowler. This person is known as the umpire. He provides the guidelines of the game and ensures that the standards of the game are maintained.
Similarly, in capital markets, SEBI acts as the umpire.
Apart from lenders, borrowers and SEBI, we also need a few intermediaries to make the process easier.
Borrower of Capital
Entrepreneurs who wish to issue shares of companies in the stock market
Entrepreneurs who wish to issue debt securities.
Government who wants to borrow money by issuing debt.
An entrepreneur who wishes to borrow money from the bank.
Lenders of Capital
Retail Investors who would directly invest in equity shares of the company.
Institutional investors such as mutual fund companies and Insurance companies.
#Question_time: If a company approaches a bank for a loan, why is the bank not known as the lender of capital but the intermediary?
That’s because the money which the bank is lending is actually deposits. It is collected from the general public. So, the lenders of capital are the depositors and the bank is a channel through which the funds are distributed in the form of loans.
Now let’s explore the various types of capital markets.
Let’s explore each one in detail.
1. Equity Markets
An equity market is a place where shares of a company are traded. It is popularly known as the stock market or share market.
As the name suggests, it is a marketplace where buyers and sellers meet to trade in stocks of publicly listed companies. The investors who invest in these stocks become part owners of the company. They are exposed to risks and rewards earned by the company.
Equities are further divided into two.
A. Primary markets
This is a market where companies issue their shares for the very first time. It is also known as new issue market.
Here are the methods of raising funds through primary markets.a. Initial Public Offering (IPO)
Let us understand IPO with a simple example.
Mr Winter is the owner of Winter Textiles Ltd. He makes a deal with Chanel to export textile cloth to their manufacturing unit. However, his company is currently operating at full capacity and has no room for new orders. To fulfil this new order, he will have to set up a new industrial unit. This new project would cost a huge sum.
Now to raise capital, Mr Winter decides to list the shares of Winter Textiles for the first time on the stock exchange. This method of raising capital through the primary market is known as Initial Public Offering (IPO).
The primary market allows companies like Winter Textiles Ltd to issue shares of their business to potential investors. In return, the investors own a small portion of the company.
To explore the process of issuing an IPO – Click here.
b. Follow on Public Offer (FPO)
When a public company issues additional shares after issuing an IPO, it is called an FPO.
For example: After a successful IPO, Winter Textiles Ltd received big orders from Gucci and Zara. To finance these activities, they require additional capital. Hence, they decide to issue additional shares or FPO of Winter Textiles.
To know the key difference between IPO and FPO – Click here.
c. Rights Issue
When a company is looking to expand their business and need more funds, they first turn to their existing investors. These existing shareholders are given the right to buy new shares at a discounted rate before the general public.
The shareholder has the right to refuse rights issue. In this case, these shares are offered to the general public.
To know more about rights issue – Click hered. Private placement
When a company offers its securities to a small group of private investors, it is called private placement. These securities may be bonds or stocks. Here the company raises funds by selling its shares privately to high net individuals (HNIs), Domestic Institutional Investors etc.
e. Preferential issue
This is one of the quickest methods for a company to raise capital. These shares are issued to financial institutions, Hindu Undivided Family (HUF) and other lending firms. Retail investors are rarely offered preference shares. The minimum investment amount is Rs 10 lakhs. In preferential allotment, the shareholders receive dividends before equity shareholders.
To explore more about preference shares – Click here.
B. Secondary Markets
A secondary market is a platform through which the shares of companies are traded among investors.
Continuing the above example, suppose Winter textiles Ltd has distributed shares of Rs 100 crores. Upon listing, the shareholders are free to buy and sell these shares through the stock exchanges. This trading is done in the secondary markets.
#Question_time: Suppose you had bought a share of Winter Textiles Ltd and sold it in less than a year, then how is it a part of capital markets?
Capital raised by companies during an IPO stays with them till the time of liquidation. While its shares are tradable in the secondary market. This means you have an option to sell your shares to another buyer in exchange for money. But there is no way to ask the company to buy the share back apart from their own will. Hence the raised capital is perpetual.
2. Debt marketDebt is a loan on the company. If a company does not wish to dilute its ownership by issuing equity shares, it issues debentures or bonds.
A. BondsBonds are fixed income instruments. It is an instrument where investors provide loans to the bond issuer. In return, the issuer promises to pay a fixed interest rate and return the principal amount on maturity. These bonds are traded in the secondary markets.
Bonds are majorly divided into two types.
Government securities (G sec)
G sec or government securities are issued by central and state governments of India. They are supervised by the Reserve Bank of India (RBI). These bonds are issued when the government needs funds for an upcoming project or infrastructural development. They pay fixed interest to its bondholders at regular intervals. These bonds carry almost zero default risk.
Corporate bonds
Corporate bonds are issued by large companies. It is a very popular method through which companies raise capital at low cost. These bonds carry more risk than government bonds but provide higher interest rates too.
To explore more about bonds – Click here.
B. Debentures
Debentures are instruments issued to raise debt capital. Here individuals like you and me, provide a loan to a company. The only difference between bonds and debentures is that bonds are mandatorily secured by a collateral. Whereas, debentures may be secured or unsecured.
Secured debentures are backed by collateral. If the company is unable to pay the interest or principal amount, then the collateralised asset can be liquidated.
Unsecured debentures are bought based on trust. There is no collateral. To explore more about debentures – Click here.
Role of SEBI in Capital Markets
SEBI is the regulator of the Indian capital markets. It was established after the Harshad Mehta scam in 1992. It works to protect interest of investors.
Following are the roles of SEBI:
It strictly monitors and curbs insider trading practices. This keeps the market fair and transparent.
It monitors company takeovers and acquisitions.
SEBI takes care of research and development to ensure the securities market is efficient at all times.
It designs guidelines and a code of conduct for the proper functioning of financial intermediaries.
It conducts inquiries and audits of the stock exchanges.
Final Thoughts
As a company, capital markets offer you the opportunity to develop and grow your business. Whereas as individual investors, you get to enjoy superior returns in the form of capital gains, dividends and interests. All you need to have is a Demat account.
To build a strong 30 storey building, you first need construct a strong base. Similarly, to excel in the journey of the stock markets, having a strong knowledge base is a must.
Understanding capital markets is the first step in the world of stock markets. To make your knowledge base stronger read our next article on – How does the stock markets work? It will help you understand the stock market better.
In the next chapter we will explore more about money markets.