Unit III: Financial Markets II: Capital Markets (9 hours)

Capital Markets - introduction, components, role and functions; equity market-methods of

issue; debt market-concept, significance and classification; capital market instruments;
primary and secondary markets- concept, similarities, differences; stock exchanges in India -
NSE, BSE; Stock Indices: concept and major stock indices in India (NIFTY and BSE-SENSEX);
SEBI and investor protection.
 Capital Markets - Introduction, Components, Role And
Functions

1.1 Introduction

Capital Market is one of the important constituent of the financial system. A good capital
market is an essential pre-requisite for industrial and commercial development of a country.
The Capital market promotes economic growth by mobilizing the funds from the surplus
sector and channelizing it in the deficit sector. Surplus sector or units refers to those who have
surplus or excess income and want to invest it in lieu of some returns. On the other hand,
deficit sector or units refers to those who have deficit income (expenditure is more than
income). Capital market mobilizes long term savings available in the surplus sector and
channelizes the same for long term investment.

Capital Market

Capital Market is a financial market which deals with long term securities i.e. debt and equity.
It is a financial market where long-term debt or equity backed securities are bought and sold.
The market provides avenues for long term investment of surplus fund. In widest sense, it
consists of a series of channels through which the savings are made available for industrial,
commercial enterprises and public authorities. A Capital Market may be defined as an
organised mechanism for effective and efficient transfer of money capital or financial
resources from the investing parties, i.e. individuals or institutional savers to the entrepreneurs
(individuals or institutions) engaged in industry or commerce or in the business either be in
the private or public sectors of an economy. Capital markets are classified as primary market
and secondary market. A market where securities are sold for the first time is called primary
market. This market plays very important role in tapping the unutilized resource leading to
capital formation. Secondary Market is a market where the already existing securities are
bought and sold. Secondary market provides liquidity to those securities which are sold in the
primary market. Secondary market is popularly known as share market or stock market. In
India, SEBI regulates the capital market.

Instruments Traded

A wide range of financial instruments is traded in capital markets, each designed to cater to
different financing and investment needs. These include:

o Equity Shares: Represent ownership in a company and entitle shareholders to a share

in the profits and assets.

o Preference Shares: These shares have preferential rights over equity shares
regarding dividend distribution and repayment during liquidation.

o Debentures: Unsecured debt instruments that companies issue to borrow money

from the public with a promise of fixed interest.

o Bonds: Debt instruments issued by governments, corporations, or municipalities.

Bonds carry fixed interest payments and are considered low-risk investments.
 o Convertible Securities: Instruments like convertible debentures or preference shares
that can be converted into equity shares at a later date.

o Derivatives: Although not long-term capital instruments per se, derivatives like
futures and options are also traded in capital markets to hedge risks.

o Mutual Funds: Pooled investment vehicles managed by fund managers that invest in
a diversified portfolio of securities.

Types of Capital Market

1. Primary Market

 Also known as the new issue market

 Where companies raise funds by issuing new shares, debentures, or bonds to

investors

 Example: Initial Public Offering (IPO), Rights Issue

2. Secondary Market

 Also known as the stock market or aftermarket

 Where existing securities are traded among investors

 Example: Trading of shares on NSE or BSE

Nature & Scope of the Capital Market

An efficient capital market is a pre-requisite of economic development. An organised and

well developed capital market i) Ensures best possible coordination and balance between the
flow of savings on the one hand and the flow of investment leading to capital formation on
the other; ii) Directs the flow of savings into most profitable channels and thereby ensures
optimum utilisation of financial resources. (121) Thus, an ideal capital market is one where
finance is used as a handmade to serve the needs of the industry. The capital market must
facilitate the movement of capital to the point of highest yield. Hence a capital market strives
for i) ii) Mobilisation or concentration of national savings for economic development and The
mobilisation and import of foreign capital and investment to augment the deficit in the
required financial resources so as to maintain the expected rate of economic growth.

Features of Capital Market

The important features of the Capital Market are as follows

1. Serves as a link between savers and investors. Capital market serves as a crucial link
between saving and investment process as it transfers money from savers to entrepreneurial
borrowers.

2. Deals in medium and long term Investment: The capital market deals with medium and
long term financial instruments. Investable funds are transferred through instruments such as
shares, debentures and bonds.
3. Promotes Capital formation: Capital formation occurs through the creation of saving, the
mobilisation of savings and the investment of savings. Capital market mobilise such savings
through IPOs and issuance of the bonds in the primary market. Such mobilisation of savings
leads to capital formation.

4. Presence of intermediaries: Capital market operates with the help of intermediaries such as
brokers, underwriters, merchant bankers, government and private financial institutions etc.

5. Types of Investors: Capital market has both individual and institutional investors such as
mutual funds, insurance companies, financial institutions etc

6. Rules and Regulations: The capital market operates under the rules, regulation and policies
framed by the Government from time to time. SEBI is the regulator of capital market in India.

Functions of Capital Market

While from a broader perspective, Capital Markets is viewed as a market of financial assets
with long or infinite maturity, it actually plays a very important role in mobilizing resources
and allocating them to productive channels. So it can be said that the process of economic
growth of a country is facilitated by the Capital Markets.

Links Savers and Investors

The capital market serves an intermediary between the people having excess funds and the
ones who are in need of funds. It channels the ideal lying resources to more productive
sources where it can generate income and increase productivity. It mobilises people’s savings
by directing and guiding them for productive investment. These investments provide regular
income and growth to the investors.

Capital formation

The capital market has an efficient role in capital formation in the economy. It fulfils and
caters to the financial needs of different sectors of the economy by providing them with
sufficient funds timely. It transfers funds from ideal lying sources to more productive and
development sources. it mobilises the saving of peoples through investments and lends that
money for large development projects in the economy. This way it fulfils the overall fund
requirement and helps in adding on to the existing stock of capital in the economy.

Regulate security prices

It helps in regulating the stable and systematic prices of securities. The capital market
continuously monitors the trading of securities. It keeps an eye over whole processes and
avoids any unproductive and speculative activities. Funds are provided at standard and
minimum interest rates to the borrower. This helps in security prices stabilisation in the
economy.

Provision of investment avenues

The capital market provides different long term investment avenues to the investors looking
for long term investments. It deals in trading of long term securities thereby raising and
lending money for long periods. It provides and offers good interest rates options to the
people for investing their surplus funds. People are encouraged to invest their fund and earn
regular income in the form of interest.

Liquidity Provision: Capital markets offer liquidity to investors by allowing them to buy and
sell securities. This encourages investors to commit their capital to longer-term investments
with the assurance that they can exit when needed.

Price Discovery: Through the interaction of demand and supply in the securities market,
capital markets determine the fair price of securities. This helps investors make informed
decisions.

Risk Management: Capital markets enable investors to diversify their investment portfolios
across various sectors and instruments, thereby reducing overall risk exposure.

Encouragement of Corporate Governance: Listed companies are subject to regulatory

oversight and disclosure requirements. This fosters transparency, accountability, and better
corporate governance.

Economic Indicator: The performance of capital markets reflects the general economic
conditions of a country. Bullish markets often signal a healthy, growing economy, while
bearish markets may indicate recessionary trends.

Economic growth and development

It helps in economic growth and development in the country. Capital market speeds up the
economic growth rate in the country by providing funds among different sectors of the
economy continuously.

It provides funds for the large infrastructural development requiring huge funds in the
country. Long term finance requirement of various business houses are met by the capital
market. Thereby it improves the productivity of the economy by improving infrastructural
facilities and generation of employment.

Minimises Transaction Cost and Time

The capital market facilitates the trading of long-term securities. It reduces the overall cost
and time involved in the whole trading process. The entire trading process is conducted
electronically through automated systems and programs which speed up the entire process.

Continuous Availability of Funds

The capital market ensures the sufficient availability of funds in the economy. It continuously
provides long term investment avenues to investors. It is a liquid market as buyers and sellers
of securities are continuously available here. It always circulates funds among the different
sectors of society, thereby ensuring adequate availability of funds.

Role of Capital Market

The important significance of the markets have been discussed below:

 1. Link between savers and investors: The capital market functions as a link between the
savers and investors. It plays an important role in mobilising the savings and diverting them
in productive investment. Thus, capital market plays a vital role in transferring the financial
resource from surplus and wasteful areas to deficit and productive areas and increases the
productivity and prosperity of the country.

2. Promotes Saving Habits: The development of Capital Markets, the taxation system, and
the banking institutions provide facilities and provisions which encourages the investors to
save more. In the absence of Capital Markets, they might have invested in unproductive assets
like land or gold or might have indulged in unnecessary spending.

3. Promotes Investment: The capital markets both the primary and secondary provides
various investment avenues to those who have kept aside certain savings from their income.
This savings are invested in various avenues including shares, debentures, bonds etc.

4. Promotes Economic Growth: Saving leads to investment and well planned investment
leads to economic development. The capital market not only promotes savings and investment
but also smoothens and accelerates the process of economic growth. The proper allocation of
resource results in the expansion of trade and industry in both public and private sectors thus
promoting balanced economic growth in the country.

5. Stable and Systematic Security prices: Apart from the mobilization of funds, the Capital
Markets helps to stabilize the prices of stocks. Reduction in the speculative activities and
providing capital to borrowers at a lower interest rate help in the stabilization of the security
prices.

Promoting Innovation and Entrepreneurship: Access to capital encourages innovation and

entrepreneurship, which leads to job creation, technological progress, and increased
productivity.

Efficient Resource Utilization: Capital markets ensure that scarce financial resources are
allocated to the most productive sectors and enterprises, promoting optimal use of capital.

Improving Corporate Governance: Publicly traded companies are required to adhere to

stringent reporting and governance norms, enhancing transparency and efficiency in the
corporate sector.

Reducing Cost of Capital: The competition in capital markets leads to lower borrowing
costs for companies, facilitating investment and expansion.

Integration with Global Markets: A robust capital market attracts foreign direct investment
(FDI) and foreign portfolio investment (FPI), increasing foreign exchange reserves and
strengthening the domestic economy.
Components and Structure of Capital Market

The capital market is a complex system, formed by various components. Various components
and structure of capital market can be classified into the following 3 categories.

Capital Market Participants

Capital Market participants include the individuals and institutions that interact within the
market. These participants can be, broadly, categorized into 2 groups:

 Investors or Suppliers of Capital: These are entities with surplus funds and are
looking to invest. They include individuals, pension funds, insurance companies, and
commercial banks.

 Borrowers or Issuers of Securities: These are entities that raise funds by issuing
various types of securities. They include businesses looking to expand, governments
financing projects, and individuals seeking loans.

Capital Market Instruments

Capital Market Instruments or the Instruments of Capital Market refer to various types of
financial tools used within the market. They include financial securities and derivatives that
serve as mediums and facilitate the flow of money among the participants of the capital
market.

Various capital market instruments can be, broadly, classified into the following types:
  Share or Stock

 Debt Instruments

 Derivatives

 Mutual Funds

 Exchange Traded Funds (ETFs)

 Instruments of Foreign Investments

Each type of capital market instrument has been discussed in detail in our article Instruments
of Capital Market.

Capital Market Infrastructure

Capital Market Infrastructure refers to the institutions that facilitate the smooth operation of
the market. These institutions play a crucial role in connecting various participants and
ensuring their regulated interactions for trading through instruments available in the market.

Major types of institutions forming part of the capital market infrastructure are as follows:

 Stock Exchanges: Stock exchanges are essentially marketplaces for buying and
selling financial instruments. They act as a central platform where investors and
companies connect.

o Various concepts regarding Stock Exchanges have been dealt with in detail
below.

 Regulatory Bodies: These organizations ensure fair and transparent practices within
the market. Major regulators involved in regulation of Capital Market in India are:

o Securities and Exchange Board of India (SEBI)

o Reserve Bank of India (RBI)

o Union Ministry of Corporate Affairs, and

o Department of Economic Affairs, Union Ministry of Finance.

 Financial Intermediaries: These institutions connect investors with those seeking

capital.

o Brokers, investment banks, and underwriters are some examples.

Types of Capital Market

Based on the type of securities traded, the Capital Market is of 2 types:

Primary Market or New Issue Market

 The Primary Market is the type of Capital Market where new securities are issued
for the first time.
 o Thus, it is also called the New Issue Market.

 The primary market provides the channel for the sale of new securities. The issuer of
securities sells the securities in the primary market to raise funds for investment
and/or to discharge.

o In other words, the market wherein resources are mobilized by companies

through the issue of new securities is called the primary market.

Secondary Market or Old Issue Market

 The Secondary Market refers to a market where those types of securities are
traded, which have already been issued and offered to the public in the Primary
Market and/or listed on the Stock Exchange.

o Thus, it is also called the Old Issue Market.

 The secondary market enables securities holders to adjust their holdings in response
to changes in their assessment of risk and return or to buy/sell their securities as per
their liquidity needs.

Difference between Primary Market and Secondary Market

Primary Market Secondary Market

New market securities are sold. Only existing securities are traded.

Investors have the option of only buying the

Investors can both buy and sell securities.
securities.

The price of securities is mostly decided by the The price of securities is determined by the demand
management of the issuing company. and supply of the market.

Primary Markets have no fixed geographical Secondary Markets are located at specified places,
location. known as Stock Exchange.

Major intermediaries – Merchant Banks,

Underwriters, Debenture Trustees, Portfolio Major intermediaries – Brokers, Jobbers, etc.
Managers, etc.

The functioning dynamics of both types of markets are discussed in detail in the sections that
follow.
Primary Market or New Issue Market: Concepts

Types of Issues in Primary Market

The issue of new securities in the Primary Market occurs through various methods as
discussed below.

Public Issue or Public Offering

 Under this method company issues a prospectus to inform and attract general public.
In prospectus company provides details about the purpose for which funds are being
raised, past financial performance of the company, background and future prospects
of company. The information in the prospectus helps the public to know about the
risk and earning potential of the company and accordingly they decide whether to
invest or not in that company Through IPO company can approach large number of
persons and can approach public at large. Sometimes companies involve
intermediaries such as bankers, brokers and underwriters to raise capital from general
public.

 Public Issue or Public Offering refers to the process of a company offering its
securities (usually stocks or bonds) for sale to the general public for the first time
or subsequently.

 It is the usual way through which companies raise capital from a broad range of
investors.

 There are 2 main types of public issues:

Initial Public Offering (IPO)

 Initial Public Offering (IPO) refers to the process when a private or unlisted
company sells its shares to the public for the very first time.

 This process transforms the company from being privately owned to a public
company.

o This is why an IPO is also referred to as “going public”.

 It is generally used by new and medium-sized firms that are looking for funds to grow
and expand their business.

 After IPO, the company’s shares are traded in an open market.

o Those shares can be further sold by investors through secondary market

trading.

Follow on Public Offering (FPO)

 Follow on Public Offering (FPO) refers to the process when a company, that has
already issued shares and is listed on a stock exchange, issues shares again to raise
additional fund.
  Public companies have to sell at least 25% of their shares to the public to be traded on
a stock exchange. Usually, it is this requirement that makes companies go for FPOs.

Offer For Sale

 Under this method, securities are not issued directly to the public but are offered for
sale through intermediaries like issuing houses or stock brokers.

 In this case, a company sells securities enbloc at an agreed price to brokers who, in
turn, resell them to the investing public.

 Under this method new securities are offered to general public but not directly by the
company but by an intermediary who buys whole lot of securities from the company.
Generally the intermediaries are the firms of brokers. So sale of securities takes place
in two steps: first when the company issues securities to the intermediary at face
value and second when intermediaries issue securities to general public at higher
price to earn profit. Under this method company is saved from the formalities and
complexities of issuing securities directly to public.

Bonus Issue or Scrip Issue or Capitalization Issue

 It refers to offer of share to the existing shareholders against their distributable profit.

 Thus, under this, shareholders’ share in profit is converted as shares.

Rights Issue

 This is the issue of new shares to existing shareholders. It is called right issue because
it is the pre-emptive right of shareholders that company must offer them the new issue
before subscribing to outsiders. Each shareholder has the right to subscribe to the new
shares in the proportion of shares he already holds. A right issue is mandatory for
companies under Companies’ Act 1956.

 Rights Issue is an invitation to existing shareholders to purchase additional new

shares in the company.

 This type of issue gives existing shareholders rights to purchase new shares at a
discount to the market price on a stated future date.

o That’s why it is called Rights Issue.

Private Placement

When an issuer makes an issue of securities to a limited group of pre-selected investors, and
which is neither a rights issue nor a public issue, it is called a private placement.

Under this method the securities are sold by the company to an intermediary at a fixed price
and in second step intermediaries sell these securities not to general public but to selected
clients at higher price. The issuing company issues prospectus to give details about its
objectives, future prospects so that reputed clients prefer to buy the security from
intermediary. Under this method the intermediaries issue securities to selected clients such as
UTI, LIC, General Insurance, etc.
Private placement can be of 2 types:

Preferential Allotment

When a listed issuer issues shares or convertible securities to a select group of persons, it is
called a Preferential Allotment.

Qualified Institutional Placement (QIP)

When a listed issuer issues shares or convertible securities to a select group of Qualified
Institutional Buyers (QIBs), it is called a Qualified Institutional Placement (QIP).

2-Secondary Market (Stock Exchange):

The secondary market is the market for the sale and purchase of previously issued or second
hand securities.

In secondary market securities are not directly issued by the company to investors. The
securities are sold by existing investors to other investors. Sometimes the investor is in need
of cash and another investor wants to buy the shares of the company as he could not get
directly from company. Then both the investors can meet in secondary market and exchange
securities for cash through intermediary called broker.

In secondary market companies get no additional capital as securities are bought and sold
between investors only so directly there is no capital formation but secondary market
indirectly contributes in capital formation by providing liquidity to securities of the company.

If there is no secondary market then investors could get back their investment only after
redemption period is over or when company gets dissolved which means investment will be
blocked for a long period of time but with the presence of secondary market, the investors can
convert their securities into cash whenever they want and it also gives chance to investors to
make profit as securities are bought and sold at market price which is generally more than the
original price of the securities.