Capital market is a market where buyers and sellers engage in trade of financial securities like bonds, stocks, etc. The buying/selling is undertaken by participants such as individuals and institutions.
Capital markets help channelise surplus funds from savers to institutions which then invest them into productive use. Generally, this market trades mostly in long-term securities.
Capital market consists of primary markets and secondary markets. Primary markets deal with trade of new issues of stocks and other securities, whereas secondary market deals with the exchange of existing or previously-issued securities. Another important division in the capital market is made on the basis of the nature of security traded, i.e. stock market and bond market.
In a primary market, securities are created for the first time for investors to purchase. New securities are issued in this market through a stock exchange, enabling the government as well as companies to raise capital.
Functions of the primary market
- New issue offer
The primary market organises offer of a new issue which had not been traded on any other exchange earlier. Due to this reason, it is also called a New Issue Market. Organising new issue offers involves a detailed assessment of project viability, among other factors. The financial arrangements for the purpose include considerations of promoters’ equity, liquidity ratio, debt-equity ratio and requirement of foreign exchange.
- Distribution of new issue
A new issue is also distributed in a primary marketing sphere. Such distribution is initiated with a new prospectus issue. It invites the public at large to buy a new issue and provides detailed information on the company, issue, and involved underwriters.
- underwriting services
Underwriting is an essential aspect while offering a new issue. An underwriter’s role in a primary marketplace includes purchasing unsold shares if it cannot manage to sell the required number of shares to the public. A financial institution may act as an underwriter, earning a commission on underwriting.
Investors rely on underwriters for determining whether undertaking the risk would be worth its returns. It may so thus happen that an underwriter ends up buying all the IPO issue, and subsequently selling it to investors.
Types of primary market issuance
Public issue is the most common method of issuing securities of a company to the public at large. It is mainly done via Initial Public Offering (IPO) resulting in companies raising funds from the capital market. These securities are listed in the stock exchanges for trading.
A privately held company converts into a publicly-traded company when its shares are offered to the public initially through IPO. Such public offer allows a company to raise funds for expansion of business, improving infrastructure, and repay its debts, among others. Trading in an open market also increases a company’s liquidity and provides a scope for issuance of more shares in raising further capital for business.
The Securities and Exchange Board of India is the regulatory body that monitors IPO. As per its guidelines, a requisite due enquiry is conducted for a company’s authenticity, and the company is required to mention its necessary details in the prospectus for a public issue.
- Private placement
When a company offers its securities to a small group of investors, it is called private placement. Such securities may be bonds, stocks or other securities, and the investors can be both individual and institutional.
Private placements are easier to issue than initial public offerings as the regulatory stipulations are significantly less. It also incurs reduced cost and time, and the company can remain private. Such issuance is suitable for start-ups or companies which are in their early stages. The company may place this issuance to an investment bank or a hedge fund or place before ultra-high net worth individuals (HNIs) to raise capital.
- Preferential issue
A preferential issue is one of the quickest methods available to companies for raising capital. Both listed and unlisted companies can issue shares or convertible securities to a select group of investors. However, the preferential issue is neither a public issue nor a rights issue. The shareholders in possession of preference shares stand to receive the dividend before the ordinary shareholders are paid.
- Qualified institutional placement
Qualified institutional placement is another kind of private placement where a listed company issues securities in the form of equity shares or partly or wholly convertible debentures apart from such warrants convertible to equity shares and purchased by a Qualified Institutional Buyer (QIB).
QIBs are primarily such investors who have the requisite financial knowledge and expertise to invest in the capital market. Some QIBs are –
- Foreign Institutional Investors registered with the Securities and Exchange Board of India.
- Foreign Venture Capital Investors.
- Alternate Investment Funds.
- Mutual Funds.
- Public Financial Institutions.
- Scheduled Commercial Banks.
- Pension Funds.
Issuance of qualified institutional placement is simpler than preferential allotment as the former does not attract standard procedural regulations like submitting pre-issue filings to SEBI. The process thus becomes much easier and less time-consuming.
- Rights and bonus issues
Another issuance in the primary market is rights and bonus issue, in which the company issues securities to existing investors by offering them to purchase more securities at a predetermined price (in case of rights issue) or avail allotment of additional free shares (in case of bonus issue).
For rights issues, investors retain the choice of buying stocks at discounted prices within a stipulated period. Rights issue enhances control of existing shareholders of the company, and also there are no costs involved in the issuance of these kinds of shares. For bonus issues, stocks are issued by a company as a gift to its existing shareholders. However, the issuance of bonus shares does not infuse fresh capital.
Advantages of Primary Market
- Companies can raise capital at relatively low cost, and the securities so issued in the primary market provide high liquidity as the same can be sold in the secondary market almost immediately.
- The primary market is an important source for mobilisation of savings in an economy. Funds are mobilised from commoners for investing in other channels. It leads to monetary resources being put into investment options.
- Chances of price manipulation in the primary market are considerably less when compared to the secondary market. Such manipulation usually occurs by deflating or inflating a security price, thereby deliberately interfering with fair and free operations of the market.
- The primary market acts as a potential avenue for diversification to cut down on risk. It enables an investor to allocate his/her investment across different categories involving multiple financial instruments and industries.
- It is not subject to any market fluctuations. The prices of stocks are determined before an initial public offering, and investors know the actual amount they will have to invest.
Disadvantages of Primary Market
- There may be limited information for an investor to access before investment in an IPO since unlisted companies do not fall under the purview of regulatory and disclosure requirements of the Securities and Exchange Board of India.
- Each stock is exposed to varying degrees of risk, but there is no historical trading data in a primary market for analysing IPO shares because the company is offering its shares to the public for the first time through an initial public offering.
- In some cases, it may not be favorable for small investors. If a share is oversubscribed, small investors may not receive share allocation.
After the primary market is the secondary capital market. This is more commonly known as the stock market or the stock exchange. Here the securities (shares, debentures, bonds, bills etc) are bought and sold by the investors.
The main point of difference between the primary and the secondary market is that in the primary market only new securities were issued, whereas in the secondary market the trading is for already existing securities. There is no fresh issue in the secondary market.
The securities are traded in a highly regularised and legalized market within strict rules and regulations. This ensures that the investors can trade without the fear of being cheated. In the last decade or so due to the advancement of technology, the secondary capital market in India has seen a great boom.
Functions of secondary market
- Providing liquidity
An organised stock exchange provides the investors with a place to liquidate their holdings meaning that securities can be sold in the stock exchange at any time.
- Media of asset pricing
Security price is determined by the transaction that flows from the investor’s demand and supply preferences. This market usually make their transaction price public which helps investors make better decisions.
- Stimulate new financing
If the investors can trade their security in a liquid secondary market, they will be encouraged to invest in IPOS that will directly help the issuing authority to collect new finance.
- Monitoring activities
Being a self-regulatory organization, a secondary can monitor the integrity of members, employees, listed firms, clients, and other related bodies.
- Provide a risk premium
Without an active secondary market, the issuers would have to provide a much higher rate of return to compensate investors for the substantial liquidity risk.
- An indicator of the economy
An organized stock plays the role as indicator of the state of the economy of a nation.
- Savings-investment linkage
Providing the linkage between the savings and the investment, stock exchange helps in mobilizing savings and channeling them into the corporate sector as securities.