Capital Market: Primary and Secondary Market | Commerce & Accountancy Optional Notes for UPSC PDF Download

What is Capital Market?

• Definition of Capital Market: The capital market is the arena where financial products and securities, typically of a long-term nature such as debt, bonds, and shares, are bought and sold. This trading occurs among institutions like firms or governments and individual investors.
• Characteristics of Capital Market: The capital market, as a subset of financial markets, deals exclusively with long-term financial instruments like shares, bonds, and debentures. These securities are held by investors for extended periods, generally exceeding a year, distinguishing them from short-term products found in the money market.
• Purpose of Capital Market: The capital market serves as a crucial platform for obtaining funds through the sale of securities. This platform is utilized by trades, firms, and individuals, allowing them to raise capital for their various needs.
• Regulation by SEBI: The Securities Exchange Board of India (SEBI) acts as the regulatory authority for the capital market. It formulates and enforces rules and regulations that trading entities, including firms and individuals, must adhere to during transactions.
• Capital Providers: Various entities serve as suppliers of funds in the capital market. These include commercial banks, insurance firms, and financial institutions, among others, contributing to the overall liquidity of the market.
• Role of Stock Exchanges: Stock exchanges play a pivotal role in the functioning of the capital market. They facilitate the buying and selling of shares, especially after the initial issuance of securities.
• Function of Capital Market: The primary function of the capital market is mobilization, contributing to the economy's vitality by channeling funds to businesses. Investors purchase securities, enabling the flow of funds to those entities in need. This process ensures the efficient allocation of financial resources.

How Does a Capital Market Work?

The capital market operates within the framework of circular money supply, where funds circulate from savers or investors to borrowers or firms in need.
The process is elucidated below:

• Firm's Fundraising Intentions: Let's consider a hypothetical scenario where a firm, XYZ, has the intention of raising funds. This capital infusion is earmarked for the development of a new product line within the consumer goods sector.
• Choice of Financing Method: In pursuit of capital, the firm decides to opt for the issuance of shares. By doing so, individuals with surplus funds have the opportunity to purchase these shares. In return, these shareholders acquire ownership rights in the company, and they may also be eligible to receive dividends based on the firm's profitability.
• Share Issuance and Capital Inflow: Through the issuance of shares, the firm successfully raises funds from investors within the capital market. This process results in an inflow of capital for the firm, providing the financial resources required for its intended endeavors, such as the development of the new product line.

Structure of Capital Market 

• Primary Market:
  • Definition: The primary market is where newly issued shares are first introduced to the market. It is the initial point of sale for securities.
  • Participants: Major investors in the primary market include several banks and financial institutions.
  • Activities: New firms that decide to go public issue their shares in the primary market.
• Secondary Market:
  • Definition: The secondary market is where all subsequent trades of securities occur after the initial issuance in the primary market.
  • Participants: Sellers and buyers engage in trading securities, and the stock exchanges serve as secondary markets for firm shares.
  • Activities: Prices of securities in the secondary market are determined by the forces of demand and supply.
• Regulatory Authority: The Securities and Exchange Board of India (SEBI) oversees the Indian capital market, aiming to prevent fraud and financial crimes. It is responsible for establishing and enforcing trading regulations essential for both firms and investors, ensuring compliance with necessary rules to maintain market integrity. 

Importance of Capital Market

• Facilitation of Fundraising: Capital markets play a crucial role in aiding companies to generate funds by allowing them to issue the necessary securities for financing.
• Efficient Allocation of Resources: Capital markets contribute to the efficient allocation of resources by directing funds to businesses or individuals engaged in economic activities.
• Price Determination of Securities: The capital market assists in determining the prices of various securities based on the prevailing demand and supply conditions.
• Maintenance of Liquidity: Capital markets ensure liquidity, enabling investors to easily sell their securities when needed.
• Promotion of Saving Habits: Capital markets are essential for fostering saving habits as they provide a practical platform for individuals to grow and multiply their savings.

Types of Capital Market 

• Primary Market: The primary market serves as the arena for new companies or the introduction of fresh securities. Newly public firms utilize the primary market, with the issuance of securities typically occurring through methods such as initial public offerings (IPOs), rights issues, or preferential allotments. The pricing of shares during the initial offering is generally determined by an investment bank, after which the shares become available on the stock market.
• Secondary Market: Referred to as the aftermarket, the secondary market is where previously issued shares are traded subsequent to the initial offering. In this market, traders engage in buying or selling securities, and prices are influenced by the demand and supply dynamics of a company's shares. Stock exchanges serve as the secondary markets, providing a platform for the purchase or sale of desired shares.

Primary vs. Secondary Markets

• Facilitating Fundraising: Capital markets play a pivotal role in assisting companies in raising capital by allowing them to issue pertinent securities for financial support.
• Efficient Resource Allocation: Capital markets contribute to the effective allocation of resources by channeling funds to businesses or individuals engaged in economic activities.
• Price Determination of Securities: The capital market aids in establishing the prices of diverse securities based on the prevailing demand and supply dynamics.
• Ensuring Liquidity: Capital markets guarantee liquidity, providing investors with a seamless process for selling securities when needed.
• Encouraging Saving Practices: Capital markets are essential for cultivating saving habits as they offer a practical platform for the growth and multiplication of one's savings.

Features of a Capital Market 

• Long-Term Securities Trading: The capital market in India primarily focuses on the exchange of long-term securities, where various financial instruments are bought and sold.
• High Investment Returns: Participation in the capital market can yield substantial investment returns, as investors experience capital appreciation over an extended period.
• Lower Liquidity Compared to Money Markets: Capital markets exhibit lower liquidity levels in comparison to money markets due to the nature of long-term investments involved.
• Inclusive Participation: Both companies and individuals actively engage in the Indian capital market, contributing to a diverse and dynamic trading environment.
• Linking Investors and Borrowers: The capital market serves as a crucial connecting platform, facilitating the interaction between investors seeking investment opportunities and borrowers in need of capital.

Functions Of Capital Market

• Capital Movement: The capital market in India functions as a mechanism to mobilize and allocate capital efficiently, enabling savers to invest their funds in projects undertaken by firms in need of financial resources.
• Trade Facilitation: The capital market simplifies the trading of financial securities, providing investors with an accessible platform for buying and selling such instruments.
• Transaction Cost Reduction: Capital markets play a role in reducing transaction costs by providing investors with comprehensive details on platforms, making the investment process more efficient and cost-effective.
• Valuation: The capital market contributes to the valuation of securities by assessing them based on a firm's performance and market dynamics, providing investors with a reliable benchmark for their investment decisions.
• Risk Mitigation: The capital market helps mitigate overall risk by facilitating derivative trading, allowing investors to manage and reduce their exposure to various financial risks.
• Fund Availability: Capital markets in India offer diverse measures for fund availability, ensuring that firms have access to ongoing funds to support their operations and growth.

Objectives of Capital Market 

• Investor Protection: The primary objective of the capital market is to safeguard investors through regulatory oversight, ensuring the smooth execution of trades and providing a protective framework for those involved.
• Transparent Trades: Capital markets prioritize transparency by making prices and trade information readily available on stock exchanges. This transparency fosters fairness and guards against fraudulent activities.
• Risk Reduction: Capital markets employ various instruments, such as derivatives, to minimize overall risks. However, it is imperative for investors to comprehend the market's functioning before engaging in transactions.
• Economic Growth: Facilitating the movement of funds where needed, the capital market plays a vital role in ensuring that both firms and individuals have access to necessary capital. This, in turn, stimulates demand and contributes to overall economic development.
• Ease of Trade: Capital markets aim to simplify the trading process, constantly introducing reforms to make buying and selling accessible and convenient for all categories of investors. This enhances the ease with which transactions can be conducted within the market.

What Is Market Capitalization? 

The valuation of a firm in the stock market is often determined by its market capitalization, a measure that proves useful during mergers or firm takeovers.
The formula for calculating market capitalization is as follows:
Market Capitalization = Number of Firm’s Outstanding Shares × Prevailing Market Value of One Share
The term "outstanding shares" refers to all the shares of the firm that are currently held by its shareholders. This formula essentially multiplies the number of outstanding shares by the prevailing market value per share to arrive at the overall market capitalization of the firm.

Conclusion

In conclusion, capital markets are indispensable components of any economy, providing a flexible and efficient platform for investment. They enable firms to showcase their services and secure funding while empowering investors to evaluate and choose optimal options for their savings. The accessibility of comprehensive data facilitates well-informed decision-making among investors. Capital markets, as a critical element of the financial system, play a pivotal role in the allocation of funds from savers and investors to various entities, contributing significantly to the growth and development of economies globally.