Chapter 21 –

Capital Markets

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 Learning Objectives
• Define ‘financial system’ and describe its three main components—financial
assets/ instruments, financial intermediaries/institutions and the two key
financial markets, namely, capital and money markets
• Compare and contrast the two parts of the capital/securities markets—stock
exchanges/ secondary market and new issue/primary market
• Discuss the three vital functions of secondary markets—nexus between savings
and investments, market place and continuous price formation
• Understand the triple-service-functions of primary market—origination,
underwriting and distribution—and the methods by which issues are made in the
primary market

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 Financial System
• Financial system includes a complex of institutions and mechanism which affects
generation of savings and their transfer to those who invest.
• The main elements of the financial system are a variety of
 financial instruments/ assets/ securities,
 financial intermediaries/institutions and
 financial markets.

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 Financial Assets
• Financial asset/ instrument/ security is a claim against another economic unit
and held as a store of value and for the expected return.
• The entity/economic unit that offers the future cash flows is the ‘issuer of the
financial instrument’ and the owner of the security is the ‘investor’.
• Depending upon the nature of claim/return, an instrument may be
 debt (security) such as bonds, debentures, term loans,
 equity (security) shares and
 hybrid security such as preference shares and convertibles.
• Based on the type of issuer, the security may be
 direct
 indirect and
 derivative.
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 Financial Intermediaries
• Financial intermediaries convert direct financial assets into indirect securities.
• Financial intermediaries are institutions that channelise the savings of investors into
investments/ loans.
• The services/benefits that tailor indirect financial assets to the requirements of the
investors are
 convenience,
 lower risk,
 expert management and
 lower cost.

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Convenience
• Financial intermediaries convert direct/primary securities into a more convenient
vehicle of investment.
• They divide primary securities of higher denomination into indirect securities of
lower denomination.
Lower Risk
• The lower risk associated with indirect securities results from the benefits of
diversification of investments.
Expert Management
• Indirect securities give to the investors the benefits of trained, experienced and
specialised management together with continuous supervision.
Low Cost
• The benefits of investment through financial intermediaries are available to the
individual investors at relatively lower cost due to the economies of scale.

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 Financial Markets
• Financial markets provide a forum in which suppliers of funds and demanders of
loans/investments can transact business directly.
• Financial markets perform a crucial function in the financial system as facilitating
organisations.
• The two key financial markets are:
 the money market and
 the capital market.

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 Money Market
• Money market is created by a financial relationship between suppliers and
demanders of short-term funds having maturities of one year or less.
• It exists because investors have temporarily idle funds that they wish to place in
some type of liquid asset or short-term interest-earning instrument.
• At the same time, other entities/organisations find themselves in need of
seasonal/temporary financing.
• The broad objectives of money market are three-fold:
An equilibrating mechanism for evening out short-term surplus and
deficiencies in the financial system;
A focal point of intervention by the central bank (e.g. Reserve Bank of
India) intervention for influencing liquidity in the economy; and
A reasonable access to the users of short-term funds to meet their
requirements at realistic/ reasonable cost and temporary deployment of
funds for earning returns to the suppliers of funds.
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 Capital Market
• Capital market/securities market is a financial relationship created by a number
of institutions and arrangements that allows suppliers and demanders of long-
term funds with maturities exceeding
one year to make transactions.
• It is a market for long-term funds.
• The capital market comprises of
 stock/security exchanges/markets (secondary markets) and
 new issue/primary market [initial public offering (IPO) market].

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 Relationship Between New Issue Market
and Stock Market
• The industrial securities market is divided into two parts, namely, NIM and stock
market.
• The relationship between these parts of the market provides an insight into its
organisation.
• One aspect of their relationship is that they differ from each other
organisationally as well as in the nature of functions performed by them.
• They have some similarities also.

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 Differences
• The differences between NIM and stock exchanges pertain to
Types of securities dealt,
Nature of financing and
Organisation.
Types of securities deal
New securities are offered to the investing public for the first time.
Old securities are securities which have been issued already and listed on a stock
exchange.
Nature of Financing
• The primary market provides additional funds to the issuing companies whereas, the
secondary markets can in no circumstance supply additional funds.
Organisational Differences
• The stock exchanges have physical existence and are located in a particular geographical
area whereas, the NIM is not rooted in any particular spot and has no geographical
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existence.
 Similarities
• Nevertheless, in spite of organisational and functional differences, the NIM and the
stock exchanges are inseparably connected.
Stock Exchange Listing
• One aspect of this inseparable connection between them is that the securities issued
in the NIM are invariably listed on a recognised stock exchange for dealings in them.
• Listing enables dealings in securities on a stock exchange.
Control
• The stock exchanges exercise considerable control over the organisation of new
issues.
Economic Interdependence
• The markets for new and old securities are, economically, an integral part of a single
market—the industrial securities market.

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 Functions of Stock/ Secondary Markets/
Exchanges
• Stock exchanges discharge three vital functions in the orderly growth of capital
formation:
Nexus between savings and investments,
Market place and
Continuous price formation.
Nexus between Savings and Investment
• First and foremost, they are the nexus between the savings and the investments
of the community.
Market Place
• The second important function discharged by stock markets/ exchanges is that
they provide a market place for the purchase and sale of securities

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Continuous Price Formation
• The third major function, closely related to the second, discharged by the stock
exchanges is the process of continuous price formation.

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 Functions of New Issue/ Primary Market
• The general function of the NIM can be split into three services:
 Origination,
 Underwriting, and
 Distribution.
Origination
• Origination is the work of investigation and analysis and processing of new issue
proposals.
Underwriting
• Underwriting is a form of guarantee that the new issues would be sold by
eliminating the risk arising from uncertainty of public response.
Distribution
• Distribution is the sale of securities to the ultimate investors.
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 Issue Mechanism
• The success of an issue depends, partly, on the issue mechanism. The methods by
which new issues are made are:
 Public issue through prospectus,
 Tender/Book building,
 Offer for sale
 Placement and
 Rights issue
Public Issue through Prospectus
• Public issue are securities that are offered to the general public directly at a
stated price.
Tender/Book Building Method
• Book building is a price discovery and investors response mechanism.
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Offer for Sale
• Offer for sale is the sale of existing shares by promoters to the investing public.
Placement Method
• Placement of securities is the sale of unquoted securities.
Rights issue
Rights issue is the sale of securities to the existing shareholders.

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