Capital Markets - Explained
What are Capital Markets?
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Table of ContentsWhat are Capital Markets?How Do Capital Markets Work?Benefits of the capital marketClassifications of Capital MarketsAcademic Research on Capital Markets
What are Capital Markets?
A capital market refers to the financial market where individuals or institutions buy or sell securities. This is the place to trade stocks, bonds and debt securities. Capital markets allow companies to sell their stocks to many investors to get working capital and expand the company.
How Do Capital Markets Work?
- An investor owns part of the company they buy shares from in proportion to the percentage of shares he holds.
- Capital markets make the buying and selling of securities easy by adding liquidity.
- Capital markets are also responsible for the volatility of security prices.
- The investor is not guaranteed benefits when he sells or buys securities.
- Investors choose when to buy or sell securities as there is no specific purchase or sale period
Benefits of the capital market
- Offers short term or long term benefits to investors.
- Allows investors to diversify their risk portfolio.
- Allows easy access to investment in the best companies in the world.
- Gives companies a platform to source for finances for daily running and for expansion.
- Investors have access to a wide range of products and different levels of risk.
- It allows institution to concentrate on more productive activities.
Classifications of Capital Markets
Capital markets are categorized based on the assets traded in them, time and structure. According to structure, there are organized markets which are regulated and supervised and there are OTC markets where investors can negotiate. Bases on time, there are primary/issue markets and secondary markets. In primary markets, securities issued are transferred for the first time while in secondary markets, there are purchases and sales of the securities that were issued in primary markets.
Academic Research on Capital Markets
- Efficient capital markets: A review of theory and empirical work, Malkiel, B. G., & Fama, E. F. (1970). The journal of Finance, 25(2), 383-417. This paper looks at the operations of capital markets and how the prevailing economic and financial crises affect them. It looks at how these markets are supposed to operate and how they actually operate.
- Information asymmetry, corporate disclosure, and the capital markets: A review of the empirical disclosure literature, Healy, P. M., & Palepu, K. G. (2001). Journal of accounting and economics, 31(1-3), 405-440. This paper looks at the importance of financial reporting for the communication of firm performance. It analyzes how managers report and disclose information in capital markets. The research shows that there are loopholes in reporting and there are some questions that are left unanswered.
- Small firm growth, access to capital markets and financial structure: Review of issues and an empirical investigation, Chittenden, F., Hall, G., & Hutchinson, P. (1996). Small business economics, 8(1), 59-67. The research looks how small firms structure their finances with the aim of growing fast enough to join the capital markets. The research looks at financial shock and financial regression of small businesses. It further looks at the relationship between the financial structure of small businesses and profitability, size of business, age and stock market floatation.
- Efficient capital markets, inefficient firms: A model of myopic corporate behavior, Stein, J. C. (1989). The Quarterly Journal of Economics, 104(4), 655-669. This paper looks at how inefficient management in small and large firms affect their placement in the stock market. It shows that in a bid to boost current earnings, managers may choose to forego good investments. In such as case, there will be earnings inflation and the market registers growth. With increased earnings, the managers continue to behave myopically.
- Capital markets research in accounting, Kothari, S. P. (2001). Journal of accounting and economics, 31(1-3), 105-231. This paper reviews the relationship between financial statements and capital markets. It further looks at market efficiency and how research and valuation enhances capital markets and the decisions of investors and managers.
- Internal capital markets and the competition for corporate resources, Stein, J. C. (1997). The Journal of Finance, 52(1), 111-133. This article examines the role of corporate headquarters in allocating scarce resources to competing projects in an internal capital market. Unlike a bank, headquarters has control rights that enable it to engage in winnerpickingthe practice of actively shifting funds from one project to another. By doing a good job in the winnerpicking dimension, headquarters can create value even when it cannot help at all to relax overall firmwide credit constraints. The model implies that internal capital markets may sometimes function more efficiently when headquarters oversees a small and focused set of projects.
- Exchange rates and foreign direct investment: an imperfect capital markets approach, Froot, K. A., & Stein, J. C. (1991). The Quarterly Journal of Economics, 106(4), 1191-1217. This paper looks at the relationship between foreign direct investment and exchange rates. The paper finds that when the relative wealth of domestic capital agents is lowered, domestic currency depreciates and this can lead to foreign acquisition of domestic assets.
- The dark side of internal capital markets: Divisional rentseeking and inefficient investment, Scharfstein, D. S., & Stein, J. C. (2000). The Journal of Finance, 55(6), 2537-2564. This paper looks at how rent-seeking in division managers affects internal capital markets. It shows that, through rent-seeking, divisional managers increase their bargaining power for better compensation from CEOs. This form of compensation is not monetary but preferential budgeting allocations.
- Internal versus external capital markets, Gertner, R. H., Scharfstein, D. S., & Stein, J. C. (1994). The Quarterly Journal of Economics, 109(4), 1211-1230. This study seeks to provide an efficient framework to analyze costs and benefits of internal and external capitalization. It compares bank loans with internal capital markets. It notes that while both forms of capitalization are centralized, internal markets are owner-provided. It concludes that internal capital allocation enhances monitoring, reduces mangers entrepreneurial incentives and makes it easy to redeploy assets.
- The weighted average cost of capital, perfect capital markets, and project life: a clarification, Miles, J. A., & Ezzell, J. R. (1980). Journal of financial and quantitative analysis, 15(3), 719-730. This paper develops a model that helps corporates determine the market value of a project correctly. The study observes that a good model should account for the effects of investment and financing decisions and how these two decisions relate.