Let’s assume you’re the CEO of The Best Widgets, Inc. Your Chief Technology Officer (CTO) slaps a proposal on your desk that promises to create an innovative new type of widget that will be a huge market success. The downside is that the plan requires a substantial investment in new technology and employee training. The CTO’s plan is certainly feasible, but it is going to take more money to implement than the company has to invest. So, how do you make this technological revolution possible? That is where capital markets come into play.
Capital Markets Defined
According to Shailesh Kumar at Value Stock Guide, the simplest definition of capital markets is that they are markets in which companies, or governments, sell securities to investors in order to raise money for things like building, business expansion, infrastructure upgrades, etc. The stock market is a capital market because companies sell shares in order to finances their business ventures. Governments typically sell bonds, which makes the bond market another type of capital market. Although, it is important to note that although government or municipalities are the first bond issuers that most people think of, corporations can sell bonds as well.
Other Capital Markets
Stock and bonds are the two biggest types of a capital markets, but other derivatives, such as options and futures are capital markets as well. For example, if a farmer wants to lock in a good return on his crop yield, the farmer may sell future contracts to investors. If the crop grows beyond expectations, then the investors makes money and the farmer gets his guaranteed return, which ensures that he’ll have money to plant more crops.
The Importance of Capital Markets
Without capital markets, the farmer would have no guarantee what he’ll get for his crops and that would make his situation very precarious. Even more important, if capital markets didn’t exists, then governments would have to find other ways to fund projects, which would likely result in outrageous tax hikes, or they just wouldn’t be able to do as much for their citizens. By the same token, corporations rely on capital markets to raise money to keep their business growing and to continue to offer new products to customers.
Why Companies Need Capital Markets
To use a fairly recent example, Facebook started publicly selling shares of their company because the service’s popularity had grown beyond the company’s assets. In order to keep introducing new features to users and improve their business processes and increase revenue, the company started selling stocks to investors. Most major corporations go public (offer stocks) at some point in order to keep growing.
On a final note, remember that capital markets are different than money markets. Money markets are typically debt markets in which a corporation borrows money from investors. In a capital market, such as the stock market, the company sells shares that give investors partial ownership of the company in exchange for money upfront. The investors may or may not see a good return on their investment, which makes some capital markets a bit riskier.