Capital markets are markets where people, companies, and governments with more funds than they need (because they save some of their income) transfer those funds to people, companies, or governments who have a shortage of funds (because they spend more than their income). Stock and bond markets are two major capital markets. Capital markets promote economic efficiency by channeling money from those who do not have an immediate productive use for it to those who do. 1. Capital Markets Efficiently Direct Capital to Productive Uses Capital markets carry out the desirable economic function of directing capital to productive uses. The savers (governments, businesses, and people who save some portion of their income) invest their money in capital markets like stocks and bonds. The borrowers (governments, businesses, and people who spend more than their income) borrow the savers' investments that have been entrusted to the capital markets. When savers make investments, they convert cash or savings (risk-free assets) into risky assets with the hopes of receiving enhanced benefits in the future. Since all investments are risky, the only reason a saver would put cash at risk is if returns on the investment are greater than returns on holding risk-free assets. Buying stocks and bonds and investing in real estate are common examples. The savers hope that the stock, bond, or real estate will "appreciate," or grow in value. 2. Finance can be Direct or Indirect
The example we just used illustrates a form of "direct" finance. In other words, the companies borrowed directly by issuing securities to investors in the capital markets. By contrast, indirect finance involves a financial intermediary between the borrower and the saver. For example, if Carlos and Anna put their money in a savings account at a bank, and then the bank lends the money to a company (or another person), the bank is an intermediary. Financial intermediaries are very important in the capital marketplace. Banks lend money to many people, and in so doing create economies of scale. That is, by lending out funds many times each day, costs per transaction decrease. 3. Capital Markets are Important because they Promote Efficiency and Productive Investments Capital markets promote economic efficiency.
B. The Structure of Capital Markets
1. Many Types of Securities are Sold in Primary and Secondary Capital Markets The primary market is where new securities (stocks and bonds are the most common) are issued. The corporation or government agency that needs funds (the borrower) issues securities to purchasers in the primary market. Big investment banks assist in this issuing process. The banks underwrite the securities. That is, they guarantee a minimum price for a business's securities and sell them to the public. Since the primary market is limited to issuing new securities only, it is of lesser importance than the secondary market C. Internationalization of Capital Markets in the Late 1990s One of the most important developments since the 1970s has been the internationalization, and now globalization, of capital markets. Let's look at some of the basic elements of the international capital markets. 1. The International Capital Market of the Late 1990s was Composed of a Number of Closely Integrated Markets with an International Dimension Basically, the international capital market includes any transaction with an international dimension. It is not really a single market but a number of closely integrated markets that include some type of international component. The foreign exchange market was a very important part of the international capital market during the late 1990s. Internationally traded stocks and bonds have also been part of the international capital market. Since the late 1990s, sophisticated communications systems have allowed people all over the world to conduct business from wherever they are. The major world financial centers include...