We saw how companies and industries raise short-term funds through the money market. But what if the funds that they require are for a long term? This is where the Capital Market comes in. There are two types of capital markets- primary and secondary. Let us study the capital market in some depth.
There are broadly two types of financial markets in an economy – capital market and money market. Now capital market deals in financial instruments and commodities that are long-term securities. They have a maturity of at least more than one year.
Capital markets perform the same functions as the money market. It provides a link between the savings/investors and the wealth creators. The funds will be used for productive purposes and create wealth in the economy in the long term.
One of the important functions of the capital markets is to provide ease of transactions for both the investors and the companies. Both parties should be able to find each other with ease and the legal aspect of things should go smoothly. Now let us take a look at the two major types of capital markets.
The most important type of capital market is the primary market. It is what we call the new issue market. It exclusively deals with the issue of new securities, i.e. securities that are issued to investors for the very first time.
The main function of the primary market is capital formation for the likes of companies, governments, institutions etc. It helps investors invest their savings and extra funds in companies starting new projects or enterprises looking to expand their companies.
The companies raise money in the primary market through securities such as shares, debentures, loans and deposits, preference shares etc. Let us take a look the various methods of how new securities are floated in the primary market.
Read the Concept of Financial Market here.
Methods of Raising Funds
1] Offer through Prospectus
This is a method of public issue. It is also the most used method in the primary market to raise funds. Here the company invites the investors (general members of the public) to invest in their company via an advertisement also known as a prospectus.
After a prospectus is issued, the public subscribes to shares, debentures etc. As per the response, shares are allotted to the public. If the subscriptions are very high, allotment will be done on lottery or pro-rata basis.
The company can sell the shares directly to the public, but it generally hires brokers and underwriters. Merchant banks are another option to help out with the process, especially Initial Public Offerings.
2] Private Placement
Public offers are an expensive affair. The incidental costs of IPO’s tend to be very high. This is why some companies prefer not to go down this route. They offer investment opportunities to a select few individuals.
So the company will sell its shares to financial institutes, banks, insurance companies and some select individuals. This will help them raise the funds efficiently, quickly and economically. Such companies do not sell or offer their securities to the public at large.
3] Rights Issue
Generally, when a company is looking to expand or are in need of additional funds, they first turn to their current investors. So the current shareholders are given an opportunity to further invest in the company. They are given the “right” to buy new shares before the public is offered the chance.
This allotment of new shares is done on pro-rata basis. If the shareholder chooses to execute his right and buy the shares, he will be allotted the new shares. However, if the shareholder chooses to let go of his rights issue, then these shares can be offered to the public.
It stands for Electronic Initial Public Offer. When a company wants to offer its shares to the public it can now also do so online. An agreement is signed between the company and the relevant stock exchange known as the e-IPO.
This system was introduced in India some three years ago by the SEBI. This makes the process of the IPO speedy and efficient. The company will have to hire brokers to accept the applications received. And a registrar to the issue must also be appointed.
After the primary market is the secondary capital market. This is more commonly known as the stock market or the stock exchange. Here the securities (shares, debentures, bonds, bills etc) are bought and sold by the investors.
The main point of difference between the primary and the secondary market is that in the primary market only new securities were issued, whereas in the secondary market the trading is for already existing securities. There is no fresh issue in the secondary market.
The securities are traded in a highly regularised and legalized market within strict rules and regulations. This ensures that the investors can trade without the fear of being cheated. In the last decade or so due to the advancement of technology, the secondary capital market in India has seen a great boom.
Solved Question for You
Q: The secondary market directly promotes capital formation. True or False?
Ans; This statement is False. It is the Primary Capital Market that assists in capital formation by raising funds. The secondary market will promote liquidity and disinvestment and reinvestment. This will ensure the funds are diverted to the most productive sections of the economy.