Capital market instruments are securities that exist in order to help a company or government entity raise money for long-term goals.
The capital market deals with long-term securities, whereas the money market deals with short-term investments. So what are capital market instruments exactly?
The term capital market instruments refers to the physical securities, such as stocks and bonds, that you trade.
The capital market is vital to economic growth for three key reasons.
It enables the transfer of funds from entities with a surplus to those in need of capital, it promotes investments and savings, and it facilitates overall balanced economic growth.
Primary And Secondary Capital Market
When discussing the capital markets, it is important to note there are primary and secondary markets. The primary market is where new money is set in motion, typically through an IPO (initial public offering).
If a government or business needs to raise capital, they will utilize the two main financial instruments for this type of market: equities (stocks) and debts (bonds).
The money is kept on hold in the company until it expires, it sells on the secondary market, or the company issues a buyback on its stocks.
The secondary market is where old debt/ stocks are traded between investors. The debt essentially acts as real money. Investors buy from the secondary market in order to gain assets for a passive income.
They may also sell in order to get liquid cash.
Capital Market instruments include:
There are two types of capital market instruments: bonds and stocks.
Debt securities, also known as bonds, are securities the government or another municipality, or a corporation issues.
Most bond trades take place “over-the-counter” because of how diverse bonds are in offerings, meaning that the trades are not happening on the formal exchanges.
There are several different types an investor may choose from:
Corporate Bonds – Investment-Grade
Businesses that need investments use corporate bonds. In return, investors receive a “bond” at a fixed rate of interest. There are three levels of maturity for corporate bonds:
- Short-term lasting five years or less
- Intermediate lasting 5 to 12 years
- Long-term lasting 12+ years
Investment-grade bonds are typically for businesses that are unlikely to default such as larger corporations. They are riskier than government bonds but not as risky as junk bonds, making them a good option for investors looking for moderate-risk investments.
Corporate Bonds – Junk bonds
Junk bonds come with a high risk, but also offer higher yields. This is because the companies who put out these bonds tend to be small or unreliable.
This makes it unlikely investors will get their initial investment back. However, because junk bonds provide smaller businesses with the credit they may not have access to, they are still a viable investment choice if the business can turn a profit.
Foreign bonds allow a foreign entity to raise capital in the currency of another company.
This provides an investor a unique way to diversify their portfolio and provides some protection from economic fluctuations within their country.
However, it can be risky for the company itself due to currency fluctuations. Nevertheless, it does provide the foreign business with another avenue to obtain capital.
Even gold misses the mark.
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Treasury bonds, also known as government bonds, are from the federal government for a set period of time, normally 10+ years.
These bonds are low risk, meaning the interest they earn is below the market average. While these are close to risk-free, it depends on the country you are receiving the bond from.
Municipal bonds often are not treasury bonds and while they are similar, they are not the same. These bonds aren’t issued by the federal government.
They are issued by the state or local governments or one of the federal agencies. These bonds are generally “safe” but do present a greater risk than treasury bonds.
What makes municipal bonds popular is that they come in a tax-exempt version for certain infrastructure projects such as building roads or bridges.
Zero-coupon bonds come at a heavy discount because there is no interest until the bond expires. Essentially, its value gains over time.
This may concern investors, however, these bonds are indexed to account for inflation which ensures the owner maintains their purchasing power.
Common Stock refers to a corporation selling a percentage of their company in return for capital. This normally takes place in a local stock market such as the New York Stock Exchange.
Common stocks are the default when discussing investments. The shareowners not only have a stake in the company, but they get dividend payments where applicable.
While stocks offer a higher yield, they come with a higher risk than bonds. If a company goes bankrupt, the likelihood of an investor getting their money back is slim since they come after creditors, bondholders, and preferred stockholders.
Preferred stocks, just like common stocks, can be bought through a broker on the stock market, but they have different benefits.
Both stockholders represent part of the company, but preferred shareholders have a fixed dividend rate which is due each year.
While a business does not have to pay in the event of financial hardship, the dividend can be back-dated, meaning it may be paid when the business recovers.
Examples of Capital Market Instruments
Capital market instruments are not just securities such as stocks and bonds. Yhey can also include derivative options such as loans, treasury bills, debentures, etc.
Stocks and bonds may have higher yields for the investor, but they come with more risk.
Derivatives come in the form of options and futures contracts, both of which are a type of instrument in the capital market.
Options provide investors the opportunity to sell a financial security at a later date. The price that the security will be sold at is determined beforehand.
A futures contract is similar in that its basis is on an action that will take place at a later date.
The traders must follow through with a promised item or service, otherwise, they may settle a contract in exchange for cash.
Debentures are fixed-interest securities that a company uses to borrow money from investors. The principal amount is set to be paid at a future date.
In the event that a company is liquidated before paying the investor based on their rate and maturity of the debenture, these shareholders will be the first to be paid off.
Which of the following is/are capital market instruments?
- 10-year corporate bonds
- 30-year mortgages
- 20-year Treasury bonds
- 15-year US govt agency bonds
- All of the above
The answer is E: All of the above. Bonds are classified by their fixed maturity lasting longer than one year.
While a mortgage is not a type of bond, it does represent a capital market instrument because it’s an equity with a fixed interest rate and maturity.
What Are Capital Market Instruments: Final Thoughts
Capital market instruments are key components to the stock market. Without them, economic growth would be diminished.
As an investor, it is important you understand the function of each instrument, and which ones will help you reach your personal goals.
Without a basic understanding of the functions of these instruments, you may be making riskier investments you would not otherwise make.
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