Capital Market and Its Functions

In this article we will discuss about capital market and its functions.

In a very basic sense, a market matches the needs of sellers to those of buyers and establishes the price at which trades occur.

In a capital market, lenders have preferences as to:

(1) The maturity of the loans they make,

(2) The ease and security of liquidating any assets they purchase,

(3) The amount and kind of risks they wish to bear,

(4) The regularity of payments they wish to receive; and

(5) The price they can get for lending capital.

1. Liquidity:

Liquidity is the ease with which an asset can be converted into cash. It can emerge from short maturity assets, as, for instance, a savings account or a deposit “on call” (that is, a deposit that the borrower can withdraw on very short notice), or from having a good resale or secondary market for long- term assets. Similarly, a company depositing money in a bank may receive a negotiable certificate of deposit, which it could sell to any other company, if it needs the money sooner than expected.

For less secure assets, buyers take the credit risk that the market’s assessment of the likelihood of repayment will change (as in a bond), and so they may have to sell at a discount to what they expected. Liquidity is less in smaller markets.

Liquidity is higher in larger markets because the secondary markets are much more active. The volume of sales in stock and bond markets is very much greater. The more unusual assets have very small secondary markets and so are less liquid.

2. Pooling Risk and Matching Risk:

A capital market serves to pool risk such that an individual lender is not tied to the chance, however remote, that the borrower will be unable to pay. The market serves to pool risk in the same way that insurance pools risks of accidents. Pooling also works to reduce other forms of risk, such as that the interest rate will change.

Banks are only one form of risk pooling. Syndicated loans, in which many banks participate as part of a “syndicate”, were popular for a time and were a favoured means for financing Third World debt. Mutual funds, life insurance arrangements and pension funds similarly allow the saver to accumulate relatively small amounts of saving and, through the fund or company, lend that saving to various types of borrowers.

3. Assessing Risk and Gain:

The ability to feel how a loan is related to the underlying risk is known as transparency. If a loan is transparent, the lender can understand and assess the underlying risk. One of the functions of a capital market is to assess the risk, to make transparent what might be quite vague or unclear.

Bond rating services, stockbrokers, credit rating companies, investors’ reports, newspa­per reports, auditing investigations, government monitoring and bank assessments of creditability are usual means of assessing risk. As the market has become more complicated and more international, and in the process, less transparent, the ability to assess risk has fallen.

Economic Functions:

A well-functioning capital market increases the efficiency of the economy. It gives the lender a combination of risk, reward and security that fits individual needs while providing borrowers with a different combination (or matches them with lenders who want the same combination the borrow­ers do) more suited to the borrowers’ needs.

The market serves to adjust the product (the loan instrument) and the price to work out a compromise satisfactory to all parties. In such a situation, saving should flow from those who are willing to save to the projects that have the highest benefits (risk and yield combinations) at the lowest risk.

Even fifty years ago, the nineteenth-century family had a rather restricted set of opportunities to invest. Today family can put its saving anyplace in the world, and has sophisticated institutions to help assess risk, limit downside risk and move the money (or financial capital) for them.

In an international context, a well-functioning financial market might function to move saving from nations with high saving to nations with high returns. However, the growth of the international capital market may have some negative effect on government saving because it makes borrowing less costly.

Alternatively, the effect may be principally microeconomic, match preferences of lender and borrower, and does so by providing a large number and wider variety of financial instruments in highly liquid markets. The French invest in Germany, Germans in France in accordance with the differing knowledge and needs of French and German leaders and borrow­ers, much as French and Germans buy each other’s cars, clothing and machines.

The effect is to lower the costs of borrowing in both nations, but not to change the pattern of financial flow. In a broad sense, trade in securities can be compared to intra-industrial trade with differentiated products. Each instrument is another product, traded in narrow market are, in large international markets sooner or later. Just as intra-industrial trade does not alter trade balances greatly, so trade in debt instruments does not much alter net flows of capital.