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Economics Terms A-Z

Capital Markets

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In capital markets, capital is exchanged between investors (who supply it from their assets) and investees (who need it to fund projects and ventures).  The investment horizon is usually at least one year. At its core, economics is about the efficient allocation of scarce resources.  If the initial division of resources in an economy is not efficient then the individuals within that economy can be made better off through a reallocation.  Capital markets exist to smooth the process of reallocation.  Indeed, without capital markets, many investments that help an economy to grow would not take place.  Entrepreneurs with their bright ideas need access to finance in order to turn them into reality.  Similarly, governments often require funding beyond their tax revenues in order to commission large infrastructure projects or new services that are critical to the economy.  Capital markets offer the opportunity for entrepreneurs and governments to be matched with individual and corporate investors in order to access the necessary capital.

Capital markets are generally categorised into two groups: primary and secondary

In a primary capital market, investors provide capital directly to investees, who issue a “security” (typically equity in the business, or a promise of repayment with interest) in exchange.  Investors in primary capital markets tend to spend time getting to know the investee and exploring the proposed projects and ventures in detail to assess whether they can make a positive return.  Examples of primary capital markets include fora where private-equity investors and providers of venture capital (also known as angel investors) meet potential investees, initial public offerings (IPOs) where new stock in a company is issued to the public for the first time, as well as bond markets where firms and governments issue new debt securities to fund their spending.

In a secondary capital market, a security that has already been issued in a primary market can be traded between investors.  There is no need for direct contact between investors and the original investee/ issuer of the security.  Public stock markets such as the New York Stock Exchange and the London Stock Exchange are examples of secondary capital markets.  By their public nature, secondary capital markets offer access to very high numbers of traders and they tend to be more liquid than primary capital markets.  The prices of securities traded in secondary capital markets are transparent, guaranteeing fair deals to buyers and sellers.

In theory, prices of securities in a capital market reflect all available information about the corresponding projects and ventures. It follows that there is no room for arbitrage because no one would buy a security for more than its fair value, nor would they sell it for less than its fair value.  This idea is known as the “efficient-market hypothesis” and the assumption of its validity underpins much economic thinking.  However there are some obvious flaws to it in practice: there is a real cost to obtaining and processing information and this cost can differ among market participants.  Indeed, the way that information is interpreted differs from individual to individual so the notion that the price of a security must be the same for everyone is also doubtful.

A sub-field of behavioural economics, behavioural finance, has gained traction since the global financial crisis of 2007-2009 when traditional economics failed to predict the market crash.  In behavioural finance, insights from psychology are combined with economic modelling to study what happens in capital markets when their participants are not perfectly rational and instead react to information according to their emotions.  An important example here is the phenomenon of “herd instinct”, where investors have been shown simply to follow what they think others are doing rather than processing information independently for themselves.

Further reading

Eugene Fama is one of three economists to have won the Nobel Prize in 2013 for empirical analysis of asset prices.  See in particular his formulation of the efficient-market hypothesis in “Efficient Capital Markets: A Review of Theory and Empirical Work” (Journal of Finance, 1970).

Good to know

Most transactions in capital markets today are performed by computers and there is a very high degree of automation.  Exchange-traded funds, which are financial instruments that automatically track stock-market indices, have emerged as a cheap and increasingly popular alternative to traditional stock-broking for trading transactions.  Yet despite their computing power, machines are only ever as good as their makers: a small human error in the programming can quickly lead to so-called “flash crashes” and a lot of lost money!