Capital Markets, huh? Sounds like a snoozer. I promise, it’s not and it’s important to understand how capital markets work if you’re going to buy stocks and bonds and even if you are buying mutual funds.
Why do Capital Markets Exist?
Most of us have heard of the stock market where stocks are traded. We’ve seen the trading floor in movies from the 70’s and 80’s and it looks like a huge mosh pit. There are lots of other capital markets. There is a bond market, a commodities market, currency market….for today, we’ll stick with the stock and bond markets.
A capital market provides 2 main functions. It allows businesses to raise capital, and it provides liquidity (an open marketplace for investors to trade securities). Let’s look at how this works.
Equity Market Example
Let’s say I started a software company that is doing quite well. I’d like to expand, but I don’t have the money (capital) to pay for new buildings, staff, etc. I go to an investment bank and tell them I’m looking for a large infusion of capital to grow my business. The investment bank recommends that I sell shares of my business to the public. This is called “going public” and is done through an Initial Public Offering (IPO). I say this sounds great, how does it work. Here are the (much simplified) steps:
- The investment bank helps me value my company – we come up with a $ figure based on my assets, liabilities and growth projections.
- Based on the valuation and the sum of money I need to fund my growth, I need to decide how much of the company I am going to offer to the public. Typically, an owner will want to retain some shares so that they can maintain a controlling interest.
- The investment bank takes me on a road-show. We visit investment firms and share our prospectus to try and drum up demand for our shares.
- We may sell some pre-IPO shares to investors. The rest will be offered for sale to the public.
- We choose a ticker symbol and list our company on one of the exchanges (NYSE, NASDAQ, AMEX)
My purpose in going public was to raise capital. After the IPO, this is done. I’ve sold shares, I’ve got the cash from the sale and I go about my business of running a software company.
Shares Continue to Trade
The shares of my company will continue to trade on the exchange indefinitely – likely until my company goes out of business, is bought by another company, or is taken private.
So here’s the big mystery. If the point of capital markets is to allow businesses to raise capital and this is complete after the IPO, why do the shares continue to trade? This is the part about liquidity. Let’s take an example.
Let’s say you were lucky enough to get a few shares of my company at IPO. You know me, you believe in the company and you expect to get a handsome return on your investment. A year or so after buying shares, you find out the kids need braces. UGHH. This is more than your emergency fund can handle so your only alternative at this point is to sell your shares.
Selling Shares
You sell your shares by going to your brokerage company’s website, logging in, and opening a sell order. Because we have capital markets, there is always a market for securities. Buyers and sellers come together bid for securities they want, and offer securities they want to sell. As we saw in the posting on stocks, some of these securities like Coca-Cola, trade millions of shares per day. There is no guarantee that you’ll get the price you want, but there is always a market.
If capital markets didn’t exist in this way, you’d be stuck once you bought the initial shares. How would you go about selling them? Would you put an add on craigslist? Investors would not be willing to buy shares in an IPO unless they were confident that they could easily sell them at some point in the future.
Fixed Income Market Example
Back to my problem raising capital. I sleep on this and decide that I don’t want to share my company. I go back to the investment bank and ask them for alternatives. Their next suggestion is to issue debt in a bond offering. I’m not familiar so I ask them to explain how this works.
A bond offering is a way to raise capital without selling any ownership stake in my company. I’m essentially asking investors to give me a loan. The bond is like the contract for the loan. A bond has 3 key pieces of info. The face value (a.k.a par value), the expiration date, and the coupon.
How do Bonds work?
The face value for a bond is typically $1,000. This is the amount that the bond-holder will be paid back when the bond expires. The expiration is the date that the bond face value is paid out and interest payments cease. The coupon is the value of the interest payment, expressed as an annual percentage rate (APR) but is typically spread out into quarterly payments.
I like this idea better than selling shares of my company, but I need to have a plan for how I am going to be able to pay the quarterly interest to all the bond holders, and when I’ll be able to pay the entire sum back so that I can determine the bond expiration date. I’ll also need some help from the investment bank to determine a competitive coupon (interest rate). I’ll need to pay more than treasuries (which are very low risk) but I can’t afford to overpay as this will eat into the capital I’m borrowing. We’ll talk more about how bonds work in a future post.
Selling Bonds
So again, you buy some of my bonds and you’re in the same situation. The kids need braces. Similar to the stock market, there is a bond market as well. You can offer your bonds for sale. You may get more than face value, you could get less, but there is always a market.
Exchanges & How they Work
So back to the comment about the stock markets of the 70’s and 80’s being like a mosh pit. They were. There were spots throughout the trading floor where investors – typically members of large brokerage firms – would trade securities. Those wishing to buy would shout out a bid price and order size (# shares). Those wishing to sell would shout out an ask price and a number of shares they were willing to sell.
Today this is all automated. The exchange’s computers take in buy and sell orders all day and match them up. This makes trading much more efficient.
There are also market makers. These are firms or individuals who are prepared to make a market for a given security. They are prepared to buy securities, or sell from their own inventory to ensure liquidity.
In summary, capital markets exist to help companies raise capital, and they provide a marketplace where investors can be confident that they can trade their securities. As an investor, capital markets provide the foundation that enables you to buy and sell securities.