Purpose and users of capital markets:

We have seen that investment is nothing but postponed consumption. So there are investors who are willing to lock in their funds in the expectation of earning higher returns, making capital gains. On the other side, there are business firms, organisations, and individuals who need funds and finance for making physical investments in the hope of making profits or gains, or even for  consumption. Capital markets constitute a mechanism for bringing together buyers and sellers of various types of financial assets.  Exchanges of these financial assets determine their prices.

The financial system of a nation consists of financial institutions, financial markets, and financial instruments and services. A  financial market is an arrangement that facilitates the exchange of financial assets, including deposits and loans, corporate stocks and bonds, government bonds, and derivatives like futures and options. You will read about derivatives in the next unit. Financial markets can be classified in several ways: as primary and secondary markets, that is markets in new issues and markets and markets in existing issues; as organised or formal markets, and unorganised or informal markets; and financial markets can also be classified as money markets, or markets for short-term funds, and capital markets, or markets for long run funds.
Capital markets can be markets where long-term debt contracts are traded, like bond markets or debentures, or these can be  equity markets where financial claims are sold which allows the holder a share in the profits of the firms issuing these shares. The markets where shares are issued initially are called primary markets, and the markets where markets where the holders of these shares further trade these in the expectations of making capital gains are called secondary markets.

Let us look now at the basis for the need and provision of finance, as this will enable us to know about debt as the foundation of finance, and see who the participants in the markets are. Capital markets are all about the raising of capital and matching those who want capital (borrowers) with those who have capital (lenders). One way of matching these are financial institutions like  banks and other depository institutions. For more complex transactions, markets are needed in which borrowers (and their agents) can meet lenders (and their agents). Commitments to borrow and lend are created. There are also markets where these  commitments to borrow and lend are themselves sold off to other people. For example, companies can raise money by selling shares to investors and existing shares can be freely bought and sold. Who are the borrowers? Individuals can borrow for domestic purchases or for longer term such as financing and mortgages of houses, or consumer durables, or education...   companies need short-term funds to finance their cash flow. They need longer term funds for growth and expansion. Governments are huge borrowers. 

They often borrow by issuing securities like bonds. Their total borrowing is called National Debt. Public sector companies may also borrow for expansion and growth. Borrowing may also be done from foreign agencies, institutions etc. Similarly, lenders may be individuals, or financial institutions, or even companies. A company can use some of its idle funds to lend for short periods in order to make gains, in the money market.

When money is lent, in many cases the borrower issues a receipt for the money, a promise to pay back. These receipts are called securities, and the lender has claims on these securities. Thus securities are financial claims. The holders of financial securities are the lenders, and the issuers of financial securities are the borrowers. There are many types of securities like Treasury Bills,  Certificates of Deposits, Commercial Paper, bonds, debentures, equity shares, and so on. All securities show key information about how much is owed, when it will be paid back, and how much is the rate of interest.

So we have seen that markets exist for finance and the main participants are borrowers, lenders, their agents and other individuals and agencies that facilitate exchanges. Borrowers issue securities. Lenders purchase these securities. For example when the government issues a bond, we say that the government is selling the bonds. When you purchase the bond, you are  actually lending money to the government, and the government is borrowing money from you. The market for long-term securities is called capital market. Capital markets perform several important functions in a market economy. The capital markets makes information processing and dissemination easier, which allows better decisions can be taken regarding investment, selling of  assets, and so on. Capital markets allow quick valuation of financial instruments - both debt and equity. Capital markets also enable operational efficiency by simplifying transactions procedure and lowering search costs and transactions costs. Capital markets help to develop integration among several sectors of the economy such as between real and financial sector, between debt and equity instruments, between short-term and long-term funds, and between domestic and external funds. Finally, capital markets facilitate the flow of funds into efficient channels through proper investment.