Expert Guidance: Understanding capital markets With Professor Samuel L. Hayes, Harvard Business School Understanding capital markets You may not be confident that you know exactly what the capital markets are, but you almost certainly participate in them. Capital markets involve two parties on either end of a financial transaction. On one side, there are investors with capital who want to earn a return on their money. On the other, there are the companies, governments, or individuals who need to raise money. The capital markets allow these two groups to come together so that both can meet their goals.

Capital markets are an essential part of many countries’ economies, making it possible for businesses to grow, for governments to provide essential services, and for individuals to invest and build their assets. The bigger and more robust a country’s capital markets are, the more investment vehicles there typically are and the larger the potential investment capital that is available to fuel growth.

At the same time, most capital markets are regulated, by the government, the markets themselves, or by both. The goal is to increase investor confidence, and, by extension, investor participation. Achieving it often depends on the perception that everyone has equal access to good information and the best prices.

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What are capital markets? Capital markets are the mechanism that allows the exchange of money between companies and investors, companies and banks, and investors and banks as each party seeks to raise capital or put capital to work.

Mutual benefit

While companies generally rely on their sales to keep their businesses going and on profits to underwrite new growth, there are times when a company might need a large amount of capital — perhaps to expand operations or cover operating losses. The capital markets are a place to raise that money, letting companies offer ownership or promise repayment to investors in exchange for capital.

The capital markets also enable individuals to buy a home, pay for college, or start a business. They can take a loan from a bank that lends its depositors’ money to borrowers in exchange for the promise of future repayment and interest. It might help to think of the bank in this case as the investor, providing an individual with capital.

In both cases, the availability of capital can contribute to economic growth. Expanding businesses typically create new jobs, putting more money into circulation. Homebuyers spend money to remodel and furnish their properties, creating or sustaining jobs.

Of course, in any economy there are periods when investment capital dries up and the economy slows down — or when too much capital encourages inflation. Left unchecked by government or industry oversight, either situation could create serious problems.
From the Expert
Among the factors that have the greatest positive impact on capital markets are the rule of law, the enforceability of property rights, and the predictability of inflation rates and currency values.

The dynamism of the renewal process is a hallmark of vibrant capital markets. Creative destruction, while often painful for many of those who are directly affected, is like nature using fire to burn off dead wood and create an environment for new growth.
Capital refers to money or assets used to generate more money. Capitalism is an economic system that relies on private ownership for the creation, exchange, and distribution of wealth.
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Private sources of funds The capital markets offer companies many different ways to raise funds from many different investors, including individuals and large institutions. Usually, the first options an entrepreneur explores are private sources of funds. This part of the capital markets may provide limited amounts of money, but allows companies to remain privately held and founders to retain control over their operations.

One private option is a corporate loan or line of credit from a bank. The process of qualifying is similar to what you might be familiar with if you’ve arranged a mortgage or large loan. Based on a company’s financial history and prospects, a bank may determine that the company is likely to repay the loan plus interest and advances the company the money.

Another private option is to tap friends and family — private individuals who have some affiliation with the company or its officers and are willing to take investment risk for a share of future profits. A third choice is venture capital, or the assets of private investors channeled through a professional investment firm that may add funds to a start-up or maturing company in exchange for a piece of ownership, some say over operations, and a share in the profits.
From the Expert
In the past, U.S. government loans and tax breaks for smaller businesses helped to offset the difficulty those firms had in accessing private capital markets. In less-developed and developing countries, government sponsored financing programs for smaller businesses might still have validity. But private equity vendors have begun actively penetrating some of these markets to fill the need for capital, just as, over the last 20 years, they have in the United States, where there are any number of financial intermediaries who focus on providing financing to small and medium-sized businesses. That includes private equity groups as well as secured lenders, such as banks.
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Public sources of funds When companies need a greater amount of capital than their earnings or private sources can provide, they may turn to the public capital markets. In the U.S., that means going to Wall Street — shorthand for the financial markets.

Issuing stock and bonds are the primary public ways of raising capital. A company that issues stock sells shares of ownership in the company and becomes publicly held. That means the company has a fiscal responsibility to its shareholders, who have a vote in how the company is run and a right to benefit from the company’s success.

Once a company is publicly held it can also issue bonds to borrow money from investors, taking on the responsibility to repay the capital at some point in the future and pay interest for its use.

Public sources of funds in the capital markets generally involve far greater sums than private sources. But using this money means that a company takes on a number of new responsibilities in exchange for the cash infusion.
Muddy waters
In the technical definition, the term capital market refers to the marketplace where all securities with a term longer than one year are traded. That includes stocks and bonds.

On the other hand, money market is the marketplace where securities with a term shorter than one year are traded. That includes U.S. Treasury bills, or T-bills, short-term bonds, and commercial paper.

What may make both definitions a bit hard to follow in the electronic age is that the marketplace in question isn’t necessarily a physical place, as it once was. Nor is there a single market where all the transactions in question occur.
From the Expert
Capital markets in the United States may attract both savers and users of capital from abroad. This enhances the liquidity and efficiency of the markets and also creates additional economic momentum as the country’s financial services industry prospers. Overseas investors can also provide support for U.S. currency when there’s a current account deficit caused by U.S. consumers buying more goods and services abroad than international consumers are buying from the U.S.

If international investors pull money out of the U.S. economy, or invest at a slower rate, the capital markets may become less stable. Such a move could be prompted by concerns about the dollar’s value or other economic or political events that made the investors wary.
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The value of diversity You’re probably aware of the advantages diversification offers for your investment portfolio. The same principles hold true for companies when they’re raising funds: There are benefits to using a combination of methods. A company might take a loan when starting up, or work with venture capitalists that invest in the company. Several years later they may go public by issuing stock to expand into new markets, and then issue bonds at some time after that to cover the cost of upgrading equipment.

The availability of several methods to raise funds is appealing to companies because it means they can continue to tap new sources of money over time. And by choosing several ways to raise funds, it’s possible to balance the advantages and disadvantages of each method. For example, a publicly held company may issue bonds to raise additional funds because issuing more stock would dilute the value of existing stock, upsetting current shareholders.

Going global

Companies can also look to international capital markets. Some countries may offer better opportunities for raising capital than others, since there may be more potential investors in one country than in another. For example, a company in a small or developing nation might face a limited domestic capital market, so it could choose to offer shares to the much larger pool of investors through American Depositary Receipts (ADRs) traded in the United States, or Global Depositary Receipts (GDRs) traded in markets around the world.

On the other hand, a European company might raise capital internationally by issuing bonds in a country with lower interest rates than it might have to pay at home, reducing the costs of raising that capital.
From the Expert
For most developing countries, access to international capital is essential to a robust rate of economic growth. That’s because unless capital is available to produce marketable goods and services and to provide working capital to finance business transactions, business — and country — growth is stymied.

When investors put capital into developing markets, they usually provide management and financial expertise as well. That has a positive effect on growth.

There are many examples of countries whose economies withered when outside capital was cut off.
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The role you play You participate in the capital markets whenever you purchase stocks or bonds, invest in a partnership, or put money in your savings account.

And even if you think your investing or saving dollars are just a drop in the bucket of the vast capital markets, you should keep in mind that your participation can have an exponential effect, as you earn return on your investment and reinvest or stash the savings, increasing your contributions to the markets themselves.

You also add to and benefit from the capital markets when you take a loan to pay for a new home or build your small business.
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Savings acoounts Even if you save rather than invest, you’re still participating in the capital markets. That’s because when you put your money in a bank account, that bank will pay you interest in return for the use of your savings. That’s true whether you open a money market account or a regular savings account or purchase a certificate of deposit (CD).

Once your money has been deposited, banks can use it to offer loans to companies and to individuals, feeding the capital markets. And as the interest on your savings compounds, it adds to your wealth, providing you with new capital that you might eventually choose to invest in stock or use as a down payment on a new home, cycling cash back into the capital markets.

The safety tradeoff

Unlike most other ways to participate in the capital markets, though, you don’t take any financial risk when you put money in a savings account. That’s because the FDIC insures the value of your account up to $100,000. The trade off for that security is that your return from interest is low compared to what you could potentially earn on uninsured investments.
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Mortgages and loans When you arrange for a mortgage or other type of loan, you’re raising capital in the same way a company does when it takes a corporate loan. You’re investing in your future and expect that these loans will increase your financial worth in the same way a company takes on debt in the belief that it will help the business increase profits in the long term. You also believe that you’ll earn enough in the future to pay back the value of the loan as well as any interest.

The bank that lends you the money anticipates that you’ll use the capital in ways that will help your worth grow, and that you’ll be able to pay back the loan plus interest.

Lenders often have a type of insurance as well, in the sense that major loans are often secured. That means the bank has the right to repossess your home if you fail to make timely payments. It may also seize the assets of a company that defaults or revoke a line of credit if it feels the company is overextended.
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Buying stock and bonds Whenever you buy a corporate stock or bond, you’re buying a piece of the company or lending the company money. If you buy a government bond, you’re actually lending money to the government — whether local, state, or federal — depending on the type of bond you choose.

You’re supplying the capital that the company or government needs to fund its growth, jumpstart a new project, or keep its operations running. You expect that your investment will increase your net worth or provide a source of income, or both, because you believe the stock issuers will grow in value or the borrowers will be able to repay their debt to you.

You’re not alone

Though as an individual you're essential to the capital markets, so are institutional investors including mutual funds, pension funds, and other money managers. They have large amounts to invest on a regular basis — some of it the money you put into retirement savings plans, individual retirement accounts (IRAs), and taxable accounts.

Because of the number of shares or amount of debt they hold, institutional investors can have a major impact on the way that the issuing company operates.
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Issuing stock If a company decides to issue stock in a regulated capital market, it must go through a lengthy process before the shares can be sold to the general public. That’s true whether it’s the company’s initial public offering (IPO), or if the company is already a public company and has decided to make a secondary offering of shares.

Considering the consequences

Issuing stock is a means to raise capital, but it can also dramatically change the nature of the company. A well-publicized or successful IPO affects the company’s national reputation, and selling ownership shares means the company must answer to new bosses, in a sense, allowing shareholders a voice in the way a company is run, and in some cases opening the company to the possibility that the founders may be replaced as company executives.

But for many companies, the benefits of the added capital are well worth the potential downside, which is why thousands of companies are listed on the stock market.

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How an IPO works A public company doesn’t sell stock directly to investors. Instead, it partners with an underwriting firm, usually an investment bank. The firm agrees to buy all the shares from the company at a set price. The underwriters, in turn, will sell the shares in an IPO. In return for assuming the financial risk of the IPO, the underwriting firm receives a fee, usually as a percentage of each share price, from the company going public. That fee is the underwriting firm’s profit.

The underwriting firm works with the issuing company to create a prospectus detailing all aspects of the company and its financial outlook. Potential investors can then refer to the prospectus to analyze whether the company’s stock meets their investment criteria.

The underwriting firm and the company going public determine the initial price for the shares based on a valuation of the company’s product or service, history, and financial prospects. Everyone who buys the stock through the IPO pays that price.
The auction alternative
While most IPOs are handled the traditional ways, some firms prefer to go public by auctioning shares to investors willing to submit competitive bids. When the auction ends, the sale price is determined and all bidders at that price and higher have purchased shares at the sale price.
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Who buys the shares After the underwriting firm purchases the shares, they release them to their associated brokerage firms, called the syndicate, who in turn sell the shares at the set IPO price to institutional investors or wealthy clients who are able to assume the financial risk.

The number of shares released in the IPO is the total number of shares available in that company at that time. But it does not include the shares that the original owners, venture capitalists, and others may hold. Those stocks generally are restricted and can’t be sold for a specific period of time after the IPO.

On the market

Once the IPO shares are distributed, the shares become available on the secondary market, which means shares that were purchased through the IPO will be available for sale on stock exchanges. When the shares are trading freely, the price will change depending on market demand and what investors think the shares are worth.

After the IPO, any gains or losses in price affect only the investor buying or selling the shares.

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What the company gets The money the company raises by going public is the amount the underwriting firm pays it to buy the IPO shares. Neither the company nor the underwriting firm receives any profit from trading on the secondary market. The company, though, still has a stake in the stock performing well, since the shareholders are now part owners in the company. If the stock price falls, the shareholders might demand restructuring or other changes in the way the company is run.

Companies gain in other ways when their stock performs well. Positive publicity and satisfied shareholders can enhance the company’s reputation, which might help it win new customers and business partners.

Stock as incentive

Additionally, company officers and employees may be offered shares in the stock as part of a bonus or retirement plan, and therefore the individual workers at a company may benefit if the stock price rises. That’s meant to encourage hard work from the employees, and if the price rises, it benefits the shareholders as well. The risk, of course, is that the price could fall.
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The secondary market As long as shares of a stock are trading in the secondary market, the issuing company is required to release regular reports detailing its financial status and other information that investors need to make informed decisions.

How the capital markets benefit

The investors who profit from the trades will put their earnings into savings accounts or use them to make more investments, swelling the capital markets. And the more activity in the capital markets, the larger the potential sources of capital in future years, when the company might decide to raise money once again.
From the Expert
Think of a company as a giant machine and of capital as the grease that makes its gears turn. Companies need capital to buy new plants, machines, computers, software, and other tangible fixed assets we see listed on a company’s balance sheet. They need capital to finance their inventories and cover uncollected invoices. And they sometimes use capital to pay for research and development, which will, hopefully, fuel future company growth.
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Issuing bonds Bonds offer advantages to companies interested in raising capital, especially if a company has already made an initial public offering (IPO). That’s because a secondary offering, or issuing more shares of stock, could dilute, or reduce, the worth of shares already on the market.

For governments, at the local, state, and federal level, bonds are the only way to raise capital other than levying taxes. Your local government might float a bond to help pay for new construction or needed repairs, for example.

The differences are key

If a company decides to offer, or float, bonds, the procedure is in some ways similar to that for issuing stock. But bonds are fundamentally different from stocks as a means of raising capital since the investor becomes a creditor of the company, not an owner. And the company is taking a loan, not selling ownership. That makes the process of floating and purchasing bonds different from issuing and buying stock in key ways.
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How it works Just as it does when issuing stock, a corporation that intends to issue bonds partners with an underwriting firm that purchases the bonds from the company and then sells them to investors. In return for taking on this financial risk, the company issuing the bond pays the underwriting firm a fee.

Working with the underwriters, the company will determine the term of the bond, or the number of years before the bond’s face value will be paid to the holder, as well as the coupon, or interest rate that the bondholder will earn.

Municipal bonds issued by state and local governments are also brought to market as needed by underwriters. But U.S. Treasury issues are auctioned to institutional and individual investors on a regular schedule, from as frequently as once a week for bills to as infrequently as quarterly for 10-year notes.

Determining interest

For corporate bonds, the interest rate is usually linked to the term and the financial risk that the holder undertakes: The higher the risk that the company won’t be able to meet its debt, the higher the interest rate. The underwriters then distribute the bonds to their associated brokerage firms, who typically sell the bonds to institutional or individual investors at the par, or face value — in most cases $1,000 per bond.

The same factors influence the cost of municipal bonds, though their rates are generally lower than similarly rated corporate bonds because the interest they pay is tax deductible to investors. Rates on Treasury bonds, in contrast, are affected by term but not rating as they are considered free from default risk.
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Who buys the bonds Once the underwriting firm purchases the bonds, they are usually sold at face value in the primary market. After the initial sale, the bonds may be traded on the secondary market, which means they’re available for anyone to buy or sell, and the price will change depending on market demand, current interest rates, and the perceived financial risk of the company.

Rating bonds

That perceived risk can change, and if a rating service downgrades its rating of a particular company, existing bonds drop in value on the secondary market. That doesn’t directly hurt the company financially, only the bondholder, but it’s usually the result of financial problems at the company, and can further hurt its reputation. And if the company wants to issue new bonds, it will have to offer a higher interest rate to make it worth the risk to investors. That means raising future capital will be more expensive.
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What the company gets The company receives the total amount the underwriting firm paid for the bond, less the fee it pays for the underwriting service. The company doesn’t receive any profit from the trading on the secondary market.

Since bonds are debt, the company now has a group of investors to whom it owes money that must be repaid at a certain time. The company doesn’t grant the bond holders any stake in making company decisions, and it can use the new funds as it sees fit. However, the amount of debt a company carries may have a negative influence on its stock price and the way analysts and investors evaluate it as an investment.

Planning for the future

A company that issues bonds has to manage the new influx of capital carefully, so that it has enough cash on hand to pay periodic interest and the full value of the bonds when they come due.

If the bonds are callable, the company also has the option of redeeming the bonds, or paying holders the face value or slightly more, before the maturity date. A company might decide to call its outstanding bonds if the interest rates drop, for example, because it could issue a new bond or take a loan at a lower cost than the original bond issue.
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The secondary market Once a bond is available on the secondary market, the company receives no additional cash when it is traded. However, just as with stocks, investors who profit from the trades will add fuel to the capital markets either by making new investments or stashing earnings in savings accounts, adding to the funds available for banks to lend to businesses.

And since healthy capital markets are fueled by a healthy economy, companies hope that the capital markets will continue to grow, widening their potential customer base as well as future available capital.
Market ups and downs
The secondary bond market receives more investor attention when stocks are performing poorly, since bonds tend do well under the same circumstances that cause stock prices to suffer — and vice versa.
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Regulating the markets While there is a lot of give and take in the capital markets, with supply and demand setting the prices for securities, it’s not a total free-for-all. Several different groups regulate the markets, including government and financial industry organizations.

The government regulates the capital markets and the securities industry primarily through the Securities and Exchange Commission (SEC). Publicly held companies, the securities they offer, and the exchanges that trade securities are all subject to SEC regulations meant to prevent fraud.

Once a company has issued stock it must regularly report its financial position to the SEC and have that report audited by an outside source. Additionally, the exchanges and investment advisers who manage investments for clients are must register with the SEC and are subject to anti-fraud rules.

Internal monitoring

Self-regulatory organizations (SROs) are groups within the financial industry that also monitor market activity to ensure fair trading. The Financial Industry Regulatory Authority (FINRA) is one such group. It has the responsibility of investigating investor complaints about brokerage firms and reviewing financial advertising to ensure accuracy and full disclosure.

All this capital markets regulation is meant to protect investors from fraudulent activities. That protection is important for its direct benefit to investors, but it also increases the available capital for companies, since investors who are confident in a fair marketplace are more likely to invest their money.
From the Expert
In an idealized economy, there would be no need for government regulation as the markets would regulate themselves and entrepreneurial activities would flourish. In contrast, in the real world, which isn’t a perfect, rational economic environment, there needs to be enough regulation to assure the public that the markets are fair and transparent.
Consumer protections don’t only apply to securities. When you take a loan, for example, the bank must disclose how much you’ll pay in interest and any fees, so that you can determine the actual cost of borrowing the money.
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The Fed's influence The government influences the capital markets in ways other than regulation too. The Federal Reserve System, or Fed, controls the money supply. The Fed decides to increase or decrease the money supply in an effort to keep the economy expanding without running into inflation problems or recession.

When the Fed increases the amount of money in circulation, interest rates drop. That means individuals are more likely to take loans, since they’ll pay less interest, which makes borrowing more affordable. It also means that individuals might be more likely to invest in stocks, since the interest they earn on money left in a savings account has dropped, making the potential returns of the stock market more attractive.

Shifting focus

When the Fed decreases the money supply, interest rates rise, which may spur investors to turn to bonds, or to stash their money in savings accounts. That may shift the trend of the capital markets for a time. But while the Fed’s monetary policies do affect the economy, it is an indirect relationship. That means there may be delays between when a policy shift is implemented and when evidence of the desired result emerges.
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Impact of capital markets The capital markets are key to understanding the way a mature economy grows, and the way emerging markets develop and expand. Whether or not you hold international investments, the health of global economies affects the U.S. economy. And the expansion of the means and affordability of raising capital translates into more resources for companies and more investing choices for you.

Of course it’s possible to invest without understanding the capital markets — without wondering why the stock you’re buying is for sale, and who benefits from your purchase. But realizing that raising capital is a goal individuals and businesses share, and that a successful stock issue will provide capital for both parties in the long run, gives you additional perspective into the marketplace and a better knowledge of the impact of your investments.
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