Capital markets are place where investor buy and sell company and government securities with their trading decision reflecting information on company performance insight provided by financial analyst, dividend announcement by companies expectation on the future levels of interest rate and inflation the investment decision of financial managers and so on.
At both levels, companies and investor will want the capital markets to assign fair prices to the financial securities being traded.
In the language of corporate finance. Companies and investor want the capital markets to be efficient. It is possible to describe the characteristics of an efficient capital market by considering the relationship between market prices and the information available to the market.
Whether capital market are infact efficient has been studied extensively for many years.
Capital markets bring investor lender and firms (borrowing) together. Hence the financial manager has to deal with capital markets. He or she should fully understand the operations of capital market and the way in which the market value securities. He or she should also know-how risk is measured and how to cope with it in investment and financing decision.
For example, if a firm uses excessive debt to finance its growth investor many perceive it as risky. The value of the firm’s share may therefore decline. Similarly investor may not like the decision of a highly profitable growing firm to distribute dividend.
They may like the firm to reinvest profits in attractive opportunities that would enhance their prospects for making high capital gains in the future.
Investments also involve risk and return. It is through their operations in capital markets that investor continuously evaluate the actions of the financial manager.
Investor financial managers and capital market obtain a great deal of information about companies from their financial statements from financial database from the financial press, and so on.Through the application of ratio analysis financial statements can be made to yield useful information concerning the profitability, solvency performance, efficiency of operation and risk of individual companies.
This information will be used for example by investor when reaching decision about whether, and at what price to offer finance to companies by financial manager in making decisions in the key area of investment financing and dividend and by share holders making decision on which securities to add or remove from their portfolio.
The capital markets are markets for trading in long-term financial instrument or securities , but the most important ones for companies are ordinary shares or ordinary equity preference share and debt securities such as debenture, unsecured loan stock and convertible loan stock.
For companies capital market have two main function.
1) They act as a means whereby long-term funds can be raise by companies from those with fund to invest such as financial institutions and private investment.
In the fulfilling this function they act as primary market for new issue of equity or debt.
2) Second function capital provide a ready means for investor to sell their existing holdings of share and bonds or to increase their portfolios by buying additional ones.
Here, they act as secondary market for dealing in exciting securities. The secondary market plays an important role in corporate financial management, because by facilitating the ready buying and selling of securities it increase their liquidity and hence their value.
Investor would pay less for security that was difficult to dispose of.
The secondary market is also a source of pricing information for the primary market, increasing the efficiency with which new funds are allocated.