How Capital Markets Work

The easiest way to understand how capital markets is know how the various types of capital markets operate.

Stock Market

Businesses that are listed on stock exchanges (secondary markets for stocks) are called public companies. As a public company, the business is required to have an investor base of a certain size and file audited financials with the SEC each quarter.  

Businesses then trade on an exchange, like the New York Stock Exchange (NYSE) or the NASDAQ. Each exchange has its own listing requirements that companies must follow to stay on the exchange.

When you buy a stock in your brokerage account, you are buying a fractional share of the business. The broker works with the exchange and other intermediaries to buy and sell stocks.  

Bond Market

The federal government raises funds by issuing treasury bonds, bills, and notes that trade on the secondary market. These bonds are considered to be safe investments because they are backed by the government’s massive tax revenue. Other bonds are often priced relative to treasuries based on how risky they are perceived to be. 

Municipal bonds, or “munis,” are the local form of treasury bonds. They are backed by the tax base of local cities, counties, or states. Like treasuries, many munis pay tax-free interest. While not considered risk-free, munis are generally thought of as one of the least risky asset classes.  

Currency Market

Currency trading is commonly referred to as “FOREX trading.” Currencies don’t often move much so FOREX trading often includes a ton of leverage. This can lead to big returns but it can also lead to getting wiped out quickly.   

Businesses can use the currency market to make sure they don’t lose money on otherwise profitable deals because of currency fluctuations.

Derivatives Market

Futures contracts are an agreement to buy or sell a certain quantity of an asset at a future date. For example, you could agree to buy 10 pounds of gold bullion at $2,000 per ounce in six months. If the price goes over $2,000 per ounce, you make money. 

Speculators want to buy futures contracts for the huge potential gains (futures trading uses a ton of leverage just like FOREX trading). Businesses use it to hedge. If you’re a gold miner uncertain of where the gold price will be in six months, you may decide to sell the futures above to lock in a price of $2,000 per ounce now. That way, if the price drops, you still make money.

One of the most famous examples of a company using a derivatives market is Southwest hedging future oil prices. 

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