What Is The Purpose Of The Capital Market? How Do Capital ✓ Solved

What is the purpose of the capital market? How do capital

Answer each of the 2 essay questions below with a response that is at least 500 words in length.

Introduction

The capital market plays a fundamental role in the economy by facilitating the transfer of funds from savers to borrowers in an organized environment where securities are traded. This market is crucial for driving economic growth and development by providing businesses and governments with the necessary capital to fund their projects. In contrast, money market securities are generally characterized by short-term maturities and low risk. This essay will explore the purpose of the capital market, the differences between capital market and money market securities, and analyze the impact of significant events like the 2001 terrorist attacks and the Enron scandal on stock prices using the Gordon growth model.

Purpose of the Capital Market

The primary purpose of the capital market is to facilitate the raising of long-term funds by corporations, governments, and other entities. By issuing stocks and bonds, companies can attract investment from the public, enabling them to finance expansion, research, development, and other potential opportunities. Furthermore, the capital market provides investors with a platform to purchase equity and debt securities, contributing to wealth accumulation over time.

The capital market also contributes to the liquidity of financial assets. Investors can buy and sell securities quickly, ensuring they can convert their investments into cash when needed. This liquidity enhances investor confidence and encourages participation, leading to more funds being available for businesses and government initiatives.

Moreover, capital markets promote price discovery and transparency. As various market participants trade securities, the prices reflect the collective opinions and expectations of future performance, thereby providing valuable information about the financial health of companies and the overall economy.

Differences between Capital Market and Money Market Securities

Capital market securities differ significantly from money market securities in several aspects. Firstly, capital market securities, which include stocks and bonds, are typically long-term investments with maturities of more than one year. In contrast, money market securities, such as Treasury bills, commercial paper, and certificates of deposit, have short-term maturities, usually less than one year.

Secondly, the risk and return profiles of these two types of securities vary. Capital market securities tend to be more volatile and carry a higher degree of risk due to the uncertainty associated with equity ownership and the potential for changes in interest rates that can affect bond prices. Conversely, money market securities are considered safer investments, offering lower yields due to their short-term nature and reduced risk.

Lastly, the mechanisms for trading these securities are also different. Capital market transactions occur on stock exchanges or through over-the-counter (OTC) markets, where prices fluctuate based on supply and demand. In contrast, money market securities are typically traded in a decentralized market and involve direct participation from financial institutions.

The Gordon Growth Model and Market Reactions

The Gordon growth model, also known as the dividend discount model, is used to determine the intrinsic value of a stock based on its expected future dividends that grow at a constant rate. This model suggests that stock prices are influenced by expectations of a company's future performance and payout ratio. The formula is expressed as:

Value = D / (r - g)

Where D represents the expected dividends, r is the required rate of return, and g is the growth rate of the dividends.

Following the terrorist attacks on September 11, 2001, there was a significant decline in consumer confidence and economic activity, especially in sectors like travel and insurance. This atmosphere of uncertainty prompted investors to reevaluate their expectations of future growth and dividends, leading to an increase in the required rate of return (r) used in the Gordon growth model. Consequently, the intrinsic value of stocks decreased, resulting in a sharp decline in stock prices.

Similarly, the Enron scandal, which exposed widespread corporate fraud and accounting malpractice, significantly impacted investor sentiment. The scandal undermined trust in market institutions and led to increased scrutiny of corporate governance practices. As the repercussions of the scandal unfolded, many investors re-assessed their expectations of future returns from various companies, resulting in a higher required rate of return. This reaction, again using the Gordon growth model, led to a further reduction in stock prices as the perceived risk associated with holding equities increased.

Conclusion

In conclusion, the capital market serves a vital role in the economy by providing a platform for raising long-term funds and ensuring liquidity for financial assets. Understanding the differences between capital market and money market securities is critical for investors making prudent investment decisions. Additionally, significant events such as the 2001 terrorist attacks and the Enron scandal illustrate how external factors can influence stock prices through shifts in investor expectations, as demonstrated by the Gordon growth model. These scenarios underscore the interconnectedness of economic stability and investor confidence in shaping market dynamics.

References

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• Investopedia. (2022). Capital Market. Retrieved from https://www.investopedia.com/terms/c/capitalmarket.asp
• Malkiel, B. G. (2016). A Random Walk Down Wall Street. W. W. Norton & Company.
• Modigliani, F., & Miller, M. H. (1958). The Cost of Capital, Corporation Finance and the Theory of Investment. American Economic Review.
• Penman, S. H. (2013). Financial Statement Analysis and Security Valuation. McGraw-Hill Education.
• Shiller, R. J. (2015). Irrational Exuberance. Princeton University Press.
• Volatility Institute. (2020). The Impact of Economic Shocks on Financial Markets. Volatility Studies Review.
• Williams, J. C. (2020). Understanding the Gordon Growth Model: Applications and Implications. Journal of Financial Education.
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