What is the Difference Between Capital Markets and the Stock Market?

The difference between the capital market and the stock market is like the difference between a rectangle and a square…

A rectangle has four sides connected at 90-degree angles. A square is a special type of rectangle because its four sides are all the same length. So, squares are part of the rectangle family, but not all rectangles are squares. In the same way, the stock market is part of the capital market. All stock market transactions happen on the capital market, but not all capital market transactions occur on the stock market.

The short answer is that the stock market is part of the capital market. While the stock market deals exclusively with stocks, the capital market includes stocks, bonds, and other forms of long-term capital. So, when someone brings up the stock market, they are probably talking about the trading activity that happens on the stock exchanges — such as the New York Stock Exchange (NYSE) or the NASDAQ. If someone says something about the capital market, they're probably talking about ways for companies to raise capital by selling equity or issuing debt.

The capital market is where companies and governments go to raise capital. There are two general ways to do that. One option is to sell equity; the other is to issue debt. That’s why there are two significant parts of the capital market. The stock market deals with equity, and the bond market handles debts. The capital market itself is part of the broader financial market — which encompasses all of the places buyers and sellers trade financial instruments.

So, the relationship looks like this:

• The financial market is where all trades involving financial assets happen.
  • The capital market is where companies and governments go to raise long-term capital.
    • The stock market is where people buy and sell equity in listed corporations.
    • The bond market is where people buy and sell bonds.
    • The over-the-counter market is where people buy and sell equity in unlisted companies and various derivatives (assets that derive their value from other assets).
  • The money market consists of short-term debt instruments, like certificates of deposit (bank-issued debt), treasury bills (federal debt of under a year), and interbank loans.
  • The currency market is made up of foreign exchanges and cryptocurrency trades.
  • There are other various markets in which financial assets change hands that fall under the financial markets.

The capital market focuses on longer-term debt instruments, generally longer than a year. Most notable among these instruments are long-term bonds. A bond is a piece of paper that entitles the owner to a payment at a future date. When that date arrives, the bond has matured and can be redeemed. Companies issue corporate bonds, the federal government issues US treasury bonds, and local governments issue municipal bonds.

Many bonds include periodic interest payments over their lives. For example, a 10-year bond might have a maturity value of $1,000 and also include $10 interest payments every six months. The bond’s owner can transfer their rights to that $1,000 payout and those interest payments to another investor at any point before maturity. Any exchange of bonds like this happens on the bond market, which is part of the capital market.

Selling equity in a company also happens in the capital market. Equity is an ownership interest in a business, which entitles the owner to a part of the company’s profits. Companies usually sell equity by issuing shares of common stock. They contract with an investment bank to manage an initial public offering (IPO), which allows interested investors to purchase shares at a specified price.

After buying those shares, the buyer can sell their shares to other investors on the stock exchange. Unlike a bond, common stock doesn’t have scheduled payments. Instead, companies distribute their net income to their owners, usually every quarter, or reinvest that income into making the business more valuable. So, the underlying value of equity is directly tied to the success of the company, along with the supply and demand for its shares. Investors might prefer owning equity rather than debt because of the potential for greater gains. Of course, bonds have preferential rights to the company’s income. If there’s not enough money to make bond payments and issue dividends, the bond payments happen first. So, bonds are less risky than stocks.

Various other contracts sometimes also get included in the capital market category. These are securitized financial instruments that trade over-the-counter (OTC). One example is commodity futures contracts, in which a producer commits to sell future production at a predetermined price. For instance, an agricultural company might commit to selling its fall harvest before it’s even planted.

By most definitions, bank loans don’t happen on the capital market — even though those loans are ways for companies to raise capital. The rationale is that bank loans are more heavily regulated than selling equity or issuing bonds. Then, those loans don’t necessarily become securitized assets. The lack of trade between investors makes it hard to classify loans as open market transactions.

But some business loans do become securities sold on a secondary debt market. In those cases, the commercial paper might fall under the definition of capital markets. So, there isn’t a clear line on what’s included in the capital market and what’s not. Regardless, all of these transactions do happen in the financial market.

Capital markets bring together people or companies that have excess capital they want to invest and businesses that need money to expand. Companies that have excess capital are usually pension funds, mutual funds, insurance companies, and financial institutions. These organizations hold money for some future use, such as providing income during retirement or paying future insurance claims.

In exchange for putting their money at risk, these investors receive a return on investment. Meanwhile, business owners might have great ideas to provide products to their customers. But they might not have the capital (money) required to get the business off the ground. To raise capital, they go to the capital market.

In exchange for using other people’s money, they either promise to pay them a return on their investment, or they commit to giving them a part of the company’s profits. The capital market brings these two groups of people with opposite needs together. It allows the economy to expand far faster than it otherwise could.

There are two ways that capital markets work. The primary market includes the initial sales of stock during an initial public offering (IPO) and the issuance of new bonds. In the primary market, an investor is buying the asset directly from the issuing entity. The corporation gets the money, and the investor receives the newly created financial instrument. During an IPO, that instrument is a stock certificate, which shows that the investor has an ownership interest in the company and its profits. With a bond, the investor gets the bond certificate, which entitles them to a payout in the future.

The secondary market is where investors buy and sell capital assets that get created in the primary market. In the case of stock certificates, investors go to a stock exchange to buy and sell them with one another. Investors also might want to sell a bond before it matures. If so, they turn to the bond market to find a buyer. Any sales of a bond, or any other financial instrument, after the initial issuance, happens on the secondary capital market.

The stock market is where traders buy and sell shares of company stock — which is a certificate of ownership in a small piece of a corporation. To be traded on the stock market, a company must be listed on a stock exchange.

Each exchange has listing requirements, which include certain financial disclosures and oversight by the securities and exchange commission (SEC). These requirements ensure investors that the stock they purchase is for a legitimate company and allows investors to have proper insight into what they buy.

Thousands of companies are listed on the stock market. These companies have issued shares of equity in the company, which they sold to investors during an initial public offering (IPO). After the IPO, investors own stock certificates that establish their ownership interests. Investors can take those certificates to the stock exchange and sell them to other investors.

There are several stock exchanges, which list companies whose shares are bought and sold. The New York Stock Exchange and the NASDAQ make up the stock market in the United States. The London Stock Exchange, Japan Exchange Group, and the Hong Kong Stock Exchange are some of the larger stock exchanges outside the U.S.

When investors want to buy and sell equity in a listed company, they go to the stock market. Companies often sell millions of shares of stock, each representing a tiny fraction of ownership in the corporation. Owning a stock entitles the investor to a portion of the company’s profits, which generally get distributed through dividends.

Every day, millions of people buy and sell these stocks. Doing so requires a brokerage account, through a broker. Traders direct their broker to buy and sell stocks via market orders. Then, the broker finds another trader looking to take the opposite position. For example, if you place a buy market order, your broker will find someone that placed a sell market order for the same stock. Then, ownership of that stock will transfer from the seller to the buyer in exchange for the market price.

Traders can also place advanced conditional orders, which execute when the specified conditions are met. For example, an owner of stock could set a stop-loss order at $25. If the market price of that stock falls to $25, it converts to a sell market order. Limit orders are similar. If the desired stock hits a specified limit, it triggers an order to buy or sell the stock (depending on whether it is a buy limit or a sell limit order) at that price or better.

In a nutshell, here are some key differences between capital and stock markets:

• The stock market is part of the capital market.
• The stock market deals only with equity capital, while the capital market deals with equity and debt instruments.
• The stock market exclusively works with corporations regulated by the Securities Exchange Commission (SEC), while the capital market extends beyond regulated securities.
• The stock market doesn't have trades of any government instruments, while the capital market includes US treasuries and municipal bonds.
• The stock market deals only with simple shares of equity, while the capital market also includes much more sophisticated derivatives.