Capital market identifies as a financial market whereby equity and debt are sold and bought. A capital market is a crucial financial market in any economy noting that it channels wealth to those who invest in it usually companies or governments. The purposes of the capital market include the following. The capital market serves as a market where companies seeking capital through debt and equity instruments are brought together with investors holding capital (Weeks, 2011). The implication in this is that the capital market provides a source of financing for companies. There are numerous of companies that operate in the bond and stock market which are the most significant elements of the capital market. The companies sell their bond and stock IPOs to investors to raise money. On the other hand, investors are motivated to buy from the companies to earn dividends or interest. The other purpose is that capital markets provide a secondary market where those holding various securities exchange with one another. It provides for trading of securities based on market prices.
The capital market securities vary from the money market securities in various ways. The first aspect is that capital market securities are equity and debt markets. While money market securities are short term the capital market securities are used for long-term assets. It means that the maturity of the assets used is more than one year. The institutions operating in the capital markets use this market to raise capital for long-term investments. Capital market securities are suitable to use when a given institution wants to raise capital to enter into a new business, to expand a line of business or for the merger. The nature of capital market calls for a serious scrutiny of its aspects which makes it formal, unlike the money market. The other notable element is that capital market instruments include shares, bonds, debentures, retained earning and Euro issues among others while money market instruments include trade credit, certificate of deposit, commercial papers and treasury bills.
The financial market is greatly influenced by political and economic events. The conditions surrounding an economy have a direct impact on the performance of the financial market. it is right to note that the 2001 terrorist attack and the Enron financial scandal marks as key events which caused the stock prices to decline. The Gordon growth model can be used to explain how the two events caused stock prices to decline. The model is noted by PO= DI/ (k-g). The Gordon growth model employs various elements that are crucial in determining how stocks perform in the market. For instance, the stocks most recent dividend paid, expected rate of growth of dividends and the required rate of return. The model is used in calculating the intrinsic value of the stock. The 2001 terrorist attack brought the attitude that the US would crumble due to terrorism. In the capital market speculation plays an important role in determining the market prices (Kahn, 2001). The fears of terrorism led to the decline of the stock prices of the US companies. The implication in this is that it lowered the dividends growth rate ‘g’ in the Gordon model leading to declining in the value of the stock (PO). The attack led DI to decrease which means that then PO would decrease.
On the other hand, the Enron scandal caused a significant decline in the stock market. It was identified that companies had overstated their earning which lowered the investor’s motivations. The investors now doubted the forecast of earnings and dividend growth for the companies. It caused the revising ‘g’ downward and ‘k’ upward due to increasing uncertainty on the reliability of the accounting information. Companies used to overstate their profit which meant ‘D1’ increase according to investors. The expected rate of return would be the same which means an increase in ‘Ke’ for the companies leading to an inverse effect on ‘PO’. The disclosure resulted in less growth of companies, less investment and reduced stock value.
Financial crisis can largely impact the capital markets and money markets leading to devastating conditions of the economy. Financial crisis identifies as disruptions of the financial market and is attributed to a tremendous decline in the prices of assets and the collapsing of both non-financial and financial firms (Engelen et al, 2011). There are various aspects that may pave the way to the financial crisis such as when moral hazard problems in the financial markets become more significant. The implication of this is that economic activities sharply contract to limit the flow of money and its value. The sequence of events in the financial crisis is attributed by following events. The first stage is attributed by precipitating factors which entails the following. There is deterioration of the financial statements, increase in interest rates, stock market decline and an increase in uncertainty. The second stage leads to a banking crisis whereby an economy where the banking system has failed there is a decline in economic activities.
Moreover, the banking system is crucial for an economy because it steers the movement of money. A smooth flow of money in an economy means that companies and investors are able to carry on their activities properly. There is an accumulation of capital in that economy which leads to growth and development. It is contrary to the case where there is a banking crisis since there is limited access to money and lending contracts (Sornette, 2017). The third stage is debt deflation which entails an unanticipated decline in price levels. Under these conditions, the economy is not favourable for producers and consumers which mean a decline in the economic activities.
Engelen, E., Ertuk, I., Froud, J., Johal, S., Leaver, A., Ertürk, I., … & Nilsson, A. (2011). After the great complacency: Financial crisis and the politics of reform. Oxford University Press.
Kahn, F. S. (2001). Bombing Markets, Subverting the Rule of Law: Enron, Financial Fraud, and September 11, 2001. Tul. L. Rev., 76, 1579.
Sornette, D. (2017). Why stock markets crash: critical events in complex financial systems. Princeton University Press.
Weeks, J. (2011). Capital, exploitation and economic crisis. Routledge.
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