What Is the Equity Market & How Does It Work?
Understand the equity market's role in finance. Learn how company shares are traded and how capital is raised for businesses.
The equity market facilitates the buying and selling of company shares. It is a central mechanism where businesses raise capital and investors participate in company ownership and growth. This market enables the flow of investment that supports economic activity.
Understanding the Equity Market
The equity market, also known as the stock market, is where ownership interests in companies are traded. Equity represents shares of ownership in a company, meaning that when an investor buys a company’s stock, they acquire a small piece of that business. This allows companies to secure funding for operations, expansion, and other initiatives without incurring debt.
Companies raise capital by issuing shares, a process known as equity financing. This contrasts with debt financing, where companies borrow funds that must be repaid with interest. The market also provides a platform for investors to buy and sell shares, offering liquidity that allows shareholders to convert their investments into cash easily.
The prices of shares within the equity market are influenced by the forces of supply and demand. High demand for a company’s stock, coupled with limited supply, can lead to an increase in its share price. Conversely, if demand is low and supply is high, the share price may decline. This dynamic helps in the ongoing valuation of companies based on market sentiment and performance expectations.
Key Elements of the Equity Market
The equity market includes several interconnected elements. A share signifies a unit of ownership in a corporation. There are two main types: common stock and preferred stock. Common stock provides voting rights on company matters and offers potential for capital appreciation, though common stockholders are last in line to receive assets if a company liquidates.
Preferred stock, conversely, carries preferential rights, such as receiving fixed dividend payments before common stockholders and having a higher claim on assets in the event of liquidation. Preferred stockholders do not have voting rights. While common stock offers higher potential returns, it also involves greater volatility, whereas preferred stock is less volatile but has lower growth potential.
Stock exchanges are marketplaces where the buying and selling of securities occur. Examples include the New York Stock Exchange (NYSE) and Nasdaq. These exchanges provide a transparent setting for price discovery and ensure fair trading practices.
Various participants interact within the equity market. Companies are the issuers, selling shares to the public. Individual investors, also known as retail investors, participate by buying and selling shares to grow their wealth, often seeking income through dividends or capital gains from price increases. Institutional investors, such as mutual funds, pension funds, and hedge funds, manage large pools of capital. Intermediaries, including brokers, market makers, and investment banks, facilitate transactions.
How Shares are Traded
The process of trading shares begins in the primary market, where companies first issue new securities to the public. This initial offering is known as an Initial Public Offering (IPO). During an IPO, a private company becomes public by selling shares for the first time.
Investment banks, acting as underwriters, play a role in the IPO process. They advise the issuing company and manage the offering. Once the IPO is completed, the newly issued shares become publicly traded on a stock exchange.
After shares are initially sold in the primary market, most trading occurs in the secondary market. Here, investors buy and sell existing shares from other investors. The issuing company is not involved in these transactions; proceeds go to the selling investor. The secondary market provides liquidity, allowing investors to sell their holdings easily.
Transactions in the secondary market are facilitated by brokers and stock exchanges. Investors place orders through a brokerage firm, which routes the order to an exchange. Common types of orders include market orders and limit orders.
A market order is an instruction to buy or sell a security immediately at the best available current price. While it guarantees execution, it does not guarantee a specific price, which can fluctuate. A limit order allows an investor to specify a maximum price when buying or a minimum price when selling. This order type provides more control over the price but does not guarantee execution if the market price does not reach the specified limit. Trading occurs during specific market hours, though some platforms offer extended-hours trading.