CHAPTER 1: THE CAPITAL MARKET

Transcription

1 CHAPTER 1: THE CAPITAL MARKET Topic One: Investment Capital 1. Characteristics of Capital. A. Capital is invested in political and economic climates in which profit can be created. It is highly sensitive to risk, but not necessarily averse to risk; risk must be balanced against returns. 2. The Need for Capital. A. Capital investment is required to maintain and increase economic output. Expanded economic output is a sign of a vigorous and growing economy in which the standard of living is improving. (1) Productivity is increased by capital invested in new plants and equipment. (a) Competition in domestic and foreign markets can be enhanced, because higher levels of productivity can lead to cost advantages. (b) Capital investment in research and design can lead to new products. Topic Two: The Sources and Users of Capital 1. Sources of Capital. A. Capital results from savings. There are three primary sources of capital: (1) Individual investors (also known as retail investors). Some of their savings provide capital for institutional investors. (2) Institutional investors. These are the financial firms (such as mutual funds) that invest in stocks, bonds, and other financial products on behalf of their investors. (3) Foreign investors. They provide capital to many Canadian industries but concentrate on the manufacturing, oil and natural gas, and mining sectors. (a) Foreign investment is prevented in some Canadian corporate sectors, as specified in government legislation.

2 2. Users of Capital. A. Individuals need capital to finance consumption, such as a mortgage or a loan in order to buy a car. B. Businesses need capital in order to operate and expand. A. Some capital required by businesses is generated by profits and some by borrowing. (1) Borrowing is done through the chartered banks and the securities market. i. Bonds, preferred and common shares, and money- market paper are financial instruments used in the securities market to raise capital. C. The federal government requires capital to meet expenses and for capital projects. It borrows by issuing: (1) Treasury bills (T-bills). (2) Marketable bonds: bonds that trade in secondary markets. (3) Canada Savings Bonds (CSBs). (4) Canada Premium Bonds (CPBs). D. The provincial and municipal governments borrow for the same reasons as the federal government. They raise capital by: (1) Treasury bills (T-bills). (2) Non-marketable bonds. (3) Borrowing from the Canada Pension Plan. (4) Savings bonds similar to the CSBs. (5) Marketable debentures in foreign markets (provinces only). (6) Instalment debentures (also called serial debentures); (municipalities only): Instalment debentures are bonds in which a predetermined amount of principal matures each year.

3 Topic Three: Financial Instruments 1. Debt or Fixed-income Securities. A. A debt instrument is one in which there is a lender and a borrower. The borrower (a corporation or government) is called the issuer. B. An issuer of a debt instrument promises to pay interest to the investor during the term of the loan and then repay the principal of the loan at its maturity. The term of the loan depends on the instrument. C. Debt instruments include: (1) Bonds. (2) Debentures. (3) Commercial paper. (4) Treasury bills. (5) Mortgages. D. Bonds are differentiated from debentures by the form in which they are secured. (1) A bond is secured by the assets of the issuer. (2) A debenture is secured by the general creditworthiness of the issuer. 2. Equity instruments. A. Equities are the stocks or shares of a company. They represent ownership. Owning a share of a company allows the investor to participate in the fortunes of the company. If the company is profitable, the shares may receive dividends and thus increase in value. Conversely, their value can go to zero. B. Shares are issued as common shares or preferred shares. (1) Common shareholders have the right to vote at a company s annual meetings and may be issued dividends. (2) Preferred shareholders receive fixed dividends before dividends are paid to common shareholders. (a) If a business should close, preferred shareholders have access to the company s assets before common shareholders. (b) Preferred shareholders have no voting rights, unless the company fails to pay them their dividends.

4 3. Investment Funds. A. Investment funds are pools of money in which shares or units are distributed in proportion to each investor s contribution. (1) A mutual fund is an open-end investment fund in which units are continually issued and redeemed. B. Investment funds provide investors with professional management and portfolio diversification. 4. Derivatives. A. Derivatives, options, and futures are financial products whose value is derived from the value of an underlying security, asset, or market index. Topic Four: The Financial Markets 1. Securities Markets (also Known as the Capital Market). A. A security is first sold to investors on the primary market. For example, an initial public offering, in which the first sale of corporate shares to investors is made, occurs on the primary market. B. The secondary market is the market in which trading occurs between investors for already-issued securities. Secondary markets are classified as auction, or dealer, markets. 2. Auction Markets. A. Bids for stocks openly compete against each other in the auction markets. (1) All Canadian stock exchanges are auction markets. (2) Investment advisors (IAs) and bond dealers serve as intermediaries between buyers and sellers. B. The five Canadian exchanges and the products they list are: (1) Toronto Stock Exchange (TSX); part of the TMX Group with the TSX Venture Exchange and the Montreal Exchange (MX): senior equities, certain debt instruments, income trusts, and exchange-traded funds (ETFs). (2) TSX Venture Exchange (TSX-V): junior securities and certain debentures. (3) Canadian National Stock Exchange (CNSX), formerly Canadian Trading and Quotation System (CNQ): an alternative equities market for emerging companies.

5 (4) The Montreal Exchange (MX): all financial and equity futures and options. (5) ICE Futures Canada (ICE): agricultural futures and options. C. Liquidity is essential to trading. It is evidenced by frequent sales, little difference between bid and ask prices, and small price fluctuations from sale to sale. D. There are two types of stock exchanges: not-for-profit and for-profit. (1) A member of a not-for-profit stock exchange owns a seat on the exchange. The seat is an asset and can be sold or leased, depending on the laws of the exchange. (2) A for-profit exchange is set up as a private company owned by shareholders. These shareholders have trading privileges on the exchange. (a) All Canadian exchanges are for-profit. E. Participating Organizations or Approved Participants may access trading facilities without being shareholders. F. Many investment dealers have access rights to multiple exchanges in Canada and the United States. G. Membership and access to an exchange, including capital requirements for each firm and senior management qualifications, are determined by each exchange. H. Each Canadian stock exchange is managed by a group of exchange officials and governors, who serve for a specified term of office on the Board of Directors. (1) Boards are comprised of a president, or other permanent exchange official, and of governors, who are experienced stockbrokers. Two to six Public Governors are appointed to represent the interests of investors. I. The statutory responsibilities for an exchange include: (1) Designing the behavioural standards for member firms and their employees. (2) Setting out the rules for the trading of all securities and instruments on the exchange. (3) Establishing listing requirements and reporting requirements for all listed companies. (4) Helping to screen statements of material facts and exchange-offering prospectuses.

6 J. The exchanges are financed by: (1) Transaction fees for each order. (2) Listing fees. (3) Annual fees paid by corporations to keep listings in good standing. (4) Fees paid when there are changes in a listed company s capital structure. (5) The sale of trading and market information. K. International Markets. (1) More than 80 stock exchanges exist in over 60 countries in the world. As of 2007, the New York Stock Exchange was the largest stock exchange in the world in terms of market capitalization and total value of trading. 3. Dealer Markets (Also Called Over-the-counter Counter [OTC] or Unlisted Markets). A. Dealer markets are the second-largest for trading securities after the auction markets. (1) In the dealer markets, dealer bid and ask quotations are entered by dealers who act as market-makers. Price is then negotiated. (a) Market-makers hold an inventory of securities and buy to add to their inventory and sell from their inventory to buyers. (b) An investor in the OTC market pays a broker a commission to determine the best price for a given security. The broker then contacts the dealer to make the purchase or sale. (c) The dealers bid and ask quotations supply liquidity to the market. (2) The OTC markets do not have a physical location; instead, the "buying and selling" takes place on a computer-and-telephone-linked network, operating 24 hours a day. (a) Almost all bond and debenture trading takes place on dealer markets. (3) Derivatives are also traded OTC, primarily by financial institutions. B. There are no listing requirements for stocks traded OTC and no regulation of the companies that trade OTC. The OTC market is a much smaller market than the auction market. (1) Stocks on the unlisted market tend to be speculative and have less liquidity than listed securities. (2) Firms in Canada (except in Ontario) are not required to report unlisted trades. The Ontario Securities Commission (OSC) requires trades of unlisted securities to be reported through the Canadian Unlisted Board Inc. (CUB).

7 C. Alternative Trading Systems (ATS) are privately owned (by brokerage firms), for profit, computerized networks for matching orders for securities outside of the recognized exchanges. (1) ATS are also referred to as Proprietary Electronic Trading Systems (PETS) or Non-SRO-operated Trading Systems (NETS). (2) Orders are matched from the operating firm s own inventory, or the firm coordinates buyers with sellers and vice versa. Bypassing the exchanges means that dealers keep more of the commission charged to clients. (3) Most ATS traders are institutional investors. (4) ATS facilitate global trading, because they operate when traditional exchanges are closed. (5) Market stability could be challenged by ATS, because of the fact trades are less visible, and there are issues of cross-border trading and technological issues of technology, such as adequate system capacity. (6) ATS are members of IIROC. D. Most bond and money-market securities trade OTC in Canada on one of three electronic trading systems: (1) CanDeal is a member of IIROC and is a joint venture among Canada s six largest investment dealers. It is operated by the TSX. CanDeal is an ATS and an investment dealer. Institutional investors are granted access to federal bond and bid offers, prices, and yields. (2) Perimeter Markets operates retail and institutional live multi-dealer fixedincome marketplaces. It is also an ATS and a member of IIROC. (a) The retail marketplace (CBID Retail) is used by investment dealers and investment counsellors for their retail clients. (b) The institutional marketplace (CBID Institutional) is used by registered dealers, institutional investors, governments, and pension funds. (3) The CanPX, a joint venture between IIROC and the Investment Industry Association of Canada (IIAC), monitors real-time bid and ask prices, yields, transaction prices, and volumes for Government of Canada T-bills and bonds, provincial bonds, and some actively traded corporate bonds.

8 4. Private Equity. A. When a company is unable to raise funds by issuing stocks or bonds, it may choose to do so through a private equity arrangement. B. Private equity entails greater risk for investors and possibly higher returns than traditional equity investment. C. Investment minimums are high, and so private equity investment is generally restricted to: (1) Pension plans. (2) Endowments. (3) Foundations. (4) Wealthy individuals and families. D. Private equity takes the form of: (1) Leveraged buyouts, in which a company is acquired by another using equity and debt. (2) Growth capital, in which capital is infused into a company so that the investors gain access to acquisitions the company is making or to its high rate of growth. (3) Turnaround, in which capital is infused into a company that is in financial difficulty. (4) Early-stage venture capital, in which a firm is at an early stage of product or service development. (5) Late-stage venture capital, in which the level of profitability does not allow the company to be self-sustaining. (6) Distressed debt, in which bonds are trading below par due to underlying financial distress by in their issuing firms. E. Private equity provides: (1) Portfolio diversification. (2) Lower liquidity. (3) Higher returns than traditional equity investment.