Capital Markets: Stocks, Bonds and Securities

• Capital markets channel savings and investments between suppliers and those in need
• Capital markets are financial markets where stocks and bonds are traded
• Suppliers are entities with capital for lending or investment

Two Main Segments of Capital Market

• Stock Market

• Bond Market

• Bonds are debt securities from governments/corporations raising capital

• Stocks represent company ownership, giving investors a claim on earnings/assets

• Derivatives are financial instruments deriving value from assets like stocks, bonds, commodities

• Primary market sells securities for the first time

• Secondary market trades securities after initial issuance

Market Types

• Auction Market: Direct interaction between buyers/sellers to bid on prices

• Dealer Market: Trading via electronic networks/intermediaries

• Principle of Valuation: Asset value equals the present value of expected future cash flows

• Deflation increases purchasing power of money over time

• Current Yield: Annual coupon payment; the guaranteed annual interest payment from bond issuer

• Yield to Maturity: Rate equating the present value of all future cash flows to bond's current market price

• Bond Price: Price at which a bond is traded

• Yield: Return an investor receives based on the bond's market price & coupon payments

Capital Market Instruments

• Stocks
• Bonds
• Derivatives

Participants in Capital Markets

• Households
• Non-Financial Institutions
• Institutions
• Governments

Functions of Capital Market

• Raising Capital
• Facilitating Investment
• Ensuring Liquidity

Benefits of Investing in the Capital Market

• Liquidity
• Diversification
• Wealth Growth

Risks of Investing in Capital Market

• Risk of Loss
• Volatility Risk
• Liquidity Risk

Different Types of Capital Market

• Bond Market
• Stock Market
• Foreign Exchange Market

Different Types of Capital Market Instruments

• Stocks
• Bonds
• Derivatives

Types of Bonds

• Corporate Bonds
• Government Bonds
• Foreign Bonds
• Municipal Bonds

Types of Stocks

• Common Stocks
• Preferred Stocks

Types of Risk in Capital Market

• Market Risk
• Liquidity Risk
• Default Risk
• Inflation Risk

Capital Market Theory

• Extends Portfolio Theory and develops a model for pricing risky assets

• Aims to price risky assets based on the trade-off between returns and inherent risks

• Portfolio: Collection of financial and real investments identifying an efficient frontier

• Efficient Portfolio: Portfolios with maximum return for a given risk level, or minimum risk for every level of return

• Market Portfolio: Portfolio consisting of all securities where the proportion invested in each security corresponds to its relative market value

• Capital Market Line (CML): Linear efficient set of CAPM

• Security Market Line (SML): Graphical representation of CAPM estimating risk/return relationship in a stock price

• Capital Asset Pricing Model (CAPM) is an equation describing expected return on any asset as a linear function of its beta, ß, which is the measure of the asset's sensitivity to movements in the market

• CAPM equals the risk-free rate of return, plus asset's beta times the difference between expected return on market portfolio and risk-free rate of return

• Beta: Measures the asset's sensitivity to market movements

• Systematic Risk: Risk inherent in the market

• Unsystematic Risk: Risk specific to a company's financial situation

• Global Minimum Variance Portfolio: Portfolio of risky assets having the minimum variance

• Capital Allocation Line: Efficient frontier with a linear portion tangent to the efficient frontier defined using risky assets

• Tangency Portfolio: Market portfolio of risky assets held in market value weights

• Mean-Variance Analysis: Modern portfolio theory assessing trade-offs between risk, return variance, and expected return, assuming investors are risk-averse

• Weighted Average of Expected Return: The expected return

• Capital Market: For long-term investments with over a year lock-in period

• Money Market: For short-term investments

Functions of Capital Market

• Bridges gap between capital suppliers and users
• Helps minimize transaction and information costs

Limitations of Capital Markets

• Risk of monetary losses due to market risks

• Market fluctuations may hinder investment gains and fixed income

• Wide range of investment alternatives can be confusing

• Trading costs (brokerage fees) increase transaction expenses

• Investors offer money for capital gains through investment growth

• Companies, entrepreneurs, governments look for funds

• Stock Exchange operates the market

• Regulatory Bodies monitor and eliminate illegal activities

Basic Capital Market Instruments

Equity Securities

• Equity Shares
  • Owning rights to the company that gets dividend only when the company earns sufficient profit that comes with voting rights but also risky because it is not secured.
  • Part of the share capital of the company, which are not preference shares. These shareholders are the real owner of the company.
• Preference Shares
  • known as preferred stock that has two priorities: repayment of capital and payment of dividend
  • Types
    • Participating and non-participating
    • Redeemable or irredeemable
    • Cumulative or non-cumulative
    • Convertible or non-convertible
• Debt Securities
  • Debentures
    • When a corporation is in need of fund in addition to share capital it borrows money by issuing debentures. The debenture holder gets interest which is fixed at the time of issue.
    • Types
      • Redeemable or irredeemable
      • Convertible or non-convertible
      • Secured or unsecured
      • Bearer or registered
  • Bonds
    • Issued by public authorities, credit institutions, companies and super national institutions in the primary market.
    • A bond is a negotiable certificate which entitles the holder of repayment of the principal sum plus interest
    • Types
      • Bearer Bonds
      • Registered Bonds
      • Callable Bonds
      • Convertible Bonds
      • Zero Coupon Bonds
      • Fixed Rate Bonds

Capital Market Instruments

• Equity Shares
  • Merits
    • A permanent source of finance to the company
    • No fixed rate of dividend
    • Easy liquidity and marketability
  • Limitations
    • No guarantee on returns to shareholders
    • Loss of managerial control
• Preference Shares
  • Merits
    • Hybrid security
    • Absence of voting rights
    • No dilution of control
    • Fixed return
  • Limitations
    • Not secured
    • Not an attractive investment
    • No right to participate in the management
• Debentures
  • Merits
    • No loss of managerial control
    • A Flexible source of finance
    • Reduces burden of tax of the company
  • Limitations
    • Fixed rate on interest
    • Companies may have to mortgage their assets
    • Not an attractive investment from company's point of view.