Financial Markets, Trading and Participants

• Financial markets involve transactions in debt, equity, currencies, commodities, and derivatives
• Market efficiency is a key focus, involving frequent buying and selling, especially of shares
• Efficiency measures how well trading pushes share prices towards their true values

Trading on Financial Markets

• Transactions use instruments like shares, bonds, and treasury bills
• These instruments are IOUs or notes reflecting financial obligations

Types of Markets

• Wholesale markets involve transactions between firms, handling large sums, typically without intermediaries
• Money markets focus on shorter-term financing, usually under one year
• Capital markets cater to longer-term financial needs, generally over one year

Participants in Financial Markets

• Major participants include 'blue chip' companies and governments issuing shares/bonds
• Small and Medium Enterprises (SMEs) rely on intermediated finances and retained earnings

Equity Capital and the Stock Exchange

• Share types include ordinary shares and preference shares
• Initial Public Offerings (IPOs) and Rights Issues are key events

Purpose of Stock Exchanges

• Stock Exchanges facilitate the raising of equity capital through securities

Ordinary Shares

• Shareholders hold fractional ownership and receive dividends from residual profits
• Voting rights are typically conferred, but can vary
• Firms have no legal obligation to pay dividends to ordinary shareholders

Preference Shares

• Less common than ordinary shares, with dividends as a fixed percentage of value
• Dividend accrual for unpaid amounts is possible

Capital Types - Debt vs. Equity

• Generally lack voting rights unless dividends are overdue and have preference over ordinary shares in liquidation
• Debt capital provides leverage opportunities, and interest payments are tax-deductible for firms
• Risks for firms include obligations to repay and potential insolvency if mismanaged
• Debt offers fixed income and lower risk compared to equities for investors
• Investor risks include credit risk and potential default on interest/principal

The Bond Market

• Bonds are defined by face value, maturity, and coupon rate and are essential parameters for determining bond value
• Example denominations are £100 in the UK and $1000 in the US.
• Coupon payments are interest on bonds, a fixed percentage based on face value, and provide a predictable income stream
• Maturity is a set expiration date when the total borrowed amount is repaid
• Markets primarily deal with debt and equity financing

Financial Markets Overview

• Market efficiency and characteristics of wholesale markets are important
• Equity and debt capital, bond valuation, and fixed cash flow definitions must be understood

Securities Markets

• Securities markets raise capital and provide liquidity for trading securities
• Primary markets issue new securities to raise capital, such as IPOs
• Secondary markets trade existing securities like shares and bonds
• Key global exchanges include London, New York, Tokyo, Hong Kong, and Frankfurt

Money Markets

• Focus: trading short-term, highly liquid instruments with maturities under one year
• Instruments include Government Treasury Bills (short-term government debt), Commercial Paper (short-term unsecured debt by corporations), Certificates of Deposit (CDs) (issued by banks to depositors) and Interbank Market (banks trade short-term funds)

Foreign Exchange Markets (Forex)

• The purpose of Forex is buying and selling currencies globally
• Banks dominate facilitate currency transactions for businesses, investors, and governments

Futures and Options Markets (Derivatives)

• Futures and Options Markets hedge risks or speculate on price movements
• UK's main derivatives market is ICE Futures Europe

Derivatives

• Derivatives are financial instruments whose value depends on underlying assets
• They manage risk caused by price volatility
• Types of Derivatives include forward agreements, futures, options and swaps

The Stock Exchange

• Instruments Traded include: ordinary shares, preference shares, debentures, loan stocks and gilts, and local authority bonds

The Stock Exchange Regulations

• Recognized as a regulated exchange under the Financial Services and Markets Act 2000
• Supervised by the Financial Conduct Authority (FCA) to ensure orderliness and investor protection

Information for Investors

• Data is made available on securities (prices, volumes) via the Stock Exchange Daily Official List (SEDOL)
• Website: www.londonstockexchange.com

Settlement of Trades

• Process where securities are transferred, and payments are completed
• Share transactions settle within three working days (T+3)
• Uses CREST, a computerized system that records securities holdings and trade settlements

Central Banks

• Example: Bank of England
• Roles: Maintain monetary value and financial system stability and promote financial market efficiency and competitiveness
• Instrumental in monetary policy and financial oversight

Debt Management Office (DMO)

• Handles government debt and cash management, which issues treasury bills to cover short-term government needs (typically 90 days)
• Gilts are bonds paying fixed interest semiannually until maturity

Financial Institutions

• Investment Banks offer strategic advice on mergers, acquisitions, and takeovers, help raise capital, underwrite securities, and act as issuing houses for new financial instruments

• Clearing Banks obtain financing from individuals via deposit accounts, facilitate money transfers, provide loans, and fund loans using deposits, requiring sound lending practices to avoid risks

• Building Societies primarily lend for house mortgages

• Smaller and less diversified than banks and have limited exposure to commercial money markets

Money Multiplier Effect

• Banks lend a portion of deposited money to borrowers
• Borrowers spend money, which is redeposited into banking, enabling further loans, creating a cycle of credit expansion
• Banks rely heavily on borrowed funds
• Large-scale loan defaults can destabilize the system, as with Northern Rock in 2007
• Funded mortgages via interbank lending and US subprime crisis froze interbank markets
• Northern Rock required Bank of England assistance and was nationalized

Investment Vehicles

• Investment Trusts raise equity and debt to invest in other assets and are traded on stock exchanges
• Unit Trusts, operated by management companies, not traded on exchanges; units are bought/sold directly with the company
• Pension Funds designed to provide retirement pensions, fund managers invest in equities, gilts, and property, and are funded by employer and employee contributions
• Life Insurance Companies maintain capital adequacy to match liabilities and invest in equities, bonds, overseas securities, and property
• General Insurance Companies provide short-term coverage (e.g., motor, home insurance)
• They invest in short-term fixed interest and money market instruments
• Financial markets are categorized securities, money, forex, and derivatives markets to serve specific purposes

Internal Sources of Finance

• Long-term Finance: Retained Profits are profits reinvested back into the business instead of distributed as dividends
• Short-term Finance: Tight Credit Control, reducing inventories, and delaying payments to suppliers

External Sources of Finance

• Share Capital are funds raised through the sale of shares, where shareholders become owners
• Ordinary Shares returns include dividends and capital appreciation, voting rights, higher risk, and higher reward
• Variations: Redeemable shares/Non-voting shares
• Preference Shares returns include fixed dividends and no voting rights
• Variations include participating/convertible shares

Loan Capital

• Funds borrowed, repayable with interest
• Debentures secured against specific assets or floating charges
• Unsecured Loan Stocks have high risk, may include conversion rights

Eurobond Loan Capital

• Loans issued in foreign currency and traded globally
• Unsecured, fixed interest payments, often for $75M+

Medium-term Financing Options

• Hire Purchase: Payments made over time. Ownership transfers after the final payment
• Leasing: Renting an asset for a period without transferring ownership

Short-term Financing Options

• Bank Overdrafts: Borrowing where immediate repayment can be demanded. Interest charged on the overdrawn amount
• Trade Credit: Agreement with suppliers to delay payments, often interest-free
• Factoring: Selling accounts receivables to a factoring company
• Commercial Paper: Unsecured, short-term debt instruments for large denominations issued at discount, redeemed at face value (1-270 days maturity)

Capital Ranking in Winding Up

• Fixed Charge Creditors: Secured loans
• Floating Charge Creditors: General secured claims
• Preferential Creditors: Employee claims, unpaid taxes
• Unsecured Creditors: Trade payables, unsecured loans
• Connected Creditors: Directors' loans, salaries
• Preference Shareholders: Priority over ordinary shareholders
• Ordinary Shareholders: Last to be paid, if anything remains

Key Financing Terms

• Loan Covenants: Terms imposed on borrowers
• Mortgages: Loans secured on specific real assets
• Floating Charges: Secured against current and future assets

Raising Finance on the Stock Market

• Companies can raise funds by issuing or restructuring share capital

Why Obtain a Stock Exchange Quotation?

• Advantages: capital raising, exit opportunitg, and marketability for investors
• Disadvantages include high costs, disclosure requirements, investor pressure and regulatory compliance

Routes to Listing on the Stock Exchange

• Offer for Sale (Fixed Price) offers shares at a predetermined price
• Offer for Sale by Tender is where shares are auctioned with potential investor specifying the number of shares and the price they will pay
• Offer for Subscription: Similar to an offer for sale in that the company directly sells shares to the public
• Placing (Selective Marketing): Cheaper method for smaller share issues. Shares are sold directly to institutional investors

Underwriting

• Protects again risk of unsold shares
• Market events influence outcome

Rights Issues:

• Protects existing ownership, raise funds while distributing equity

• Offered discount to market price. Shareholders can take up, sell or lapse right

• Alternative Investment Market (AIM) Advantages: Managed by London Stock Exchange and is designed for smaller companies

• Summary: Listing on stock exchange provides advantages such increased marketibility (AIM can assist)

• Companies must consider order of payments during liquidation