Introductory Finance Notes - Capital Markets, Bonds, and the Stock Exchange

Introductory finance ==================== ### Module 1. ### Introduction to Capital Markets - Overview of Financial Markets - Financial markets consist of transactions related to debt, equity, currencies, commodities, and derivatives. - Key focus: ***Market Efficiency***...

Introductory finance ==================== ### Module 1. ### Introduction to Capital Markets - Overview of Financial Markets - Financial markets consist of transactions related to debt, equity, currencies, commodities, and derivatives. - Key focus: ***Market Efficiency*** ### Market Efficiency - Definition and Importance - Frequent buying and selling in financial markets, particularly with shares. - Efficiency: How effectively does trading push share prices toward their true underlying values? - This question will be explored further in subsequent discussions. ### Trading on Financial Markets - Transaction Types - Involves various instruments including: - **Shares** - **Bonds** - **Treasury Bills** - Commonly referred to as ***IOUs*** or notes reflecting financial obligations. ### Characteristics of Financial Markets #### Types of Markets - **Wholesale Markets** - Transactions mainly occur between firms, handling large sums of money. - Borrowing and lending typically occur 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** - Primarily larger \'blue chip\' companies and sovereign governments that issue shares and bonds. - Small and Medium-sized Enterprises (SMEs) often rely on intermediated finances and retained earnings. ### Equity Capital and the Stock Exchange - Share Types - **Ordinary Shares** and **Preference Shares**. - **Initial Public Offerings (IPOs)** and **Rights Issues**. - Activity: Research top 10 IPOs of all time; reflect on familiarity with these companies. - Purpose of Stock Exchanges - The main goal is to facilitate the raising of equity capital through securities like ordinary and preference shares. ### Ordinary Shares - Ownership and Payouts - Shareholders hold fractional ownership and receive dividends from residual profits. - Voting rights typically conferred, but this can vary. - No legal obligation exists for firms to pay dividends to ordinary shareholders, who are compensated only after creditor claims during liquidation. ### Preference Shares - Characteristics - Less common than ordinary shares, with dividends that are a fixed percentage of the value. - Dividend accrual for unpaid amounts until payment is possible. - Generally lack voting rights unless dividends are overdue; preference over ordinary shares in liquidation. ### Capital Types - Debt vs. Equity #### Debt Capital - **Benefits** for firms: - Leverage opportunities, interest payments can be tax-deductible. - **Risks** for firms: - Obligations to repay, potential insolvency issues if mismanaged. - **Benefits** for investors: - Fixed income, lower risk compared to equities. - **Risks** for investors: - Credit risk; potential default on interest or principal. ### The Bond Market #### Key Features - **Bond Characteristics** - Defined by face value, maturity, and coupon rate---essential parameters determining bond value. - Example denominations: £100 in the UK, \$1000 in the US. - **Coupon Payments** - Interest on bonds known as the coupon, a fixed percentage based on face value, providing a predictable income stream. - **Maturity** - Bonds have a set expiration date where the total borrowed amount is repaid (bullet repayment). ### Key Points - Summary of capital markets: - Markets primarily deal with debt and equity financing. - Importance of market efficiency and characteristics of wholesale markets. - Understanding equity and debt capital, bond valuation, and fixed cash flow definitions. ### Financial Markets Overview 1. **Securities Markets**: - Purpose: Raise capital and provide liquidity for trading securities. - Types: - **Primary Market**: New securities are issued to raise capital (e.g., IPOs). - **Secondary Market**: Trading of existing securities like shares and bonds. Key global exchanges include London, New York, Tokyo, Hong Kong, and Frankfurt. 2. **Money Markets**: - Focus: Trading short-term, highly liquid instruments with maturities under one year. - Instruments: - **Government Treasury Bills**: Short-term government debt. - **Commercial Paper**: Short-term unsecured debt by corporations. - **Certificates of Deposit (CDs)**: Issued by banks to depositors. - **Interbank Market**: Banks trade short-term funds among themselves. 3. **Foreign Exchange Markets (Forex)**: - Purpose: Buying and selling currencies globally. - Dominated by banks facilitating currency transactions for businesses, investors, and governments. 4. **Futures and Options Markets** (Derivatives): - Function: Hedge risks or speculate on price movements. - Example: UK's main derivatives market is **ICE Futures Europe**. ### Derivatives - **Definition**: Financial instruments whose value depends on underlying assets (e.g., stocks, commodities, currencies). - **Purpose**: Manage risk caused by price volatility. - Example: Farmers may agree to sell their future harvest at today's fixed price to avoid future price drops. - Types: - **Forward Agreements**: - Customized contracts between two parties. - Typically brokered, not standardized. - - Standardized contracts traded on exchanges. - Obligate parties to buy/sell at a set price on a future date. - - Right (but not obligation) to buy/sell at a specific price within a timeframe. - - Exchange series of payments, such as currency or interest rate swaps. ### The Stock Exchange 1. **Instruments Traded**: - **Ordinary Shares**: Most traded and have the highest market value. - **Preference Shares**: Fixed dividends with priority over ordinary shares in liquidation. - **Debentures**: Long-term securities backed by collateral. - **Loan Stocks and Gilts**: Government bonds. - **Local Authority Bonds**: Issued by local governments. 2. **Regulation**: - 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. 3. **Information for Investors**: - Data available on securities (prices, volumes) via the Stock Exchange Daily Official List (SEDOL). - Website: [**www.londonstockexchange.com**](http://www.londonstockexchange.com/). 4. **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 1. **Example: Bank of England**: - Roles: - Maintain monetary value and financial system stability. - Promote financial market efficiency and competitiveness. - Instrumental in monetary policy and financial oversight. 2. **Debt Management Office (DMO)**: - Handles government debt and cash management. - Issues: - **Treasury Bills**: Covers short-term government needs (typically 90 days). - **Gilts**: Bonds paying fixed interest semiannually until maturity. ### Financial Institutions 1. **Investment Banks**: - Specialized roles: - Offer strategic advice on mergers, acquisitions, and takeovers. - Help raise capital (e.g., IPOs, Eurobond issues). - Underwrite securities. - Act as issuing houses for new financial instruments. 2. **Clearing Banks**: - Core services: - Obtain financing from individuals via deposit accounts. - Facilitate money transfers and provide loans. - Fund loans using deposits, requiring sound lending practices to avoid risks. 3. **Building Societies**: - Focus: Primarily lend for house mortgages. - Smaller and less diversified than banks. - Have limited exposure to commercial money markets. ### Money Multiplier Effect 1. **How It Works**: - Banks lend a portion of deposited money to borrowers. - Borrowers spend the money, which is redeposited into the banking system, enabling further loans. - This creates a cycle of credit expansion. 2. **Risks**: - Banks rely heavily on borrowed funds. - Large-scale loan defaults can destabilize the system, as seen with **Northern Rock in 2007**: - Funded mortgages via interbank lending. - US subprime crisis led to frozen interbank markets. - Northern Rock required Bank of England assistance and was later nationalized. ### Investment Vehicles 1. **Investment Trusts**: - Companies raising equity and debt to invest in other assets (e.g., stocks, bonds, property). - Traded on stock exchanges. 2. **Unit Trusts**: - Operated by management companies. - Not traded on exchanges; units are bought/sold directly with the company. 3. **Pension Funds**: - Designed to provide retirement pensions. - Fund managers invest in equities, gilts, and property. - Funded by employer and employee contributions. 4. **Life Insurance Companies**: - Maintain capital adequacy to match liabilities. - Investments: UK equities, bonds, overseas securities, property. 5. **General Insurance Companies**: - Provide short-term coverage (e.g., motor, home insurance). - Invest in short-term fixed interest and money market instruments. ### Key Takeaways 1. Financial markets are categorized into securities, money, forex, and derivatives markets, each serving specific purposes. 2. Derivatives and stock exchanges play critical roles in managing risk and liquidity. 3. Central and investment banks are pivotal in maintaining financial stability and facilitating growth. 4. Financial institutions like pension funds, insurance companies, and building societies cater to specific needs, from retirement planning to general insurance. Module 2. ### Internal Sources of Finance 1. **Long-term Finance**: - **Retained Profits**: Profits reinvested back into the business instead of distributed as dividends. 2. **Short-term Finance**: - **Tight Credit Control**: Faster collection of receivables. - **Reducing Inventories**: Efficient stock management to free up cash. - **Delaying Payments to Suppliers**: Extending payment terms to retain cash temporarily. ### External Sources of Finance 1. **Share Capital**: - Funds raised through the sale of shares. Shareholders become company owners. - **Ordinary Shares**: - Returns: Dividends and capital appreciation. - Voting rights included. - Higher risk but higher reward. - Variations: - **Redeemable**: Shares that can be repurchased. - **Non-voting**: Shares without voting rights. - **Preference Shares**: - Fixed dividends, no voting rights. - Rank above ordinary shares if the company is wound up. - Variations: - **Participating**: Entitled to extra profits after a set level. - **Convertible**: Can be converted into ordinary shares later. 2. **Loan Capital**: - Funds borrowed, repayable with interest. - **Debentures**: - Secured against specific assets (e.g., mortgage debentures) or floating charges. - **Unsecured Loan Stocks**: - Higher risk, reflected in the market value. - May include conversion rights to ordinary shares. - **Eurobond Loan Capital**: - Loans issued in foreign currency and traded globally. - Unsecured, fixed interest payments, often for large sums (e.g., \$75M+). ### Medium-term Financing Options 1. **Hire Purchase**: - Payments made over time; ownership transfers after the final payment. 2. **Leasing**: - Renting an asset for a period without transferring ownership. - **Finance Leases**: Lessee assumes risks (e.g., repairs, insurance). - **Operating Leases**: Owner retains risks of the asset. 3. **Credit Purchases**: - Immediate ownership with payments made in installments. 4. **Bank Loans**: - Secured loans with fixed-term repayment schedules. ### Short-term Financing Options 1. **Bank Overdrafts**: - Short-term borrowing where immediate repayment can be demanded. - Interest charged only on the overdrawn amount. 2. **Trade Credit**: - Agreement with suppliers to delay payments. Often interest-free. 3. **Factoring**: - Selling accounts receivables to a factoring company. - **Non-recourse Factoring**: Factor assumes the credit risk. - **Recourse Factoring**: Original seller retains credit risk. 4. **Commercial Paper**: - Unsecured, short-term debt instruments for large denominations (minimum £500,000). - Issued at a discount, redeemed at face value (1--270 days maturity). 5. **Bills of Exchange**: - A credit agreement where a buyer agrees to pay a seller (or their nominee) on a future date. Can be sold to others for immediate payment at a discount. ### Capital Ranking in Winding Up (Payment Order) 1. **Fixed Charge Creditors**: Secured loans against specific assets. 2. **Floating Charge Creditors**: General secured claims over company assets. 3. **Preferential Creditors**: - Employee claims for wages, holiday pay, pensions. - Unpaid taxes. 4. **Unsecured Creditors**: Trade payables, unsecured loans. 5. **Connected Creditors**: Directors\' loans or unpaid salaries. 6. **Preference Shareholders**: Priority over ordinary shareholders. 7. **Ordinary Shareholders**: Last to be paid, if anything remains. ### Key Financing Terms 1. **Loan Covenants**: - Terms imposed on borrowers (e.g., maintaining financial ratios). 2. **Mortgages**: - Loans secured on specific real assets. 3. **Floating Charges**: - Secured against all current and future company assets. ### Capital in the Stock Market #### Financing Limited Companies When a company is wound up, creditors and shareholders are paid in a specific order of priority: 1. **Fixed Charge Creditors**: These are lenders whose loans are secured against specific assets (e.g., a mortgage on a property). They are paid first. 2. **Floating Charge Creditors**: These creditors have claims on assets not tied to any specific item but secured by the business as a whole. 3. **Preferential Creditors**: - Employees\' claims for unpaid wages, holiday pay, and pensions (subject to legal caps). - Unpaid taxes owed to authorities. 4. **Unsecured Creditors**: - Includes trade payables (e.g., suppliers owed money but not secured by assets). 5. **Connected Creditors**: - Loans or unpaid salaries owed to directors, their spouses, and close family members. 6. **Preference Shareholders**: - Holders of shares with fixed dividends, paid before ordinary shareholders but after creditors. 7. **Ordinary Shareholders**: - Residual owners of the company who are paid last after all other claims are settled. #### 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**: Ability to raise funds immediately and access easier capital in the future. - **Exit Opportunity**: Provides an exit route for current shareholders. - **Marketability**: Improves liquidity of shares, making them more attractive to investors. - **Disadvantages**: - **Cost**: High costs involved in listing and ongoing compliance. - **Disclosure Requirements**: Companies must disclose financial details and comply with transparency rules. - **Investor Pressure**: Public shareholders may demand high performance and returns. - **Regulatory Compliance**: Must adhere to rules, including those on insider trading. #### Routes to Listing on the Stock Exchange 1. **Offer for Sale (Fixed Price)**: - **Process**: - Shares are offered at a predetermined price. - An issuing house (e.g., an investment bank) buys the shares and sells them to the public. - The issuing house advises the company on the pricing and prepares a prospectus. - **Steps**: - A prospectus is issued containing detailed information (e.g., financial position, activities, reasons for listing). - Applications are collected from the public. - In cases of oversubscription, allocations are scaled down. - Accepted applicants receive share certificates and refund cheques (if applicable). - Shares become tradable on the stock exchange. 2. **Offer for Sale by Tender**: - Shares are auctioned where potential investors specify: - The number of shares they want. - The price they are willing to pay. - **Strike Price**: - The issuing house sets a price that ensures all shares are sold. - Investors who bid at or above the strike price are allocated shares but pay the strike price, even if their bids were higher. - **Example**: - **BCG plc** plans to sell 1,000,000 shares by tender. - Applications received: - Miss A: 400,000 shares at £1.10. - Mr. B: 300,000 shares at £1.30. - C Ltd: 800,000 shares at £1.15. - Ms. D: 100,000 shares at £1.40. - **Allocations**: - Ms. D: 100,000 shares at £1.15. - Mr. B: 300,000 shares at £1.15. - C Ltd: 600,000 shares at £1.15. - Miss A receives no shares as her bid was below the strike price. 3. **Offer for Subscription**: - Similar to an offer for sale but: - The company directly sells shares to the public. - Shares are not underwritten, meaning the company bears the risk of undersubscription. - Typically priced at a fixed rate. 4. **Placing (Selective Marketing)**: - A cheaper, simpler method for smaller share issues. - Shares are sold directly to institutional investors through an issuing house. - The public is not involved. 5. **Introduction**: - No sale of shares occurs. - Existing shares are quoted on the stock exchange to increase marketability. - Used when shares are already widely held. #### Underwriting - **Purpose**: Protects against the risk of unsold shares. - **How it Works**: - The issuing house agrees to buy any unsold shares at an agreed price. - The company pays a fee or percentage of the share value to the issuing house. - Sub-underwriting may be arranged to spread risk. - **Key Risk**: Market events between agreeing and closing the offer could affect the outcome. #### Rights Issues - **Purpose**: - Protect existing shareholders' proportional ownership. - Raise funds while maintaining equity distribution. - **Details**: - Offered at a discount to the market price. - Shareholders can: - Take up the rights. - Sell their rights. - Let their rights lapse. - **Example**: - A company with 10 million shares at £1.30 issues new shares on a 1-for-5 basis at £1.20. - **Theoretical Ex-Rights Price (TERP)**: - Value of 5 original shares: £6.50. - Value of 1 new share: £1.20. - Combined value: £7.70. - TERP = £7.70 ÷ 6 = £1.28. - Value of rights: £1.28 - £1.20 = £0.08 per share. #### Scrip (Bonus) Issues - **Details**: - Free shares issued to existing shareholders (e.g., 1-for-4). - No money is raised; the total company value remains unchanged. - Share price falls in proportion to the new shares issued. - **Purpose**: - Increase marketability of shares. - Utilize accounting reserves when cash is unavailable. - Signal confidence in future prospects. #### Alternative Investment Market (AIM) - Managed by the London Stock Exchange. - Designed for smaller, growing companies. - **Advantages**: - Lower costs compared to full listing. - Less stringent requirements. ### Summary - Companies must consider the order of payment during liquidation. - Listing on the stock exchange can provide significant advantages but comes with costs and challenges. - Several methods exist for raising finance, including: - Share issues - Rights issues - Bonus (scrip) issues - AIM provides a viable alternative for smaller businesses seeking marketability.