Chapter 2 - Capital and Money Markets - Overview PDF

# Capital and Money Markets - Overview ## Chapter 2 This chapter provides an overview of the capital and money markets, including the type of securities that are traded and why they exist. ### Lessons * Lesson 1: Overview of the Capital and Money Markets * Lesson 2: Summary Problem ## Capital...

# Capital and Money Markets - Overview ## Chapter 2 This chapter provides an overview of the capital and money markets, including the type of securities that are traded and why they exist. ### Lessons * Lesson 1: Overview of the Capital and Money Markets * Lesson 2: Summary Problem ## Capital and Money Markets - Overview Financial markets exist to allow financial instruments to be bought and sold between market participants. Financial instruments include shares, bonds, derivatives, commodities, and currencies. The market participants set prices for these assets through their trading activity, allowing corporations and governments to raise capital in the form of shares and bonds. ### Financial Market * **Intermediaries** These institutions such as commercial banks, insurance companies, and pension funds that pool the savings of various sectors (investors) and then loan the pooled funds to borrowers. Brokers that arrange transfers between lenders and borrowers by matching their specific needs without changing the nature of the underlying financial asset. * **Markets** * **Capital** The financial markets in which securities are issued to raise medium- to long-term financing, and where market participants trade those securities. The capital Market includes the stock market and bond market * **Money** A segment of the financial market in which financial instruments with high liquidity and very short maturities are traded. The money market is used by participants as a means for borrowing and lending in the short term, from several days to just under a year. Money market securities consist of term deposits, treasury bills, commercial paper, and so on. ### Market Segments * **Primary Market** is where the new issues of shares and bonds are made * **Secondary Market** is where investors buy securities from other investors * **Over-the-Counter Market** is where issued securities that are not traded on an exchange can be bought and sold, usually by dealers ### Issuing Securities * **Private Placement** Selling securities directly to a single investor or group of investors. * **Public Offering** Selling shares or bonds on a securities exchange to the general public. * **Underwriter** An entity that assists with the issuing process by advising on the offer price and helping to market and sell the new securities. ## Lesson: 1 Overview of the Capital and Money Markets **Technical competency:** 5.1.2 Develops or evaluates financial proposals and financing plans **Learning outcomes:** * Describe the types of financial markets. * Explain the role of intermediaries in financial markets. * Describe a public issue and private placement of securities. * Explain market efficiency. ## 2.1 Introduction Financial markets exist to allow financial instruments to be bought and sold between market participants. Financial instruments include shares, bonds, derivatives, commodities, and currencies. The market participants set prices for these assets through their trading activity, allowing corporations and governments to raise capital in the form of shares and bonds. The market also allows buyers and sellers to trade these financial assets, ensuring liquidity and the transfer of risk from the seller to the buyer. Liquidity is the ability or ease with which assets can be converted into cash. Buyers and sellers include corporations, governments, financial institutions, pension funds, and individuals, among other groups. Those with excess funds will want to buy financial securities; those who need funds will obtain these funds from those with surplus funds by selling (issuing) financial securities. Overall, households are the primary supplier of funds to both government and business. Investors transfer their excess funds in exchange for a promise of future repayment, often using intermediaries. These promises take the form of financial securities as debt or equity and include short-term debt, long-term debt (bonds and loans), preferred shares, and common (ordinary) shares. These financial securities also vary in nature depending on the type of issuer (government or corporation). They represent an obligation or a liability (or equity) for the issuer and an asset to the buyer; the sum of all financial securities, at any time, will be zero. ## 2.2 Capital Markets Capital markets are the financial markets in which securities are issued to raise financing (usually medium- to long-term financing), and where market participants trade those securities. Securities that are traded in the capital market include shares (also referred to as stocks, or equity, a share, or a credit relationship with a government body or a corporation (a bond). Capital markets serve two purposes. First, they provide a conduit for demand and supply of debt and equity. That is, they channel the money purchased by savers (bond and shares) institutions, to borrowers and investors through the sales and purchase of securities and depository. Second, they provide a secondary market where holders of these securities can exchange them with one another at market price. Companies use the capital markets to raise funds needed to finance activities such as purchasing new assets and expanding operations. Corporations are not the only participants in the capital market, however. Companies, banks, foundations, colleges, universities, and more recently pension funds, insurance companies, mutual funds, represent only a major portion of such other essential-corporate individuals. Much of the money comes from small institutions and wealthy individuals who save and invest. They use their savings in capital markets to identify and buy positions in securities they deem attractive. The capital markets have two components: the stock market and the bond market. * **The stock market** is where shares of publicly traded companies are issued, bought, and sold. This market allows companies to access capital in return for giving the investor a proportionate ownership in the company. Investors can then buy and sell these shares on the stock market. * **The bond market** is where bonds are issued by corporations and governments. A bond is a debt instrument that has a fixed interest rate and maturity date. Generally, publicly traded bonds pay interest on a semi-annual basis and the principal amount is paid at maturity. Publicly traded bonds are rated by credit rating agencies, as discussed further in the chapter Capital Markets - Information Impact on Prices. Within both the stock and bond markets are specific trading markets: the primary market, the secondary market, and the over-the-counter market. ### 2.2.1 Primary Market The primary market is where the new issues of shares and bonds are made. Companies issue shares for the first time in the primary market using underwriters and brokers as intermediaries. Investors buy these newly issued shares, and the issuing company receives the cash on sale (after the deduction of issue costs). There are a variety of methods that can be used by companies to raise capital in the primary market. These are discussed in the Capital Markets - Issuing Securities chapter. In the primary market, the initial offer prices are often determined in advance based on the advice of the underwriter. ### 2.2.2 Secondary Market Shares and bonds can only be issued in the primary market for the first offering. When shares and bonds are sold subsequently, the secondary market is where investors buy securities from other investors. The buying and selling of securities in the secondary market allows investors to liquidate their holdings when necessary. In the secondary market, it is the selling investor who receives the cash on sale and the buying investor who pays the cash to receive ownership of the security. Transactions in the secondary market create the ability to freely trade a security. The creation of liquidity through the existence of a secondary market increases the willingness of investors to invest in the primary market, as they rely on the secondary market to liquidate their position should the need arise. Prices in the secondary market are influenced by past and current information, and this is further discussed in the Capital Markets - Information Impact on Prices chapter. Most capital market transactions take place in the secondary market. As noted above, in the primary market, each security can be sold only once; however, in the secondary markets, there is no limit on the number of times a security can be traded. ### 2.2.3 Over-the-Counter Market The over-the-counter (OTC) market is where issued securities that are not traded on an exchange can be bought and sold, usually by dealers. It is another form of a secondary market in which the buyer and the seller (or a broker or bank acting on their behalf) agree to a trade contract. Generally, the type of shares that trade on this market are for small companies that do not meet the listing requirements to trade on an exchange. Although listed shares can be traded in the OTC market, this rarely occurs. In addition to unlisted shares, bonds, currencies, commodities, and derivatives can also be traded. The OTC market is less regulated and less transparent in comparison to an exchange, since trade prices may not always be available to the public. ### 2.2.4 Regulators In Canada, there is no federal securities regulator; this responsibility is assigned to the provinces. The three main regulators in Canada are the provincial securities commissions in Ontario, Quebec, and British Columbia. The role of these provincial regulators is to protect the public from both fraudulent and misleading financial securities. For example, the definition of securities in the Ontario Securities Act is broad; the provincial regulator looks at the promotion of investments, their expectation of profit, the control over the funds advanced, and the risk involved. It regulates primary market offerings, secondary market trading, insider trading, takeover activity, and the activities of the various players in the investment profession. Publicly traded companies must register with a securities commission before they can offer their securities to the public. ## 2.3 Money Market The money market is also a part of the financial market. The money market is used by participants as a means for borrowing and lending in the short term, from several days to just under a year. Companies and governments use the money market to raise short-term funds for their operations. Investors looking to invest surplus cash will buy the money market securities issued by these entities. The financial assets traded in the money markets are highly liquid and have maturities of less than one year, and include term deposits, treasury bills, and commercial paper. Term deposits are short-term investments held at a bank or credit union and have a fixed interest rate and maturity date. Treasury bills are short-term debt securities issued by the government and have fixed interest rates and maturities of less than one year. Commercial paper is a short-term, unsecured debt instrument, issued by a corporation or a bank, with a fixed term between two and 270 days. Commercial paper allows companies to borrow for flexible periods of time at interest rates that are often slightly below the company's bank borrowing rate. This flexibility of terms can also be beneficial to investors who are looking for short-term, highly liquid investments with low risk. Commercial paper is rated by credit rating agencies. Credit ratings are further discussed in the Capital Markets - Information Impact on Prices chapter. ## 2.4 Information and Market Efficiency The market price is the price at which a security can be bought or sold in the market. It is said to be an efficient capital market when prices of securities traded regularly in the market fully reflect available information related to their valuation and adjust quickly to new information. In an efficient market, the market price of a security is equal to its intrinsic value. The intrinsic value (or economic value) is determined by the present value of all expected future cash flows from the security. ### 2.4.1 Credit Rating Agencies Credit rating agencies are one source of information. These agencies assess the creditworthiness of companies and governments that have issued bonds and, in some cases, preferred shares in the capital market. Each agency has developed its own credit scoring models and a scoring system to rate the creditworthiness of the issuers. The credit rating provides a measure of financial risk - that is, the level of probability that the issuer will default on payments required on the bond. The largest credit rating agencies are DBRS Morningstar, Moody's Investors Service, S&P Global Ratings, and Fitch Ratings. ## 2.5 Issuing Securities The sale of new securities is affected by general market conditions. Firms normally attempt to sell new shares during a rising market and try to time their sales when the market peaks. During these periods, the demand for new shares is particularly strong and firms should be able to realize the highest prices for their shares. The following are two of the decisions that a company has to make when issuing new securities: 1. Will the sale be completed through a private placement or a public offering? 2. Will the company need the assistance of an underwriter to undertake this issuance, advise on the price, and assist with marketing? The specific steps related to the issuance of shares is detailed in the Capital Markets - Issuing Securities chapter. ### 2.5.1 Public Offering A public offering is a sale of securities on an exchange to the general public. Once issued, these shares trade on a stock exchange (or bond exchange, depending on the nature of the security). The issuer is required to publish a prospectus and distribute it to all potential buyers. A prospectus is a written document outlining the amount of funds to be raised in the offering, the nature and terms of the securities to be issued, the use of the funds, a description of the issuer's business and strategy, and historical financial statements. Canadian securities laws require the issuer to register the security issue with provincial securities commissions (for example, the Ontario Securities Commission). Approval of registration by a securities commission certifies that all information relevant to the issue is included in the prospectus and that the information is accurate. Approval does not imply any conclusion regarding the merits of the security or the fairness of the sale price. Once approved, the shares can be traded freely in the market. If a company is issuing public equity for the first time, this is referred to as an initial public offering (IPO). This is also known as an unseasoned offering. If an entity is issuing new securities, but the company is already traded on the stock exchange, this is known as a seasoned offering or a secondary offering. ### 2.5.2 Private Placement In a private placement, the securities issue is sold to a group of institutional investors such as an insurance company, pension plan, or mutual fund. The issuer is not required to publish and distribute a prospectus, but instead provides an offering memorandum that describes the proposed terms of the security and provides information regarding the issuer. Securities commissions consider such investors to be sophisticated enough to request and obtain the information that would normally be provided by a prospectus before buying the securities. Thus, an issue sold in a private placement cannot be freely traded in the market. The majority of bonds and preferred shares are sold through private placements. There are advantages and disadvantages with a private placement, which are further discussed in the Capital Markets - Issuing Securities chapter. ### 2.5.3 Role of the Investment Banker Public offerings generally involve one or more investment bankers, and normally a syndicate (group) of bankers. The investment banker serves as an intermediary between the issuer and the purchasers of the securities, providing advice regarding the type and terms of the securities to be issued and the market in which the securities are to be sold (private or public, foreign or domestic). In public offerings, the investment banker assists in preparing documentation such as the prospectus, securing approval from the securities commissions, and distributing the prospectus to potential investors. The investment banker also assists in setting the offer price and marketing the shares. In private placements, the investment banker assists in preparing the offering memorandum and in negotiating the sale price. ## Lesson 2: Summary Problem **** **Technical competency:** 5.1.2 Develops or evaluates financial proposals and financing plans **Learning outcome:** Apply knowledge of the capital and money markets to a scenario. **** **Summary Problem** Halten Metals Inc. (HMI) is a metal fabricator that produces sheet metal components for use in construction and manufacturing. It is a large national company that has grown quickly over the past five years. The CEO, Sanjay Panwar, recently met with Martha Tremblay, his vice president of finance, to discuss the possibility of the company going public. Martha has determined that, based on the new strategic direction Sanjay wants to take the company in, it will be necessary for the company to raise about $50 million. HMI also has surplus cash that is available for about the next 200 days before the company needs to use it for daily corporate activities. However, Sanjay has some questions that he needs answered to be prepared when he goes to the board of directors with his proposal. **Required:** Answer the following questions from the CEO: a) How might HMI use the primary and secondary capital markets in its financial activities? b) How will going public and having access to these various markets help the current shareholders of HMI? c) How might HMI use the money markets in its financial activities? **Solution** a) To raise $50 million in the public market, HMI will first have to be registered with the provincial securities regulator. Once it has met the regulatory requirements, including preparing and filing a prospectus, it can then use the primary market to issue shares and/or bonds to investors. The primary stock market would be used by HMI to issue new shares. The primary bond market would be used by HMI to issue new bonds. HMI will use an underwriter to help with the sale of these securities, and HMI will receive the net proceeds on sale. Bonds that are publicly issued usually have semi-annual interest payments and the principal is due on maturity. Once the shares are issued, investors will trade these in the secondary stock market. The market price in the secondary market is influenced by available information, and investors will buy and sell the shares based on these prices. HMI will not receive any funds from investors trades of its securities. However, HMI will get an indication of how the share is performing based on the number of trades and the price of the shares. Similarly, any issued bonds will trade in the secondary bond market. Again, the bond price will be influenced by information available and investors will buy and sell these bonds based on the prevailing market prices. If HMI is ever interested in repurchasing its issued shares or publicly traded bonds, then this would occur in the secondary market at the prevailing prices at the time of purchase. b) The secondary market provides liquidity for investors in that it is a market where issued securities are traded and investors can buy and sell HMI's shares or bonds when desired. Existing shareholders who own shares in a private company must find potential investors that are willing to buy their shares from them. This makes for a very illiquid investment, because there might not be any buyers or it may take time to find a buyer when the shareholder wants to sell. However, once HMI is a publicly traded entity, current shareholders can sell their shares in this secondary market, making HMI shares more liquid. The increased liquidity and the ability to sell when an investor is no longer interested in being an HMI shareholder expands the number of possible investors that will be available to be purchasers. The only drawback is that the sale will take place at whatever the prevailing market price is at the time of the trade. However, if the seller is under no compulsion to act, they can choose to sell when they believe the public prices reflect what their shares are worth. c) HMI currently has some surplus cash that it would like to invest for about 200 days (before it is needed for other corporate daily activities). The money market is the venue for securities that are highly liquid and low risk with short-term maturities. In addition, the financial assets available in the money market have more flexible terms than similar instruments from the bank. For example, the company could invest in a term deposit that has been issued by a bank, a treasury bill issued by the government, or commercial paper that has been issued by a corporation. Commercial paper has extremely flexible periods that range from two days to 270 days. ## End of Chapter Practice ### Practice Problem 1 (25 minutes) FQR Corp. is a software developer that has been successfully operating for the past eight years and are now wanting to expand operations. The directors are considering issuing shares to raise the required capital. Currently, management owns 75% of the outstanding shares of the company. The board of directors is considering taking the company public since it wants to raise sufficient funds to acquire companies and expand its product lines. However, before the final decision is made, the directors have some questions. **Required:** Answer the following questions raised by the directors. 1. In which financial market will FQR issue its shares and what is the role of the underwriter in this process? How much in proceeds would FQR receive on initial issue of shares and on subsequent sales of shares by investors? 2. Which market could the current shareholders use to change their proportionate ownership if FQR goes public? How are prices set in this market? 3. If FQR cannot meet the listing requirements because it is considered too small, is there any other market that could be used by shareholders to sell their shares? If so, how does this market work? 4. If FQR goes public, how would the provincial securities regulator review the company, management, and its shareholders? **** ### Solution to Practice Problem 1 **Competency:** 5.1.2 Develops or evaluates financial proposals and financing plans (Entry - Level C) **Knowledge Item:** Nature of and accessibility to capital markets (financial markets, public offerings and underwriters, private placements, secondary markets) (Entry - Level C) 1. If FQR meets the listing requirements, it will issue new shares in the primary stock market. An underwriter will assist FQR in selling these shares and will help to determine the initial selling price. FQR will receive the proceeds on sale, net of any underwriter's fees. Once the shares are trading, future trades between investors will occur in the secondary stock market. These subsequent buys and sells will be between investors, and FQR will not receive any further proceeds from these trades. There is a variety of investors interested in purchasing shares, such as those of FQR, including individuals investing their savings, insurance companies and pension plans investing their available funds, and other corporations wanting to make investments. 2. Existing shareholders will be able to sell their shares in the secondary stock market if they wish to reduce their proportionate ownership in FQR. They will also be able to purchase more shares if they wish to increase their proportionate ownership in FQR through the primary stock market, initially and then later, after the shares have been traded, through the secondary stock market. Prices in the secondary stock market are determined based on information that is publicly available. Purchases and sales of the shares will take place at the prevailing market price on the date of the trade. 3. The over-the-counter (OTC) market can be used to sell shares of companies that are not listed on an exchange. These trades are usually completed by dealers on behalf of the shareholders. It is another form of a secondary market in which the buyer and the seller (or their broker or bank acting on their behalf) agree to a trade contract. Generally, the type of shares that trade on this market are for small companies that do not meet the listing requirements to trade on an exchange. The OTC market is less regulated and less transparent compared to an exchange since trade prices may not always be available to the public. 4. The role of the provincial securities regulators is to protect the public from both fraudulent and misleading financial securities. The first step for FQR would be to register with a securities regulator before it can offer its securities to the public. Once it is registered, the provincial regulator would review for items such as FQR's promotion of share investments, the expectation of profit from holding the FQR shares, the control over the funds advanced from the issue, and the risk related to FQR shares. It would regulate FQR's primary market offering, secondary market trading of the FQR shares, insider trading by management of FQR's shares and other trades of interest, and FQR's takeover activity or other acquisitions.