The Capital Market, CSC Volume 1 Chapter 2 PDF

The Capital Market 2 CHAPTER OVERVIEW In this chapter, you will learn about investment capital, including what it is, why we need it, where it comes from, and who uses it. You will also learn about the diff...

The Capital Market 2 CHAPTER OVERVIEW In this chapter, you will learn about investment capital, including what it is, why we need it, where it comes from, and who uses it. You will also learn about the different types of financial instruments that are traded in the financial markets. In discussing the financial markets themselves, we explain the difference between primary and secondary markets and between auction and dealer markets. Finally, you will learn about the electronic trading systems that are used in both equity and fixed-income markets. LEARNING OBJECTIVES CONTENT AREAS 1 | Describe the role of investment capital in the Investment Capital economy, including its supply and use. 2 | Differentiate between the types of financial The Financial Instruments instruments used in capital transactions. 3 | Describe the distinguishing features and The Financial Markets operation of the various types of financial markets. © CANADIAN SECURITIES INSTITUTE 2 2 CANADIAN SECURITIES COURSE      VOLUME 1 KEY TERMS Key terms are defined in the Glossary and appear in bold text in the chapter. alternative trading system investment advisor ask price last price auction market liquidity bid-ask spread MarketAxess bid price market maker Canadian Securities Exchange money market Canadian Unlisted Board Inc. Montréal Exchange CanDeal over-the-counter market CanPX preferred share capital primary market CBID retail investor CBID Institutional secondary market Cboe Canada stock exchange common share stocks dealer market Toronto Stock Exchange equity securities TSX Alpha Exchange ICE NGX Canada TSX Venture Exchange institutional investor unlisted market © CANADIAN SECURITIES INSTITUTE  CHAPTER 2      THE CAPITAL MARKET 2 3 INTRODUCTION The securities industry plays a significant role in sustaining and expanding the Canadian economy. The industry is growing and evolving to meet the ever-changing needs of Canadian investors, from both domestic and international perspectives. The vital economic function the securities industry plays is based on a simple process: the transfer of money from those who have it (suppliers of capital) to those who need it (users of capital). Three elements are of central importance to the securities industry: financial intermediaries, financial markets, and financial instruments. In the previous chapter, we focused on the intermediaries that have evolved to enable the transfer of capital, such as investment dealers, banks, and trust companies. In this chapter, we discuss the characteristics of capital, and we look at the markets within which suppliers and users of capital transfer it through the intermediaries. We also provide a brief introduction to some of the financial instruments that make capital transfer possible. INVESTMENT CAPITAL 1 | Describe the role of investment capital in the economy, including its supply and use. Capital is synonymous with wealth, both real (i.e., land, buildings, and other material goods) and representational (i.e., money, stocks, and bonds). All of these items have economic value that represents the invested savings of individuals, corporations, governments, and other organizations. Representational capital becomes more significant when it is harnessed productively, through either direct or indirect investment. Table 2.1 shows examples of each investment type. Table 2.1 | Direct and Indirect Investing Direct Investment Indirect Investment A couple invests their savings in a home. An investor buys stocks or bonds. A government invests in a new highway. A parent invests in an education savings plan. A company pays start-up costs for a new plant. A couple deposits their savings at a bank. The indirect investment process, where investors purchase representational items such as stocks or bonds, is the principal focus of this course. Indirect investment occurs when a person or entity with accumulated savings buys the securities issued by a government or corporation, which in turn invests the funds it receives directly for a productive purpose. Indirect investment is normally made with the help of an investment advisor in the retail or institutional sales department of a securities firm. CHARACTERISTICS OF CAPITAL Capital has three important characteristics: mobility, sensitivity to its environment, and scarcity. These characteristics allow capital to be selective about where it settles, which is usually countries or locations where favourable conditions exist. Favourable conditions include stable government, economic activity that is not heavily regulated, a hospitable investment climate, and profitable investment opportunities. The flow of capital is therefore guided by country risk evaluation. © CANADIAN SECURITIES INSTITUTE 2 4 CANADIAN SECURITIES COURSE      VOLUME 1 In evaluating the various components of country risk, you should consider the following factors: The political Is the country involved, or likely to be involved, in internal or external conflict? environment Economic trends How strong is growth in key areas such as gross domestic product, inflation rate, and economic activity? Fiscal policy How high are taxes and government spending, and to what degree does the government encourage savings and investment? Monetary policy How sound is the nation’s money supply management, and to what extent does it promote price and foreign exchange stability? Investment What opportunities exist for investment, and how satisfactory are the returns on opportunities investment in comparison to the risk? The labour force What percentage of the labour force is skilled and productive? Because capital is limited in quantity and considered scarce, it is in great demand everywhere in the world. And because it is mobile and sensitive, it moves in or out of countries or localities in anticipation of changes to taxation, exchange rates, trade barriers, regulations, and government attitudes. It tends to move to areas where it can be best used and where it can avoid less favourable conditions. In other words, capital always moves towards uses and users that offer the highest risk-adjusted returns. THE SUPPLIERS AND USERS OF CAPITAL An adequate supply of capital is essential for Canada’s well-being. In manufacturing, for example, capital provides the means to expand facilities, improve productivity, increase competitiveness in domestic and foreign markets, and develop innovative, sought-after new products. When capital investment is deficient, industry slackens, unemployment rises, and living standards decline. The suppliers and users of this necessary capital are described below. SUPPLIERS OF CAPITAL The lone source of capital is savings in various forms. When revenues exceed expenditures, the investor can use savings to invest. This basic tenet applies to all of the following types of investors: Individuals If the compensation to postpone current consumption is high enough, individuals tend to save their money to spend it at an opportune time in the future. They become more inclined to spend when, for example, the compensation to postpone current consumption is low, or incentives, such as tax breaks, are provided. Non-financial Corporations such as Canadian steel makers, food distributors, and machinery domestic corporations manufacturers generate large savings, mainly in the form of corporate earnings. However, these internally generated funds are usually retained by the corporation and are available only for internal use; they are not normally invested in other companies’ stocks and bonds. Therefore, corporations are not significant providers of permanent funds to others in the capital market. © CANADIAN SECURITIES INSTITUTE  CHAPTER 2      THE CAPITAL MARKET 2 5 Governments Some governments are able to operate at a surplus and invest their profits, thus becoming suppliers of capital. Other governments, who are in a less favourable position, borrow in the capital markets to fund their deficits, thus becoming users of capital. Foreign investors Foreign investors, both corporate and individual, have long regarded Canada as a good place to invest. Canada, in turn, has traditionally relied on foreign savings for both direct investment in Canadian industries and portfolio investment in Canadian securities. USERS OF CAPITAL Users of capital may be individuals, businesses, or governments, whether Canadian or foreign. Capital flows into Canada, from foreign individuals, businesses, and governments, and equally flows out of Canada, as foreign users of capital (mainly businesses and governments) take capital out of the country. They do so by borrowing from Canadian banks or by making their securities available to the Canadian market. Canadian capital is attractive to foreign users when its dollar value is low relative to their own currency. For their part, Canadian investors benefit from access to foreign securities by using them to diversify their investments. SUPPLIERS AND USERS OF INVESTMENT CAPITAL: A SUMMARY Table 2.2 summarizes who the sources and users of investment capital are and how users obtain capital. Table 2.2 | The Sources and Users of Investment Capital Sources of Capital Retail investors Retail investors are individual clients who buy and sell securities for their personal accounts. Institutional Institutional investors are organizations, such as pension and mutual fund investors companies, that trade in large-share quantities or dollar amounts. They typically have a steady flow of money to invest. Foreign investors Foreign direct investment in Canada tends to concentrate in manufacturing, petroleum, natural gas, mining, and smelting. Some industries have restrictions on foreign investment. Users of Capital Individuals Individuals need capital to finance large purchases such as houses, cars, and major appliances. They usually obtain it in the form of personal loans, mortgage loans, and charge accounts. Businesses Businesses require massive sums of capital to finance day-to-day operations, renew and maintain plants and equipment, and expand and diversify their activities. They generate much of that capital internally, in the form of profits retained in the business. They borrow from financial intermediaries for other needs, and they raise the remainder in securities markets. Governments Governments are major issuers of securities in public markets, either directly or through guaranteeing the debt of their Crown corporations. When revenues fail to meet expenditures, or when they undertake large capital projects, governments must borrow. © CANADIAN SECURITIES INSTITUTE 2 6 CANADIAN SECURITIES COURSE      VOLUME 1 SOURCES AND USERS OF CAPITAL Where does capital come from, and what is it used for? Complete the online learning activity to assess your knowledge. THE FINANCIAL INSTRUMENTS 2 | Differentiate between the types of financial instruments used in capital transactions. Financial instruments in the form of securities are formal, legal documents that set out the rights and obligations of the buyers (capital suppliers) and sellers (capital users) of the securities. As such, these instruments have many advantages as a means of distributing capital in a sophisticated economy. They tend to have standard features, which facilitates their trading. Both suppliers and users of capital can also choose from many types of securities to meet their particular needs. Table 2.3 briefly describes some of the different types of financial instruments and provides examples of each type. Although you may already be familiar with some of these products, they will all be discussed in detail in later chapters of the course. Table 2.3 | The Different Types of Financial Instruments Financial Instrument Definition Examples Fixed-income Fixed-income securities (also called debt securities) Treasury bills securities formalize a relationship in which the issuer promises to Bonds repay the loan at maturity and, in the interim, makes interest payments to the investor. The term of the loan varies depending on the type of instrument. Equity securities Equity securities (commonly called stocks, equities, or Common stock (also shares) represent some form of ownership stake in the called common shares) company that issued them. For example, if the value Preferred shares of a company increases, the owner of stock in that company receives a capital gain upon selling it. Derivatives A derivative is a product whose value is derived from Options the value of an underlying instrument, such as a stock Forwards or an index. Unlike stocks and bonds, derivatives are more suited to sophisticated investors. Managed products Managed products (also called investment funds) are Mutual funds typically pools of capital gathered from investors to buy Exchange-traded funds securities according to a specific investment mandate. Private equity funds Structured products A structured product is a financially engineered Principal-protected notes product with the characteristics of debt, equity, and an Index-linked guaranteed investment fund. investment certificates © CANADIAN SECURITIES INSTITUTE  CHAPTER 2      THE CAPITAL MARKET 2 7 THE FINANCIAL MARKETS 3 | Describe the distinguishing features and operation of the various types of financial markets. So far in this chapter, we discussed the characteristics of capital, its sources, and its users. We also provided a brief introduction to the various financial instruments available. We now focus our discussion on the financial markets where people come together to complete their financial transactions. A financial market provides a forum in which buyers and sellers meet. Instead of meeting face to face, intermediaries such as investment advisors and bond dealers act on their clients’ behalf. Financial instruments and securities are a key element in the efficient transfer of capital from suppliers to users—an element that benefits both sides. Many of the benefits of financial instruments, however, depend on the efficient markets in which these securities can be bought and sold. A well-organized financial market provides speedy transactions and low transaction costs, along with a high degree of liquidity and effective regulation. Unlike most markets, a financial market often has no physical location. In Canada, for instance, the trading of securities, such as stocks, bonds, derivatives, takes place via electronic platforms. The capital market is made up of many individual financial markets, including stock markets, bond markets, and money markets. Only short-term fixed-income securities with a term of one year or less trade in the money market. Markets can also be categorized as primary markets and secondary markets, and further as auction markets and dealer markets. We will now discuss all of these different types of markets. PRIMARY AND SECONDARY MARKETS In the primary market, newly issued securities are sold by companies and governments to investors. In other words, investors purchase securities directly from the issuing company or government. Companies raise capital by selling stocks or bonds, whereas governments sell bonds only. These newly issued distributions of securities are known as IPOs, or initial public offerings. In the secondary market, investors trade securities that have already been issued by companies and governments. In this market, buyers and sellers trade among each other at a price that is mutually beneficial to both parties, and securities are transferred from the seller to the buyer. The issuing company does not receive any of the proceeds from transactions in the secondary market; it receives payment only when the securities are first issued in the primary market. An example here is the buying and selling of stocks on the Toronto Stock Exchange. AUCTION MARKETS In an auction market, securities are bought and sold by investors. Investment dealers, who typically act as agents, execute the buy and sell orders on behalf of their clients. Buyers enter bids and sellers enter offers. These orders are channelled to a single central market where they compete against each other. A trade is executed only when there is a match in the bid and ask prices. Between trades, the best bid is lower than the best offer. The difference between the two prices is called the bid-ask spread. © CANADIAN SECURITIES INSTITUTE 2 8 CANADIAN SECURITIES COURSE      VOLUME 1 Figure 2.1 shows the bid-ask spread and defines some of the basic terminology of stock trading. Figure 2.1 | The Bid-Ask Spread Ask Price − Bid Price = Bid-Ask Spread The bid price is the highest price a buyer is willing to pay for the security being quoted. The ask price (or offer) is the lowest price a seller will accept. The bid-ask spread is the amount that the ask price exceeds the bid price. The last price is the price at which the last trade occurred on a stock. This price can fluctuate between the bid price and the ask price as buying and selling orders are filled. Note that the last price is not necessarily the price at which a stock can currently be bought or sold. It is simply the latest price at which a transaction occurred. EXAMPLE Three investors each want to buy a share of ABC Inc. They enter three bids on the company’s stock of $5.00, $5.03, and $5.06. On the other side of the trade, three investors each want to sell their share of ABC. They enter three offers to sell their stock at $5.06, $5.07, and $5.11. Because a trade is executed only when a bid matches an offer, only one trade is executed—a trade between the investor who entered the bid of $5.06 and the seller who entered the offer of $5.06. The other bids and offers are not immediately executed. After the execution of the trade at $5.06, the best bid and offer become $5.03 and $5.07, respectively, creating a price spread of $0.04. EXCHANGES A stock exchange is an auction market where buyers and sellers of securities meet to trade with each other and where prices are established according to the laws of supply and demand. On Canadian stock exchanges, trading is carried out in common and preferred shares, rights and warrants, exchange-traded funds, income trusts, and a few convertible debentures. On some U.S. and European exchanges, bonds and debentures are traded along with equities. DID YOU KNOW? One property that is fundamental to the operation of the exchanges is liquidity. A liquid market has the following characteristics: Frequent trades Narrow price spread between bid and ask prices Small price fluctuations from trade to trade The following exchanges operate in Canada: The Toronto Stock Exchange (TSX) lists equities, some debt instruments that are convertible into a listed equity, income trusts, and exchange-traded funds. The TSX Venture Exchange lists equities and a few debenture issues. TSX Alpha Exchange offers trading in securities listed on the TSX and the TSX Venture Exchange. The Montréal Exchange trades all financial and equity futures and options listed for trading in Canada. © CANADIAN SECURITIES INSTITUTE  CHAPTER 2      THE CAPITAL MARKET 2 9 ICE NGX Canada provides electronic trading, central counterparty clearing, and data services to the North American natural gas and electricity markets. The Canadian Securities Exchange lists equities of emerging companies. Cboe Canada is an exchange that provides listing services and facilitates trading in public companies, exchange- traded funds, Canadian Depositary Receipts™, special purpose acquisition companies, and closed-end funds. Approximately 15% of all volume traded in Canadian-listed securities trade through Cboe Canada. DID YOU KNOW? TMX Group Limited is an amalgamation of TSX Group companies that include the TSX, TSX Venture Exchange, TSX Alpha Exchange, and the Montreal Exchange, creating an integrated, multi-asset class exchange group. TMX Group Limited lists, trades, clears and offers market data for both cash and derivatives markets across multiple asset classes. TMX Group Limited common shares trade on the Toronto Stock Exchange under the symbol X. DEALER MARKETS Dealer markets, or over-the-counter (OTC) markets, consist of a network of banks and investment dealers. Unlike an auction market, where the orders of individual buyers and sellers are entered in a centralized marketplace, a dealer market is a negotiated market where market makers post bid-and-ask quotations via electronic platforms and computer networks. In the OTC market, investment dealers typically act as principals. Almost all bonds and debentures are sold through dealer markets. Compared to auction markets for equities, dealer markets are less visible. Perhaps surprisingly, the volume of trading (in dollars) for debt securities is significantly larger than that of the equity market. Dealer markets are also called unlisted markets because securities that trade on them are not listed on an organized exchange, as they are on auction markets. There is no central marketplace for most dealer market transactions. Instead, they are routinely conducted on the OTC market. Trades are made by means of the computer systems of inter-dealer brokers that facilitate trades between investment dealers. DID YOU KNOW? The Unlisted Equity Market The volume of unlisted equity business in dealer markets is much smaller than the volume of stock exchange transactions. Although many junior issues trade OTC, the shares of some industrial companies also trade on the OTC market. For various reasons, the boards of these companies have decided not to list one or more issues of their equities on a stock exchange. The unlisted market does not set minimum listing requirements for the stocks traded on its system, nor does it attempt to regulate the companies. Many of the stocks sold on the unlisted market are more speculative and, in most cases, offer lower liquidity than listed securities. TRADING IN THE UNLISTED EQUITY MARKET Over-the-counter trading in equities is conducted in a similar manner to bond trading. Individual investors’ orders are not entered into a centralized market and made public. Instead, investment dealers, who act as market makers, quote their own bids and offers. These market makers hold an inventory of the securities in which they have agreed to make a market (i.e., the securities in which they are willing to deal). They sell from this inventory to buyers and add to the inventory when they acquire securities from sellers. © CANADIAN SECURITIES INSTITUTE 2 10 CANADIAN SECURITIES COURSE      VOLUME 1 The willingness of the market makers to quote bid and ask prices provides liquidity to the system (although they do have the right to refuse to trade at quoted prices). When an investor wishes to buy or sell an unlisted security, the investor’s dealer consults the bid or ask quotations of the various market makers to identify the best price, and then contacts the market maker to complete the transaction. The dealer charges a commission for this service. OVER-THE-COUNTER DERIVATIVES MARKET The OTC derivatives market is dominated by large international financial institutions, such as banks and investment dealers that trade with corporate clients and other financial institutions. Traders do not meet in person to negotiate transactions, and the market stays open 24 hours a day. One of the attractive features of OTC derivative products is that they can be custom designed by the buyer and seller, with special features added to the basic properties of options and forwards. As a result, these products tend to be somewhat complex. REPORTING TRADES IN THE EQUITY UNLISTED MARKET In most of Canada, investment dealers do not have to report unlisted trades. In Ontario, however, the Ontario Securities Act requires that trades of unlisted securities and unquoted equity securities be reported through the web-based system of the Canadian Unlisted Board Inc. ALTERNATIVE TRADING SYSTEMS Along with the traditional exchanges and dealer markets, the Canadian financial markets include alternative trading systems (ATS). These systems are electronic marketplaces that provide automated matching and execution of trades in both the equity and fixed-income markets. EQUITY ELECTRONIC TRADING SYSTEMS Alternative trading systems in the equity markets provide automated trade matching and execution of orders from multiple buyers and sellers, a role once performed exclusively by stock exchanges. The Canadian Securities Administrators allow ATSs to compete with recognized exchanges and also among other ATSs, thus providing participants with a range of options in executing trades. An ATS must be registered as an investment dealer and a member of the Canadian Investment Regulatory Organization (CIRO). ATSs and traditional exchanges are subject to regulatory filings and provide similar trading services. However, ATSs are not permitted to carry out all of the same functions as traditional exchanges, such as the TSX. One notable difference is that ATSs trade securities that are listed on traditional exchanges, but they cannot themselves list securities. FIXED-INCOME ELECTRONIC TRADING SYSTEMS With the exception of a few debentures listed on the TSX and TSX Venture Exchanges, all bond and money market securities are sold through dealer markets. In Canada, these markets include the following fixed-income electronic trading systems: CanDeal is a member of CIRO, and it is a joint venture between Canada’s six largest bank-owned investment dealers. It is operated by the TMX Group Limited and is recognized as both a debt ATS and an investment dealer. It offers institutional investors access to government securities and money market instruments. CBID, and CBID Institutional, is an ATS that operates two distinct fixed-income marketplaces: retail and institutional. The retail fixed-income marketplace is accessible by registered dealers on behalf of retail clients. The institutional fixed-income marketplace is accessible by registered dealers, institutional investors, governments, and pension funds. © CANADIAN SECURITIES INSTITUTE  CHAPTER 2      THE CAPITAL MARKET 2 11 MarketAxess provides market data and a trading platform with access to multi-dealer competitive pricing for a wide range of corporate bonds and other types of fixed-income instruments. MarketAxess is a member of CIRO and operates in Ontario and Quebec. CanPX is a joint venture between several Canadian investment dealers and inter-dealer brokers (firms that facilitate trades between investment dealers). The CanPX system combines digital feeds from participating dealers to provide a composite display of real-time bid and offer quotations, in price and yield terms and with volume information. The service covers Government of Canada bonds and Treasury bills. AUCTION AND DEALER MARKETS What are the features of the different types of markets? Complete the online learning activity to assess your knowledge. KEY TERMS & DEFINITIONS Can you read some definitions and identify the key terms from this chapter that match? Complete the online learning activity to assess your knowledge. © CANADIAN SECURITIES INSTITUTE 2 12 CANADIAN SECURITIES COURSE      VOLUME 1 SUMMARY In this chapter, we discussed the following key aspects of the capital market: Capital has three characteristics: mobility, sensitivity, and scarcity. It can be invested directly or indirectly. An example of the first type is a house purchase. The second type might be the purchase of a company’s stock. Individuals use investment capital for major purchases and to fund savings accounts. Businesses use capital to finance operations, plants, equipment, or growth. Governments use it to finance social programs and infrastructure. Foreign investors use Canadian capital when it costs less to borrow than other currencies. Bonds and debentures represent the issuers’ debt, which investors purchase with a promise of repayment at maturity, usually in whole and with interest. Equity represents shares of ownership in a company, through which investors hope to profit as the company gains value. The financial markets facilitate the transfer of capital between investors and users, either on the primary market (where initial public offerings and other new issues are bought and sold) or the secondary market (where previously issued securities are bought and sold). The individual markets include stock markets, bond markets, and money markets. The markets can be further classified as auction markets and dealer markets. In an auction market, clients’ bid and ask quotations for a stock are channelled to a stock exchange, where they compete against each other. Dealer markets are networks of dealers that negotiate a price with each other. REVIEW QUESTIONS Now that you have completed this chapter, you should be ready to answer the Chapter 2 Review Questions. FREQUENTLY ASKED QUESTIONS If you have any questions about this chapter, you may find answers in the online Chapter 2 FAQs. © CANADIAN SECURITIES INSTITUTE