AFM 121

Chapter 1 - The Capital Market

Introduction

Vital function of financial markets:

Help facilitate transfer of capital:

Those who Those who

have extra require capital
wealth (ie. (ie. Want to
Have saved invest money)
money)

Question: Why would those who have extra wealth / capital transfer it to
those who require it?
Introduction (contd)

3 components of wealth transfer process:

1. Financial instruments (what is actually bought / sold);

2. Financial markets (facilitate buying / selling of #1); and

3. Financial intermediaries (people / companies involved in #1 and #2)

Suppliers and Users of Investment Capital

What exactly is capital?

Savings of:
Individuals (you and me)
Corporations
Governments

How is capital utilized / transferred / invested???

Direct Investment

Assets that generate wealth (land, real estate, equipment)

Indirect Investments

Financial assets:
Stocks
Bonds
Treasury bills

Companies and governments issue these financial assets and receive funds

They then take these funds and invest the funds directly

Investors buy these financial assets to generate a return (ie. Make more
money than originally invested)
Efficient allocation of capital

Capital is mobile, scarce and sensitive

In other words

Those who have capital will only transfer / invest it if it is easy, cheap and
generates a good return

This depends on
Capital flows depend on

political environment - stable government or banana republic?;

Economic trends;
Fiscal policy (government spending and taxation);
Monetary policy (government by central banks);
Investment opportunities;
Labour force (highly educated / laws governing rights of labour force)
Sources of capital

Retail, institutional and foreign investors provide capital

Retail investors individuals like you and me (okay, maybe not you given
size of tuition payments)

Institutional investors
Pension funds (Canada Pension Plan Investment Board; Ontario Teachers)
Mutual funds (Trimark, AGF)

Foreign investors:
Can include foreign retail, institutional and government investors
Investments are made directly in Canadian firms or through stocks / bonds for Canadian
firms listed on foreign exchanges
Users of capital
Users of capital
Individuals dont (if needed they will go to a bank for a loan)
Companies / businesses:
Earn money internally through existing operations and reinvest that money (think Apple
with its huge pile of cash)
Raise $ by issuing stocks / bonds (think Facebook initial public offering)

What do they invest these funds in?

New products / markets / machinery that they hope will grow the company more and
generate additional returns
Users of capital

Governments (federal, provincial, municipal) issue debt

Treasury bills (debt due in less than one year)
Longer term debt
Canada Savings Bonds (federal / provincial governments only)

What do they spend these funds on?

All forms of government spending that arent covered by tax and other
revenues
Health care, education, infrastructure spending (roads, sewars, water)

Question: Why dont governments issue equity?

The Role of Financial Instruments
Financial instruments are the mechanisms by which wealth / capital is
transferred

Debt
Funds are borrowed
At a specific date (the maturity date) these funds are paid back
Between the borrowing date and the maturity date, interest payments are paid
In the interim, interest payments are made

Equity
Typically represented by stock / shares in a company
As an equity investor, you own part of the company
At annual meetings, you have voting privileges
You may also received regular dividend payments (but not necessarily)
The Role of Financial Instruments (contd)

Investment Funds
Buys and sells stocks / bonds typically through a mutual fund

Derivatives
These products derive their value from another assets (stock, bond, commodity,
currency)
Often used for hedging (ie. Mitigate the effect of a strong C$ or higher oil prices)

Private Equity
Invest in both debt and equity
Typically investments are made directly in companies (not through purchases of stock or
bonds)
Funds are provided by pension funds, endowments, wealthy individuals

Question: Why might authorities restrict who can invest funds in

derivatives and private equity (hint: both are very risk)?
Financial markets

Financial instruments only work well if accompanied by efficient markets

What is meant by efficient?

Fast (can I buy / sell a stock with minimal delay);
Cheap (low fees to buy / sell); and
Liquid (are there many buyers and sellers)

Buying or selling a house may not be efficient

Buying or selling a stock or a bond should be

Financial Markets (contd)

Primary markets:
Securities (ie. shares or bonds) are sold by issuers for the first time
The issuer receive the money from this sale
It may be an IPO or a subsequent equity offering

Secondary markets:
Where securities previously issued (above in the primary markets) are
bought and sold:
Note: funds do not go to the issuer
Example: If I buy 100 shares of TD Bank on the TMX today the
funds go to the shareholder who sold me the shares (not TD Bank)
Financial Markets (contd)

What is an IPO?
Initial pubic offering
The first time a company sells its shares to the public and its shares are
listed on a stock exchange (ie. Toronto Stock Exchange)
See previous Facebook example
Financial intermediaries

People and companies that improve market efficiency by facilitating the

flow of capital from buyers to sellers
Examples:
Bank of Canada
Banks
Insurance companies
Pension funds
Investment dealers
Private equity / venture capital firms
Etc.

Question: Do all of these companies operate for the purposes of market

efficiency. Hmmmm I dont think so.
Why do they operate then? This might have something to do with it.
 Financial intermediaries may work in their self interest

Regulations are meant to be structured such that market efficiency is a by-

product of this self interest

The financial crises exposed areas where firms were working in their self
interest and also working against market efficiency / a product economy.
Auction markets

Where all transaction converge in one location

In Canada: 3 exchanges:
The TSX (Canadas main exchange for medium to large size companies)
The TSX Venture Exchange (junior companies)
The Canadian National Stock Exchange (alternative exchange for junior / emerging
companies)

80 exchanges in over 60 countries

TSX is the 8th largest in the world; New York Stock Exchange is the largest

Most exchanges today are public companies that are listed on stock
exchanges themselves
Stock Exchange Fees and Trends

How does a stock exchange make money:

Transaction fees (if you buy or sell a stock you pay a fee)
Initial listing fees (if a company conducts an IPO they pay a fee)
Fees from companies making capital structure changes
Sale of historic data

Trends:
Stock exchanges have largely transferred from physical locations to
trading systems.
As a result, speed and cost efficiency are crucial
Stock exchanges around the world have been joining together (through
mergers & acquisitions) to become bigger and better
Dealer Markets: The Unlisted Market

Dealer markets also known as Over-the-counter (OTC) markets

Investment dealers who trade directly with each other over the phone or
a computer network (not an exchange)
Most bonds are traded through these networks; very few stocks are
There are no listing requirements
Unlisted trades are not reported except in Ontario
Alternative Trading Systems (ATS)

Computerized systems that executive orders outside traditional exchanges such

as the TSX.
Buyers / sellers ofter contact each other directly
Systems are privately owned (by investment dealers / other medium to large
size companies involved in buying / selling securities)
Costs / fees are lower
Most customers are institutional

Question: Is this a problem?

Maybe particularly if youre a retail investor (that would be me and you) and
dont have access to these systems

Increased scrutiny and regulation is likely to come for the alternative trading
systems.
Currently, ATS are governed by IIROC (Investment Industry Regulatory
Organization of Canada)