CSC Volume 1 (Ch 1) PDF

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CSC Volume One Chapter 1 The Capital Market Investment Capital  In general terms, capital is wealth – both real, material things such as land and buildings and representational items such as money, stocks, and bonds  Capital represents the savings of individuals, corporations, governments and many other organizations and associations  Capital savings can be used directly – for example, a couple investing their savings in a home; a government investing in a new highway or hospital  Capital savings can also be harnessed indirectly – through the purchase of such representational items as stocks or bonds or through the deposit of savings in a financial institution (main focus of CSC)  Indirect investments occur when the saver buys the securities issued by governments and corporations, which in turn use the funds for direct productive investment in plant, equipment, etc.  Characteristics of Capital  Capital has 3 important characteristics – it is mobile, sensitive to its environment and scarce (limited resources)  Therefore capital is extremely selective  It attempts to settle in countries or localities where government is stable, economic activity is not over-regulated, the investment climate is hospitable and profitable investment opportunities exist  The decision as to where capital will flow is guided by country risk evaluations, which analyzes such things as:  Political Environment – whether the country is involved or likely to be involved in internal or external conflict  Economic Trends – growth in gross domestic product, inflation rate, levels of economic activity, etc.  Fiscal Policy – levels of taxes and government spending and the degree to which it encourages savings and investment  Monetary Policy – the sound management of the growth of the nation’s money supply and the extent to which it promotes price and foreign exchange stability  Opportunities for Investment and Satisfactory Returns on Investment – when considering the risks to be accepted  Characteristics of the Labour Force – whether it is skilled and productive  Because of its mobility and sensitivity, capital moves in or out of countries or localities in anticipation of changes in taxation, exchange policy, trade barriers, regulations, government attitudes, etc  An adequate supply of capital is essential for Canada’s future well-being Sources of Capital  The only source of capital is savings 1

 When revenues of non-financial corporations, individuals, governments and nonresidents exceed expenditures, they have savings to invest  Retail Investors as Capital Suppliers  Retail investors are individual investors who buy and sell securities for their own personal accounts  Canada has historically exhibited a relatively high rate of personal savings: as a percentage of personal disposable income, savings are historically around 10%, compared to 5% in the US  In 2007, Canadians had more than $500 billion in personal savings deposits at the banks alone  Strong incentives in our tax system encourage Canadians to save and to invest these savings, either directly in securities, or by depositing savings with financial institutions  Such tax incentives include the dividend tax credit system, tax deferral plans (i.e., RRSPs)  Foreign Investors as Capital Suppliers  Historically, Canada has depended upon large inflows of foreign investment for continued growth  The flow of foreign capital into Canada is substantial – both short-term (especially if higher interest rates make Canada more attractive compared to the US and elsewhere) and long-term  Foreign direct investment in Canada has tended to concentrate in particular industries – manufacturing petroleum and natural gas, and mining and smelting  Some industries have restrictions with respect to foreign investment  Canada’s reliance on foreign investment, while necessary, has its costs, the main “control”  Many feel foreign investment leads to long-term outflows of interest and dividend payments, negatively affecting our international balance of payments Users of Capital  Individuals, business, governments, and foreigners are users of capital  Individuals  May require capital to finance housing, consumer durables (e.g. automobiles, appliances) or other types of consumption  Businesses  Canadian businesses require massive sums of capital to finance day-to-day operations, to renew and maintain plant and equipment as well as to expand and diversify activities  A substantial part of these requirements is generated internally (e.g. profits retained in the business) while some is borrowed from financial institutions  Remainder is raised in securities markets through the issuance of short term money market paper, short & long term debt, & preferred and common shares  Federal Government Finance  Why the Federal Government Borrows

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Each year the Minister of Finance presents the government’s budget to parliament  The Budget details the government’s estimate of its revenues and expenses, which in turn results in a projection of surplus or deficit  Canada’s long history of budget deficits has resulted in the accumulation of a very large public debt  How the Federal Government Borrows  The federal government makes use of four main instruments to finance its debt: Treasury bills (T-bills), marketable bonds, Canada Savings Bonds (CSBs), and Canada Premium Bonds (CPBs) Provincial Finance  Like the federal government, the 10 provinces issue debt directly themselves and may guarantee unconditionally the interest and principal of securities issued by their Crown corporations such as Hydro Quebec  Like the federal government, when revenues fail to meet expenditures and/or large capital projects are planned, provinces must borrow  Why Provinces Borrow  A few of the provinces’ more important functions are: highway construction and maintenance, providing public education, construction and maintenance of hospitals and related health services Municipal Finance  Municipalities are responsible for the provision of streets, sewers, waterworks, police and fire protection, welfare, transportation, distribution of electricity and other services  Why Municipalities Borrow  Since many of the assets used to provide these services are expected to last for 20 or more years, municipalities attempt to spread their cost over a period of years through the issuance of instalment or serial debentures 

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What Are The Financial Instruments?  Debt Instruments  Formalize a relationship in which the issuer promises to repay the loan at maturity, and in the interim makes interest payments to the investor  The term of the loan ranges from very short to very long, depending on the type of instrument  Bonds, debentures, mortgages, treasury bills and commercial paper are all examples of debt instruments (also referred to as fixed-income securities)  The term bond is sometimes used colloquially to refer to both bonds and debentures, but these two instruments differ in terms of how they are secured  A bond is secured by specific assets of the issuer, while a debenture is secured only by the general credit of the issuer and not by a specific pledge of assets Equity Instruments  Equities are usually referred to as stocks or shares because the investor actually buys a “share” of the company, thus gaining an ownership stake in the company

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As an owner, the investor participates in the corporation’s fortunes If the company does well, the value of the company may increase, giving the investor a capital gain when the shares are sold In addition, the company may distribute part of its profit to shareowners in the form of dividends Unlike interest on a debt instrument, however, dividends are not obligatory Two main types of stock: common and preferred  Common shares – ownership usually gives shareholders the right to vote at the company’s annual meeting and also a claim on its profits. The company may issue a dividend to common shareholders when business is profitable, but is under no obligation to do so  Preferred shares – generally are entitled to a fixed dividend that must be paid out of earnings before any dividend is paid to common shareowners. As well, should the firm wind up its affairs, preferred shareholders have a prior claim on the assets of the company before common shareholders. Unlike common shareholders, however, preferred shareholders usually have no vote on the direction of management unless the company fails to pay preferred dividends.

Investment Funds  An Investment Fund is a company or trust that manages investments for its clients  The most common is the Open-end Fund also known as a mutual fund  The fund raises capital by selling shares or units to investors, and then invests the capital  As unit holders, the investors receive part of the money made from the fund’s investments  The key advantages are:  They are professionally managed  They provide a relatively inexpensive way to diversify a portfolio Derivatives and Other Financial Instruments  Unlike stocks & bonds, derivatives are suited mainly for more sophisticated investors  Derivatives are products based on or derived from an underlying instrument, such as a stock or an index

What Are The Financial Markets?  The capital market or securities market is made up of many individual markets  For example, there are stock markets, bond markets, and money markets  Like a farmers’ market, a securities market provides a forum in which buyers and sellers meet

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In the securities market, buyers and sellers do not meet face to face. Instead, intermediaries, such as Investment Advisors or bond dealers, act on the clients’ behalf In addition, securities are sold on primary and secondary markets  The primary market is the market where a security is sold when it is first issued and sold to investors  For example, a company will use an Initial Public Offerings (IPOs) to sell common shares to the public for the very first time  Subsequent trading takes place in the secondary market and it is here where individual investors trade among themselves  The secondary market is extremely important as it enables investors who originally bought the investment products to sell them and obtain cash  Without the secondary market liquidity, the ability to sell the securities with ease at a reasonable price – investors would not buy securities in the primary market

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Auction Markets – The Stock Exchanges in Canada  A stock exchange is a marketplace where buyers and sellers of securities meet to trade with each other and where prices are established according to laws of supply and demand  E.g. Toronto stock exchange (TSX), TSX Venture Exchange, Canadian Trading and Quotation System (CNQ) Bourse de Montreal (aka the Montreal Exchange or ME)  The TSX lists senior equities, some debt instruments that are convertible into listed equity, income trusts and ETFs  The TSX Venture Exchange trades junior securities and a few debenture issues  The Bourse de Montreal trades all financial and equity futures and options  Liquidity is fundamental to the operation of a stock exchange  A liquid market is characterized by:  Frequent sales  Narrow price spread between bid and offering prices  Small price fluctuations from sale to sale

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Exchange Memberships  When a stock exchange is founded, memberships are sold to different individuals  Historically, in order to trade on an exchange, a firm had to own a “seat”  The term seal originated with the old practice of brokers trading securities while seated around a table  Today, the term means “a right of entrance to a stock exchange”

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The seat itself is a valid and valuable asset that may be sold or leased subject to conditions in the exchange’s by-laws  There are currently 2 types of exchange ownership:  Not-for-Profit – CDNX  For Profit – where the exchange is owned by shareholders (TSE)  Many exchanges, throughout the world, are moving in this direction  Each exchange sets its own requirements for membership and for permitting access to trading facilities  Member firms may be publicly owned  There are requirements regarding the amount of capital necessary to carry on business and key personnel (officers and directors) must complete required courses of study Governing Bodies and Administration  The administration and policy setting of the exchanges are the responsibility of each exchange’s governing body  Each governing body is comprised of at least one permanent exchange official (President) plus some experienced senior executives from the member firms who serve as Governors for stipulated terms of office  Included on each governing body’s board are 2-6 highly qualified Public Governors appointed or elected from outside the brokerage community  Public Governors represent the interests of investors as a whole as well as listed companies and provide governing bodies with outside points of view and expertise Stock Exchanges around the World  There are over 80 stock exchanges in over 60 nations  Usually a good gauge of a country’s economy is the size and organization of its exchanges  The World Federation of Exchanges reports that the New York Stock Exchange (NYSE) was the largest stock exchange in the world in terms of the market capitalization – a reflection of the comprehensive value of the stock exchange at that time  The TSX ranked 8th, down slightly from 2006 

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Dealer Markets – The Unlisted Market  Dealer markets or over-the-counter (OTC) markets are the second major type of market on which securities trade  They consist of a network of dealers who trade with each other, usually over the telephone or over a computer network  Unlike auction markets where the individual buyer’s orders are entered, a dealer market is a negotiated market where only the dealers’ bid and ask quotations are entered by those dealers acting as market makers in a particular security  Almost all bonds and debentures are sold through dealer markets

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 These dealer markets are less visible than the auction markets for equities, so many people are surprised to learn that the volume of trading on the dealer market for debt securities is 31 times larger than the equity market  Size of the Unlisted Market for Equities  The volume of unlisted equity business is much smaller than the volume of stock exchange transactions  The exact size of Canadian OTC dealings cannot be measured because complete statistics are not available  The unlisted market does not set listing requirement for the stocks traded on its system nor does it attempt to regulate the companies  The Mechanics of Trading  Over-the-counter trading in equities is conducted in a similar manner to bond trading  In the OTC market individual investors’ orders are not entered into the market or displayed on the computer system  Instead, dealers, who are acting as market makers, enter their bid and ask quotations  These market makers hold an inventory of the securities in which they have agreed to “make a market”  They sell from this inventory to buyers & add to the inventory when they acquire from sellers  The market makers post their individual bid (the highest price the maker will pay) and ask (the lowest price the maker will accept) quotations  The willingness of the market makers to quote bid and ask prices provides liquidity to the system (although the market makers do have the right to refuse to trade at these prices)  Reporting Trades in the Unlisted Market  In most of Canada, there is no requirement for firms to report unlisted trades  Ontario is the exception. The Ontario Securities Commission (OSC) requires that trades of unlisted securities be reported through the Canadian Unlisted Board Inc. (CUB)  CUB was launched as an automated system after the reorganization of the equity markets in Canada. It offers an Internet web-based system for dealers to report completed trades in unlisted and unquoted equity securities in Ontario, as required under the Ontario Securities Act. Quotation and Trade Reporting Systems (QTRS)  Are recognized stock markets that operate in a similar manner to exchanges and provide facilities to users to post quotations and report trades  Traditionally, a QTRS is a mechanism for dealers to post quotations indicating the prices at which they are willing to buy and sell stock  The market itself does not match buy and sell orders; they are negotiated and trades are reported after the fact  This is the traditional model for NASDAQ Alternative Trading Systems (ATS)

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Are privately-owned computerized networks that match orders for securities outside of recognized exchange facilities These are also referred to as Proprietary Electronic Trading Systems (PETS) or NonSRO-operated Trading Systems (NETS) They can be owned by individual brokerage firms or by groups of brokerage firms Profits are made via revenues from the trading system itself and go to the owner(s) of the system, as opposed to the regular exchange system in which opportunities are provided for members to make profits These systems bypass the exchanges because a brokerage firm operating an ATS can match orders directly from its own inventory, or act as an agent in bringing buyers and sellers together Since there is one less intermediary, more of the commission charged to the client is kept by the dealer Most client users of these systems are institutional investors, who can reduce transaction costs greatly Some non-brokerage-owned ATSs even allow buyers and sellers to contact each other directly and negotiate a price These systems also facilitate global trading, since these markets operate while the exchanges are closed Have the potential to threaten market stability due to lessened market transparency, cross-border trading issues and technological glitches such as insufficient system capacity Therefore, some sort of regulatory oversight is preferable IIROC was established through the consolidation of the Investment Dealers Association of Canada (IIROC) and Market Regulation Services Inc. (RS) that became effective June 1, 2008

Electronic Trading Systems  With the exception of a few debentures listed on the TSX and TSX Venture Exchanges, all bond and money market securities trade OTC  In the past few years, three electronic trading systems have been launched in Canada  CanDeal  A member of IIROC, is a joint venture between Canada’s six largest investment dealers, and is operated by the TSX  It is recognized as both an ATS and an investment dealer  It offers institutional investors access to federal bond bid and offer, prices and yields from six bank-owned dealers, which represent more than 80% of the transactions in the bond market

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 Intends to expand to provincial bonds, corporate debt and commercial paper CBID  Also a member of IIROC and an ATS, operates two distinct marketplaces (Retail & Institutional)  The retail marketplace, Canada’s first electronic fixed-income multi-dealer retail marketplace, was launched in July 2001 and is accessible by registered dealers on behalf of retail clients  The institutional marketplace was launched in July 2002, and is accessible by registered dealers, institutional investors, governments and pension funds  Currently has over 2,500 Canadian debt instruments trading CanPX  Is a joint venture of Investment Industry Association of Canada (IIAC) / and IIROC member firms  System provides investors with real time bid and offer prices and hourly trade data  Issues include Government of Canada bonds and treasury bills, provincial bonds and some corporate bonds

Trends in Financial Markets  There have been many changes to global capital markets over the last several years  Physical marketplaces (the trading floors) are becoming obsolete, while virtual marketplace or electronic trading systems are reducing the need for human participants in the market mechanism  Exchanges are merging to meet the c...