©2009 McGraw-Hill Ryerson Limited1 of 30

1414 Capital MarketsCapital Markets

Prepared by:

Michel PaquetSAIT Polytechnic

©2009 McGraw-Hill Ryerson Limited

©2009 McGraw-Hill Ryerson Limited2 of 30

Chapter 14 - Outline

• Structure of Capital Markets

• Demand for Funds in the Capital Markets

• Supply of Funds in the Capital Markets

• The Organization of the Security Markets

• Market Efficiency

• Government Regulation

• Summary and Conclusions

©2009 McGraw-Hill Ryerson Limited3 of 30

Learning Objectives

1. Define primary, secondary, money and capital markets. (LO1)

2. Outline the primary participants raising funds in the capital markets. (LO2)

3. Describe the Canadian economy as three major sectors allocating funds amongst themselves. (LO3)

©2009 McGraw-Hill Ryerson Limited4 of 30

Learning Objectives

4. Outline the organization of the securities markets. (LO4)

5. Discuss the concept of market efficiency and its benefits to the economic system. (LO5)

6. Describe the changing financial regulatory environment. (LO6)

©2009 McGraw-Hill Ryerson Limited5 of 30

Structure of Capital Markets

Capital Markets can be classified into:(1) Primary vs. Secondary Markets- A new security is first issued in a primary markets and there is cash

flow to the issuer.- Any security currently outstanding are bought and sold amongst

investors in a secondary market but no cash flows to the security issuer.

(2) Money vs. Capital Markets- Fixed income securities with maturities of one year or less are

traded in a money market (e.g., T-bills, commercial paper)- Long-term securities with maturities greater than one year are

traded in a capital market (e.g., bond, common and preferred stock)

LO1

©2009 McGraw-Hill Ryerson Limited6 of 30

Figure 14-1 Canadian Money and Capital Markets: securities outstanding 2008

LO1

Source: Bank of Canada, Banking and Financial Statistics, March 2004; F2 + G6 for money total, K8 for bond total; Statistics Canada Catalogue Nos. 67-202, 61-008 (stock market at book value).

©2009 McGraw-Hill Ryerson Limited7 of 30

Demand for Funds in the Capital Markets

• Corporations are not the only demander for funds in the capital markets.

• All levels of governments also compete for funds in the capital markets.

LO1

©2009 McGraw-Hill Ryerson Limited8 of 30

Figure 14-3 Canadian money market: securities outstanding

LO1

Source: Bank of Canada, Banking and Financial Statistics, June 2008, F2 and G6 series.

©2009 McGraw-Hill Ryerson Limited9 of 30

Figure 14-4 Canadian bond market: securities outstanding (C $ and foreign currencies)

LO1

Source: Bank of Canada, Banking and Financial Statistics, March 2008, K8 series.

©2009 McGraw-Hill Ryerson Limited10 of 30

0

20

40

60

80

100

120

140

160

180

Government of Canada

Provincial and Municipalities

Corporations

$ b

illi

on

s

Figure 14-5

Canadian bonds outstanding: foreign currencies

___1997

___2007

LO1

Source: Bank of Canada, Banking and Financial Statistics, March 2008, K8 series.

©2009 McGraw-Hill Ryerson Limited11 of 30

Government Securities

• Government of Canada Securities T-bills: short-term securities Long-term bonds: active secondary market Canadian Savings Bonds: illiquid long-term bonds After 1998, the federal budget surpluses reduce demand for new

debt and amount of debt outstanding.

• Provincial and Municipal Government Bonds Historically, provinces have borrowed mainly long term but

during the 1990s became active in the short-term market as well. Provinces and municipalities borrow actively in the foreign

markets Municipal bonds account for a small portion of the bond market

LO2

©2009 McGraw-Hill Ryerson Limited12 of 30

Corporate SecuritiesCorporate Bonds

– most widely used form of financing in recent years– significant amounts raised abroad

Preferred Stock– least used of all long-term corporate securities

Common Stock– 25% of net new financings in some years– more equity is being raised abroad by Canadian

corporations

LO2

©2009 McGraw-Hill Ryerson Limited13 of 30

Figure 14-6 Net new corporate financings by type of security

LO2

Source: Bank of Canada, Banking and Financial Statistics, F9 series.

©2009 McGraw-Hill Ryerson Limited14 of 30

Corporate Financing in General

• Debt-to-equity ratios among Canadian non-financial private corporations from the 1960s are fluctuating.

• Managers attempt to time their issues of common stock.

• Over a recent period, internally generated funds, consisting of retained earnings and capital consumption allowance generated over 60% of the firm’s funding needs.

• Managers are reluctant to use external financing.

LO2

©2009 McGraw-Hill Ryerson Limited15 of 30

Figure 14-7Debt-to-equity ratios for nonfinancial private corporations

LO2

Source: Statistics Canada, “Financial Statistics for Entreprises”, Catalogue No. 61-008, 4 th quarter, 2007.

©2009 McGraw-Hill Ryerson Limited16 of 30

Figure 14-8Funding Sources of Non-financial Private Corporations

LO2

Source: Statistics Canada, 61-008-XIE, 2008, 1st quarter, Table 3-2.

©2009 McGraw-Hill Ryerson Limited17 of 30

Supply of Funds in the Capital Markets

• The major supplier of funds for investment in a three-sector economy is the household sector.

• The transfer of funds from savers to borrowers can be accomplished directly in the capital markets.

• Alternatively, a saver can indirectly invest his or her funds through a financial intermediary.

• These financial intermediaries help make the flow of funds very efficient and competitive.

LO3

©2009 McGraw-Hill Ryerson Limited18 of 30

FIGURE 14-9Flow of fundsthrough theeconomy

LO3

©2009 McGraw-Hill Ryerson Limited19 of 30

Figure 14-10 Total assets of financial intermediaries

LO3

Source: Bank of Canada, Banking and Financial Statistics, June 2008, C3, D1-D5 series; Statistics Canada, CANSIM 280-0002 to 0004.

©2009 McGraw-Hill Ryerson Limited20 of 30

The Organization of the Security Markets

• Security markets exist to facilitate the direct transfer of capital among households, corporations, and governments.

• After a security is sold initially as an original offering, it then trades among investors, a process known as secondary trading.

• Secondary trading is vitally important as it provides liquidity for investors.

• Secondary market trading activity is divided between organized exchanges and over-the-counter (OTC) markets.

LO4

©2009 McGraw-Hill Ryerson Limited21 of 30

Figure 14-11 Secondary Market: Annual Value of Trading

LO4

Source: Investment Dealers Association Reports, 2007, www.iiac.ca.

©2009 McGraw-Hill Ryerson Limited22 of 30

Organized Stock Exchanges

An organized stock exchange is a marketplace where buyers and sellers of securities come together to trade securities in a single location.

Toronto Stock Exchange (TSX) – largest and most important market for stocks in Canada– strict requirements in order for a firm to be traded on that

exchange– smaller and less significant globally than the NYSE

New York Stock Exchange (NYSE) – largest and most important market for stocks in the world

LO4

©2009 McGraw-Hill Ryerson Limited23 of 30

Figure 14-2Market capitalization (value) of top 12 equity markets

LO4

Source: World Federation of Exchanges, 2007.

©2009 McGraw-Hill Ryerson Limited24 of 30

Over-the-Counter (OTC) Markets

• Have no central location

• Networks of dealers connected by computer terminals and telephones

• Buy and sell securities which are not listed on a stock exchange

• Bulk of all bond trading is done OTC

• The Canadian Dealing Network (CDN) is Canada’s OTC market in equities

LO4

©2009 McGraw-Hill Ryerson Limited25 of 30

Challenges for Canadian Exchanges

• The extremely liquid markets in the US have tended to attract business away from Canadian exchanges.

• Another threat is the “upstairs rooms” practice, that is, dealers matching large trades in shares through their own trading floors.

• Internet trading systems such as Alternative Trading Systems (ATS) are also competing for business.

• It takes reform for Canadian exchanges to survive these challenges.

LO5

©2009 McGraw-Hill Ryerson Limited26 of 30

Market Efficiency

Efficient markets allocate capital to its best use without undue costs.

Criteria of Efficiency prices adjust rapidly to new information there is a continuous market in prices the market can absorb large dollar amounts of

securities without price destabilizationBased on these criteria:

• The NYSE is the world’s most efficient capital market.• The TSX is reasonably efficient.

LO5

©2009 McGraw-Hill Ryerson Limited27 of 30

The Efficient Market Hypothesis

• Based on the nature of information included in the price of a security, 3 forms of market efficiency are grades as to the degree of market efficiency.– Weak form:

• all past information is included in the price

– Semi-strong form:• all public and past information is included in the price

– Strong form:• all private, public and past information is included in the price

LO5

©2009 McGraw-Hill Ryerson Limited28 of 30

Securities Regulation• Good capital markets should be fair, transparent, liquid,

competitive and efficient.

• Regulation helps to develop and nurture these key aspects.

• In Canada, the securities markets are regulated by:Provincial securities commissions such as the Ontario

Securities Commission (OSC)Stock exchanges and Trade organizations such as the Investment Dealers

Association (IDA)

• One of the major regulation tasks is to protect investors from fraud and manipulation.

LO6

©2009 McGraw-Hill Ryerson Limited29 of 30

Summary and Conclusions

• In capital markets, corporations and governments issue securities to raise funds.

• After a new security is issued in a primary market, it is shifted to a secondary market.

• Short-term debt securities are traded in a money market while long-term debt securities and equity securities are traded in a capital market.

• Households are the major fund suppliers and provide their funds to the fund users directly in capital markets or indirectly through a financial intermediary.

©2009 McGraw-Hill Ryerson Limited30 of 30

Summary and Conclusions

• Security markets are divided into organized exchanges and over-the-counter (OTC) markets.

• The Toronto Stock Exchange (TSX) is Canada’s senior organized stock exchange.

• Bonds are traded OTC.• Efficient markets are crucial for an economy as

they allocate financial capital efficiently.• The goal of security market regulation is to make

it fair, transparent, liquid, competitive and efficient.