Chapter 2 – The Capital Market

2.1 Investment Capital

Capital has two meanings:
1. Economist view – machinery, factories and inventory required to product other products
2. Investor view – total of financial assets invested in securities, a home and other fixed asset, plus cash
o Assets: everything a company or a person owns or has owned to it  statement of financial
position category
Capital – aka wealth  economic value that represents the invested savings of individuals, companies, gov’ts
and other orgs

 Real – land, buildings, and other materials goods

 Representational – money, stocks and bonds
o More significant when harnessed productively either direct/indirect investment
o Direct investment ex:
 Couple invests their savings in a home
 Gov’t invests in a new highway
 Company pays start-up costs for a new plant
o Indirect investment ex:
 Investor buys stocks or bonds
 Parent invests in education savings plan
 Couple deposits their savings at a bank
Indirect investment  a person/entity with accumulated savings buys the securities issued by a gov’t/corp

 Invests the funds it receives directly for a productive purpose

 Made with help of investment advisor in retail/institutional sales department of a securities firm
o Investment advisor (IA): individual licensed to transact in full rage of securities
 Registered by securities commission of the province that they work in
 Refers to employees of SRO member firms only
 SRO: self-regulatory organization i.e. Investment Industry Regulatory
Organization of Canada
 Aka Registrant/Registered Representative (RR)

Characteristics of Capital
Capital has three important characteristics  allow
capital to be selective about where it settles
(countries/location) where favourable conditions
exist:
1. Mobility
2. Sensitivity to its environment
3. Scarcity
Favourable conditions  stable gov’t, economic
activity that is not heavily regulated, hospitable investment climate & profitable investment opportunities
Flow of capital guided by country risk evaluation
Capital is limited in quantity & scarce = great demand everywhere in the world
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  Mobile & sensitive  moves in and out of countries or localities in anticipation of changes to:
o Taxation o Regulations
o Exchange rates o Gov’t attitudes
o Trade barriers

 Move to areas where it can be best used & avoid less favourable conditions
Capital always move towards uses and users that offer the highest risk-adjust returns

The Suppliers and Users of Capital

In a manufacturing setting, capital provides:

 The means to expand facilities  Increase competitiveness in domestic and

 Improve productivity foreign markets
 Develop innovation & sought-after

 new products
Investment is deficient:

 Industry slackens  Living standards decline

 Unemployment rises
Suppliers of Capital:
Revenues exceed expenditures = investors use savings to invest
Individuals:

 Compensation to postpone current consumption is high enough  save their money to spend it at an
opportune time in the future
 More inclined to spend when the compensation to postpone current consumption is low/incentives
(i.e., tax breaks) are provided
Non-Financial Domestic Corporations:

 Corps like steel makers, food distributors, & machinery manufacturers generate large savings in form of
corporate earnings
 Funds retained by corporation and available only for internal use  not invested in other companies’
stocks and bonds
 Corporations are not significant providers of permanent funds to others in the capital market
Governments:

 Able to operate at a surplus and invest their profits = supplier of capital

 Gov’ts who are in less favourable position borrow in the capital markets to fund their deficits = users of
capital
Foreign Investors:

 Both corporate and individuals regard Canada as a good place to invest

 Canada has relied on foreign savings both direct investment in Canadian industries & portfolio
investment in Canada securities

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Users of Capital:
May be individuals, businesses, or gov’ts whether Canadian or foreign
Capital flows into the country from:

 Foreign individuals
 Businesses
 Gov’ts
Capital also flow out of Canada b/c foreign users of capital, take capital out of the country

 Borrowing from Canadian banks

 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

 Canadian investors benefit from access to foreign securities by using them to diversify their investments
Suppliers and Users of Investment Capital: A Summary:
Sources of capital:

 Retail investors: individual investors who buy and sell securities for their own personal accounts, and
not for another company/org
o Buy smaller quantities than larger institutional investors
 Institutional investors: organizations such as pension and mutual fund companies, that trade in
large share quantities or dollar amounts
o Have steady flow of money to invest
 Foreign investors: foreign direct investment tend to concentrate in manufacturing, petroleum, natural
gas, mining, and smelting
o Some industries have restrictions on foreign investment

Users of Capital:

 Individuals:
o Need capital to finance large purchase (houses, cars, and major appliances)
o Obtain from personal loans, mtg loans, and charge accounts
 Businesses:
o Require massive sums of capital to:
 Finance day-to-day operations
 Renew and maintain plans & equipment
 Expand and diversify their activities
o Generate most of their capital internally  profits retained in the business
o Borrow from financial intermediaries for other needs
 Raise remainder in security markets
 Governments:
o Major issuers of securities in public markets directly/guaranteeing the debt of their Crown corps
o Revenue fail to meet expenditures/undertake large capital projects = gov’t must borrow

2.2 The Financial Instruments

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Financial instruments in form of securities are formal, legal docs that set out the rights & obligations of the
buyers (capital suppliers) and sellers (capital users) of securities
Suppliers & users of capital can choose from many types of securities to meet their needs
Different Types of Financial Instruments:

 Fixed-income securities – aka debt securities formalize a relationship

o Issuer promises to repay the loan at maturity & makes interest payments to the investor
o Term of loan varies depending on type of instrument
o Ex/ treasury bills, bonds
 Equity securities: evidence of a share of ownership stake in the company that issued the security
o Stocks: ownership interest in a corporation’s that represent a claim on its earnings and assets
o Aka stocks, equities or shares
o Ex/ if the value of the company increases, the owner of the stock in that company receives a
capital gain upon selling it
o Ex/ common stock (common shares), preferred shares
 Common shares: securities representing ownership in a company
 Carry voting privileges and are entitled to the receipt of dividends, if declared
 Preferred shares: class of share capital that entitles owners to a fixed dividend ahead
of the company’s common shares and to a stated dollar value per share in the event of
liquidation
 Do not have voting rights unless a stated number of dividends have been
omitted
 Aka preference shares
 Dividend: type of financial instrument whose value is based on the performance
of an underlying financial asset, commodity, or other investment
o Derivatives are available on interest rates, currency, stock indexes
 Voting rights: stockholder’s right to vote in the affairs of the company
o Most common shares have one vote each
o Preferred stocks usually have right to vote only when tis dividends are in
arrears
 Arrears: interest/dividends that were not paid when due but are
still owned
 When payment resumes, dividends in arrears must be paid to the
preferred shareholders before the common shareholders
o Right to vote may be delegated by the shareholder to another person aka
proxy
 Proxy: Written authorization given by a shareholder to someone
else, who need not be a shareholder, to represent him/her and
vote his/her shares at a shareholder’s meeting
 Derivatives – product whose value is derived from value of an underlying instrument (i.e., stock/an
index)
o More suited to sophisticated investors
o Ex/ options, forwards
 Managed products – aka investment fund  pools of capital gathered from investors to buy securities
according to a specific investment mandate
o Ex/ mutual funds, exchange-traded funds, private equity funds
 Structured products – finically engineered product w/ the characteristics of debt, equity, and an
investment fund

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 o Ex/ principal-protected notes, index-linked guaranteed investment certificates

Financial markets  where people come together to complete their financial transactions

 Provides a forum in which buyers & sellers meet

 Don’t meet face to face, intermediaries (investment advisors & bond dealers) act on clients’ behalf
Financial instruments & securities are key element in the efficient transfer of capital from suppliers to users

 Benefits of financial instruments depends on the efficient market in which these securities can be
bought and sold
Organized financial market = speedy & low transaction costs, high degree of liquidity and effective regulation
Financial market has no physical location

 Trading of securities (stocks, bonds, derivatives) takes place via electronic platforms
Capital market is made up of individual financial markets:

 Stock market
 Bond markets
 Money markets: part of the capital market in which short-term financial obligations are bought and
sold which includes
o Treasury bills: short term gov’t debt issued in denominations ranging from $1000 to
$1,000,000
 Don’t pay interest but are sold at a discount and mature at par (100% of face value)
 Difference btwn the purchase price and par at maturity represents the lender’s
(purchaser’s) income in lieu of interest
 Gains are taxed as interest income in purchaser’s hands
 Face value: value of a bond/debenture that appears on the face of the certificate
o Amount the issuer will pay at maturity
o No indication of market value
o Federal gov’t securities
o Commercial paper: unsecured promissory noted issued by a corporation/asset backed
security backed by pool of underlying financial assets
 Issue terms range from less than 3 months to 1 year
 Corporate paper trades in $1000 multiple, w/ a minimum initial investment of $25000
 Bought and sold in secondary market before maturity at prevailing market rates
o Bankers’ acceptances: commercial draft (written instruction to make payment) drawn by a
borrower for payment on a specified date
 Guaranteed at maturity by the borrower’s bank
 Sold at a discount and mature at their face value w/ difference representing the return to
the investor
 Sold before maturity at prevailing market rates  offer a higher yield than T-Bills
o + other instruments w/ one year or less left to maturity
o Longer term securities when their term shortens to the limits mentioned are also traded in the
money market
Markets are categorized as:

 Primary markets: market for new issues of securities

o Proceeds of sale of securities go directly to the company issuing the securities
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  Secondary markets: securities are traded through an exchange/over the counter subsequent to
primary offering
o Proceeds from trades o to selling dealers and investors rather than to companies that originally
issued the shares in the primary market
o Over the counter: market for securities made up of securities dealers who may or may not be
members of a recognized stock exchange
 Market conducted over the telephone
 Aka unlisted inter-dealer or street market
 Ex/ NASDAQ
o Primary offering: original sale of any issue of a company’s securities
 Action markets: securities are bought and sold by brokers acting as agents for their clients – ex/ TSX
 Dealer markets: trades are conducted over-the counter
o Dealers acts as principals when buying and selling securities for clients aka unlisted market

Primary and Secondary Markets

Primary market – newly issued securities sold by companies and gov’ts to investors

 Investors purchase securities directly from the issuing company of gov’t

 Companies raise capital by selling stocks/bonds
 Gov’t sells bonds only
 Newly issued distributions of securities  IPOs (initial public offerings)
Secondary market – investors trade securities that have already been issued by companies & gov’ts

 Buyers and sellers trade among each other at a price that is mutually beneficial to both parties
 Securities are transferred from the seller to the buyer
 Issuing company doesn’t receive any of the proceeds from transactions – it receives payment only when
securities are first issued in primary market
 Ex/ buying and selling stocks on the TSX

Auction Markets
Securities are bought and sold by investors

 Investment dealers act as agents, execute the buy and sell orders on behalf of their clients
 Buyers enter bids and sellers enter offers
 Orders are channelled to a single central market where they compete against each other
 Trade is executed only when there is a match in the bid and ask prices
 Between trades, best bid is lower than the best offer
 Difference btwn two prices ^ called bid-ask spread
Bid-Ask Spread:

 Ask Price – Bid Price = Bid Ask Spread

 Bid price: highest price a buyer is willing to pay for the financial instrument (security) being quoted
aka ask
 Ask price aka offer: lowest price a seller will accept for the financial instrument being quoted aka bid
 Bid-ask spread: difference btwn the current bid and ask
 Last price: price at which the last trade on a stock occurred
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 o Price can fluctuate btwn the bid price and the ask price as buying and selling orders are filled
o Not necessarily the price at which a stock can currently be bought/sold
o Last price at which a transaction occurred

Exchanges
Stock exchange: marketplace where buyers and sellers of securities meet to trade w/ each other and where
prices are established according to laws of supply and demand
In Canada - trading is carried out in common and preferred shares, rights and warrants, exchange-traded
funds, income trusts and a few convertible debentures
U.S & European exchanges – bonds and debentures, equities are traded
One property that is fundamental to the operation of exchanges is liquidity

 Characteristics of liquid market

o Frequent trades
o Narrow price spreads btwn bid and ask prices
o Small price fluctuations from trade to trade

Following exchanges operate in Canada:

 Toronto Stock Exchange TSX: largest stock exchange in Canada w/ over 1700 companies listed on
the exchange
o List equities, some debt instruments that are convertible into a listed equity, income trusts, and
exchange-traded funds
 TSX Venture Exchange: Canada’s public venture marketplace, the result of the merger of the
Vancouver and Alberta Stock Exchanges in 1999
o List equities and a few debenture issues
 TSX Alpha Exchange: exchange that provides trading in securities listed on TSX and TSXV
o Order price and volume info is publicly available
o Alpha Exchange is wholly owned by TMX Group Inc
o Offers trading in securities listed on TSX and TSX Venture Exchange
 Montreal Exchange or Bourse de Montreal: deals exclusively w/ non-agricultural options and
futures in Canada including all options that previously traded on TSX and all futures products that
previously traded on the Toronto Futures Exchange
o Trades all financial and equity futures and options listed for trading in Canada
 ICE NGX Canada: natural gas exchange, headquartered in Calgary, Alberta that provides electronic
trading, central counterparty clearing and data services to the North American natural gas an electricity
markets
 Canadian Securities Exchange: launched in 2003 as an alternative marketplace for trading equity
securities and emerging companies
o Lists equities and emerging companies
 Neo Exchange: exchange that provides listing services and facilitates trading in securities listed on
NEO Exchange, TSX, and TSX Venture Exchange

Dealer Markets
Network of banks and investment dealers

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Order of individual buyers and sellers are entered in a centralized marketplace  dealer market is a negotiated
market here market makers post bid-and-ask quotations via electronic platforms and computer networks

 Market makers: trader employed by securities firm who is authorized and required by applicable self-
regulatory orgs (SROs) to maintain reasonable liquidity in securities markets by making firm bids or
offers for one or more designated securities
Over the counter (OTC) market – investment dealers act as principals
All bonds and debentures are sold through dealer markets
Volume of trading (in dollars) for debt securities is larger than that of the equity market
Aka unlisted markets b/c securities that trade on them are not listed on an organized exchange as they are on
auction markets
No central marketplace for most dealer market transactions

 Conducted on OTC market

 Trades made by means of comp systems of inter-dealer brokers that facilitate trades btwn investment
dealers
Trading in the Unlisted Equity Market:
OTC trading in equities is conducted in a similar manner to bond travelling
Individual investors’ orders are not entered into a centralized market and made public

 Investment dealers who act as market makers quote their own bids and offers
 Market makers hold an inventory of the securities in which they have agreed to make a market
 Sell from this inventory to buyers and add to the inventory when they acquire securities from sellers
Willingness of market makers to quote bid and ask prices provides liquidity to the system

 Investor wishes to buy or sell an unlisted security  investor’s dealer consults the bid/ask quotations of
various market makers to identify the best price
o Then contacts the market maker to complete the transaction
o Dealer charges a commission for this service

Over-The-Counter Derivatives Market:

OTC derivatives market is dominated by large international financial institutions (i.e., banks and investment
dealers that trade w/ corporate clients and OFI)

 Traders don’t meet in person to negotiate transactions

 Market stays open 24 hours a day
Attractive features of OTC derivative products – can be custom designed by the buyer & seller

 Special features added to basic properties of options and forwards

 Products tend to be complex
Reporting Trades In The Equity Unlisted Market:
Investment dealers don’t have to report unlisted trades in Canada
Ontario  Ontario Securities Act requires trades of unlisted securities and unquoted equity securities be
reported through the web-based system of the Canadian Unlisted Board Inc.

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  Canadian Unlisted Board Inc.: for investment dealers to report completed trades in unlisted and
unquoted equity securities in Ontario

Alternative Trading Systems

Alternative trading systems (ATS): privately-owned computerized networks that match orders for
securities outside of recognized exchange facilities aka Proprietary Electronic Trading Systems (PETS)

 Electronic marketplaces that provide automated marching and execution of trades in both the equity
and fixed-income markets
Equity Electronic Trading Systems:
ATS in equity markets provide automated trade matching & execution of orders from multiple buyers & sellers
Canadian Securities Administrators allow ATSs to compete w/ recognized exchanges and also among other
ATSs  providing participants w/ a range of options in executing trades
ATS must be registered as an investment dealer & a member of a self-regulatory org
ATSs and traditional exchanges are subject to regulatory filings and provide similar trading services

 ATSs are not permitted to carry out all of the same functions as traditional exchanges
ATSs trade securities that are listed on traditional exchanges but they can’t themselves list securities
Fixed-Income Electronic Trading Systems:
All bond and money market securities are sold through dealer markets
In Canada, these markets include the following fixed-income electronic trading systems:

 CanDeal: provides institutional investors w/ electronic access to federal bond bid and offer prices and
yields from its six bank-owned dealers
o Member of IIROC – joint venture btwn Canada’s 6 largest bank-owned investment dealers
o Operated by TMX Group Ltd and is recognized as both a debt ATS and an investment dealer
o Offers institutional investors access to gov’t securities and money market instruments
 CBID & CBID Institutional:
o ATS operates two distinct fixed-income marketplaces: retail and institutional
o CBID: electronic trading system for fixed-income securities operating in the retail market
 Accessible by registered dealers on behalf of retail clients
o CBID Institutional: electronic trading system for fixed-income securities operating in the
institutional market
 Accessible by registered dealers, institutional investors, gov’ts and pension funds
 MarketAxess: provides market data and a trading platform w/ access to multi-dealer competitive
pricing for a wider range of corporate bonds & other types of fixed-income instruments
o Member of IIROC
o Operates in Ontario & Quebec
 CanPX: joint venture of several IIROC member firms and operates as an electronic trading system for
fixed income securities providing investors w/ real-time bid and offer prices and hourly trade data
o Joint venture btwn several Canadian investment dealers & inter-dealer brokers (firms that
facilitate trades btwn investment dealers)
o Combines digital feeds from participating dealers to provide a composite display of real-time bid
and offer quotations, in price yield terms & w/ volume info
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o This service covers Gov’t of Canada and T-Bills

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