Chapter 1: The Capital Market Flashcards
what is the vital function of financial markets
to help facilitate transfer of capital (money) from those who have extra wealth to those who require capital
how do financial markets drive economic growth
by turning savings into investments
why would those who have extra wealth/capital transfer it to those who require it
because they expect to make a return on it
what are the 3 components of the wealth transfer process
- financial instruments
- financial markets
- financial intermediaries
what are financial instruments
- what is actually being bought/sold
- mechanisms wealth/capital is transferred
what are financial markets
a marketplace where the buying/selling of financial instruments are facilitated
what exactly is capital
it is savings of:
- individuals (you and me)
- corporations
- governments
what are financial intermediaries
People and companies that improve market efficiency by facilitating the flow of capital from buyers to sellers
what are some points to note about capital
- it is scarce and valuable
- only economically significant when properly used
what are the types of investment
- direct investment
- indirect investment
what is direct investment
assets that generate wealth directly (ex. land, real estate, equipment) - something physically tangible
what is indirect investment
financial assets such as stocks, bonds, and treasury bills
what are stocks/shares/equity
ownership of a company/asset
what are bonds/fixed income
debt of a company or government (liability for those who issue it)
what are treasury bills
debt of a government
how does indirect investments work
- companies and governments issue (sell) financial assets and receive funds
- they then take the funds and invest them directly
- investors are the ones who are buying the financial assets to generate a return (ex. expecting to make more than originally invested)
what are the characteristics of capital
- mobile
- scarce
- sensitive
what is the affect of efficient allocation of capital
efficient allocation promotes economic growth
what is the affect of inefficient allocation of capital
inefficient allocation constrains economic growth
Where does capital tend to flow
capital is selective & tends to flow towards attractive economic environments
when will those who have capital transfer/invest their wealth
- only if it is easy, cheap, and generates a good return
- if it isn’t investors won’t provide capital
- and people who need it (ex. the government) won’t receive it
what does capital flows depend on
- the political environment (whether it is a stable government or a banana republic)
- economic trends
- fiscal policy (government spending & taxation)
- monetary policy (government by central banks)
- investment opportunities
- labour force (highly educated/laws governing rights of labour force)
who finds the availability of capital important and what do they do
- availability of capital is important to any nation
- all countries try to promote economic output, improve productivity, encourage innovations, & improve competitive position
what are the sources of capital (who are those that provide capital)
- retail investors
- institutional investors
- foreign investors
who are retail investors
- individuals like you and me
- those that invest for their own personal account
- represent a significant source of investment capital in Canada
who are institutional investors
- those that invest on behalf of another entity
- are set up to serve those people
- pension funds (Canada Pension Plan Investment Board; Ontario Teachers’)
- Mutual funds (Trimark, AGF)
what is a pension fund
a financial vehicle established by employers, employees, or both, to contribute and invest funds over time, with the goal of providing retirement benefits to employees
what is a mutual fund
an investment vehicle that pools money from multiple investors to collectively invest in a diversified portfolio of stocks, bonds, or other securities, managed by a professional fund manager
who are foreign investors
- those that are not Canadian but invest in the Canadian market
- 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
who are users of capital
- companies/businesses
- governments
who is not a user of capital
- individuals
- they only used money for consumption purposes
- that is why they invest their capital
- if they need capital, they will go to the bank for a loan
how do companies raise capital
- internally through existing operations and reinvest it into the company to grow
- by issuing stocks/bonds and/or bank loans
what do companies invest their capital in
new products/markets/machinery that they hope will grow the company more capital and general additional returns
how do governments raise capital
- by issuing debt
- they usually face deficits & need to borrow money to finance their expenses so they issue debt
what are the types of debt governments issue
- treasury bills (t-bills)
- longer term debt
- Canadian Savings Bonds (only the federal & provincial governments issue these ones)
what are treasury bills
- debt due in less than one year
- can be bought by foreign investors
what is longer term debt
- debt due in longer than one year
- can be bought by foreign investors
who can buy Canada savings bonds
only Canadian residents
what do governments spend their capital on
- all forms of government spending that aren’t covered by tax and other revenues
- health care, education, infrastructure spending (roads, sewers, water)
why don’t governments issue equity
- equity = ownership
- people should not own the government, so they can’t give out ownership
what are the different types of financial instruments
- debt
- equity
- investment funds
- derivatives
- private equity
what is debt
- funds are borrowed
- at a specific date (maturity date) funds (principal) are paid back
- between the borrowing date & the maturity date, interest payments are paid
- ex. bank loans, bonds, mortgages
what is equity
- typically represented by stock/shares in a company
- As an equity investor, you own part of the company
- money is given and not paid back
- At annual meetings, you have voting privileges
- You may also receive regular dividend payments (but not necessarily)
- preferred shareholders comes before common shareholders when receiving dividends
what are derivatives
- These products derive their value from another asset (stock, bond, commodity, currency)
- Often used for hedging (ie. Mitigate the effect of a strong C$ or higher oil prices)
what are investment funds
- a pooled financial vehicle that gets capital from multiple investors to collectively invest in a diversified portfolio of securities, aiming to achieve specific investment objectives
- usually done through a mutual fund
what is 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
Why might authorities restrict who can invest funds in derivatives and private equity
because both are very risky
where are financial instruments sold
in the financial markets
when do financial instruments work well
only work well if they are accompanied by efficient markets
what does it mean to be “efficient”
- Fast (can I buy / sell a stock with minimal delay)
- Cheap (low fees to buy / sell)
- Liquid (are there many buyers and sellers)
what financial instruments would be considered inefficient and efficient
- Buying or selling a house may not be efficient
- Buying or selling a stock or a bond should be
what are the different types of financial markets
- primary markets
- secondary markets
Do all of financial intermediary companies operate for the purposes of “market efficiency”?
- no
- may work in their self-interest
what is the difference between the primary and secondary market
who gets the money
what are primary markets
- Securities (ie. shares or bonds) are sold by issuers for the first time
- The issuer receives the money from this sale
- It may be an IPO or a subsequent equity offering
- money goes between investors and the company
what are 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)
- money goes between investors
what is an IPO
- Initial public offering
- The first time a company sells its shares to the public and its shares are listed on a stock exchange (i.e. Toronto Stock Exchange)
- prior to the IPO, the company was private
- investors couldn’t buy shares on stock exchanges, only private investors could buy their shares
what are examples of financial intermediaries
- Banks; Bank of Canada
- Insurance companies
- Pension funds
- Investment dealers
- Private equity / venture capital firms
what did the financial crises reveal in terms of self-interest and market efficiency
The financial crises exposed areas where firms were working in their self-interest and also working against market efficiency / a productive economy
what is an auction market
- Where all transactions converge in one location
- Like any other market where items are bought and sold
- A stock exchange is an auction market where stocks are bought and sold
what do governments do to help create market efficiency
they set up regulations are meant to be structured such that market efficiency is a by-product of this self-interest
what are some facts about auction markets
- at the start of 1999, there were 5 stock exchanges in Canada
- then there was a complete overhaul in 1999 & 2000, leaving only 3 stock exchanges
- In Canada: the main exchange is the TSX
- TSX is the official exchange for trading Canadian senior stocks (big companies with sold history of profits)
- 80 exchanges in over 60 countries
- TSX is the 8th largest in the world; New York Stock Exchange is the largest
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
what are some trends in stock exchanges
- 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”
