Financial Market Analysis
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U N I T 1 –C A P I T A L M A R K E T S
Financial Market Analysis ACCT3602
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Capital Markets
Capital Markets is the sector of the financial market where long-term
financial instruments issued by corporations and governments trade.
“Long-term” refers to a financial instrument with an original maturity greater than one year and perpetual securities (those with no
maturity).
There are two categories of capital market securities:
Equity - shares of ownership interest issued by corporations; e.g. common and preferred shares
Debt - those that represent indebtedness and is issued by
corporations, and state and local governments; e.g. bonds, syndicated loans.
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Capital Markets 3
Equity includes common stock and preferred stock. Common stock represents ownership of the corporation, and because the corporation has a
perpetual life, common stock is a perpetual security; it has no maturity.
Preferred stock also represents ownership interest in a corporation and can either have a redemption date or be perpetual.
A capital market debt obligation is a financial instrument whereby the borrower promises to repay the maturity value one year after issuance. These debt obligations can be broken into two categories: bank loans and debt securities. While at one time, bank loans were not considered capital market instruments, in recent years
a market for the buying and selling of these debt obligations has developed. One form of bank loan that is bought and sold in the market is a syndicated bank loan.
This is a loan in which a group (or syndicate) of banks provides funds to the borrower. The need for a group of banks arises because the amount sought by a borrower may be too large for any one bank to be exposed to the credit risk of that borrower.
Capital Markets 4
Debt securities include bonds, notes, medium-term notes, and asset-backed securities.
The distinction between a bond and a note has to do with the number of years until the obligation matures when the security is originally issued. Historically, a note is a debt security with a maturity at issuance of 10 years or less; a bond is a debt
security with a maturity greater than 10 years.
Notes and bonds are distinguished by whether or not there is an indenture agreement - a legal contract specifying the terms of the borrowing and any restrictions, and identifying a trustee to watch out for the debtholders’ interests. A bond has an indenture agreement, whereas a note does not.
The distinction between a note and a medium-term note has nothing to do with the maturity, but rather the way the security is issued.
We will refer to a bond, a note, or a medium-term note as simply a bond and the investors in any debt obligation as either the debtholder, bondholder, or noteholder.
Capital Markets 5
The funds raised from the issuing of these securities in the capital market comprise the firm’s capital structure.
Capital structure refers to the specific mix of debt and equity used to finance a company's assets and operations.
Important elements of the capital market are:
the organized security exchange
the over-the-counter markets
Organized Securities Exchange (Stock Exchange) 6
These are tangible entities that physically occupy space such as a building or
part thereof, and where financial instruments are traded on their premises.
A Stock exchange has an limited number of members and has an elected governing body (Board of Governors).
Members were said to have “seats” on the exchange which are bought and
sold, and gives the holder the right to trade on the exchange. The NYSE, for example, now require a license to trade and has four different membership
options: Designated Market Makers
Trading Floor Brokers
Supplemental Liquidity Providers
Retail Liquidity Providers
Organized Securities Exchange (Stock Exchange) 7
Stock exchanges are open on normal working days with members meeting in a large room to conduct their trade.
Benefits of stock markets to corporations and investors include:
Providing a continuous market – this provides a series of continuous security prices where the bid-ask spread tends to be narrow; resulting in less price volatility.
Establishing and publishing fair security prices – competitive forces determine security prices and the bidding process flows from the demand and supply underlying each security in the manner of an auction.
Help businesses raise new capital –due to the continuous secondary market where prices are competitively determined, it makes it easier for firms to float new issues successfully.
Types of Stock Market Transactions 8
Primary Market – the market in which firms issue new securities to raise corporate capital.
Secondary Market – the market in which “used” stocks are traded after they have been issued by the corporation.
Going Public – the act of selling stock to the public at large by a closely held corporation or its principal stockholders for the first time.
Initial Public Offering (IPO) – the market for stocks of companies that are in the process of going public.
NB. It is important to note that firms can go public without raising any additional capital.
Over-the-Counter Markets 9
Many publicly held firms do not meet the listing requirements of major stock
exchanges while others want to avoid the reporting requirement and fees to maintain listing.
As an alternative, their securities may trade in the over-the-counter market.
These include all security markets except the organized exchanges.
Money markets, we can say then, is an over-the-counter market.
Most over-the-counter transactions are done through a loose network of
security traders who are known as broker-dealers and brokers. Brokers do not purchase securities for their own account, whereas dealers do.
Broker-dealers buy and sell specific securities at selected prices. They are said to “make a market” in those securities. Their profit is the spread between the price they will pay for a security (bid price) and the price at which they will sell the security (ask price).
Importance of Capital Market
It is only with the help of capital market, long-term funds are raised by the business community.
It provides opportunity for the public to invest their savings in attractive securities which provide a higher return.
A well developed capital market is capable of attracting funds even from foreign country. Thus, foreign capital flows into the country through foreign investments.
It enables the country to achieve economic growth as capital formation is promoted through the capital market.
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Importance of Capital Market 11
Existing companies, because of their performance will be able to expand their industries and also go in for diversification of business due to the capital market.
Capital market is the barometer of the economy by which you are able to study the economic conditions of the country and it enables the government to take suitable action. Barometers are data points that represent trends or sentiment in the market or the general
economy. The S&P 500 Index and the Dow Jones Industrial Average (DJIA) serve as barometers of stock market performance, and are often used as barometers for the U.S. economy as a whole.
Capital market provides opportunities for different institutions such as commercial banks, mutual funds, investment trust; etc., to earn a good return on the investing funds. They employ financial experts who are able to predict the changes in the market and accordingly undertake suitable portfolio investments.
Capital Market Instruments 12
Capital Market Instruments
Types of Capital Market Instruments
Equity Instruments the amount of shares an investor is holding is the extent of his ownership.
Credit market instruments such as debts instrument
Insurance instruments
Foreign Exchange (Forex) instruments
Hybrid instruments: they can be mixture of equity and debt financing
Derivative Instruments like options, commodity related derivatives.
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The Equity Market 14
Equity market is one of the key sectors of financial markets where long- term financial instruments are traded. The purpose of equity instruments issued by corporations is to raise funds for the
firms.
The provider of the funds is granted a residual claim on the company’s income, and becomes one of the owners of the firm.
For market participants equity securities mean holding wealth (investors), as well as a source of new finance (issuers)
The equity market is of great significance for the savings and investment process in a market economy.
The Equity Market 15
The purposes of equity are as follows: A new issue of equity shares is an important source of external corporate financing;
Equity shares perform a financing role from internally generated funds (retained earnings);
Equity shares perform an institutional role as a means of ownership.
Within the savings-investment process the level of retained earnings exceeds that of the new stock issues and constitutes the main source of funds for the firms.
Equity instruments can be traded publicly and privately.
The Equity Market 16
External financing through equity instruments is determined by the following financial factors:
The degree of availability of internal financing within total financing needs of the firm;
The cost of available alternative financing sources;
Current market price of the firm’s equity shares, which determines the return of equity investments.
The Equity Market 17
Internal equity financing of companies is provided through retained earnings. When internally generated financing is scarce due to low levels of profitability and
retained earnings, and also due to low depreciation, but the need for long-term investments is high, companies turn to look for external financing sources.
Firms may raise funds by issuing equity that grants the investor a residual claim on the company’s income.
Low interest rates, however, provide incentives for use of debt instruments; thus lowering demand for new equity issues. High equity issuance costs force companies to look for other sources of financing as
well. However, during the period of stock market growth high market prices of equity shares encourage companies to issue new equity, providing with the possibility to attract larger magnitude of funds from the market players.
Equity Markets: Common Shares 18
Common (ordinary) Shares
represent partial ownership of the company and provide their holders claims to future streams of income (dividends), paid out of company profits.
Common shareholders are residual claimants
i.e. they are entitled to a share only in those profits which remain after bondholders and preference shareholders have been paid.
If the company is liquidated, shareholders have a claim on any remaining assets only after prior claimants have been paid.
Therefore common shareholders face larger risks than other stakeholders of
the company (e.g. bondholders and owners of preferred shares. On the other hand, if the value of the company increases, the shareholders are entitled to
larger potential benefits, which may well exceed the guaranteed interest of bondholders.
Equity Markets: Common Shares 19
The variability of returns to shareholders is affected by the proportion
of debt to equity financing (called the debt to equity ratio) of the company.
The higher the proportion of debt financing, the larger the fixed interest payments and the lower is the number of shares over which the net profit is to be distributed.
When earned profits exceed the level necessary to pay the interest on debt, all the excess profit accrues to the smaller number of shareholders. On the other hand, if profits decrease below interest payments, the whole reduction in payments is borne by the company shareholders.
The higher is the debt to equity ratio, the greater is the variability in dividend payments to shareholders.
Equity Markets: Common Shares 20
The law requires that: the company provides the owners with specified information in the annual report and
accounts.
the firm must hold an annual general meeting at which management conduct is subject to approval by common (ordinary) shareholders,
each of whom has a number of votes matching the size of his shareholding.
The decision to issue equity against debt is based on several factors:
Tax incentives. In many countries interest payments are tax deductible, however dividends are taxed.
Thus the tax shield of debt forms an incentive to finance company by debt.
Equity Markets: Common Shares 21
Cost of Distress - Increasing company leverage (debt), increases the risk of financial liquidation and may cause distress as well as lead to bankruptcy.
Thus companies tend to minimize their credit risk and increase the portion of equity in the capital structure.
Agency Conflicts - When a company is financed by debt, an inherent conflict arises between debt holders and equity holders.
Shareholders have incentives to undertake riskier operating and investment decisions, hoping for higher profits in case of optimistic outcomes. Their incentives are mainly based on the limited liability of losing only their investments.
In case of worst outcome debt holders may suffer more, in spite of their priority claims towards company assets.
Signalling Effect - The companies that issue equity to finance its operations, provide signals to the market that current share selling price is high but the company could be overvalued.
Equity Markets: Preferred Shares 22
Preferred shares is a financial instrument, which represents an equity interest in a firm and which usually does not allow for voting rights of its owners. Typically the investor is only entitled to receive a fixed contractual amount of
dividends (a fixed income instrument) and this make this instrument similar to debt.
However, it is similar to an equity instrument because the payment is only made after payments to the investors in the firm’s debt instruments are satisfied. Therefore it is called a hybrid instrument.
Technically preferred shareholders share ownership of the firm with common shareholders and are compensated when company generates earnings. Therefore, if the company does not earn sufficient net profit, from which to pay the preferred share dividends it may not pay dividends due to the risk of bankrupt.
Equity Markets: Preferred Shares 23
Preferred stock investments may have tax advantage to institutional investors.
Majority of preferred shares have cumulative dividend provision which entitles them to preferred share dividend payments for current and from
previous periods.
Usually, however owners of preferred shares do not participate in the net profit of the company in excess to the stated fixed annual dividend.
Due to the fact that preferred dividends can be omitted, the company risk is less compared to risk in case of company debt. However in this case, company may find it difficult to raise new capital before all
preferred dividends are paid because investors may be unwilling to make new investments before the company is able to compensate its existing equity investors.
Equity Markets: Preferred Shares 24
Preferred stock is an attractive source of financing for highly leveraged companies.
Equity markets offer a variety of innovations in preferred shares issues. These varieties include: cumulative preference shares non-cumulative preference shares irredeemable redeemable preference shares convertible preference shares participating preference shares stepped preference shares
With the exception of the first two, these characteristics are not excluding each other. For example it is possible to issue non-cumulative, redeemable, convertible preferred
shares.
Equity Markets: Preferred Shares 25
Non-cumulative preferred shares do not have an obligation to pay any missed past dividends, with the effect that missed dividends may be lost forever.
A redeemable preferred share has a maturity date on which the original sum invested is repaid, most preference shares have no maturity date (the issuer may pay the dividends
forever and never repay the principal sum).
Some redeemable preference shares provide the issuer with the right to redeem at a predetermined price without the obligation to do so; in effect such preference shares provide the issuer with a call option, which would be paid for by means of a higher dividend for the investors.
Equity Markets: Preferred Shares 26
Convertible preferred shares give the holder the right to convert preference shares into ordinary shares at a predetermined rate; the investor pays nothing to convert, apart from surrendering the convertible
preference shares.
In some cases the right to convert arises only in the event of a failure to pay dividends.
Participating preferred shares allow the issuing company to increase the dividends if profits are particularly high;
the preference share dividend can exceed the fixed level if the dividend on ordinary shares is greater than a specified amount.
Stepped preferred shares pay a dividend that increases in a predetermined way.
Equity Markets: Preferred Shares 27
Specific adjustable rate preferred shares are attractive in increasing interest environment. If the dividend is reset each quarter according to a pre-established formula based on
Treasury bill rate, these issues can be considered as company capital.
Auction rate preferred shares (ARPS) or Single point adjustable rate shares (ARPS) reset dividend periodically using Dutch auction method.
The reset date can be as frequent as 49 days.
Because of characteristics close to money market securities, they have significantly lower yields.
Equity Markets: Preferred Shares 28
Preferred equity redemption cumulative stocks (PERCS) are shares that pay dividends and are automatically converted into common
stock at a conversion price and date.
These can be callable at any date after the issuance for price above the issue price (e.g. by 40%) and
gradually declines as the conversion date approaches.
The cost of preferred equity financing may be higher, compared to debt financing. Preferred dividend is not a tax deductible expense to the company.
Besides, investors are compensated more, as they assume its risk is higher due to the fact, that the company legally is not required to pay preferred dividends. As a rule, preferred equity has no maturity, thus it may force company to permanent preferred dividend payments.
Equity Markets: Private Equity 29
When companies are organized as partnerships and private limited companies their shares are not traded publicly. The form of equity investments, which is made through private
placements, is called private equity.
In such case investors’ liability may not be limited to the amount of contributed capital, and may be extended to total wealth of private owners.
Private equity is used mainly by small and medium-sized companies, young or start-up business in need to raise significant funds for investment. However, their access to bank or public stock market financing is limited.
Equity Markets: Private Equity 30
Typically banks do not finance start-ups
due to significant risks of their operations, and a limited company equity base.
A public offering of shares for such companies may be feasible only if it has
a significant shareholder base to support an active secondary market. Without an active secondary market such shares are illiquid and founders of the companies
find it difficult to “cash out” (selling their original equity investment)
They can be forced to sell shares at a discount to the fundamental company value,
Fixed costs of being a public company are high, and this prohibits company from being public.
Therefore such companies attempt to raise additional capital from wealthy individual or institutional investors.
This type of investments has grown significantly since late 1990s, mainly in US and is slowly gaining ground in European countries.
Equity Markets: Private Equity 31
The most important sources of private equity investments come from venture capital funds, private equity funds and in the form of leveraged buyouts.
Venture Capital Funds receive capital from wealthy individual or institutional investors, willing to maintain
the investment for a long-term period (5-10 years). Venture capital market brings together private businesses that need equity financing and
venture capitalists (business angels) that can provide funding.
Venture capital fund identifies potential of the business, negotiates the terms of investment, return from the investments, exit strategy. The invested funds are not withdrawn before a set deadline.
Common exit strategies are either through the public sale of the equity stake in public stock offering, or through cash out if the company is acquired by another firm.
Equity Markets: Private Equity 32
Private equity funds pool resources of their partners to fund most often new business start-ups. They can rely heavily on debt financing, also. Thus, they perform the role of financial intermediaries.
Private equity funds usually take over the businesses, manage them and control the restructuring, charge annual fee for managing the fund.
Exit strategies are similar to the ones used by venture capital funds.
Leveraged buyouts are company equity purchases by individual or institutional investors, which are financed by a minor portion of share capital and a major portion of debt, provided by banks or other financial intermediaries.
Global Shares 33
Investors may invest into foreign shares by purchasing shares directly, purchasing American Depository Receipts (ADRs), Purchasing Global Depository Receipts (GDRs).
Alternatively, investments can be made by investing into international funds or purchasing exchange traded funds (ETFs).
Direct purchases of foreign shares can be limited due to limited access to the stock exchange, a limited available set of shares, high transaction costs through specialized brokerage companies.
Shares in International Funds (International Mutual Funds (IMFs)) offer possibility of investing into a portfolio of international securities, created and managed by various financial institutions. Thus individual investors may get access and diversify across international stocks.
IMFs can be specializing on specific country or across several countries or regions.
Global Shares 34
Exchange Traded Funds (ETFs) are passive funds, that track specific index.
An investor can invest into a specific index, representing a country’s (e.g. foreign) stock market.
Although ETFs are denominated in US dollars as a rule, the net asset value of an international ETF is determined by translating foreign currency value of the foreign securities into dollars.
While the price of each international ETF is denominated in US dollars, the underlying securities that make up the index are denominated in non-US currencies. Thus the return on ETF will be influenced by the movement of the country’s
currency against the dollar. If the country’s currency appreciates, this will increase the value of the index as measured in dollars. On the other hand, if the foreign currency depreciates, this will reduce the value of the index as measured in dollars. This is also true for IMFs.
Global Shares 35
American Depository Receipts (ADR) is an arrangement under which foreign shares are deposited within a US bank, which in turn issues ADRs in the name of foreign company.
In this way the shares of a foreign company is admitted to the well developed stock market, like US or UK.
When issued in US, they are denominated in US dollars. Dividends are also paid in US dollars, even if the underlying security’s cash
flows are denominated in terms of foreign issuer’s home currency.
ADR may represent a combination of several foreign shares (e.g. lots of 100 shares). Trading takes place in negotiable certificates representing ownership of shares
of the company.
Global Shares 36
Unsponsored ADR - an ADR program created without company’s involvement.
Sponsored ADR – when the ADR program is created with the assistance of the company. Such shares can be registered with the Securities Exchange Commission and comply
with reporting requirements, and thus be traded on an organized stock exchange.
Without such registration and reporting compliance, they can be traded on the over- the counter market.
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Debt Instruments
Debt Instruments are paper or electronic obligations that enable the issuing party to raise funds by promising to repay a lender in accordance with terms of a contract.
Debt instruments allows for quick and easy transferal of debt ownership through trading thereby increases liquidity.
Without debt instruments acting as a means to facilitate trading, debt is an obligation from one party to another.
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Debt Instruments: Bonds
Bonds – long-term contracts under which a borrower agrees to make payments of interest and principal on a specific date to the holders of the bond.
The four main types of bonds are: Treasury Bonds/government bonds – bonds issued by the federal
government. It is reasonable to assume that the government will make good on its promised payments so Treasuries have no default risk. However, these bonds’ prices do decline when interest rates rise so they are not completely riskless.
Corporate Bonds – bonds issued by corporations can be secured or unsecured. Secured means that some form of collateral is pledged to ensure repayment of the debt using for example, a first-priority lien on substantially all of the issuer’s real property, machinery, and equipment, and by a second priority lien on its inventory, accounts receivables, and intangibles.
Some corporate bonds, called convertible bonds, have the additional feature of allowing the holder to convert them into a specified number of shares of stock at any time up to the maturity date.
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Debt Instruments: Bonds 40
Municipal Bonds (Munis) – bonds issued by state and local governments.
Like corporate bonds, munis are exposed to some default risk;
Default risk is often referred to as “credit risk” and the larger this risk, the higher the interest rate investors demand.
But they have one major advantage over all other bonds: the interest income is exempted from federal income tax and in many cases, state and
local taxes as well.
Foreign Bonds – bonds issued by either foreign governments or foreign corporations and subsequently traded in the home country. Each country has a nickname for foreign bonds. For example, in the United States,
“Yankee bonds” are bonds issued by non-U.S. entities and then traded in the U.S. market. In the United Kingdom, foreign bonds are called “bulldog bonds.”
Regulation of the Security Markets
Organized securities markets are regulated by the: Securities and Exchange Commission (SEC) Self-regulation of the exchanges
Three laws govern the sale and trading of securities The Securities Act of 1933 The Securities Exchange Act of 1934 The Securities Acts Amendments of 1975
Primary purpose: To protect unwary investors from fraud and manipulation To make markets more competitive and transparent
The Sarbanes-Oxley Act of 2002 also provides additional protection for investors
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