1. ©2009 McGraw-Hill Ryerson Limited 1 of 30 14 Capital Markets Prepared by: Michel Paquet SAIT Polytechnic ©2009 McGraw-Hill Ryerson Limited

2. 2 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

3. ©2009 McGraw-Hill Ryerson Limited 3 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)

4. ©2009 McGraw-Hill Ryerson Limited 4 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)

5. ©2009 McGraw-Hill Ryerson Limited 5 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

6. ©2009 McGraw-Hill Ryerson Limited 6 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).

7. ©2009 McGraw-Hill Ryerson Limited 7 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

8. ©2009 McGraw-Hill Ryerson Limited 8 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.

9. ©2009 McGraw-Hill Ryerson Limited 9 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.

10. ©2009 McGraw-Hill Ryerson Limited 10 of 30 Figure 14-5 Canadian bonds outstanding: foreign currencies ___1997 ___2007 LO1 Source: Bank of Canada, Banking and Financial Statistics, March 2008, K8 series.

11. ©2009 McGraw-Hill Ryerson Limited 11 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

12. ©2009 McGraw-Hill Ryerson Limited 12 of 30 Corporate Securities Corporate 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

13. ©2009 McGraw-Hill Ryerson Limited 13 of 30 Figure 14-6 Net new corporate financings by type of security LO2 Source: Bank of Canada, Banking and Financial Statistics, F9 series.

14. ©2009 McGraw-Hill Ryerson Limited 14 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

15. ©2009 McGraw-Hill Ryerson Limited 15 of 30 Figure 14-7 Debt-to-equity ratios for nonfinancial private corporations LO2 Source: Statistics Canada, “Financial Statistics for Entreprises”, Catalogue No. 61-008, 4 th quarter, 2007.

16. ©2009 McGraw-Hill Ryerson Limited 16 of 30 Figure 14-8 Funding Sources of Non-financial Private Corporations LO2 Source: Statistics Canada, 61-008-XIE, 2008, 1 st quarter, Table 3-2.

17. ©2009 McGraw-Hill Ryerson Limited 17 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

18. ©2009 McGraw-Hill Ryerson Limited 18 of 30 FIGURE 14-9 Flow of funds through the economy LO3

19. ©2009 McGraw-Hill Ryerson Limited 19 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.

20. ©2009 McGraw-Hill Ryerson Limited 20 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

21. ©2009 McGraw-Hill Ryerson Limited 21 of 30 Figure 14-11 Secondary Market: Annual Value of Trading LO4 Source: Investment Dealers Association Reports, 2007, www.iiac.ca.

22. ©2009 McGraw-Hill Ryerson Limited 22 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

23. ©2009 McGraw-Hill Ryerson Limited 23 of 30 Figure 14-2 Market capitalization (value) of top 12 equity markets LO4 Source: World Federation of Exchanges, 2007.

24. ©2009 McGraw-Hill Ryerson Limited 24 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

25. ©2009 McGraw-Hill Ryerson Limited 25 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

26. ©2009 McGraw-Hill Ryerson Limited 26 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 destabilization Based on these criteria: The NYSE is the world’s most efficient capital market. The TSX is reasonably efficient. LO5

27. ©2009 McGraw-Hill Ryerson Limited 27 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

28. ©2009 McGraw-Hill Ryerson Limited 28 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

29. ©2009 McGraw-Hill Ryerson Limited 29 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.

30. ©2009 McGraw-Hill Ryerson Limited 30 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.