Chapter 1: The Capital Market

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Esther Mosley
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1 Chapter 1: The Capital Market The fundamental function served by the capital market is the transfer of wealth from those who have extra wealth to those who need capital. Essentially, capital markets help turn savings into investments. 3 components of the wealth transfer process: Financial instruments Financial markets FInancial intermediaries Capital: Consists of the savings of individuals, corporations, governments, and other entities. How can you utilize capital? 1. Direct Investment: By investing in real assets that generate wealth directly. Real assets include PP&E and human capital. 2. Indirect Investment: Investment in financial assets such as stocks and bonds. Capital is mobile, scarce and sensitive. Capital is very selective and only flows through attractive economic environments. Capital reacts to variables such as: Political environment Economic trends Fiscal and monetary policy Investment and risk-return opportunities There are 2 types of investors: Retail : Invest for personal purposes Institutional : Invest in behalf of an entity/organization Users of capital: Individual: For consumption process with funds being obtained through personal loans, mortgage loans, or charge accounts. Businesses: To finance day-to-day operations, to upgrade and maintain plant and equipment and finance growth. Federal government finances its debt using: Treasury bills Marketable short and long term bonds Canada savings bonds and premium bonds Financial Instruments Legal, formal documents that set out the rights and obligations of parties involved Enable the transfer of capital from suppliers to users. Debt: Legal obligation to repay borrowed funds at a specified maturity date. Equity: Represents part-ownership of a company. Common shares: provide voting rights and may receive dividends Preferred shares: Receive a fixed dividend amount that be paid before others

2 Financial Markets: An efficient market allows for fast and low cost transactions. Primary Markets: Sale of securities by the issuer for the first time. Ex. IPO or seasoned offerings. Secondary Markets: Sale of previously issued securities. Make securities transferable. Financial Intermediaries: Improve the efficiency of markets by facilitating the trading of the financial instruments. Example of intermediaries: Bank of Canada, chartered banks, credit unions etc. Auction Market: These are stock exchanges. All transactions converge to one location. There are 3 stock exchanges in Canada:TSX, TSX venture exchange, CNSX TSX is the 8th largest in the world Dealers Markets: Network of dealers that trade directly with each other Majority of bonds and debentures are sold through dealers markets

3 Chapter 2: The Canadian Securities Industry Intermediaries- Facilitate transfer of capital from suppliers to users. Securities regulation is provincial responsibility regulated through the securities commissions and enforce regulatory laws SRO s establish these rules and enforce industry regulations SRO s players include: 1. Canadian Depository for Securities - Clears/settles trades 2. Canadian Investor Protection Fund (CIPF) - Insures brokerage account contents 3. Canadian Securities Institute (CSI) - Offers courses required for licensing by regulators Brokers - Can be full-service or discount - High fees include offering high touch service and advice - Discount brokers offer limited services, e.g. bond trade execution but no advice Leverage - Financial services industry is highly leveraged - Short-term borrowing finances long-term investment - To finance 20-year mortgage, money is borrowed every 90 days Technological Changes - Evolution of technology, particularly in telecommunications has changed the financial industry, which increased interconnectedness of markets, with interlisted and multiple listing for securities Globalization - Markets no longer restricted to local suppliers and issuers of capital, - Eurobond and Eurocurrency markets, with euro denoting a security trading outside of its home jurisdiction Regulatory Changes - Post-crisis financial regulation is increasing compliance responsibility for financial firms - Technology increasingly facilitates easier capital flows, regulation creates additional barriers Primary Markets/New Issues - Also known as Debt or Equity Underwriting/Financing - Sell newly issued securities to investors - As principals, investment dealer agree to price with issuer and buys shares/bonds - As agents, investment dealers market newly issued securities on best efforts basis

4 Secondary Markets - Investment dealers buy and sell financial securities on financial markets - Enhance the effectiveness of of the primary market, facilitate the transfer of existing securities - As principals, IDs invest capital and earn spread between purchase and sale prices - As agents, IDs invest client s capital and earn commission on executed trades Trade Settlement - When a trade is executed, it is settled and cash from buyer s brokerage account is transferred to brokerage account of seller - CDS clears or settles trade as central repository keeping track of who owns each share of company - When a trade is settled, cash from the buyer s brokerage account transfers to seller s brokerage account Chartered Banks - Focus on gathering funds through saving deposits and certificate of deposit and transferring them in form of mortgages and other forms of loans - Governed by Bank Act, revised periodically - Generally funded by savings deposits, retained earnings, periodic rights offering to existing shareholders, debentures and preferred share issues etc. - Important that they maintain an adequate reserve of liquid assets 3 types of banks 1. Schedule I Banks - Domestic Banks - Dominate Canada s market, which includes the Big Six banks (BMO, BNS, CIBC, TD, RY and NA) 2. Schedule II Banks - Subsidiaries of foreign banks or other financial institutions - May accept deposits, which can be eligible to be insured by the Canada Deposit and Insurance Corporation (CDIC) 3. Schedule III Banks - Branches of foreign banks permitted to accept deposits and provide loans Other intermediaries 1. Trust and Mortgage companies - Many of these services overlap with those offered by the banks, including accepting savings, make personal loans etc. - Only type of Canadian corporations in Canada acting as trustees in charge of corporate or individual financial assets 2. Credit Unions and Caisses Populaires - Co-operative membered owned businesses that provide financial services to their members - Not focused on profit, profit returned to owners

5 3. Life Insurance Companies - Act as trustees for the funds received by policyholders - Tend to be active in long-term and mortgage markets since their contracts are long-term - Insurers can own trusts and offer banking and investment products - Match liabilities with assets 4. Property and Casualty Insurance - Provide property, automobile, health and accident insurance - Much smaller than life insurance companies - Liquidity is primary investment objective - Liabilities occur more frequently in customers life 5. Investment Funds - May be set up as a corporation or as a trust, and later sell shares to public and invest in portfolios or securities - Closed-end funds issue shares only at initial start-up - They are listed on an exchange - The fixed no. of units are outstanding - Investors trade units in similar manner as shares - Open-end funds issue and redeem shares on continuous basis - No fixed no. of outstanding units - Investors can only purchase and redeem units from investment fund 6. Savings Banks - Take deposits, but do not offer lending services - Deposits are 100% guaranteed by the province in which they operate 7. Pension Plans - Contributions are made to a trustee who registers the plan and manages it in accordance with the terms of the plan s trust deed (trustee being independent trust or insurance company) - Main concerns of the plans for these plans focus on safety and principal income - Government-operated pension plans (CPP) and (QPP) originated 1965, have become significant players in global financial markets - Government sponsored E.g. CPPIB, OTPP for teachers and OMERs for municipal employees - Company sponsored E.g. Rogers, BMO 8. Sales Finance and Consumer Loans - Make direct cash loans to consumers and purchase installment sales contracts from retailers and dealers at discount

6 Chapter 3: The Canadian Regulatory Environment REGULATORY ORGANIZATIONS The Office of the Superintendent of Financial Institutions (OSFI) Regulates and supervises banks, insurance, trust and loan companies, pension plans Does not supervise the Canadian securities industry Canadian Deposit Insurance Corporation (CDIC) Insures deposits up to $100,000 per depositor (for each account) in each financial institution Not for mutual funds, stocks, bonds The Provincial Regulators:Regulators of the Canadian securities industry 13 commissions: 1 for each province (BCSC, OSC, etc.) Work closely with CIPF and SROs to maintain high standards Harper wanted to combine all the commissions into one security commission, but several provincial commissions resisted Therefore, we have CSA (Canadian Securities Administrators ): One national security commission coordinating provincial activities Credit Union Deposit Insurance Corporation (CUDIC) : Unlimited coverage for losses on deposits held with credit unions in BC The Self-Regulatory Organizations : Organizations owned by their members that regulate and police themselves Investment Industry Regulatory Organization of Canada (IIROC): Largest SRO in Canada to ensure the integrity of the marketplace and protection of investors Formulates policies and standards for primary debt & equity markets Monitor member firms for capital adequacy and business conduct If illegal trading activity is done, it's likely to hear from IIROC Other SROs: TSX, Mutual Funds Dealers Associations (MFDA) (Only for mutual fund dealers - Coverage up to $100,000 per eligible account) Canadian Investor Protection Fund (CIPF): "Backstop" for securities: coverage of up to $1 million related to losses from security & cash balances combined if a member firm goes bankrupt Canadian Mortgage and Housing Corp (CMHC) : "Backstop" for mortgages ARBITRATION SROs (i.e. IIROC) offer investors compensation through arbitration rather than in courts Resolves dispute through investment dealer Avoids high cost, time consumption, and having the investors at an unfair advantage Ombudsman for Banking Services and Investments (OBSI) investigates complaints against financial service providers => additional protection for investors

7 REGULATION AND INVESTOR REGULATION Provincial securities regulators design legislations and regulations to ensure full, true, and plain disclosure of all material facts 3 basic methods to protect investors: Registration of securities dealers and advisors Sellers of securities (usually investment dealers) and investment advisors (IAs) must be registered Disclosure of material facts Enforcement of laws and policies IAs need to: Complete a 90 day training course Be subject to a 6-month period of supervision Complete the CSI's Wealth Management Essentials (WME) course within 30 months of becoming a licensed IA Investment representatives (IRs) have similar requirements, except that the training course is 30 days and there's no WME course requirement Member firms and IAs are bound by the following: KYC (Know Your Client Rule): Due diligence to look at every financial aspect of the client's portfolio, situation & risk tolerance Only accept orders that comply with good business practice Ensure that recommendations are 'suitable' for clients First step - complete New Account Application Form Fiduciary Obligation: Client comes first before self-interest Not reveal confidential information Avoid conflicts of interest Ensure all representations to clients are made honestly and in good faith Follow client instructions Any breach of fiduciary duty could lead to discipline by SRO's 4 areas of member (IA) regulations Financial compliance Sales compliance Registration Enforcement 3 areas of market regulation Market surveillance (insider trading?) Investigation enforcement Regulatory/market policy

8 THE ETHICS OF TRADING Ethical trading is critical to the proper functioning of capital markets. Unethical behaviors (i.e. deceiving the public) can be punished by fines, suspensions or criminal charges. IIROC safeguards investor protection through a common set of trading rules (the Universal Market Integrity Rules) across all markets in Canada. Unethical practices include: Misleading any board of directors Assuring no risk Bucketing: confirming a transaction that never happened Violating statutory rights of security purchasers Right of Withdrawal within 2 business days or if a distribution occurs without the required prospectus Right of Rescission if the prospectus or other related documents contain misrepresentation Right of Action for Damages against any party who signs a prospectus without due diligence Companies are required to disclose annual & quarterly financial statements, insider trading reports, information circulars, annual information forms, press releases and material change reports Can be found at (in Canada) or (in US) V. TAKEOVERS AND INSIDER TRADING Takeover bid: acquiring greater than 20% of voting securities of another company Obligations for the acquiring firm: Takeover bid must be sent to all shareholders Any securities taken up must be paid for within 3 days When the bid is for less than all securities, the acquiring firm must accept the shares at a pro rata basis (everyone gets treated the same) Obligations for the firm being acquired: Director's circular must be sent to all shareholders Takeover bid exemptions - no need to abide with takeover bid legislation if: The bid is made through exchange facilities in accordance with appropriate regulations The acquisition of shares aggregates to less than 5% of securities within 12 months Shares purchased from 5 or fewer holders at a price less than 115% of the current price Firm being acquired is private Any person/company acquiring more than 10% of voting shares must provide early warning disclosure via press release Who s an insider? Officer Board member Investor that owns more than 10% of the shares Insiders are required to file reports of their trading activity in the company for which they are an insider

Time Value of Money - Describes the relationship between the value of the current and the future dollar - Present Value (PV) is not a cash amount, it is the value of a certain amount of cash received

9 Time Value of Money - Describes the relationship between the value of the current and the future dollar - Present Value (PV) is not a cash amount, it is the value of a certain amount of cash received from a certain period from now - Present Value = PV, Future Value = FV (Also known as Cash Flow) Formula of getting to the Present Value PV = FV/(1+r)^n Formula of getting to the Future Value FV = PV * (1+r)^n n = The amount of periods (E.g. 6 years annually= 6 periods, 6 years semi-annually = 12 periods) r = The rate (Given usually as a %) - Discount rate is for finding Present Value - Compounding/Interest rates usually to find the Future Value E.g. 1 Discount rate of 6%, $5000 cash flow for year 1 and then $8000 in years 2-4, find the total sum of the Present Values. 1. Set up the table

10 2. Use the equation to find the present values - The dollar sign means to lock the value for copying and pasting($h2) 3. Copy and paste to find the rest of the present values 4. Add up all the present values to get the present values

11 What if need to find the missing value of cash flow? E.g. Find the present value for year 3, with a value of 8% rate, given that the sum of the Future value is $15000, and $2000 present value for the remaining years 1. Set up chart, having the sum of future values on the right 2. Find the future values of years 1,2,4,5,6 using copy and paste - Lock the rate value using $, to avoid inaccuracy 3. Find the future value of year 3 by subtracting by the current total ( ) 4. Find the Present Value of Year 3 using Present Value Formula

Bonus: Rather than using the algebra, you can use goal seek from Excel 1.

Set the cell in which that wants to be changed, which is the (13326.

change to a value of 15000 by changing the present value, which at that moment is 0 This should set

12 Bonus: Rather than using the algebra, you can use goal seek from Excel 1. On the top bar, go to Data, go to What-if analysis and click Goal Seek 2. Set the cell in which that wants to be changed, which is the ( ) to by changing the cell in which it has the empty/missing present value Set cell H10 to change to a value of by changing the present value, which at that moment is 0 This should set to the same answer. Special case for time value of Money - Possibility of negative cash flows, meaning that one has to pay - Not always positive, can result in a negative present and future value

13 Chapter 6: Fixed Income Securities: Features and Types OVERVIEW AND TERMINOLOGY Fixed Income Basics Bonds, debentures, mortgages, swaps, preferred shares Often fixed/known stream of cash flows -> Principal Amount + Regular Coupon Payments Bonds Secured by specific assets (real estate, hard assets, etc. Ex. First Canadian Place: details of bond issue are written into the bond trust indenture (legal contract) Bond terms may include dates of amount coupon payments & principal repayment & covenants (restrictions) Debentures Unsecured (rated) Usually for short term financing Trading at par if index = 100 Trading at premium if index > 100 Trading at discount if index < 100 Earnings (difference b/w price and face value at maturity) are considered interest income, NOT capital gains, for tax purposes Short-term bonds 1-5 years Medium-term bonds 5-10 years Long-term bonds >10 years Liquid bonds Large trading volumes Marketable bonds Have an existing market Negotiable bonds In deliverable form The bond market is much larger than the equity market (issued by governments) II. BOND FEATURES Maturity could be modified by terms of the bond: Callable bonds (Corporation repurchases) Predetermined call prices Call protection: period prior to the first call Redemption price often based on a graduate scale Many corporate bond issues have a Canada yield call feature -> Permission to call the issue at the greater of par or a price based on yield on a government bond with same maturity + yield spread Retractable bonds (Bondholder sells bond back) At predetermined prices Reason: Need $$$, Risk goes up, Interest rate goes up 30 days notice - retraction period)

14 Planned Repurchases Sinking Fund (mandatory) Issuers avoid having to come up with the entire face value at maturity date through buying back the bonds over time Purchase Fund (option to corporation) Require repurchase of a certain amount of debt only if the debt can be repurchased at or below a given price (generally advantageous for investors) Convertible Bonds: Could be converted to shares ("selling off the common" when market price > conversion price) Protective Provision: "covenants" to restrict the borrower's behaviour (i.e. total debt allowed, debt-income ratio); violating a covenant may lead to "technical default" III. GOVERNMENT SECURITIES Government Bonds/Treasury Bonds (risk-free) T-Bills: Short-term (last less than 1 year); sold at discount, no coupon payments Treasury Bonds: medium/long-term bonds with coupon payments, transferable & non-callable Real Return Bonds: real yield - face value adjusted each year based on inflation Canada Savings Bonds (CSBs): sold every year between October & April, non-transferable, sold in registered form to protect investors from loss/theft Canada Premium Bonds (CPBs): similar to CSBs, but can only be redeemed once a year with a higher rate than CSBs when issued Direct bonds are issued directly by the government, while guaranteed bonds are issued in the name of a Crown corporation, but guaranteed by the provincial government Municipal governments usually issue installment debentures/serial bonds Corporate Bonds: Mortgage bonds are secured by real assets First mortgage bonds have first claim to these assets (repaid first) Collateral trust bonds are secured by other financial assets Equipment trust certificates are secured by equipment Subordinated debentures are junior to some other security Preferred debentures are subordinated debentures with very long maturities Floating-rate securities have rates that automatically adjust to new rates (i.e. Corporate notes - unsecured promises; Secured notes/collateral trust notes - secured by note pledging assets) Strip Bonds are created by "Stripping" a bond of its coupon payments ("interest only" component) to create a series of discount bonds Corporate Debentures are generally unsecured (credit ratings based on company's cash flow and "unencumbered" assets) Corporations can borrow for short periods of time by issuing Commercial Paper (similar to T-Bills) If guaranteed by a bank, it becomes a Banker's Acceptance Term Deposits offer guaranteed rates for short-term deposits (<1 year) Guaranteed Investment Certificates (GICs) offer fixed rates for specific periods of time (may be more than 1 year)

15 Unlike non-redeemable GICs, redeemable GICs can be cashed before maturity, and typically provide lower returns than non-redeemable GICs Some special features include: Escalating-Rate GICs : rising interest rates over time Laddered GICs: broken into equal terms to reduce interest rate risk Installment GICs: initial contribution + regular minimum deposits Index-Linked GICs: returns are linked to equity returns based on an index Interest-Rate-Linked GICs: returns are linked to changes in other interest rates (i.e. prime rate) Rating services perform detailed analysis of bond issuers to measure their ability to repay (Ranges from AAA - highest credit quality to D - default)

16 Ch 7: Fixed Income Securities: Pricing and Trading Bond Pricing Principles Coupons: Interest payment paid by regular coupon bonds The face value is paid at the maturity date. Bonds are valued by determining the present value of the cash stream provided by the bonds(consisting of the interest payments and the principal payment at maturity) Ex 1: Determining bond price: Determine the bond price of a $1,000 face value bond with four years to maturity and that pays interest semi-annually at a coupon rate of 12%. Assume the appropriate discount rate is 10% Here, pmt = coupon rate / 2 x face value =.12/2 x 1000 = $60 Nper = 8(4 years with semi annual payment) Rate = discount rate / 2 = 0.05 FV = Using the PV formula (=PV) in excel, we find the bond price = $1064,63 As rates increase, bond prices decrease, and vice versa. Ex 2: Determining Yield to Maturity: Determine the approximate yield to maturity for a six-year $1,000 face value bond that pays semi-annual coupons at an annual coupon rate of 12%, if it is presently selling for $980. Yield to Maturity: The discount rate for bonds Here, Coupon rate = 12% Pv = 980 FV = Nper = 12 Pmt = coupon rate / 2 x face value = -60 Use financial forumate (=RATE) to determine the SEMI ANNUAL yield to maturity = 6.24% Then, the annual is 12.48%

Chapter 6. October Chapter Outline. 6.3 Capital Market Securities: Long-Term Debt. 6.5 Difference between Debt and Equity Capital

Chapter 6. October Chapter Outline. 6.3 Capital Market Securities: Long-Term Debt. 6.5 Difference between Debt and Equity Capital Chapter 6 Financial Markets, Institutions and Securities October 2003 Chapter Outline 6.1 Financial Markets and Institutions 6.2 The Money Market 6.3 Capital Market Securities: Long-Term Debt 6.4 Capital