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Chapter 1: The Capital Market

Newspaper: global mail, financial times, Bloomberg, Reuters

Internet: Financial blogs like The Big Picture, Zero Hedge
Investing Sites: Yahoo Finance, The
Chapters Key Learnings:
What is Investment Capital, Its role in economy
Market Players as individual, corporates(business), government, foreign
agencies act as Supplier/User of capital
What are the Financial Instruments used in capital transactions
What are Financial Markets, types of financial markets, How Dealers &
Auction markets work, Role of financial market in Canadian Financial
Service Industry

Chapter Notes:
In some way, we are all affected by the securities industry. The vital economic
function the industry plays is based on a simple process: the transfer of
money from those who have it (savers) to those who need it (users)
This capital transfer process is made possible through the use of a variety of
financial instruments: money market, stocks, bonds, mutual funds and others.
Financial intermediaries, such as banks, trust companies and investment
dealers, have evolved to make the transfer process efficient
Investment Capital: Capital represents the invested savings of individuals,
corporations, governments and many other organizations and associations.
Capital savings are useless by themselves. Their productive utilization may
take the form of either direct (jab apna paisa khud use karo) or indirect
investment.(jab apka paisa koi aur use kare)
Capital savings can be used directly by, for example, a couple investing their
savings in a home;
A government investing in a new highway or hospital; or a domestic or
foreign company paying start-up costs for a plant to produce a new product.
Capital savings can also be harnessed indirectly through the purchase of
such representational items as stocks or bonds or through the deposit of

savings in a financial institution. The indirect investment process is the

principal focus of this course.

Indirect investment occurs when the saver buys the securities issued by
governments and corporations, who in turn use the funds for direct
productive investment equipment, supplies, etc. Such investment is
normally made with the assistance of the retail or institutional sales
department of the investment advisors firm
In My Words- Capital is the savings of individuals, corporates, govt. or
foreign agencies that is invested through some financial instruments like
securities, bonds or MF
Capital has three important characteristics. It is mobile, sensitive to its
environment and scarce. (SMS) sensitive, mobile, scarce


The only source of capital is savings
When revenues of non-financial corporations, individuals, governments and
non -residents exceed their expenditures, they have savings to invest.
Sources of Capital
Retail, institutional, and foreign investors are a significant source of
investment capital.
Retail investors: Retail investors are individual investors who buy and sell
securities for their own personal accounts, and not for another company or
Institutional investors: Institutional investors are organizations, such as a
pension fund or mutual fund company that trade large volumes of securities
and typically have a steady flow of money to invest. Retail investors
generally buy in smaller quantities than larger, institutional investors.
Foreign investors: Foreign investors also are a significant source of
investment capital. Historically, Canada has depended upon large inflows of
foreign investment for continued growth. Foreign direct investment in
Canada has tended to concentrate in particular industries: manufacturing,
petroleum and natural gas, and mining and smelting. Some industries also
have restrictions with respect to foreign investment

Users of Capital
Based on the simplest categorization, the users of capital are individuals,
businesses and governments. These can be both Canadian and foreign users.
Individuals: Individuals may require capital to finance housing, consumer
durables (e.g., automobiles, appliances) or other types of consumption. They
usually obtain it through incurring indebtedness in the form of personal
loans, mortgage loans or charge accounts.
BUSINESSES: Canadian businesses require massive sums of capital to
finance day-to-day operations, to renew and maintain plant and equipment as
well as to expand and diversify activities. A substantial part of these
requirements is generated internally (e.g., profits retained in the business),
while some is borrowed from financial intermediaries (principally the
chartered banks). The remainder is raised in securities markets through the
issuance of short-term money market paper, medium- and long-term debt,
and preferred and common shares.
GOVERNMENTS: Governments in Canada are major issuers of securities
in public markets, either directly or through guaranteeing the debt of their
Crown corporations.
Federal Government: When revenues fail to meet expenditures and/or when
large capital projects are planned, the federal government must borrow. The
government makes use of four main instruments: treasury bills (T-bills),
marketable bonds, Canada Savings Bonds (CSBs) and Canada Premium
Bonds (CPBs).
Provincial Governments: Like the federal government, the provinces issue
debt directly themselves. When revenues fail to meet expenditures and/or
when large capital projects are planned, provinces must borrow. They may
issue bonds to the federal government or borrow funds from Canada
Pension Plan (CPP) assets (or the Qubec Pension Plan in the case of
Alternatively, a province may issue debt domestically through a syndicate of
investment dealers who sell the issue to financial institutions or to retail
investors. In addition to conventional debt issues, some provinces issue
their own short-term treasury bills and, in some cases, their own savings
bonds similar to CSBs issued by the federal government.
Municipal Governments: Municipalities are responsible for the provision of
streets, sewers, waterworks, police and fire protection, welfare,
transportation, distribution of electricity and other services for individual
communities. Since many of the assets used to provide these services are
expected to last for twenty or more years, municipalities attempt to spread
their cost over a period of years through the issuance of instalment
debentures(or serial debentures)

There are three major components of securities industry: (IMI) Financial

Instruments, Financial Markets, Financial intermediaries


As a way of distributing capital in a large, sophisticated economy, securities
have many advantages. Securities are formal, legal documents, which set out
the rights and obligations of the buyers and sellers. They tend to have
standard features, which facilitates their trading.
Furthermore, there are many types of securities, enabling both investors
(buyers) and users (sellers) of capital to meet their particular needs.
Debt Instruments: Debt instruments formalize a relationship in which the
issuer promises to repay the loan at maturity and in the interim makes interest
payments to the investor. The term of the loan ranges from very short to very
long, depending on the type of instrument. Bonds, debentures, mortgages,
treasury bills and commercial paper are all examples of debt
instruments (also referred to as fixed - income securities).
Equity Instruments: Equities are usually referred to as stocks or shares
because the investor actually buys a share of the company, thus gaining an
ownership stake in the company. As an owner, the investor participates in the
corporations fortunes. If the company does well, the value of the company
may increase, giving the investor a capital gain when the shares are sold. In
addition, the company may distribute part of its profit to shareowners in the
form of dividends. Unlike interest on a debt instrument, however, dividends
are not obligatory. Different types of shares have different characteristics and
confer different rights on the owners. In general, there are two main types of
stock: common and preferred.
Investment Funds: An investment fund is a company or trust that manages
investments for its clients. The most common form is the open-end fund also
known as a mutual fund. The fund raises capital by selling shares or units to
investors, and then invests that capital. As unit holders, the investors receive
part of the money made from the funds investments. Mutual funds
continuously issue shares or units to investors and redeem these shares or
units at net asset value.
Derivatives: Unlike stocks and bonds, derivatives are suited mainly for more
sophisticated investors. Derivatives are products based on or derived from an
underlying instrument, such as a stock or an index. The most common
derivatives are options and forwards.

Other Financial Instruments: In the past few years, investment dealers

have used the concept of financial engineering to create structured products
that have various combinations of characteristics of debt, equity and
investment funds. Two of the most popular are linked notes and exchangetraded funds (ETFs).

Private Equity: Private equity is the financing of firms unwilling or unable to find
capital using public means for example, via the stock or bond markets. Long
term returns on private equity typically exceed most other asset classes. But in
exchange for these returns, private equity also exposes investors to far higher risks
A good example is venture capital. Venture capital finances businesses at a
time when they produce little or no cash flows, invest most or all revenue in
more or less unproven technologies or production processes, and have little
or no assets to offer as collateral. In such situations, firms must typically turn
to investors that are ready to take substantially more risk against significantly
higher profit prospects if the venture is successful.
There are several means by which private equity investors finance firms.
Leveraged Buyout: This is the acquisition of companies financed with
equity and debt. Buyouts are one of the most commonly used forms of
private equity.
Growth Capital: The financing of expanding firms for their acquisitions
or high growth rates.
Turnaround: Investments in underperforming or out of favour industries
that are in either financial need or operating restructuring.
Early Stage Venture Capital: Investments in firms that are in the infancy
stages of developing products or services in high growth industries such as
health care or technology. These firms usually have a limited number of
Late stage Venture Capital: The financing of firms which are more
established but still not profitable enough to be self-sufficient. Revenue
growth is still very high.
Distressed debt: This is the purchase of debt securities of private or public
companies that are trading below par due to financial troubles at the firm
For this reason, private equity investors are typically:
Public pension plans
Private pension plans

High net worth investors
The two reasons why people go for private equity as compared to other
instruments is that it provides return enhancements and to an extent portfolio
diversification. Return enhancement is a reward as private equity provides
with very low liquidity (how quickly can be converted to cash) as compared
to shares which are of high equity.
Financial Markets:
A well-organized market provides speedy transactions and low transaction
costs, along with a high degree of liquidity and effective regulation.
In the securities markets, buyers and sellers do not meet face to face. Instead,
intermediaries, such as investment advisors (IAs) or bond dealers, act on
their clients behalf. Transactions are made by brokers on clients behalf
Unlike most markets, a securities market may not manifest itself in a
physical location.
The capital market or securities market is made up of many individual
markets. For example, there are stock markets, bond markets and money
markets. In addition, securities are sold on primary and secondary markets.
Auction Market in Canada
Markets can also be divided into auction and dealer markets. In an
auction market, buyers enter bids and sellers enter offers for a stock. The
price at which a stock is traded represents the highest price the buyer is
willing to pay and the lowest price the seller is willing to accept. These
orders are then channelled to a single central market and compete against
each other.
There are a number of important terms you need to understand when talking
about trading stocks.
The bid is the highest price a buyer is willing to pay for the security being
The ask (or offer) is the lowest price a seller will accept.
The spread is the difference between the bid and ask prices.
The last price is the price at which the last trade on that stock took place.
This price can fluctuate back and forth between the bid price and the ask price as
buying and selling orders are filled. The last price is also referred to as the
market price. It is important to understand that the last price may not reflect the
price for which you can currently buy or sell the stock, and only reflects the latest
price at which a purchase or sale occurred.


A stock exchange is a marketplace where buyers and sellers of securities
meet to trade with each other and where prices are established according to
the laws of supply and demand. On Canadian exchanges, trading is carried on
in common and preferred shares, rights and warrants, listed options and
futures contracts, instalment receipts, exchange-traded funds (ETFs), income
trusts, and a few convertible debentures. On some U.S. and European
exchanges, bonds and debentures are traded along with equities.
Liquidity is fundamental to the operation of an exchange. A liquid market is
characterized by:
Frequent sales
Narrow price spread between bid and ask prices
Small price fluctuations from sale to sale

Auctions Market
Canadas stock exchanges are auction markets. During trading hours,
Canadas exchanges receive thousands of buy and sell orders from all parts of
the country and abroad.
Canada has five exchanges:
The Toronto Stock Exchange (TSX)
The TSX Venture Exchange
The Montreal Exchange (MX, also known as the Bourse de Montral),
owned by the TMX Group Inc.,
The Canadian National Stock Exchange (CNSX), and
The ICE Futures Canada. (I can see future of Canada)
Each exchange is responsible for the trading of certain products.
The TSX lists senior equities, some debt instruments that are convertible into
a listed equity, income trusts and Exchange-Traded Funds (ETFs). (PAPA
The TSX Venture Exchange trades junior securities and a few debenture
issues. (BHAI log)
CNSX trades securities of emerging companies. (GUNDU log)
The Montreal Exchange trades all financial and equity futures and options.
(FIN. Derivatives)

ICE Futures Canada trades agricultural futures and options (AGRI.

In March 1999, all major restructuring changes happened in Canada, The
Alberta Stock Exchange, the Winnipeg Stock Exchange and the Vancouver
Stock Exchange merged to create a single, national junior equities market,
called the Canadian Venture Exchange (CDNX). This new market also
consolidated the operations of the Canadian Dealing Network (CDN) as of
October 2000
TSX venture exchange was previously known as CDNX Canadian Venture
In April 2002, the Toronto Stock Exchange rebranded its abbreviated name
from the TSE to TSX
TSX, TSX Venture Exchange and TSX Markets Inc. (the arm of the TSX that
sell market information and trading services) are collectively known as the
TSX Group of companies.
In November 2002, the TSX Group Inc. went public, becoming the first listed
stock exchange in North America.
In 2004, the CNSX gained recognition as a stock exchange. Trading on
CNSX is also regulated by IIROC (Investment Industry Regulatory
Organization of Canada (IIROC).
in the same way as the other Canadian exchanges and must therefore follow
the Universal Market Integrity Rules (UMIR).
Dealers Market:
Dealer markets are the second major type of market on which securities
trade. They consist of a network of dealers who trade with each other, usually
over the telephone or over a computer network. Unlike auction markets,
where the individual buyers and sellers orders are entered, a dealer market
is a negotiated market where only the dealers bid and ask quotations are
entered by those dealers acting as market makers in a particular security.
Almost all bonds and debentures are sold through dealer markets.
Dealer markets are also referred to as over-the-counter (OTC) or as
unlisted markets - securities on these markets are not listed on an organized
exchange as they are on auction markets.
Auction market

Dealers Market

Market where individual buyers and sellers Here prices are quoted for
securities only by
Quote bid and ask prices for particular
dealers known as Market

There is an organized exchange market

There is no such organized
exchange market

Here all securities are listed on the

Here all securities are not
listed on exchange
Prices are not publicly
visible, and dealers put the
Prices are publicly visible in auctions mkt
price might differ
Canadas stock exchanges are all
known as OTC over the counter
auction market

These majorly trade in equities, and

bonds and debt
some debt instruments

Brokerage firms usually act as agents

for their clients.

the ask n bid but transaction

Posted price.
These are also

These majorly trade in

Market makers only do the


Over-the-counter trading in equities is conducted in a similar manner to bond
trading. One veteran described the OTC market as a market without a
market place. In the OTC market, individual investors orders are not
entered into the market or displayed on the computer system.
Instead, dealers, who are acting as market makers, enter their bid and ask
quotations. These market makers hold an inventory of the securities in which
they have agreed to make a market. They sell from this inventory to buyers
and add to the inventory when they acquire securities from sellers.

The market makers post their individual bid (the highest price the maker will
pay) and ask (the lowest price the maker will accept) quotations. The
willingness of the market makers to quote bid and ask prices provides
liquidity to the system (although the market makers do have the right to
refuse to trade at these prices). When an investor wishes to buy or sell an
unlisted security,
The broker consults the bid/ask quotations of the various market makers to
identify the best price, and then contacts the market maker to complete the
transaction. The broker charges a commission for this service.
In most of Canada, there is no requirement for firms to report unlisted trades.
Ontario is the exception. The Ontario Securities Commission (OSC)
requires that trades of unlisted securities be reported through the
Canadian Unlisted Board Inc. (CUB). CUB offers an Internet web-based
system for dealers to report completed trades in unlisted and unquoted equity
securities in Ontario, as required under the Ontario Securities Act
Other Trading Systems : Quotation and trade reporting systems (QTRS),
Alternative trading systems (ATSs)
Quotation and trade reporting systems (QTRS) are entities, other than an
exchange or registered dealer that disseminate price quotations for the
purchase and sale of securities and report completed transactions to the
applicable securities commission. A QTRS must be recognized by a
provincial securities regulatory authority.
Alternative trading systems (ATSs) are privately owned computerized trading
facilities that match buy and sell orders for securities traded outside of
recognized exchanges. ATSs can be owned by individual brokerage firms or
by groups of brokerage firms.
These systems compete with the exchanges because a brokerage firm
operating an ATS can match orders directly from its own inventory, or act as
an agent in bringing buyers and sellers together, thus bypassing the stock
exchange. Since there is one less intermediary, more of the commission
charged to the client is kept by the dealer. Most client users of these systems
are institutional investors who can reduce transaction costs considerably and
avoid the market impact of their trades if the orders were instead traded

through a regular exchange. Some non-brokerage-owned ATSs even allow

buyers and sellers to contact each other directly and negotiate a price.
Fixed-Income Electronic Trading Systems: With the exception of a few
debentures listed on the TSX and TSX Venture Exchanges, all bond and money
market securities are sold through dealer markets. Three fixed-income
electronic trading systems launched in Canada include:
CanDeal, a member of IIROC, is a joint venture between Canadas six
largest investment dealers, and is operated by the TMX Group. It is
recognized as both an ATS and an investment dealer.
It offers institutional investors access to Government securities and to
money market instruments.
CBID, also a member of IIROC and an ATS, operates two distinct fixedincome marketplaces: retail and institutional. The retail fixed-income
marketplace is accessible by registered dealers on behalf of retail clients.
The institutional fixed-income marketplace is accessible by registered
dealers, institutional investors, governments and pension fund.
CanPX is a joint venture of Investment Industry Association of Canada
(IIAC)/IIROC dealer member firms. The CanPX system is an information
processor for government and corporate debt securities that provides
investors with real-time bid and offer prices and hourly trade data.
The service covers Government of Canada bonds, treasury bills, and
provincial bonds, and a select list of corporate bonds from major industrial
Notes after Chapter:
Answers from Learning Activities:
Q. Difference btw Auction & Dealers Market
(My answer) Auction Market is a place where individual buyer and seller quote
prices for a particular securities. buyer quotes a BID i.e. the highest price he is
willing to pay and seller quotes an ASK i.e. the lowest price he is willing to
accept for the security. thus they both enter in a trade.
all stock exchanges in canada are Auctions Market.

Dealers Market is a place where a network of dealers either on phone or

computer based network buy and sell securities. it majorly deals with debt
instruments and money market instruments.
(By System)Canadas stock exchanges are auction markets. In an auction
market, clients bids and offers for a stock are channelled to a single central
market and compete against each other. Brokerage firms usually act as agents
for their clients. The prices of all transactions are publicly visible.
Dealer markets, also known as over-the-counter (OTC) or unlisted markets, do
not necessarily have a central trading location or exchange where trades flow.
Market makers post their bid and ask prices, but the prices at which transactions
occur are less publicly visible and may differ from the posted prices. Almost all
bond trading in Canada takes place in dealer markets.
Q. Difference btw Debt & equity Instruments?
(My ans) Debt instruments are usually issued by corporates and governments in
the form of Bonds, debenture, t-bills, commercial papers etc. to raise funds.
these usually agree to pay the amount on the time of maturity and in the interim
pays interests to it's investors. the income on them are usually fixed.
Equity instuments like common or preffered shares are provides to investors
where he becomes the shareholder of the company. and is entitled to capital
gains/loss as per the performance of company when he sells its share. they also
recieve profits of company in form of dividents.
(Their) A debt instrument is an agreement whereby the issuer promises to repay
a loan on a specified date (also referred to as the maturity date). In the interim,
the issuer makes fixed interest payments to the investor.
An equity instrument (a stock or share) allows the investor to buy an ownership
stake in the company. There are two main types of stock: common shares and
preferred shares. Investors with common shares participate in a proportional
claim to profits, losses and any declared dividends. These investors also have
voting rights at the companys annual meeting. In contrast, owners of preferred
shares are entitled to a fixed dividend and have a prior claim on the companys
assets, but do not participate in the companys growth and are not allowed to
Q. Difference btw QTRS &ATS Instruments?

QTRS are those systems that are required to disseminate prices (bid/ask) to the
public and also are required to report about all the completed trades.
ATS are systems the performs all the trades of securities apart from the stock
exchanges. These can be privately owned by brokerage firms or a group of
brokerage firms. These cut out one of the intermediary and thus makes more
brokerage from the institutional investors who uses these ATS to cut down
transaction cost and for speedy tractions.
(By system) Quotation and Trade Reporting Systems (QTRSs) are entities,
other than an exchange or registered dealer that disseminate price quotations for
the purchase and sale of securities and report completed transactions to the
applicable securities commission. A QTRS must be recognized by a provincial
securities regulatory authority.
Alternative Trading Systems (ATSs) are privately owned computerized trading
facilities that match buy and sell orders for securities traded outside of
recognized exchanges. ATSs can be owned by individual brokerage firms or by
groups of brokerage firms. ATSs must be members of the Investment Industry
Regulatory Organization of Canada (IIROC).
Q. Difference btw Candeal & CBID ?
Candeal is a member of IIROC and a joint venture btw canada's six largest
investment dealers. it is a kind of ATS for fixed income securities.
CBID is also a member of IIROC and provides two marketplaces for Retail and
Institutional Investors. where in retail can be accesed by resitered dealels on
client behalf and Institutional can be accesed by registered dealers, institutions,
governments etc.
(By system) Both CanDeal and CBID are IIROC members and are considered
to be ATSs. However, CanDeal offers institutional investors access to
Government securities and to money market instruments while CBID operates
retail and institutional fixed-income marketplaces. The CBID retail fixedincome marketplace is accessible by registered dealers on behalf of retail clients
and the institutional fixed-income marketplace is accessible by registered
dealers, institutional investors, governments and pension funds.

. Whats the difference between corporate debt and corporate commercial

Corporate debt refers to corporate bonds and debentures. The following is a
definition of commercial paper borrowed from an American
web site, though the definition suits our purposes for this discussion: An
unsecured obligation issued by a corporation or bank to finance its shortterm credit
needs, such as accounts receivable and inventory. Maturities typically range from 2
to 270 days. Commercial paper is available in a wide range of denominations, can
be either discounted or interest bearing, and usually have a limited or nonexistent
secondary market. Commercial paper is usually issued by companies with high
credit ratings, meaning that the investment is almost always relatively low risk.
Post-Test Questions: Result was 13/15 (2 wrong becoz didnt read questions
Which of the following is a difference between the auction and dealer markets?

Prices are publicly visible in the auction market but not in the
dealer market.


Prices are publicly visible in the auction market but not in the
dealer market.


The prices of all transactions are publicly visible in auction

markets. In dealer markets, market makers post bid and ask prices
but the transaction price might differ from the posted price.

Quiz question
The government of a developing country has just announced a new program to
rationalize all oil companies operating within their borders. How are investors
interested in investing in this country likely to react?
You chose:a) Investors will increase the amount of capital flowing to the
country because they feel safer now that the government is getting things
under control.
b) Investors will want to increase the amount of capital as government
controlled companies tend to be more profitable.

The correct answer is:c) It will decrease capital flowing into this country as
investors will be worried that other industries will be nationalized and they
will lose their capital.
d) It will likely have little impact as most oil companies tend to be foreignowned anyway so they will not be affected.
FEEDBACK : Capital has three important characteristics. It is mobile, sensitive to
its environment and scarce. Therefore capital is extremely selective. It attempts to
settle in countries or locations where government is stable, economic activity is not
over-regulated, the investment climate is hospitable and profitable investment
opportunities exist. The decision as to where capital will flow is guided by country
risk evaluation. Text reference: Chapter 1: The Capital Market.

4. A company acquires another company using debt. What is this known as?
a) Cash flow acquisition.
You chose:b) Distressed debt.
c) Going public.
The correct answer is:d) Leveraged buyout.
FEEDBACK : There are several means by which private equity investors finance
firms: Leveraged Buyout is the acquisition of companies financed with equity and
debt. Buyouts are one of the most commonly used forms of private equity. Text
reference: Chapter 1: The Capital Market.
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