MBI CF Session 3. Dealing With Financial Markets

MBI: CORPORATE FINANCE
Session 3
Dealing with Financial markets
MBI: Corporate Fianace Session 3: Dealing

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with financial markets
Session Summary
• Importance of financial markets and their
classifications
• Advisors to share issues
• Other sources of finance
• The Uganda capital markets
• Impact of the markets on market decisions.
• Market Efficiency

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Definition of financial markets
The term financial markets refers to any organized
structure within which individuals and /or
institutions may undertake particular types of
financial transactions / investments. Therefore a
financial market may be in the form of the
traditional market place where securities are traded,
the whole process being facilitated by financial
institutions such as commercial banks. Like in
traditional meaning of markets, parties come
together for purposes of trading .Examples in this
category are the London stock exchange, the
Nairobi stock exchange and the Uganda stock
exchange.
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Organization and functioning of financial
markets continued
Alternatively, and with the advent of technological
Advancements being witnessed today, financial markets
may have no physical place but rather the process may
involve the coming together of market participants via
ICT networks. In fact today, most of the financial
markets are embracing this new method than before due
to technological advancements.

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Organization and functioning of
financial markets continued
Financial markets may involve many
individuals and institutions that undertake
particular forms of financial activities. These
are referred to as market participants and
include dealers, brokers, investors, issuers of
stock, underwriters, Stock holders, investment
advisors etc…

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Classification of Financial markets
Financial markets are the sources of finance for
business start ups and growth. They are broadly
categorized into money and capital markets
1. Money markets:
The money market is the financial market for
short-term borrowing and lending i.e within one
year. It provides short-term liquidity funding for
the global financial system. The money market is
where short-term obligations such as Treasury
bills, commercial paper and bankers' acceptances
are bought and sold.
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Money markets:
The money market consists of financial
institutions and dealers in money or credit who
wish to either borrow or lend. Participants borrow
and lend for short periods of time, typically up to
thirteen months. Money market trades in short-
term financial instruments commonly called
"paper." This contrasts with the capital market for
longer-term funding, which is supplied by bonds
and equity.

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Treasury Bills
Types of Treasury bills used in Uganda
1. The Bearer Treasury Bills Certificates
These were used in the market earlier. They did
not activate secondary market trading because of
their security risk.
2. The book-entry Central Depository System
(CDS)

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Treasury Bills
• To counteract the safety concerns regarding the bearer
Treasury bill certificates in 1999 the Bank introduced
the electronic registry of investors in government
securities called the book-entry Central Depository
System or CDS.
• The CDS solved the problems of transferring
ownership of the securities but introduced a new
problem that the laws of Uganda were written so that a
security had to be in paper form and the Courts did not
recognize electronic securities.

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Treasury Bills
To solve the problem, the Public Finance and
Accountability Act of 2003 gave the Minister of
Finance and Economic Development and
planning powers to issue securities both in paper
and electronic form. Paper treasury bills were
discontinued. Treasury Bills securities can be for
91 days, 182 days and 364 days in the primary
market.

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Treasury Bills
The treasury bills auctions were held weekly to
start with. To stimulate the development of
secondary market trading, the Bank of Uganda
changed the auction from being weekly to
being fortnightly. This strategy aimed at
extending the interval between auctions as a
way of providing a greater incentive for
investors to source the supply of treasury bills
in the secondary market.

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2. Capital markets
• A capital market is market concerned with raising long
term funds for both corporate and public sectors; the
capital market is the market for securities, where
companies and governments can raise long term funds. It is
a market in which money is lent for periods longer than a
year. The capital market includes the stock market and the
bond market.
• Capital markets are divided into Bond market and stock
market
• A stock market is the single most important institution in
the primary and secondary security markets, especially for
ordinary shares . It is an organized market where large and
small investors buy and sell securities through stock brokers
especially for listed or quoted companies.

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Bond Market:
• The bond market (also known as the debt, credit, or fixed
income market) is a financial market where participants buy
and sell debt securities, usually in the form of bonds. In the
U.S. bond market trading takes place between broker-
dealers and large institutions in a decentralized, over-the-
counter (OTC) market. However, a small number of bonds,
primarily corporate, are listed on exchanges. Reference to
the "bond market" usually refer to the government bond
market, because of its size, liquidity, lack of credit risk and,
therefore, sensitivity to interest rates.
• Other types of bonds include the corporate bonds and
municipal bonds or “munis”

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Other categorization of capital
markets
• The capital markets consist of the primary
market and the secondary market. The
primary market is where new stock and bonds
issues are sold (underwriting) to investors. The
secondary market is where existing securities
are sold and bought from one investor or
speculator to another, usually on an exchange
(e.g. - New York Stock Exchange, Tokyo stock
exchange, Nairobi stock exchange and Uganda
stock exchange or USE).
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Primary market
The primary market is that part of the capital
markets that deals with the issuance of new
securities. Companies, governments or public
sector institutions can obtain funding through the
sale of a new stock or bond issue. This is typically
done through a syndicate of securities dealers.
The process of selling new issues to investors is
called underwriting. In the case of a new stock
issue, this sale is an initial public offering (IPO).
Dealers earn a commission that is built into the
price of the security offering, though it can be
found in the prospectus.

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Features of primary markets are:
 This is the market for new long term equity capital.
The primary market is the market where the
securities are sold for the first time. Therefore it is
also called the new issue market (NIM).
 In a primary issue, the securities are issued by the
company directly to investors.
 The company receives the money and issues new
security certificates to the investors.
 Primary issues are used by companies for the
purpose of setting up new business or for
expanding or modernizing the existing business.
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Features of primary markets
 The primary market performs the crucial
function of facilitating capital formation in the
economy.
 The new issue market does not include certain
other sources of new long term external finance,
such as loans from financial institutions.
Borrowers in the new issue market may be
raising capital for converting private capital into
public capital; this is known as "going public."
 The financial assets sold can only be redeemed
by the original holder.
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Methods of issuing securities in the
primary market are:
i) Initial public offering (IPO)
• An initial public offering (IPO), referred to simply as an "offering" or
"flotation", is when a company (called the issuer) issues common stock or
shares to the public for the first time. They are often issued by smaller,
younger companies seeking capital to expand, but can also be done by
large privately-owned companies looking to become publicly traded.
• In an IPO, the issuer may obtain the assistance of an underwriting firm,
which helps it determine what type of security to issue (common or
preferred), best offering price and time to bring it to market.
• An IPO can be a risky investment. For the individual investor it is
tough to predict what the stock or shares will do on its initial day of
trading and in the near future since there is often little historical data with
which to analyze the company. Also, most IPOs are of companies going
through a transitory growth period, and they are therefore subject to
additional uncertainty regarding their future value.

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ii) Rights issue
(for existing companies)
A rights issue is an option that a company opts for to raise capital
under a Primary market offering or seasoned equity offering of
shares to raise money. The rights issue is a special form of shelf
offering or shelf registration. With the issued rights, existing
shareholders have the privilege to buy a specified number of new
shares from the firm at a specified price within a specified time. A
rights issue is in contrast to an initial public offering (primary
market offering), where shares are issued to the general public
through market exchanges.

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Regulation of the primary markets:
Offering of the securities in the primary markets is regulated
by the capital markets authority in Uganda’s case the Uganda
capital markets authority-UCMA. Usually the issuing entity is
required to fill a registration statement which is filed with the
security exchange by the issuer of the securities. The
information contained in the registration statement includes;
 The nature and History of the issuing entity
 Provisions or the features of the security
 management structure of the organization
 Audited financial statements of the entity etc…
The registration statement is divided into 2 parts i.e.
I) the prospectus which is distributed to the public
ii) Supplementary information not distributed to the public but
available upon request from the securities exchange.

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The secondary market:
• This is also known as the aftermarket, is the financial
market where previously issued securities mentioned
above and financial instruments such as stock bonds,
options, and futures are bought and sold..
• With primary issuances of securities or financial
instruments, or the primary market, investors purchase
these securities directly from issuers such as
corporations issuing shares in an IPO or private
placement, or directly from the federal government in
the case of treasuries. After the initial issuance,
investors can purchase from other investors in the
secondary market. MBI: Corporate Fianace Session 3: Dealing 21
Functions of secondary markets
Secondary markets perform two major functions;
i) They provide investors with the necessary liquidity out of their
securities.
ii) They help the issuers of securities to track their values and the
required return on investments
In a secondary market usually business is conducted in physical
trading floor, or due to the advent of technological advancements
some markets conduct their business online (electronic means).The
market structure is continuous throughout the year.
•Role of investment Bankers :These work very closely with issuers
of new securities in order to distribute the securities to the
prospective investors. The activities of investment banks is
basically undertaken by 2 types of firms namely; Security houses
and commercial banks.

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Process of issuing new stock:
During the process of issuing new stock the investment bankers
play a leading role in the following ways:
1. Advising the issuers regarding the terms and timing of their
stock offerings.
2. Buying in bulk the securities from the issuers aiming at selling
them to investors in a secondary market arrangement.
3. Distributing the securities to the public.
The functions of buying the securities from the issuers and selling
them to the public are commonly called underwriting. The fee
earned from underwriting is called underwriters Discount or the
gross spread and is the difference between the price paid to the
issuer and the price investment bankers offer the securities to the
public.
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Process of issuing new stock
continued:
• In case of large initial public offers, a single
underwriter may be exposed to a very high risk. In order
to reduce on the risk; firms may form a syndicate to
underwrite the issue so as to spread the risk over a group
rather than a single firm. Where there is syndicate, there
must be a lead underwriter.
• A successful underwriting of a security requires the
underwriter to have a strong selling force. These people
provide a feed back on the interest in the securities plus
other market information. Such traders are called market
makers and the provide input in fixing the prices of the
securities. MBI: Corporate Fianace Session 3: Dealing
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How a stock exchange works
Companies wishing to raise capital from the public are
required to list their securities at a stock exchange. A
company is said to be listed when its shares are approved
to be bought and sold on the stock exchange.
Being listed provides the following benefits to the
company and the investor:
• Additional financing is made easier through
subsequent issuing of shares
• The exchange creates a market place where the
securities of all listed companies can be bought and
sold . This in turn adds value to the securities since the
purchase is assured of ready market for shares.
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How a stock exchange works
• There is improved liquidity for shares through
exposure to a large market base.
• The governance of firms and by managers
improves because of the high standards that
must be met and maintained by listed
companies

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Techniques of issuing shares
• Ordinary shares or common stock can be
issued using the following approaches:
i. Through making public offering using a
prospectus
A prospectus is a document which gives the
relevant information with minimum disclosures
in which the aspect for price is fixed and which
is legally guaranteed.

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Techniques of issuing shares
ii. Through private placement:
Here the issue of shares is to investors who are
well known to the company. This reduces cost of
floatation ,less time is taken and it enhances
control of ownership.
iii. Competitive bidding:
This is carried out through auction, and shares
are allotted to the highest bidder who satisfies
the conditions of offer.
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Importance of capital markets in the
economy
1. They provide an important alternative source of long-
term finance for long-term productive investments. This
helps in diffusing stresses on the banking system by
matching long-term investments with long-term capital.
2. Provides equity capital and infrastructure development
capital that has strong socio-economic benefits - roads,
water and sewer systems, housing, energy,
telecommunications, public transport, etc. - ideal for
financing through capital markets via long dated bonds
and asset backed securities.
3. Provides avenues for investment opportunities that
encourage a thrift culture critical in increasing domestic
savings and investment ratios that are essential for rapid
industrialization.MBI:
The Savings
Corporate and
Fianace Session investment ratios are
3: Dealing
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too low, below 10% of GDP.
economy
4. They encourage broader ownership of productive assets
by small savers to enable them benefit from a country’s
economic growth and wealth distribution. Equitable
distribution of wealth is a key indicator of poverty
reduction.
5.Promotion of public-private sector partnerships to
encourage participation of private sector in productive
investments. Pursuit of economic efficiency shifting
driving force of economic development from public to
private sector to enhance economic productivity has
become inevitable as resources continue to diminish.
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economy
6. They Assist the Government to close resource gap, and
complement its effort in financing essential socio-
economic development, through raising long-term project
based capital.
7.They improve the efficiency of capital allocation
through competitive pricing mechanism for better
utilization of scarce resources for increased economic
growth.
8. They Provide a gateway to foreign countries for global
and foreign portfolio investors, which is critical in
supplementing the low domestic saving ratio.

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The capital markets theory
Characteristics of a good / efficient market:
i) Availability of information:
There should be information about past, present
and future performance of the companies that
are quoted at the stock exchange market.
ii) Transaction costs:
The players in the market should not over charge
investors for whatever transaction cost.
iii) The legal framework:
This should exist for purposes of arbitration.
iv) Rapid Adjustment of prices:
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Characteristics of a good / efficient
market
The price should be able to reflect adjustments to
every new information coming to the market i.e.
shares should be responsive to the information
that comes to the market.
v) Liquidity in the market:
There should be cash flowing in the market. The
instruments or securities should be liquid i.e.
they should be capable of being transferred into
cash any moment.

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Assumptions of a capital markets
theory:
i. Investors are efficient:
As soon as new information comes to the market investor should be
able to respond to the contents of the coming information
immediately.
ii. Possibility of lending and borrowing:
The investor should be able to borrow and lend any amount of
money at a risk free rate of return.
iii. Homogeneous expectations:
• All investors in the market have homogeneous expectations. They
have the same probability distributions, about expected returns. In
other words investors in the market reason uniformly.
iv. Same time or period Horizons:
• All investors are assumed to be making decisions at the same time
/period.

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Assumptions of a capital markets
theory
v. All investments are infinitely Divisible:
In an efficient market it is possible to sell fractions of the
shareholding of any Asset or portfolio.
vi. Absence of taxes for transaction costs:
All transaction costs involved in the buying and selling of capital
market securities do not attract any form of taxation.
vii. No inflation and no changes in interest rates:
Both inflation and interest rate changes are assumed to be non-
existent in an efficient market.
viii. Equilibrium:
Efficient Capital markets are always assumed to be in equilibrium.

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Market efficiency
Efficient-market hypothesis (EMH):
The hypothesis tends to argue that capital
markets are efficient but at varying levels or
degrees. According to this hypothesis, an
efficient market is one in which security prices
adjust rapidly to the infusion of new
information and that current stock price fully
reflect all available information including the
risks involved.

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Assumptions of the efficient market
hypothesis
i. A large number of profit maximizing participants:
The market contains many investors sharing the same motive of
maximizing profits while minimizing risks.
ii. Random information:
New information coming to the market comes in a random manner
or fashion.
iii. Adjustment of security prices:
All investor are assumed to adjust security prices rapidly so as to
reflect the effect of new information that comes to the market.
iv. Unbiased position:
The security prices prevailing at any time reflect an unbiased
position about the currently available information in the efficient
market.

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Forms of Market efficiency
• The efficient-market hypothesis (EMH) asserts that
financial markets are "informationally efficient", or that
prices on traded assets, e.g., stocks, bonds, or
property, already reflect all known information. The
efficient-market hypothesis states that it is impossible
to consistently outperform the market by using any
information that the market already knows, except
through luck. Information or news in the EMH is
defined as anything that may affect prices that is
unknowable in the present and thus appears randomly
in the future.
• There are three common forms in which the efficient-
market hypothesis is commonly stated.

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There are three common forms in which the
efficient-market hypothesis is commonly
stated. These are:
1. weak-form efficiency.
2. Semi-strong-form efficiency.
3. strong-form efficiency.
Each of those forms of EMH has different
implications for how capital markets work.

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1. Weak form efficiency:
In weak-form efficiency, future prices cannot be
predicted by analyzing price from the past. Current
stock price already reflect all available stock market
information including historical information.
2. Semi-strong efficiency:
It assumes that the security prices adjust rapidly to the
release of new public information. In semi-strong-form
efficiency, it is implied that share prices adjust to
publicly available new information very rapidly and in
an unbiased fashion, such that no excess returns can be
earned by trading on that information
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3. Strong-form efficiency:
In strong-form efficiency, share prices reflect all
information, public and private, and no one can earn
excess returns. This hypothesis encompasses both the
weak form and semi strong form. It however extends
to not only public information but also any other form
of information that is not yet public. If there are legal
barriers to private information becoming public, as
with insider trading laws, strong-form efficiency is
impossible, except in the case where the laws are
universally ignored.

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END OF SESSION THREE

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MBI: CORPORATE FINANCE

MBI: Corporate Fianace Session 3: Dealing

MBI: Corporate Fianace Session 3: Dealing

MBI: Corporate Fianace Session 3: Dealing

MBI: Corporate Fianace Session 3: Dealing

MBI: Corporate Fianace Session 3: Dealing

MBI: Corporate Fianace Session 3: Dealing

MBI: Corporate Fianace Session 3: Dealing

MBI: Corporate Fianace Session 3: Dealing

MBI: Corporate Fianace Session 3: Dealing

MBI: Corporate Fianace Session 3: Dealing

MBI: Corporate Fianace Session 3: Dealing

MBI: Corporate Fianace Session 3: Dealing

MBI: Corporate Fianace Session 3: Dealing

MBI: Corporate Fianace Session 3: Dealing

MBI: Corporate Fianace Session 3: Dealing

MBI: Corporate Fianace Session 3: Dealing

MBI: Corporate Fianace Session 3: Dealing

MBI: Corporate Fianace Session 3: Dealing

MBI: Corporate Fianace Session 3: Dealing

MBI: Corporate Fianace Session 3: Dealing

MBI: Corporate Fianace Session 3: Dealing

MBI: Corporate Fianace Session 3: Dealing

MBI: Corporate Fianace Session 3: Dealing

MBI: Corporate Fianace Session 3: Dealing

MBI: Corporate Fianace Session 3: Dealing

MBI: Corporate Fianace Session 3: Dealing

MBI: Corporate Fianace Session 3: Dealing

MBI: Corporate Fianace Session 3: Dealing

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