CAPITAL MARKETS AND MONEY MARKETS.

What is a capital market?

Capital markets are concerned with the provision of long-term finance for private and public
sectors as well as trading with bonds and equities. The capital market is therefore a market for
the issue and trading of long-term securities. Traditionally, the stock exchange is the center of
capital markets. Stock exchange participants include brokers/dealers who act on behalf of their
clients in buying and selling securities.

From the perspective of a company, capital markets have two main functions, that is-;

1. They act as a means whereby long-term funds can be raised by companies from those
with excess funds to invest. As such, the capital markets act as the primary market for
new issues of equity or debt or debt capital.

2. They provide a ready means for investors to sell their existing shares and bonds or to
increase their portfolio. In this case, the capital market acts as a secondary market for
dealing in existing securities. By providing the possibilities to sell or buy existing
securities, the capital markets increases the liquidity of these securities and hence their
value. This Secondary market also acts as a source of pricing information for the primary
market thus increasing the efficiency with which new funds are allocated.

How long is long term

There is no strict definition of long-term but the original maturity of the debts will be at least one
year and usually more than five years. However, some of the debts have no maturity at all.

The term in this instance is measured as the term to maturity of the security and in order to be
classified as a capital market instrument, the term to maturity should be longer than one year and
usually more than three years. During the trading of capital instruments, the securities traded are
informally classified into –

Short-term securities, Medium-term securities, Long-term securities. This classification

depends on the term to maturity of the instrument. Where the term to maturity of the instrument
is up to one years, the security is classified as a short-term capital market instrument. Where the
term to maturity is five to ten years, the security is classified as medium term, and where the
term to maturity is more than 10 years, the security is known as long-term.

Primary and secondary capital markets.

The primary market is the market for the first issue of securities. This issue is normally done by
means of a public issue or by private placement.

The secondary market is the market for trading securities once they have been issued. The
secondary market has a big influence on the issues in the primary market, as the market rate is
determined in the secondary market. Issues in the primary market at below market rate,
determined in the secondary market, would be issued at a discount on the nominal value of the
instrument. If the volumes traded in the secondary market are high it could be an indicator that
an excess of long-term money is available in the market, and it may thus be an opportune time to
issue new securities into the market by means of the primary market. Therefore, if the liquidity in
the secondary market is high, chances are that new issues would be more successful than in an
illiquid market.

Perfect and efficient Capital market efficiency.

The theory behind efficient market is concerned with establishing the prices of capital market
securities and states that ‘the prices of securities fully and fairly reflect all relevant available
information’.
Apparently, there is no capital market known around the world that can be described as
completely perfect. An efficient market should exhibit the following features.

Operational efficiency.

The implication of this is that transactions costs in the market should be as low as possible and
that required trading should be quickly effected.

Pricing efficiency.

This implies that the prices of capital market securities fully and fairly reflect all information
concerning past events and all events that the market expects to occur in the future. The prices of
securities are therefore fair prices.

Allocational efficiency.
This means that the capital market, through the medium of pricing efficiency allocates funds to
where they can best be used.

Forms of market efficiency.

Different forms of market efficiency arise from objective tests that have been done to reflect to
what extent capital market prices reflect relevant information, that is pricing efficiency.
Allocational and operational efficiency have been difficult to measure due to lack of data. These
tests have revealed the following forms of market efficiency as pointed out by Watson and Head
(2001).

Weak form efficiency.

Markets are said to be weak form efficient if current share prices reflect all past movements of
share prices. As a result, it becomes difficult to make abnormal returns by studying past share
price movements using technical analysis in such a market.

Semi – strong form efficiency.

Markets are said to be semi – strong form efficient if share prices reflect all historic information
and all publicly available information, and react quickly and accurately too reflect any new
information as it becomes available. As a result, abnormal returns cannot be made by studying
available company information.

Strong form efficiency.

Markets are said to be strong form efficient if share prices reflect all information, whether it is
publicly available or not. If markets are strong form efficient, then no one can make abnormal
returns from share dealing, even those privy to internal information of dealings.

Capital market instruments.

Instruments issued and traded in the capital market differ in certain characteristics, such as:
• Term to maturity.
• Interest rate paid on the nominal value
• Interest payment dates
• Nominal amount in issue.

The main capital market instruments include the following -:

Common stocks

Common stock represents evidence of ownership rather than of a creditor. Common stocks are
issued by public limited companies and are actively traded on an organized stock exchange.
They are the most risky of all financial instruments but stocks of some companies can easily and
quickly be sold at prices that are relatively stable. Common stocks have no maturity date and
their yields can vary greatly over time. The main holders of common stock are individuals,
investment companies and life insurance companies. Because of the risks associated with
common stocks, banks are restricted from holding them.

Preferred stocks.

Like common stocks, preferred stocks receive dividends rather than interest. The dividends are
not a legal obligation by the issuing company and failure to pay them does not constitute default.
However, preferred stockholders must receive dividends before common stock holders.

Debt instruments.

These are classified by type or issuer. Corporations can issue corporate bonds. Bonds, unlike
stocks represent indebtedness, that is, they promise to pay a certain amount of interest each year
for a stated number of years and then repay the principal amount at maturity.
THE MONEY MARKET

The money market is the market for short-term funds. The market for short-term funds is
characterized mainly by the large deals, low transaction costs and rapid dealing. The traders
usually deal over the telephone, making verbal agreements for vast sums of money. The money
markets are not formally established like the long-term capital markets, but have expanded very
rapidly. The ever-improving technology of computers and consequent electronic “signal” type
deals on new exchanges will seek to make the money market a highly sophisticated market.

There are many types of short-term investing/funding available on the money market as
follows:-

1. Discount Market.

Discount Houses are important function in that they channel funds from banks to government.
The surplus liquid funds of the banks are largely invested via the Discount Houses in
government securities thereby ensuring that money does not remain idle for long.

The money is used to buy government treasury bills, short dated government securities,
commercial bills of exchange, fixed interest bonds, and certificates of deposit. Some of these
instruments are returned to the banks as security. Most of the bills and the quantity depend on
the government’s short term borrowing needs.

Each week, the central bank announces the amount of Treasury bills that will be offered for sale
the following week. Investors, including the discount houses then submit tenders specifying the
price at which they will buy and the numbers of bills required. Bills are then allotted to the
highest bidders. If the government wishes to restrict the short-term money supply (which in turn
will increase interest rates) they will increase the amount of treasury bills.

The discount houses operate on a narrow margin determined by how they see the trends in
interest rates and how great a differential can be achieved between the borrowed cash and the
assets they buy. It remains a well established market which is also used by many companies in
the country to raise short-term finance.

2. Finance House Market

This market essentially consists of finance houses lending money to each other, although they
can take deposits from the public so long as they have been granted the status of recognised
banks. Deposits with finance houses are commonly subject to six months notice of withdrawal,
but this may be void.

3. Inter-bank Market

This consists of the non-clearing banks lending and borrowing funds to and from each other.
The deposits usually affects inter-bank interest rates; if the Central bank injects cash into the
market, the discount houses may find that they no longer need funds from the clearing banks,
which will in turn place surplus funds in the inter-bank market.
Consequently, inter-bank interest rates would fall.

4. Local Authority Market

Local authorities, particularly in the developed countries have often to borrow large
amounts on a short and medium term basis. In several countries, most large local authorities
have loans quoted on the Stock Exchange but some authorities invite the public to lend
money directly at a fixed rate of interest for a fixed period of time. These are known as
Local Authority Bonds. The duration of the loan is not standard; meaning this may be on a
few days notice on either side, but more usually will be for a fixed term, commonly, five
years.

5. Certificates of Deposit

There are times when companies have surplus cash balances but no suitable medium to long
term investments are available. It is then that a company will consider putting the surplus cash
“on deposit.”

The more stable a deposit (in terms of time before withdrawing it) the higher the rate of interest, so
that a company may undertake to leave the cash in the bank for say one year. In return for the
deposit the bank will issue the company a receipt – a certificate of deposit (CD) – stating the
amount of the deposit, the interest (which is normally fixed for the duration of the loan), and
the length of time to maturity. If the company decides it needs the cash ahead of the redemption
date specified, it cannot then withdraw the cash having promised not to do so, so it will sell the
CD to a discount house. The value received will depend upon the CDs interest rate in
comparison with the then prevailing market rates.

What is somewhat perplexing at first is that the discount house borrows the money from a bank
to buy the CD. In fact this is just another example of cash changing hands so quickly that it does
not remain idle for a second. Everybody is satisfied; the company gets the money it needs, the
bank has dependable long term cash in the from of the original deposit, and the discount house
makes a small margin every time that money passes through its hands. Even the banks use CDS
amongst each other for longer-term loans than are available in the normal inter-bank market.

6. Commercial Papers

Large Public Limited Companies can raise short-term finance by issuing a commercial paper
(CP). A Commercial paper is issued in the form of a promissory note with a fixed maturity of
up to one year, but typically between seven days and three months. It is a negotiable
instrument, being issued in bearer form and is sold at a discount against the nominal value (so
that the rate of interest is implicit in its sale value). A variant of CP is known as medium term
notes (MTNs). They are issued with maturities of over one year and up to five years. MTNs are
not discounted, but carry an explicit interest rate.