We have discussed the biggest borrowers and lenders in Canada, and seen how financial intermediaries coexist alongside market intermediaries to help the intermediation process.
The next step is to look at the instruments and institutional arrangements that are used to transfer these funds.
Financial Instruments
Financial assets are formal legal documents that set out the rights and obligations of all the parties involved. Since we discuss the various types of securities in depth at several points later on, we will provide only a brief overview here.
There are two major categories of financial securities.
1. Debt instruments : These represent legal obligations to repay borrowed funds at a specified maturity date and provide interim interest payments as specified in the agreement. We will discuss these instruments in more detail in Chapter 6 , but note here that some of the most Learning Objective 1.4
Identify the basic types of financial instruments that are available and explain how they are traded.
debt instruments legal obligations to repay borrowed funds at a specified maturity date and to provide interim interest payments
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17 CHAPTER 1 1.4 Financial Instruments and Markets
common examples are bank loans, commercial paper, bankers ’ acceptances (BAs), treas- ury bills (T‐bills), mortgage loans, bonds, and debentures.
2. Equity instruments : These represent an ownership stake in a company. The most common form of equity is the common share , which we will discuss at length in Chapter 7 and in later chapters. Companies may also issue preferred shares , which usually entitle the owner to fixed dividend payments that must be made before any dividends are paid to common shareholders.
Aside from the debt‐versus‐equity distinction, financial instruments can be categorized in several additional ways. One way is to distinguish between non‐marketable financial assets and marketable financial assets . The most familiar forms of non‐marketable assets are sav- ings accounts or demand deposits with financial institutions, such as chartered banks. The funds invested here are available on demand, which guarantees the liquidity of these invest- ments, but you can ’ t sell them to someone else: you have to first withdraw the funds and then transfer the cash. Another widely used type of non‐marketable financial asset in Canada is the Canada Savings Bond (CSB) and its provincial counterparts, which are issued by the federal or provincial governments. These bonds are non‐marketable, unlike traditional bonds, because they are not tradable. However, CSBs can be cashed out by the owner at full par value plus eligible accrued interest at any bank in Canada at any time.
Marketable securities are those that can be traded among market participants. They are typically categorized not only according to whether they are debt or equity securities but also by their “term to maturity,” or time until the obligation must be repaid. Money market securities include short‐term (i.e., maturities less than one year) debt instruments, such as T‐bills, commercial paper, and BAs. Capital market securities include debt securities with maturities greater than one year, such as bonds, debentures, and so on. They also include equity securities, which represent ownership in a company and generally have no maturity date.
Governments raise new financing via the debt markets. They issue T‐bills as a source of short‐term financing (i.e., less than one year), and they issue traditional bonds and CSBs for long‐term financing. Businesses raise short‐term financing in the form of debt through loans, or by issuing commercial paper, BAs, and so on (all of which will be discussed in greater detail in later chapters). They raise long‐term financing in the form of debt (i.e., through loans, by issuing bonds, or by using other long‐term debt instruments) or in the form of equity (i.e., by issuing common shares or preferred shares).
Financial Markets
We have provided a brief overview of the financial instruments that are available to transfer funds from lenders to borrowers. Now we provide a brief description of the financial markets that permit the issue and trading of these instruments. It is important to recognize that finan- cial markets play a critical role in any open economy by facilitating the transfer of funds from lenders to borrowers. In addition, if markets are efficient (which is the topic of Chapter 10 ), these funds will be allocated to those who have the most productive use for them.
Primary and Secondary Markets
For discussion purposes, we will begin by distinguishing between primary and secondary markets. Primary markets involve the issue of new securities by the borrower in return for cash from investors (or lenders). For example, when the government sells new issues of T‐bills or bonds, or when a company sells new common shares to the public, these are primary mar- ket transactions; new securities are created, and the borrowing entity raises monies it can spend. Chapters 17 and 19 deal extensively with the primary markets.
equity instruments ownership stakes in a company
common share an equity instrument that represents part ownership in a company and usually gives voting rights on major decisions affecting the company
preferred shares equity instruments that usually entitle the owner to fixed dividend payments that must be made before any dividends are paid to common shareholders
non-marketable financial assets invested funds that are available on demand in instruments that are not tradable
marketable financial assets those assets that can be traded among market participants
money market securities short‐
term debt instruments
capital market securities debt securities with maturities greater than one year, and equity securities
primary markets markets that involve the issue of new securities by the borrower in return for cash from investors (or lenders)
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18 CHAPTER 1 An Introduction to Finance
Primary markets are the key to the wealth creation process, since they enable money to be transferred to those who can make best use of it in terms of developing new real assets, such as houses and factories. However, primary markets will not work properly without well‐
functioning secondary markets . Secondary markets provide trading (or market) environ- ments that permit investors to buy and sell existing securities. This service is critical to the functioning of the primary markets because governments and companies would not be able to raise financing if investors were unable to sell their investments when necessary. Consider how reluctant investors would be to buy a 20‐year corporate bond worth $1,000, or $1,000 worth of a company ’ s common shares, if they knew they would be unable to sell these securi- ties when they needed to raise money quickly or when they became nervous about the com- pany ’ s future prospects.
There are two major types of secondary markets: (1) exchanges or auction markets ; and (2) dealer or over‐the‐counter (OTC) markets . Exchanges have been referred to as auction markets because they involve a bidding process that takes place in a specific location (i.e., similar to an auction). Investors (both buyers and sellers) can be represented at these markets by brokers . In contrast, OTC or dealer markets do not have a physical location, but rather consist of a network of dealers who trade directly with one another. The distinction has become blurred in recent years because trading on most of the major exchanges in the world is now fully computerized, making the physical location of the exchanges of little conse- quence. At the same time, OTC markets have become increasingly automated, reducing the amount of direct haggling between dealers.
Money market instruments trade in dealer markets. They tend to be very large and are typically issued in sizes of $100,000 or more. As a result, money market trading is dominated by governments, financial institutions, and large corporations. Long‐term debt instruments, such as bonds, are also traded primarily through dealer markets, although some are traded on exchanges.
Equity securities generally, and common shares in particular, are the major financial secu- rities issued by corporations, and they represent a proportionate ownership (share) in a firm.
Unlike debt securities, which are normally paid back and result in constant refinancing activ- ity, common shares are generally issued once and then stay outstanding indefinitely. 9 As a result, secondary market trading in equity securities is many times the size of the primary market, whereas it is the opposite for debt securities. The overwhelming majority of equity market transactions take place through a stock exchange, although there is a small OTC equity market in Canada.
Stock Exchanges
Dramatic changes have taken place in the major stock exchanges in recent years, both at home and abroad. At the start of 1999, Canada had five stock exchanges: the Toronto Stock Exchange or TSX (formerly called the TSE), the Montréal Exchange (ME), the Vancouver Stock Exchange (VSE), the Winnipeg Stock Exchange (WSE), and the Alberta Stock Exchange (ASE). An overhaul of that structure occurred during 1999 and 2000, resulting in only two Canadian stock exchanges: the TSX and the newly created TSX Venture Exchange (TSVX) . Both of these exchanges were owned by a newly formed company, the TSX Group Inc., which became the first North American exchange to be publicly listed in November 2002. In September 2007, the Winnipeg Commodity Exchange was acquired by the Intercontinental Exchange (ICE), as ICE expanded its trading to include agricultural contracts and is now called ICE Futures Canada. On December 10, 2007, the Montréal Exchange and the TSX Group announced an agreement to combine both institutions to form the TMX Group Inc., which secondary markets trading (or
market) environments that permit investors to buy and sell existing securities
exchanges or auction markets secondary markets that involve a bidding process that takes place in a specific location
dealer or over-the-counter (OTC) markets secondary markets that do not have a physical location and consist of a network of dealers who trade directly with one another
brokers market intermediaries who facilitate the sale of financial securities and help to make the market work
Toronto Stock Exchange or TSX the major stock exchange in Canada, where most equity security transactions take place; it is the official exchange for trading Canadian senior securities
TSX Venture Exchange (TSVX) the stock exchange for trading the securities of emerging companies not listed on the TSX
9 There are occasional share repurchases, but relative to the continuous retirement of debt, the amounts are generally insignificant.
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19 CHAPTER 1 1.4 Financial Instruments and Markets
was completed on May 1, 2008. In 2012, a new company called TMX Group Limited was formed with the acquisition of Canadian Depository for Securities Limited (CDS), Alpha Trading Systems Inc., and Alpha Trading Systems Limited Partnership (collectively Alpha) in August, and the TMX Group Inc. in September.
Since March 2000, the Montréal Exchange (ME) has functioned as the Canadian national derivatives market, and it now carries on all trading in financial futures and options that previ- ously occurred on the TSX, the ME, and the now‐defunct Toronto Futures Exchange. Similarly, equity trading is now concentrated on the TSX and TSVX, where oversight and regulation can be more uniformly implemented.
Traditionally, stock exchanges were not‐for‐profit organizations. Membership in a stock exchange (in the form of a “seat”) was sold to individuals to allow them to trade on the exchange. However, when the TSX converted into a regular corporation, these seats were exchanged for shares, so now the new TMX Group is a for‐profit institution owned by its shareholders. This reflects a worldwide trend in the conversion of stock exchanges to com- petitive private companies, as global competition to list and trade securities has increased.
The result is that market intermediaries, like stock brokerages, are now called “participating organizations” or “approved participants” and do not have to own seats in order to trade on the exchange.
On April 23, 1997, the TSX closed its trading floor, and trading is now mostly computer- ized. Brokers enter orders to either buy or sell securities based on their client orders, and the computer matches buyers with sellers. At the end of 2014, there were 3,485 issuers listed in Canada on the TSX and the TSVX, with a market capitalization (that is, the total market value of all the listed firms) of over C$2.5 trillion; many of the larger ones were also listed on U.S. markets. 10 The barometer that measures the state of the Canadian equity market is the Standard & Poor ’ s/Toronto Stock Exchange (S&P/TSX) Composite Index (formerly known as the TSE 300 Composite Index). The S&P/TSX Composite Index is the TSX ’ s major stock market index and is maintained by Standard & Poor ’ s (S&P), a major U.S.
company that also maintains the S&P500 Index, which is one of the major indexes of the U.S. stock market. Figure 1-5 gives the value of the S&P/TSX Composite from May 1995 to April 2015.
TMX Group Limited the company that owns the TSX, the TSXV, the ME, CDS, and Alpha, as well as several other related subsidiaries Montréal Exchange (ME) the exchange that acts as the Canadian national derivatives market and carries on all trading in financial futures and options
market capitalization the total market value of the common equity of an entity
10 “Create Value Greater Than the Sum of the Parts,” TSX Inc., March 20, 2015.
0 2000 4000 6000 8000 10000 12000 14000 16000 18000
1995M05 1996M01 1996M09 1997M05 1998M01 1998M09 1999M05 2000M01 2000M09 2001M05 2002M01 2002M09 2003M05 2004M01 2004M09 2005M05 2006M01 2006M09 2007M05 2008M01 2008M09 2009M05 2010M01 2010M09 2011M05 2012M01 2012M09 2013M05 2014M01 2014M09 2015M05
S&P/TSX Index Value
FIGURE 1-5 S&P/TSX Composite Index, May 1995–
April 2015
Source: Data from Statistics Canada, CANSIM V122620, May 23, 2015.
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20 CHAPTER 1 An Introduction to Finance
Notice from Figure 1-5 that the S&P/TSX Composite Index reached a month‐end high (at the time) of 14,714.73 in May 2008. Then it was caught in the worldwide decline in equity mar- kets as the U.S. banking system verged on collapse. By month‐end February 2009, the TSX had declined to 8,123.02, over 45 percent down from its month‐end high less than a year earlier.
Globally, almost US$15 trillion in market capitalization had disappeared with the decline in stock markets around the world. By the end of April 2015, most stock markets around the globe had exceeded their pre‐crisis levels, and Canada was no exception, with the S&P/TSX Index closing April 2015 at 15,224.52, slightly below the all‐time high month‐end close hit in August of 2014 (before oil prices started plunging).
How big is Canada ’ s stock market relative to other global stock exchanges? Figure 1-6 shows the market capitalization of the major stock markets around the world as of December 2014. With a total value of just over US$2 trillion, the Canadian market ranked eighth. Until recently it was the sixth largest, but there has been a dramatic increase in the size of the Chinese markets, with both the traditional Hong Kong markets (#7) and the newer mainland China market in Shanghai (#5) becoming larger than the TMX, and with mainland China ’ s second‐largest stock market, Shenzhen (#9), being virtually equal in size to Toronto. Of course the world ’ s biggest market is the New York Stock Exchange, which, together with the Nasdaq, had total market capitalization of US$26.2 trillion, but the normal rule of thumb that Canada is one‐tenth the size of the United States suggests that Canada ’ s stock market is pretty significant.
19,351
6,979
4,378 4,013 3,933 3,319 3,233
2,094 2,072 1,739
0 5,000 10,000 15,000 20,000 25,000
NYSE NASDAQ OMX
Japan Exchange
Group - Tokyo
London Stock Exchange
Group
Shanghai SE
Euronext Hong Kong Exchanges
TMX Group
Shenzhen SE
Deutsche Bửrse FIGURE 1-6 World Stock
Markets, Market Cap, 2014 ($US billions)
Source: Data from the World Federation of Exchanges website on May 23, 2015, www.world‐exchanges.org/statistics/
monthly‐reports.
Other Markets
As mentioned above, in addition to listing on an organized stock exchange, common shares also trade in the OTC or unlisted markets. Trades in unlisted securities do not need to be reported, except in Ontario, where the Ontario Securities Commission (OSC) requires that they be reported on the Canadian Unlisted Board Inc. automated system. The first Canadian quotation and reporting system, the Canadian Trading and Quotation System Inc. (CNQ), was launched in 2003 and has since been renamed CNSX Markets Inc . This market has grown steadily and listed over 200 securities as of 2015. The requirements to trade on this market are less stringent than those for the TSX Venture Exchange.
In addition to the primary and secondary markets, there are also the third and fourth mar- kets. The third market refers to the trading of securities that are listed on organized exchanges in the OTC market. Historically, this market has been particularly important for “block trades,” which are extremely large transactions involving at least 10,000 shares or $100,000.
The fourth market refers to trades that are made directly between investors (usually large Ontario Securities Commission
(OSC) an agency created by the Ontario government to protect investors in securities transactions CNSX Markets Inc. an alternative market for small emerging companies third market the trading of securities that are listed on organized exchanges in the OTC market fourth market the trading of securities directly between investors without the involvement of brokers or dealers
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21 CHAPTER 1 1.5 The Global Financial Community
institutions), without the involvement of brokers or dealers. The fourth market operates through privately owned automated systems. Two of the most widely recognized systems are Instinet (Institutional Network), which is owned by Reuters, and Alpha, which is now part of the TMX Group Limited.
1. Distinguish among the various types of fi nancial assets.
2. Identify the major sources of fi nancing used by (a) governments and (b) businesses.
3. Distinguish between primary and secondary markets.
CONCEPT REVIEW QUESTIONS