Capital Markets

• Financial market that facilitate a flow of long-term funds.

• Capital markets are the markets where securities such as shares and bonds are issued to raise medium to long- term financing, and where securities are traded.

• The securities might be issued by a company which could issue shares or bonds to raise money.

• Bonds could also be issued by other entities in need of long-term cash, such as regional or national governments.

• The purpose of capital markets is to match the demand for funds with the supply of funds.

Capital markets consist of Primary and Secondary markets.Primary markets (new issue market)• It facilitate issuance of new securities. i.e.; In primary

markets, governments and companies raise cash (fund) by selling newly issued securities to buyers (surplus units), often through the mechanism of underwriting.

• Primary market transactions provide funds to the initial issuer of the securities.

• The issuance of new corporate stock or new debt securities (bonds, notes) is a primary market transaction.

Secondary Markets• Secondary markets facilitate the trading of existing

securities.• Transactions in this market do not provide funds to

initial issuer of the securities.• The sale of existing corporate stock or debt security

holding by any business or individual is a secondary market transaction.

• Important characteristic of securities that are traded in secondary markets is Liquidity.

Who buys, sells and why?• A variety of buyers and sellers come to the capital

markets with different needs and objectives. • Financial intermediaries play an important role in

facilitating transactions in which there isn’t a ready seller to match with a buyer or vice versa. Or when there are different characteristics of assets involved, such as different sizes.

• In such cases, intermediary acts as a market maker, using its own capital or holding the assets until a buyer or seller can be found.

Who buys and why?-Buyers can be individual, institutional investors, firms or government . -Buyers come to capital market with variety of needs:• To buy stocks or bonds in order to put cash to work by

investing and earning a return such as for generating income on savings.

• To buy stocks or bonds in order to gain or limit exposure to macroeconomic trends or types of companies.

• To reinvest proceeds from gains realized in other investments.

Who sells and why?Sellers can be Firms, Government, institutional investors or individuals.Sellers come to the capital markets with a variety of needs and goals:• To issue equity or debt to list on a public exchange,

which can broaden ownership in a company, establish a market value for a company, and create a currency for acquisitions and investments.

• To sell stocks or bonds in order to raise cash to reallocate into different investments.

• To realize gains on investments.

Methods of issuing securities in Primary Market• Public Issue (IPO & FPO)• Rights issue• Private placement

Public Issue- Issue of securities (stocks or bonds) to the general public is called as public issue. -IPO• An Initial public offering marks a corporation’s transition from

private to public. An IPO can bring in large funds, enriching the company.

• An investment bank handles the IPO, sets the price and sell the shares by soliciting investors interest.

-FPO• Follow on public offer is done when an already listed

company makes a fresh issue of securities to the public or an offer for sale to the public, through an offer document.

• Method to raise additional equity capital.

Rights Issue• When a listed company proposes to issue

fresh securities to its existing shareholders.• The rights are normally offered in a particular

ratio to the number of securities held prior to the issue.

• It is best for the companies who like to raise capital without diluting the stake of its existing shareholders unless they do not intend to subscribe to their entitlements.

Private placement• When a company issues financial securities such as

shares and convertible securities to a particular group of investors, it is known as private placement.

• This is neither a public nor rights issue. This is a faster way for a company to raise capital

• There are two types of private placement.-preferential allotment- listed company issues

securities to a select group of entities, which may be institutions or promoters, at a particular price.

-qualified institutional placement- listed company issues shares or convertibles to institutional buyers only.

Types of Secondary MarketSecondary market can be classified in terms of organized exchanges and over-the-counter markets.Exchanges (Auction Market)• A stock exchange is a physical place where stockbrokers and

traders trade listed stocks and other securities.• To be listed, the issuer must meet the requirements set forth by

the exchange.• Major stock exchanges of the world are: New York Stock

Exchange (NYSE), London Stock Exchange (LSE)• For a stock to be listed in LSE, firm should have minimum

market capitalization of £ 700000, 3 yrs of audited financial statements, minimum public float of 25% and sufficient working capital for 12 months.

Over-the-counter markets (Dealer market)• An OTC market is a decentralized market where non-listed

securities (stocks, bonds, derivatives)are traded by the market participants.

• In OTC market, dealers frequently buy and sell for their own accounts.

• Market makers or dealers provide a bid quote (to buy) and an offer quote (to sell), and realize revenues from the spread between the two quotes.

• Market participants are not buying from and selling to one another directly but through a dealer.

• There is no centralized place to make the trade. i.e.; trade takes place on a telecommunication network.

• Major example of OTC market is The National Association of Securities Dealers Automated Quotation (NASDAQ)

Benefits of listing in stock exchange

• Fund raising and exit routes for investors.• Ready marketability of the securities.• Supervision and control of trading securities

-transactions to be carried as per the rules of the exchange

-all transactions are monitored by the stock exchange, preventing unfair trade practices.• Fair price for the securities (price as per demand and supply)• Timely disclosure of corporate information• Collateral value of securities.

How firms issue securities• When firms need to raise capital they may choose to

sell or float securities.• These new issues of stocks or bonds are marketed to

the public by investment bankers in Primary Market.• Public offerings of both stocks and bonds typically are

marketed by Investment Bankers who in this role are called underwriters.

Underwriting-Bearing the risk of not being able to sell a security by virtue of purchasing the security for resale to the public, also known as firm commitment.

Investment Banking• Investment bankers advise firm regarding the terms on

which it should attempt to sell the securities.• A preliminary registration statement must be filed with

the regulators (SEC, FCA) describing the issue and prospects of the company.

• This preliminary prospectus is known as red herring, as the statement is printed in red and states, the company is not attempting to sell before the registration is approved.

• When the statement is approved by the regulator, it is called Prospectus. At this point the price at which securities will be offered to public is announced.

• Underwriting can be understood as a process by which investment banks help raise capital from investors on behalf of corporations and governments that are issuing securities.

• When an investment bank underwrites stock or bond issues, it also ensures that the institutional investors, such as mutual funds, commit to purchase the issue of stocks or bonds before the offer hits the market.

• In practice, Investment banks will buy new issue of securities from the issuer for a negotiated price and promotes same to investors in a process.

• More than one Investment bank usually markets the securities. A lead firm forms an underwriting syndicate of other Investment banks to share the responsibility of stock issue.

Three primary means, companies use to offer securities to the general public1. Traditional Underwriting (firm commitment)2. Best Efforts Offering3. Shelf Registration

4. Traditional UnderwritingIf the security does not sell well due to adverse effect in the market or it being overpriced, the underwriter, not the company, takes the loss.

A. Competitive Bid – The competing syndicates submit the bids and one with highest bids wins the security issue.

B. Negotiated Offering- The issuer selects an investment banking firm and works directly with the firm.

Together they discuss and negotiate a price, size and time of the issue.Depending on the size of the issue, investment bank may invite other firms to join in

sharing the risk and selling the issue.

2. Best Efforts Offering• An underwriting in which an investment bank, acting as an agent,

agrees to do its best to sell the offering to the public, but does not buy the securities outright and does not guarantee that the issuing company will receive any set amount of money.

• It is less common than firm commitment offering.

3. Shelf Registration• A procedure whereby a company is permitted to register securities

and gradually sell them to public for two years following the initial registration; also called SEC Rule 415.

• Because the securities are already registered, they can be sold on a short notice, with little additional paperwork.

• They can be sold in small amounts without incurring substantial flotation costs.

• The securities are “on the shelf”, ready to be issued, so the term shelf registration came in to use.

London Stock Exchange• The primary stock exchange of UK and the largest in the

Europe.• It is most international of all stock exchange with 2500

companies from more than 50 countries.• The Financial Times Stock Exchange (FTSE) 100 share

index is the dominant index, containing 100 of the top blue chips on the LSE

• LSE major equity markets are –Main Market, Alternative Investment Market

(AIM)• Debt issues are traded in two markets- Main Market or

Professional Securities Market (PSM)

Main Market -It is for larger and more established companies.• Underpinned by London’s balanced and globally-

respected standards of regulation and corporate governance.

• It represents a badge of quality for every companies admitted and traded on it and an aspiration for many companies worldwide.

AIM – regarded by the advisers, investors and companies as the most successful growth market in the world.• Comprises of small cap, high growth firms.

Trading ServicesLSE trading services are designed to maximize liquidity for all market participants. 3 key trading services are available in LSE.SETSIt is a LSE’s flagship electronic order book, trading FTSE 100, FTSE 250, FTSE small cap index constituents.SETSqxTrading service specially designed for securities less liquid than those traded on SETSSEAQLSE’s non electronically executable quotation service that allows market makers to provide firm quotes in AIM securities that are not traded on SETS or SETSqx.