March 26, 2007

MONEY AND CAPITAL MARKETS - AN OVERVIEW

Money and Capital Market Transactions
When you borrow money from a financial institution to finance the purchase of a car, or take out a mortgage to buy a new home, or invest in the shares of a company listed on the Stock Exchange, you are utilizing the money and capital markets. The money market typically involves securities that mature within one year. Money market instruments include treasury bills, short-term deposits, commercial paper and bankers’ acceptances. On the other hand, the capital market typically involves those securities with a life span that is beyond a year. Capital market instruments include term deposits that mature after one year, stocks and bonds.

Some Characteristics of Securities
Transactions within the money and capital markets usually involve the exchange of funds for securities. Generally speaking, a security is a written document which conveys a legal right to the investor to receive prospective future benefits under stated conditions. For example, the security provisions of certain bonds would entitle the bondholder to receive interest payments at stated periods, culminating in the repayment of the principal amount at a specified future date. A secured bond would also contain a clause that would give a bondholder a claim or lien over specific property or assets of the borrower in the event of default (non-payment).
A security can usually be transferred from one investor to another with all its rights and conditions intact. The ease with which an investor can convert his or her securities into cash depends on the “liquidity” of the market for those securities.

Primary and Secondary Securities
In general, securities can be differentiated by their underlying assets. Primary securities, such as stocks and bonds, are issued by a corporation to raise funds and are backed by the assets of the corporation. By contrast, secondary or derivative securities, such as options, futures, and swaps are not backed by the corporation’s assets and are usually used by investors and corporations to manage risk, (e.g. risk associated with fluctuations in exchange rates, stock prices). “Risk” in this context refers to the possibility that an outcome will be different than expected.

Role of Financial Intermediary
Money and capital markets facilitate the exchange of funds and securities between buyers and sellers. Although the exchange can be done directly between the borrower and the investor, the majority of transactions are performed indirectly, that is via a financial intermediary. For instance, a corporation would issue a security to a financial intermediary, (such as a commercial or investment bank), in return for funds. The financial intermediary would in turn acquire funds by inviting the general public and other financial institutions to maintain deposit accounts with them, or to purchase units or participation in a mutual fund. A similar process would apply to an individual wishing to access funds to purchase a home for example. In this case, the security document would be a deed of mortgage.

Issuance of Securities by Corporations
Corporations are not restricted to loan funding by commercial banks and other non-bank financial institutions as sources of capital. Once certain requirements are met, a corporation can also issue shares on the stock market in order to obtain the funds required for its operations. If a corporation is issuing shares to the public for the first time, (known as an “initial public offering”, (IPO), or an “unseasoned offering”), such transactions are said to be taking place within the primary market for securities. Shares that were issued previously can subsequently be traded by investors in the secondary market for securities. Primary market transactions can be handled directly between the issuer and the ultimate investor. In many instances, corporations use the services of an investment banker to manage the issuance of securities, particularly in the case of an initial public offering. Trading on the secondary market must be done through an approved intermediary, such as a licensed stockbroker.

Investors' Choices
An investor can thus select from a range of short or long-term instruments, depending on his or her investment objectives. Some investors prefer, and have the financial flexibility, to invest their funds in a long-term instrument such as a 30 year bond. Others may require the use of their funds within a relatively short term such as a 3 month certificate of deposit. The maturity of the investment is not and should not be the only criterion for an investment decision. The potential investor’s risk/return preferences also play an extremely important role. There is usually a direct relationship between a given security’s risk and its promised return. This is attributable to the fact that investors are generally risk-averse, and consequently require a higher return on an investment that carries a greater degree of risk. A “junk” bond would therefore carry a higher rate of return than an “investment grade” bond, due to the higher degree of uncertainty surrounding the actual receipt of payments, and thus a greater potential for default of the junk bond.