The Canadian Capital Market
Contributed by Dr. Khaled Soufani, Associate Professor of Finance
John Molson School of Business, Concordia University
Capital Market
The capital market plays an important role in the growth and development of our
economy; it functions as an important economic unit that facilitates the allocation of
financial resources between suppliers and demanders of funds. The efficient
performance of any economy is governed by the ability of its financial system to link
saving and investment between the different economic agents namely consumers, firms
and the government. Students commonly confuse the capital market with the financial
market. It is important to note that the financial market, in general, encompasses four
kinds of markets namely; the capital market, the money market, the stock market, and
the hedging market.
 The capital market is not a single institution. It comprises all the institutions,
including banks, insurance companies and pension funds, which are concerned with
either the supply of or demand for long-term loanable funds. The duration of
financial contracts in this market extends typically from one year to 25 years in
terms of borrowing and lending.
 The money market is the market where short-term loanable funds are traded. The
duration of financial contracts in this market can be for a period of 24 hours
(overnight lending and borrowing) up to 365 days. The interest rate in this market
usually acts as the benchmark rate for other rates in the financial system.
 The stock market is the place where the buying and selling of ownership shares of
firms take place, the main stock market in Canada in terms of volume and value is
the Toronto Stock Exchange.
 Finally, the hedging market is a market about risk management where trading of
insurance, swap, option, future, and forward contracts takes place.
Role of the Capital Market
Most Canadians participate in some form in Canada’s capital market. Individuals and
organizations that are considered financial surplus units or have more money that they
require for their present consumption and spending are considered as savers. The
savings of Canadians can be invested directly by buying stocks, bonds, T-bills, real estate,
etc. or indirectly by depositing their funds in Canadian financial institutions such as
banks, near banks (such as trust companies), credit unions (caisses populaires in
Quebec), mutual funds, pension funds, and life insurance policies. The capital market
plays an important role in channeling these savings into investments; this process has
the impact of contributing to the economic development of the country by sustaining
and stimulating successive economic growth through capital formation and job creation.
1
Many sectors and industries in the Canadian economy benefit from the role of the
capital market, such as manufacturing, natural resources, transportation,
telecommunications, high-tech, utilities, etc.
The financial market has two broad distinctions that are important to identify in
order to understand the role of the capital market in channeling savings into
investments. First, there is the distinction between the retail and wholesale markets.
Second, there is the distinction between the primary and secondary markets. Retail
market transactions are usually small scale and are usually customized to reflect the
needs of the parties to each transaction. Exactly the opposite features characterize
wholesale markets: large scale, standardized transactions in multiple and large standard
amounts. Wholesale markets normally operate by institutional traders over the
telephone and computer screens. This market is commonly referred to as the
institutional market.
A primary market is one where newly issued securities (stocks or bonds) are traded.
This involves initial public offerings (IPOs), new government bond issues such as Canada
Savings Bonds, or corporate notes that are issued by major corporations in order to
raise debt. The secondary market relates to the buying and selling of assets already
issued some time earlier. This typical exchange is conducted in the stock market.
The capital market plays other important roles in our economy in addition to the
channeling of savings into real investments. The capital market can provide a medium
of exchange by creating assets and operating the payment mechanism where money is
transferred from one holder to another. Furthermore, the capital market can facilitate
the effective and efficient working of the monetary policy where the levels of the
interest rates and money supply are determined; this function provides a source of
stability to the economic system.
THE SUPPLY OF SAVINGS
Secondary market
Primary market
Indirect Savings
Savings supplied by households
Capital Market
Stock Market
New Issues
Investments
Direct Savings
Banks, Mutual funds, etc.
In addition to the above, the capital market plays a crucial role in showing the working
of the monetary policy, and can reflect the interactions between the fiscal and
monetary policy, in other words, the conduct of economic policy as represented by the
central bank and also the government. Monetary policy is about the using of interest
rates and the money supply to direct economic activities to achieve some
macroeconomic objectives, and mainly inflation control. Fiscal policy is about the use of
government spending and taxation to achieve the goals of full employment, economic
growth, control of budget deficits and the national debt. The capital market usually
reacts positively or negatively to changes in the instruments applied by the central bank
2
or the government. When interest rates rise to put a lid on inflation, bond prices
normally drop in order to compensate investors for what they could earn if they decide
not to hold fixed interest securities, and it is always observed that the capital market
moves when the central bank moves on interest rates. The reactions of the capital
market is crucial to firms wishing to issue new securities and are considering refinancing
their capital structure, and it is also closely observed by portfolio managers who manage
the savings of many segments of the population and who might consider making
changes to their portfolio choices based on the actual and forecasted changes. Financial
institutions monitor the capital market in order to decide on the cost of capital that they
will charge when extending credit.
Role of Information in the Functioning of the Capital Market
Information is the most crucial element in making savings and investment decisions, and
also borrowing and lending decisions in the financial market, including the capital,
money, stock and hedging markets. Many types of data are needed to evaluate and
analyze the viability of financial and credit decisions, especially with regard to the
working of the capital market. Information is of two kinds, general information, which is
widely available and pertain to the economy as a whole, or to a given sector or industry,
and specific information, which pertain to the specific firm, and include accounting and
financial statements.
It is reasonable to believe that management has more information about the future
earnings of the firm than the public does, including the firm’s shareholders. This
situation gives rise to the asymmetric information problem, which can be defined as a
state where one economic agent (management of the firm) has access to more or
different information than the outsiders to the firm (creditors, shareholders, financial
institutions etc.). Information is generally used to analyze the financial performance of
the firm and evaluate the levels of profitability; hence the potential to channel different
forms of financial investments to the firm as and when needed.
The main kind of specific information that the financial market concentrates on with
regard to firms is their accounting information and financial reports. Publicly traded
companies must produce various reports to their shareholders and the financial market
at large. These annual and quarterly reports provide two kinds of information. First
there is the non-financial or verbal section, often presented as letter from the Chief
Executive Officer of the company detailing the firm’s operating results during the past
year, and outlining the new developments that will affect future business operations.
Second there is the financial section which presents four basic financial statements - the
income statement, the statement of retained earnings, the balance sheet, and the cash
flow statement. Both the financial and verbal information are equally important for the
financial market. The financial statements report the changes to earnings and dividends
over the year, while the verbal information explains the reasons for the results. The
information available is conducive to actual and potential investors for them to form
expectations about future earnings and dividends and about the riskiness of these
expected values.
3
Financial statements report on a firm’s financial position at a certain point in time
and on the results of its operations for some past period. From the financial and capital
markets standpoint the real value of information emanating from the income
statement, is the prediction of future earnings and dividends. If stocks were to be
issued on the primary market or traded on the secondary market then this kind of
information would help the pricing process of the shares. If credit is to be offered to
corporations then again financial statements help analyze the ability of firms to service
their debt by paying the interest and principal.
Role of Intermediaries in the Capital Market
Financial institutions in Canada play a very crucial role in channeling funds from savers
to investors. It is argued that financial institutions are distinguished from non-financial
firms by the fact that financial institutions borrow funds mainly to lend them out again.
However, in addition to this function, financial institutions play important functions that
facilitate the working of the capital market. Financial institutions clear and settle
payments among the economic units: consumers, firms, and institutions. They pool
funds for allocation to both large-scale and small-scale projects in different parts of the
country. They transfer economic resources over time, space, and industries by lending
for different duration and maturities. Financial intermediaries play a central role in
accumulating, processing, and disseminating information for investment purposes. In
addition, they provide solutions to deal with asymmetric information problems by
drafting contracts. Financial intermediaries tend to get involved in the process of risk
management by controlling risks and uncertainties.
Overall financial institutions conduct their intermediary role with the capital market
and tend to provide a link between the real side of the economy and the financial side,
hence facilitating the process of fund transfers between surplus units and deficit units.
This process is made efficient when financial and accounting information about firms is
accurate, and the analysis of the information is made available to decision-makers in the
investment industry both as individuals and corporations.
4