14
Capital
Markets
Chapter 14 - Outline
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Structure of Capital Markets
Demand for Funds in the Capital Markets
Supply of Funds in the Capital Markets
The Organization of the Security Markets
Market Efficiency
Government Regulation
Prepared by:
Michel Paquet
SAIT Polytechnic
©2012 McGraw-Hill Ryerson Limited
Learning Objectives
©2012 McGraw-Hill Ryerson Limited
Learning Objectives
1.  Define primary, secondary, money and
capital markets. (LO1)
2.  Outline the primary participants raising
funds in the capital markets. (LO2)
3.  Characterize the Canadian economy as
three major sectors allocating funds
amongst themselves. (LO3)
4.  Outline the organization of the securities
markets. (LO4)
5.  Assess the concept of market efficiency
and its benefits to the economic system.
(LO5)
6.  Examine the changing financial
regulatory environment. (LO6)
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LO1
Structure of Capital Markets
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LO1
Figure 14-1
Canadian money and capital markets:
securities outstanding, 2011
Capital Markets can be classified into:
(1) Primary vs. Secondary Markets
-  A new security is first issued in a primary markets and there is cash
flow to the issuer.
-  Any security currently outstanding are bought and sold amongst
investors in a secondary market but no cash flows to the security
issuer.
(2) Money vs. Capital Markets
-  Fixed income securities with maturities of one year or less are
traded in a money market (e.g., T-bills, commercial paper)
-  Long-term securities with maturities greater than one year are
traded in a capital market (e.g., bond, common and preferred stock)
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Source: Adapted in part from Statistics Canada, “Canada’s International Investment Position,”
Catalogue No. 67-202, and “Quarterly Financial Statistics for Enterprises,” Catalogue No.61-008.
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Figure 14-2
Market capitalization (value) of top 12 equity
markets
LO1
Competition for Funds in the Capital
Markets
LO2
•  Corporations are not the only demander
for funds in the capital markets.
•  All levels of governments also compete for
funds in the capital markets.
Source: World Federation of Exchanges, 2010.
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LO2
LO2
Government Securities
Corporate Securities
Corporate Bonds
•  Government of Canada Securities
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–  most widely used form of financing in recent years
–  significant amounts raised abroad
T-bills: short-term securities
Long-term bonds: active secondary market
Canadian Savings Bonds: illiquid long-term bonds
After 1998, the federal budget surpluses reduce demand for new
debt and amount of debt outstanding.
Preferred Stock
–  least used of all long-term corporate securities
•  Provincial and Municipal Government Bonds
Common Stock
§  Historically, provinces have borrowed mainly long term but
during the 1990s became active in the short-term market as well.
§  Provinces and municipalities borrow actively in the foreign
markets
§  Municipal bonds account for a small portion of the bond market
–  25% of net new financings in some years
–  more equity is being raised abroad by Canadian
corporations
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LO2
LO2
Figure 14-6
Net new corporate financings by type of
security
Corporate Financing in General
•  Debt-to-equity ratios among Canadian nonfinancial private corporations from the 1960s are
fluctuating.
•  Managers attempt to time their issues of common
stock.
•  Over a recent period, internally generated
funds, consisting of retained earnings and
capital consumption allowance generated over
60% of the firm’s funding needs.
•  Managers are reluctant to use external
financing.
Source: Reprinted with permission of Bank of Canada, “Banking and Financial Statistics”, F9 series.
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LO2
Figure 14-7
Debt-to-equity ratios for nonfinancial private
corporations
Source: Adapted from Statistics Canada, “Financial Statistics for Enterprises”, Catalogue No. 61-008, 2011.
Figure 14-8
Funding Sources of Non-financial Private
Corporations
LO2
Source: Statistics Canada, 61-008-, 2011, Table 3-2.
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LO3
LO3
The Supply of Capital Funds
Figure 14-9
Flow of funds
through the
economy
•  The major supplier of funds for investment in a
three-sector economy is the household sector.
•  The transfer of funds from savers to borrowers
can be accomplished directly in the capital
markets.
•  Alternatively, a saver can indirectly invest his or
her funds through a financial intermediary.
•  These financial intermediaries help make the
flow of funds very efficient and competitive.
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LO3
LO4
Figure 14-10
Total assets of financial intermediaries
The Organization of the Security Markets
•  Security markets exist to facilitate the direct
transfer of capital among households,
corporations, and governments.
•  After a security is sold initially as an original
offering, it then trades among investors, a
process known as secondary trading.
•  Secondary trading is vitally important as it
provides liquidity for investors.
•  Secondary market trading activity is divided
between organized exchanges and over-thecounter (OTC) markets.
Source: Bank of Canada, Banking and Financial Statistics, 2011, C3, D1-D5 Series; Statistics
Canada, CANSIM 280-0002 to 0004.
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LO4
LO4
Organized Stock Exchanges
Organized Exchanges
•  Toronto Stock Exchange (TSX)
•  Regulated marketplace where buyers and sellers of
securities come together to trade securities in a single
location
–  largest and most important market for stocks in Canada
–  strict requirements in order for a firm to be traded on that
exchange
–  smaller and less significant globally than the NYSE
•  Exchanges are auction markets where there is a price
offering and acceptance between buyers and sellers
•  New York Stock Exchange (NYSE)
–  largest and most important market for stocks in the world
•  Key components of organized exchanges are fair prices,
transparency, liquidity and integrity
•  Alternative trading systems (ATS)
–  also known as Electronic Communication Networks (ECN)
use the Internet to electronically match buyers and sellers
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LO4
LO4
The Over-the-Counter (OTC) Markets
Challenges for Canadian Exchanges
•  Have no central location
•  Networks of dealers connected by
computer terminals and telephones
•  Buy and sell securities which are not
listed on a stock exchange
•  Historically, the bulk of all bond trading
was done OTC
•  CanDeal has been established to report
real time pricing on debt inventories
•  The extremely liquid markets in the US have
tended to attract business away from Canadian
exchanges.
•  Another threat is the “upstairs rooms” practice,
that is, dealers matching large trades in shares
through their own trading floors.
•  Internet trading systems such as Alternative
Trading Systems (ATS) are also competing for
business.
•  Over the next decade, it is expected that
securities market will become more competitive
as more computer systems are used.
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LO5
LO5
Market Efficiency
Efficient markets allocate capital to its best use without
undue costs.
Criteria of Efficiency
ü  prices adjust rapidly to new information
ü  there is a continuous market in prices
ü  the market can absorb large dollar amounts of
securities without price destabilization
Based on these criteria:
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The NYSE is the world’s most efficient capital market.
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The TSX is reasonably efficient.
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The Efficient Market Hypothesis
•  Based on the nature of information included in the price
of a security, 3 forms of market efficiency are grades as
to the degree of market efficiency.
–  Weak form:
•  Prices reflect all of the information contained in the past price
history
–  Semi-strong form:
•  Prices reflect all public information
–  Strong form:
•  all information, both private and public is immediately
reflected in stock prices
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LO6
Securities Regulation
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Good capital markets should be fair, transparent, liquid,
competitive and efficient.
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Regulation helps to develop and nurture these key aspects.
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In Canada, the securities markets are regulated by:
Ø Provincial securities commissions such as the Ontario
Securities Commission (OSC)
Ø Stock exchanges and
Ø Trade organizations such as the Investment Industry
Regulatory Organization of Canada (IIROC)
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One of the major regulation tasks is to protect investors from fraud
and manipulation.
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