UNIVERSITY

Studies

MONEY AND CAPITAL

MARKET
Advance
OPEN

Lecture 3
IQBAL of

August 11th, 2015

Chenab College

Faisal Abbas
ALLAMA

faisalsialkml@yahoo.com

0
 UNIVERSITY
Studies

Today’s Class
Advance

• What is on today’s class Menu?

IQBAL ofOPEN

A. Recap
Chenab College

B. More about Markets Classification and

Trading Mechanics
ALLAMA

1
 UNIVERSITY
Studies

Recap
Advance

Financial Assets
OPEN

Equity Market
Debt Market
IQBAL of
Chenab College

Foreign Exchange Markets

Derivative markets
Issuers and investors
ALLAMA

Role of Financial intermediaries

Regulations of financial markets

2
 Chenab College
ALLAMA IQBAL of Advance
OPEN Studies
UNIVERSITY

C
3
 UNIVERSITY
PRIMARY MARKET
Studies

• The primary market is the part of the capital market that deals
Advance

with issuing of new securities. Companies, governments or

public sector institutions can obtain funds through the sale of a
OPEN

new stock or bond issues through primary market. This is

typically done through an investment bank or finance
IQBAL of

syndicate of securities dealers.

Chenab College

• The process of selling new issues to investors is

ALLAMA

called underwriting. In the case of a new stock issue, this sale is

an initial public offering (IPO). Dealers earn a commission that
is built into the price of the security offering, though it can be
found in the prospectus. Primary markets create long term
instruments through which corporate entities borrow from
capital market.
 UNIVERSITY
FEATURES
Studies

• This is the market for new long term equity capital. The primary
Advance

market is the market where the securities are sold for the first time.
Therefore it is also called the new issue market (NIM).
OPEN

• In a primary issue, the securities are issued by the company directly to

investors.
IQBAL of

• The company receives the money and issues new security certificates
Chenab College

to the investors.
• Primary issues are used by companies for the purpose of setting up
new business or for expanding or modernizing the existing business.
ALLAMA

• The primary market performs the crucial function of facilitating capital

formation in the economy.
 UNIVERSITY
Studies
SECONDARY MARKET
• The secondary market, also called
Advance

the aftermarket, is the financial market in

OPEN

which previously issued financial

IQBAL of

instruments such as stock, bonds, options,

Chenab College

and futures are bought and sold. Another

frequent usage of "secondary market" is to refer
ALLAMA

to loans which are sold by a mortgage

bank to investors such as Fannie
Mae and Freddie Mac.
 UNIVERSITY
Studies FUNCTIONS OF
SECONDARY MARKET
Advance

• Provides regular information about the value of security.

OPEN

• Helps to observe prices of bonds and their interest rates.

IQBAL of

• Offers to investors liquidity for their assets.

Chenab College

• Secondary markets bring together many interested

parties.
ALLAMA

• It keeps the cost of transactions low.

 UNIVERSITY
Studies
REGULATIONS OF ISSUANCE OF
SECURITIES
Advance

• Securities Act 2015

OPEN

• www.secp.gov.pk
IQBAL of
Chenab College
ALLAMA
 UNIVERSITY
Studies
Role of Brokers and Dealers
In financial services, a broker-dealer is a natural person,
a company or other organization that engages in the business of
Advance

trading securities for its own account or on behalf of its

customers.
OPEN

Although many broker-dealers are "independent" firms solely

IQBAL of

involved in broker-dealer services, many others are business

Chenab College

units or subsidiaries of commercial banks, investment

banks or investment companies.
When executing trade orders on behalf of a customer, the
ALLAMA

institution is said to be acting as a broker. When executing

trades for its own account, the institution is said to be acting as
a dealer.
.
 UNIVERSITY
Studies VARIATIONS IN THE UNDERWRITING PROCESS

Bought Deal
Advance

In a bought deal, the underlying firm that buys the deal

OPEN

will have presold most of the issue to institutional clients.

Under Rule 415 (Shelf Registration)
IQBAL of

underwriters may have to respond quickly to issuer needs.

Chenab College

Bids must be accepted quickly and thus require substantial

capital commitments. Risks can sometimes be mitigated,
however, by pre-selling to clients.
ALLAMA
 UNIVERSITY
Studies VARIATIONS IN THE UNDERWRITING PROCESS

Auction Process
Advance

Competitive bidding underwriting

, sometimes mandated as in the case of public utilities. The
OPEN

issuer then takes the bid with the lowest yield (highest price).
IQBAL of
Chenab College

Thanks to computer technology there now exists a service tha

t directly links issuers with institutional investors, thereby av
oiding the investment banking middlemen. Presumable the
ALLAMA

price should be higher for the issue,but investment bankers re

spond by saying that they have a larger client base and that th
ey provide the liquidity of a market maker. Therefore their co
sts should be lower. No empirical results on this
issue yet. For auction of muni-
monds, Internet auction has started in recent years.
 UNIVERSITY
Studies VARIATIONS IN THE UNDERWRITING PROCESS

Pre-emptive Rights Offering

Advance

A corporation can issue new stocks to existing shareholders. This

is called a preemptive rights offering. But not all shares of an
OPEN

issue may be sold by that means. To ensure the success of an

offering, issuers often enter into standby underwriting
IQBAL of

agreements with underwriters, who will buy the unsubscribed

Chenab College

shares. Of course, a commitment standby fee must be paid. Pre-

emptive rights offerings are not common in the United States.
ALLAMA
 UNIVERSITY
Studies World Capital Market Integration and Fund Raising Implications

• An entity may seek funds outside its local capital market with the
expectation of doing so at a lower cost than if its funds are raised in its
Advance

local capital market. Whether lower costs are possible depends on the
OPEN

degree of integration of capital markets. At the two extremes, the

world capital markets can be classified as either completely segmented
IQBAL of

or completely integrated.
• In the former case, investors in one country are not permitted to invest
Chenab College

in the securities issued by an entity in another country. As a result, in a

completely segmented market, the required return on securities of
comparable risk traded in different capital markets throughout the
ALLAMA

world will be different even after adjusting for taxes and foreign
exchange rates. An entity may be able to raise funds in the capital
market of another country at a cost that is lower than doing so in its
local capital market.
 UNIVERSITY
Studies Motivation For Raising Funds Outside Of the Domestic Market
 A corporation may seek to raise funds outside of its domestic market
for four reasons. First, in some countries, large corporations seeking
Advance

to raise a substantial amount of funds may have no other choice but

to obtain financing in either the foreign market sector of another
OPEN

country, because the fund-raising corporation's domestic market is

not fully developed enough to be able to satisfy its demand for funds
IQBAL of

on globally competitive terms.

Chenab College

 The second reason is the opportunities for obtaining a reduced cost

of funding (taking into consideration issuing costs) compared to that
available in the domestic market. In the case of debt the cost will
ALLAMA

reflect two factors: (1) the risk-free rate, which is accepted as the
interest rate on a U.S. Treasury security with the same maturity or
some other low-risk security (called the base rate); and (2) a
spread to reflect the greater risks that investors perceive as being
associated with the issue or issuer.
 UNIVERSITY
Studies Motivation For Raising Funds Outside Of the Domestic Market

The third reason to seek funds in foreign markets is a desire by

corporate treasurers to diversify their source of funding in order
Advance

to reduce reliance on domestic investors. In the case of equities,

diversifying funding sources may encourage foreign investors
OPEN

who have different perspectives of the future performance of the

corporation. Two additional advantages of raising foreign equity
IQBAL of
Chenab College

funds, from the perspective of U.S. corporations, include (1)

some market observers believe that certain foreign investors are
more loyal to corporations and look at long-term performance
ALLAMA

rather than short-term performance as do investors in the United

States;6 and (2) diversifying the investor base reduces the
dominance of U.S. institutional holdings and its impact on
corporate governance.
 UNIVERSITY
Studies Motivation For Raising Funds Outside Of the Domestic Market

Finally, a corporation may issue a security denominated in a

Advance

foreign currency as part of its overall foreign currency

management. For example, consider a U.S. corporation that plans
OPEN

to build a factory in a foreign country where the construction

IQBAL of

costs will be denominated in the foreign currency. Also assume

Chenab College

that the corporation plans to sell the output of the factory in the
same foreign country. Therefore, the revenue will be
denominated in the foreign currency.
ALLAMA
 UNIVERSITY
Studies STOCK EXCHANGE

A stock exchange is an entity that provides "trading"

Advance

facilities for stock brokers and traders, to trade stocks,

bonds, and other securities.
OPEN

Stock exchanges also provide facilities for issue and

IQBAL of

redemption of securities and other financial instruments,

Chenab College

and capital events including the payment of income and

dividends.
ALLAMA
 UNIVERSITY
Studies
OVER THE COUNTER
Advance

A security traded in some context other than on a formal

exchange such as the NYSE, TSX, AMEX, etc. The phrase
OPEN

"over-the-counter" can be used to refer to stocks that trade via

a dealer network as opposed to on a centralized exchange.
IQBAL of
Chenab College

It also refers to debt securities and other financial instruments

such as derivatives, which are traded through a dealer
ALLAMA

network.
 UNIVERSITY
Studies NEW YORK STOCK EXCHANGE

The New York Stock Exchange (NYSE) is a stock exchange

Advance

located at 11 Wall Street in lower Manhattan, New York City,

USA. It is the world's largest stock exchange by market
OPEN

capitalization of its listed companies at US$ 11.92 trillion as

of Aug 2010. Average daily trading value was approximately
IQBAL of

US$ 153 billion in 2008.

Chenab College

On the NYSE, all trades occur in a physical place.

ALLAMA

The NYSE is an auction market , wherein individuals are

typically buying and selling between one another and there is
an auction occurring
 UNIVERSITY
Studies NASDAQ

The Nasdaq is located not on a physical trading floor but on a

Advance

telecommunications network. People are not on a floor of the

exchange matching buy and sell orders on behalf of
OPEN

investors.
Instead, trading takes place directly between investors and
IQBAL of

their buyers or sellers, who are the market makers through an

Chenab College

elaborate system of companies electronically connected to

one another.
ALLAMA

The Nasdaq is a dealer's market.

The Nasdaq is typically known as a high-tech market,
attracting many of the firms dealing with the internet or
electronics. Accordingly, the stocks on this exchange are
considered to be more volatile and growth oriented.
 Chenab College
ALLAMA IQBAL of Advance
OPEN Studies
UNIVERSITY
 Chenab College
ALLAMA IQBAL of Advance
OPEN Studies
UNIVERSITY
 Chenab College
ALLAMA IQBAL of Advance
OPEN Studies
UNIVERSITY
 Chenab College
ALLAMA IQBAL of Advance
OPEN Studies
UNIVERSITY
 Chenab College
ALLAMA IQBAL of Advance
OPEN Studies
UNIVERSITY
 Chenab College
ALLAMA IQBAL of Advance
OPEN Studies
UNIVERSITY
 UNIVERSITY
Efficient Financial Market
Studies

Pricing efficiency refers to a market where prices at all times

Advance

fully reflect all available information that is relevant to the

OPEN

valuation of securities
IQBAL of

Market Efficiency Levels

Chenab College

• Weak Form Efficiency

• Semi Strong Form Efficiency
ALLAMA

• Strong Form Efficiency

 UNIVERSITY
Studies
1. Weak-form efficiency
Advance

Prices of the securities instantly and fully reflect

all information of the past prices. This means
OPEN

future price movements cannot be predicted by

IQBAL of

using past prices. It is simply to say that, past data

Chenab College

on stock prices are of no use in predicting future

stock price changes. Everything is random. In this
ALLAMA

kind of market, should simply use a "buy-and-

hold" strategy.
 UNIVERSITY
Studies

2. Semi-strong efficiency
Advance
OPEN

Asset prices fully reflect all of the publicly

available information. Therefore, only investors
IQBAL of

with additional inside information could have

Chenab College

advantage on the market. Any price anomalies are

quickly found out and the stock market adjusts.
ALLAMA
 UNIVERSITY
Studies

3. Strong-form efficiency
Advance
OPEN

Asset prices fully reflect all of the public and

IQBAL of

inside information available. Therefore, no one

Chenab College

can have advantage on the market in predicting

prices since there is no data that would provide
ALLAMA

any additional value to the investors.

 UNIVERSITY
Efficient Market Hypothesis
Studies

Security market line (SML) is the representation

Advance

of the capital asset pricing model. It displays the

expected rate of return of an individual security as a
OPEN

function of systematic, non-diversifiable risk .

IQBAL of
Chenab College
ALLAMA
 UNIVERSITY
Studies Formula
The Y-intercept of the SML is equal to the risk-free interest rate. The slope of
the SML is equal to the market risk premium and reflects the risk return trade
off at a given time:
Advance

where:
E(Ri) is an expected return on security
OPEN

E(RM) is an expected return on market portfolio M

β is a nondiversifiable or systematic risk
RM is a market risk
IQBAL of

Rf is a risk-free rate
Chenab College

When used in portfolio management, the SML represents the investment's

opportunity cost (investing in a combination of the market portfolio and the
risk-free asset). All the correctly priced securities are plotted on the SML. The
assets above the line are undervalued because for a given amount of risk
ALLAMA

(beta), they yield a higher return. The assets below the line are overvalued
because for a given amount of risk, they yield a lower return.
There is a question about what the SML looks like when beta is negative.
A rational investor will accept these assets even though they yield sub-risk-
free returns, because they will provide "recession insurance" as part of a well-
diversified portfolio. Therefore, the SML continues in a straight line whether
beta is positive or negative. A different way of thinking about this is that
the absolute value of beta represents the amount of risk associated with the
asset, while the sign explains when the risk occurs.
 UNIVERSITY
Studies

TRANSACTION COSTS
•Transaction costs consist of commissions, fees,
Advance

execution costs and opportunity costs.

•Commissions are the fees paid to brokers to trade
OPEN

securities.
IQBAL of

•Fees are separated two group custodial fees and

Chenab College

transfer fees.
•Custodial fees are fees charged by an institution that
ALLAMA

hold securities in safekeeping for an investor.

Execution costs represent the difference between the
execution price of a security and the price that would
have existed in the absence of the trade.
 UNIVERSITY
Studies

OPPORTUNITY COSTS
Advance

The cost of not transacting represents an

OPEN

opportunity cost. It may arise when a desired

trade fails to be executed. This component of
IQBAL of
Chenab College

costs represents the difference in performance

between an investor’s desired investment and
ALLAMA

the same investor’s actual investment after

adjusting for execution costs, commissions and
fees.