Financial Markets

Every company that grows beyond what its own trading can pay for has to persuade somebody else to hand over money. The financial markets are where that happens: the arrangements — some of them physical exchanges, most of them now electronic networks — through which people and institutions with spare cash are matched with the companies and governments that need it.

This chapter is about the markets themselves: what kinds there are, how they operate, and who a company deals with when it goes to them. How a company actually issues shares and bonds, and what those instruments look like, is Chapter 2; what the resulting finance costs is Chapter 3.

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1 Money markets and capital markets

Financial markets are split by the maturity of the finance traded on them, not by who is trading.

F2 is a capital-markets paper. Money-market instruments are assumed knowledge from F1 and are not examined again here.

2 How funds reach a company

There are two routes from the people who have money to the companies that want it, and a company will normally use both.

2.1 Intermediated finance

A bank takes deposits from many savers and lends the pooled money on. The saver never meets the borrower and does not carry the borrower's risk — the bank does. Intermediation is valuable because it performs four transformations at once:

• Maturity transformation — deposits repayable on demand are turned into loans repayable over years.

• Risk transformation — the bank absorbs the risk of an individual borrower defaulting; the depositor holds a claim on the bank, not on the borrower.

• Size (aggregation) transformation — many small deposits are pooled into loans large enough to fund a capital project.

• Reduced search and transaction costs — neither side has to find, assess or negotiate with the other.

2.2 Direct finance

Alternatively the company issues a security — a share or a bond — and investors buy it directly. There is no intermediary standing between the two, so the investor carries the company's risk in full and requires a return that reflects it. Direct finance is normally cheaper for a large, well-known borrower and simply unavailable to a small, unknown one.

3 Primary and secondary markets

The same exchange normally performs both functions.

3.1 Why a company should care about the secondary market

No cash reaches the company when its shares change hands between two investors, so it is tempting to treat the secondary market as somebody else's business. That is a mistake, for two reasons.

1. Liquidity lowers the cost of capital. An investor who knows the holding can be sold quickly, at a fair price and at low cost will accept a lower return for it. A lower required return is, from the company's side, a lower cost of capital and a higher share price.

2. The secondary market sets the price used for everything else. The market value of a company's equity and debt — not the book value — is what Chapter 3 uses to weight the weighted average cost of capital, what a bidder uses to price a takeover, and what the company itself uses to judge whether a new issue is well received.

4 The markets available for long-term funds

The names, admission requirements and regulators differ from country to country, and no national system is examined. What is examinable is the pattern, which is the same everywhere: markets are tiered by the size and maturity of the issuer and by how much regulation the issuer is willing to accept in return for access to investors.

5 Operations of stock markets

5.1 How a trade happens

Two trading models are in use, and many exchanges combine them.

A market maker quotes two prices: a lower bid price at which it will buy, and a higher offer (ask) price at which it will sell. The difference is the bid-offer spread, and it is the market maker's reward for standing ready to trade. The spread widens as a security becomes less liquid or more risky — which is the mechanism by which illiquidity turns into a real cost for the investor, and therefore into a higher required return from the company.

5.2 Clearing and settlement

Agreeing a trade is not the same as completing it. Clearing establishes what each side owes; settlement is the simultaneous exchange of the security for the cash, normally through a central securities depository a fixed number of business days after the trade. A central counterparty may step between the two sides so that neither is exposed to the other defaulting.

5.3 Indices

An index tracks the value of a defined basket of listed shares. It gives investors a benchmark against which to judge a company's performance, and gives index-tracking funds something to replicate — which is one practical reason companies want to be large enough to be included in one.

5.4 Listing rules and continuing obligations

Admission is not a one-off event. In return for access to public investors a listed company accepts, in every jurisdiction in some form:

• a prospectus (or admission document) on issue, setting out the business, the risks and the financial record, for which the directors take responsibility;

• a minimum free float — a proportion of the shares must be in public hands, so that a market can actually function;

• continuing disclosure — periodic financial reporting, and immediate announcement of price-sensitive information;

• restrictions on dealings by directors and on the misuse of inside information;

• shareholder approval for significant transactions with related parties or of a size that changes the business.

These obligations are the reason a listing is expensive, and the reason a listed company's cost of capital is nevertheless lower: disclosure reduces the uncertainty investors face, and less uncertainty means a lower required return.

6 Operations of bond markets

Bond markets work differently from share markets, and the differences matter for the calculations in Chapter 3.

• Mostly over the counter. Most bonds are traded by dealers negotiating bilaterally rather than through a central order book, so bond prices are quoted rather than continuously matched, and trading is far less frequent than in shares.

• Quoted per 100 nominal. A bond price is quoted as a price per 100 units of nominal (par) value, whatever the size of the issue — so a bond quoted at $94 is trading at 94% of its nominal value. Every cost-of-debt calculation in Chapter 3 is done per $100 nominal for this reason.

• Clean and dirty prices. The quoted (clean) price excludes interest accrued since the last coupon date; the amount actually paid (the dirty price) includes it. Examination calculations use the clean, ex-interest price.

• Price and yield move in opposite directions. The coupon is fixed in money terms. If required yields in the market rise, the only way an existing bond can offer the higher yield is for its price to fall — and vice versa.

• Credit ratings. Rating agencies grade issuers and issues, from investment grade down to speculative ("high yield"). A downgrade raises the yield investors demand and therefore the issuer's cost of new debt; it may also trigger a covenant.

7 Coming to the market: the process and the advisors

Whether the company is issuing shares for the first time or bringing a bond to market, the sequence is broadly the same:

1. Appoint advisors and agree the structure, the amount and the timing.

2. Due diligence — financial, legal and commercial verification of everything the company is about to say about itself.

3. Prepare the prospectus or offering document, and obtain the regulator's approval where one is required.

4. Market the issue — presentations to institutional investors, during which demand is gauged and, in a book-built issue, recorded.

5. Price the issue, allocate the securities, and complete admission to trading.

A company does not do any of this alone. In order to seek a listing on the capital markets the following advisors would be required, to ensure compliance with the rules and regulations of the market:

The methods by which the shares themselves are offered — a fixed price offer for sale, an offer by tender, a placing or an introduction — belong with the instruments, and are dealt with in Chapter 2.

8 Where this chapter leads

Two threads run out of this chapter and into the rest of section A:

• The instruments traded on these markets — what an ordinary share, a preference share and a bond actually promise the holder, and how each is issued — are Chapter 2.

• The price of using them is Chapter 3. Because that calculation is driven by market values rather than book values, it depends directly on the secondary market described in section 3 above.

9 Test your knowledge