Contributed by Dr. Khaled Soufani, Associate Professor of Finance
John Molson School of Business, Concordia University
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 (overnightlending 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. 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 marketPrimary market
Savings supplied by households
Capital Market New Issues Investments
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 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.
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.