CHAPTER 1
Capital Markets Participants, Products, and Functions

This chapter provides an introduction to the participants, products, and functions of capital. We also discuss the important role capital markets play in supporting economic growth and development (Figure 1.1). We start with a detailed discussion of key participants and how capital markets support their economic activities. We then introduce the foundational product groups offered and review their key features and uses. Then we will explain the various types of markets and how they facilitate the funding and investing needs of participants.

FIGURE 1.1 Capital markets environment.

THE BASIC PRODUCTS OFFERED IN CAPITAL MARKETS

For the focus of our discussion we view capital markets as offering two types of funding products to issuers: Equities and debt (also called fixed income) through both primary (initial issuance of securities) and secondary (ongoing trading of securities) markets. From a broader perspective, capital markets may also include the trading commodities, currencies, and derivatives.

Equities

Equities, also known as shares and stocks, represent an ownership interest in a corporation; the term share means each security is a share of ownership in a corporation. Shares have the same limited‐liability rights of the corporations they represent, which means that the liability of share owners is limited to their investment amount. Shares are initially created when a corporation is formed, whereby the owners can choose the number of shares appropriate for the corporation's plans and valuation. At this point the corporation is known as a private corporation, as all the shares are held by a close group of investors.

As corporations grow, some may choose to become a public corporation, or one that is listed on a public stock exchange, where members of the public can openly buy or sell shares. This process is known as listing where existing or additional shares may be created and offered to the public through an initial public offering (IPO).

Shares entitle their holders to a share of the dividends declared by the firm's board of directors to be distributed from the corporation's profits. Likewise, they also generally entitle owners to a vote on critical decisions at annual general meetings. Shares can be created in different classes with differing rights. There are two broad classes of shares, common and preferred. Preferred shares typically have a higher claim on dividends and on the assets of a firm in the event of liquidation, but typically have no voting rights and have a fixed dividend that will not rise with earnings.

Following an IPO, shares are traded on stock exchanges and their valuation is subject to supply and demand, which in turn is influenced by the underlying fundamentals of the business, macroeconomic factors such as interest rates, and market sentiment.

The return to shareholders is a function of both the dividends paid to them from the corporation's profits and of any movements in the share price (capital growth). Importantly, too, equities have the lowest rights in the default and liquidation of a corporation and are the last to be paid out.

Fixed Income

Fixed‐income securities, as the name suggests, promise a fixed return to investors. Fixed‐income funding is similar in nature to the provision of a loan by a bank, but issuers manage to attract a broader investor base through tapping into capital markets, generally lowering the required interest rate or improving non‐price terms for the borrower.

Fixed‐income securities typically have a maturity date when the security expires and the principal or loan amount is paid back to the investor. Most fixed‐income securities also offer interest rate payments (known as coupons) at regular intervals. Some types of securities, such as zero‐coupon bonds, do not pay out any coupons while inflation‐indexed (also called inflation‐linked) bonds index the principal amount to inflation and floating‐rate bonds offer a variable interest rate based on a benchmark market (variable) interest rate plus a premium.

There are two broad types of bonds based on the issuer: Corporate bonds are issued by corporations, and sovereign bonds are issued by governments. A third type includes municipal bonds issued by governments at the subnational level, which are particularly common in the United States. Sovereign securities are also referred to as rates, as the main risk is related to movements in market interest rates. This is based on the assumption that the sovereign is risk free—an assumption that has sometimes proven false as we have seen 30 sovereign defaults from 1997 to 2014 alone.1 Corporate bonds are also known as credit securities, as the primary risk related to these is the underlying credit risk of the issuer.

Fixed‐income securities are also tradable in the market and are thus subject to market price movements. Given that the interest rate payments are largely fixed, any decline in interest rates raises the effective yield of the security (coupon payment as a percentage of value of the security). As a result, there would be increased demand for the security, driving its price higher and reducing its yield. Thus, the prices of fixed‐income securities typically move inversely to movements in interest rates. Furthermore, a change in sentiment about the credit quality of an issuer can result in a decline in the value of those securities.

Foreign Exchange and Commodities

Foreign exchange (FX) relates to the trading of currencies in exchange for other currencies. The most basic form of FX transaction is a spot trade where two currencies are agreed to be exchanged immediately at an agreed rate. FX is frequently broken down into G10 (comprising the 10 largest developed countries) and EM (currencies of all other countries).

Commodities represent basic goods, typically used in production and commerce. There are many types of commodities traded, with each commodity represented for contract purposes using a variety of sizes and qualities based on historical conventions. When commodities are traded on an exchange, they must conform to strict quality criteria to ensure standardization of each unit. The key groups of commodities include, but are not limited to, agricultural, animal products, energy, precious metals, and base metals. Commodities are largely traded in the form of derivatives contracts.

Derivatives

Securities can be classed also as cash and derivatives. Cash securities represent direct ownership or claims on assets, such as part of a corporation or a financial obligation from an issuer. Deriv, as the name suggests, derive their value from an underlying asset such as other securities, indices, commodities, or currencies (FX).

Derivatives typically represent future claims on assets, for example, if a commodity is bought for future delivery via a forward contract. Hence, they are heavily used for hedging purposes by a wide variety of market participants. Hedging involves offsetting some form of risk, such as potential future changes in interest rates or the potential change in the price of a commodity. When used as a hedging tool, derivatives effectively transfer the risk in the underlying asset to a different party. As such, derivatives can also be thought of as providing a form of insurance. The most common types of derivatives are forwards, futures, options, and swaps:

• Forwards: Forwards represent binding contracts for the sale or purchase of a fixed quantity of an asset at a fixed point of time in the future. Forwards are most commonly used in the FX and commodities markets.
• Futures: Futures are similar to forwards except that their contract terms are standardized and they are traded on exchanges. Futures are also available on many index products including stock indices.
• Options: Options, as the name suggests, provide the right (but not obligation) for the contract holder to either buy (known as a call option) or sell (put option) a certain fixed quantity of an asset either before or at a fixed expiry date at a fixed price. Options can help provide a floor price for certain assets (i.e., through owning a put option, which guarantees a certain sale price) or a ceiling price (i.e., through a call option, which guarantees a maximum purchase price) for certain assets, thus minimizing risks faced by the option holder.
• Swaps: Swaps are contracts by which two parties agree on the swapping or exchange of two assets or commitments at some point in time. The most common form of swaps is interest rate swaps (IRSs). These contracts swap the interest rate payment commitments between two counterparties. The two main types of IRSs include float for fixed, where a floating interest rate commitment is swapped for a fixed interest rate commitment, and float for float, involving the swapping of a floating rate based on one benchmark rate with another. Both involve fixed notional or principal amounts upon which the rates are calculated.

CAPITAL MARKETS AS A SUBSTITUTE FOR BANK LENDING

We described the narrow definition of capital markets as the provision of funding to issuers. In that sense, capital markets serve similar functions to traditional banking. Banks facilitate the provision of funds to customers to support their economic activities. Banks traditionally raise their own funding through...