CSC - Chapter 2: The Capital Market

1) Describe the role of investment capital in the economy, including its supply and use.

Summary of Capital and Investment

Capital refers to wealth in two forms:

• Real capital (land, buildings, material goods)

• Representational capital (money, stocks, bonds)

Investment Types:

• Direct investment: Using money to buy tangible assets (e.g., a house, highway, factory).

• Indirect investment: Buying financial securities (e.g., stocks, bonds) that fund productive activities.

Key Capital Characteristics:

1. Mobility – Capital moves where conditions are best.

2. Sensitivity – It responds to political, economic, and regulatory factors.

3. Scarcity – Capital is limited and seeks the most favorable investment opportunities.

Indirect investment, where investors buy securities that fund businesses or governments, is a primary focus in finance.

Summary of Country Risk & Capital Flow

Country Risk Factors:

• Political Stability: Is there conflict or instability?

• Economic Trends: How strong is GDP growth, inflation control, and economic activity?

• Fiscal Policy: How high are taxes? Does the government encourage investment?

• Monetary Policy: Is the money supply stable, and are exchange rates managed well?

• Investment Opportunities: Are returns attractive relative to risks?

• Labour Force: Is the workforce skilled and productive?

Capital moves to places with the best investment conditions—low taxes, stable governments, and strong economic policies—seeking the highest risk-adjusted returns.

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Suppliers and Users of Capital

Suppliers of Capital:

1. Individuals – Save and invest based on incentives and returns.

2. Non-Financial Corporations – Retain profits for internal growth.

3. Governments – Some run surpluses and invest, others borrow.

4. Foreign Investors – Invest in Canadian industries and securities.

Users of Capital:

1. Individuals – Borrow for homes, cars, and large expenses.

2. Businesses – Need capital for operations, growth, and innovation.

3. Governments – Issue securities to fund projects and deficits.

Capital flows in and out of Canada based on currency value, investment returns, and market conditions.

2) Differentiate between the types of financial instruments used in capital transactions.

Summary of Financial Instruments

Financial instruments (securities) are legal documents that define the rights and obligations of buyers (capital suppliers) and sellers (capital users). They provide a structured way to distribute capital and have standardized features that make trading easier.

Types of Financial Instruments:

1. Fixed-Income Securities (Debt) – Issuer repays the loan at maturity and pays interest in the meantime.

   • Examples: Treasury bills, bonds

2. Equity Securities (Stocks) – Represent ownership in a company, with potential for capital gains.

   • Examples: Common stock, preferred shares

3. Derivatives – Contracts based on the value of another asset, used mainly by sophisticated investors.

   • Examples: Options, forwards

4. Managed Products (Investment Funds) – Pools of investor capital managed according to an investment strategy.

   • Examples: Mutual funds, ETFs, private equity funds

5. Structured Products – Financially engineered investments combining features of debt, equity, and funds.

   • Examples: Principal-protected notes, index-linked GICs

3) Describe the distinguishing features and operation of the various types of financial markets.

This chapter discusses financial markets, where buyers and sellers trade financial instruments. Key points include:

• Financial Markets: A platform for transactions, where intermediaries (e.g., investment advisors) facilitate trades. Efficient markets offer fast transactions, low costs, liquidity, and regulation.

• Capital Market: Includes stock, bond, and money markets. The money market deals with short-term securities (one year or less).

• Primary vs. Secondary Markets:

  • Primary Market: New securities are issued by companies or governments (e.g., IPOs).

  • Secondary Market: Investors trade previously issued securities, with no funds going to the issuing company.

• Auction vs. Dealer Markets:

  • Auction Markets: Buyers and sellers trade directly. Orders are placed at central markets, and trades happen when bids and offers match (e.g., Toronto Stock Exchange).

  • Dealer Markets: Trades occur through dealers, not in a centralized location (e.g., bonds). The OTC market facilitates these trades.

• Liquidity: A key feature of exchanges, where frequent trades, narrow price spreads, and minimal fluctuations create liquidity.

• Canadian Exchanges: Includes the Toronto Stock Exchange (TSX), TSX Venture Exchange, and others, which list stocks, bonds, and ETFs.

• Over-the-Counter (OTC) Markets: Securities are traded through dealers, not on exchanges. These markets are less visible but important for trading debt securities.

• Alternative Trading Systems (ATS): Electronic platforms for matching trades, competing with traditional exchanges but with fewer functions, like not listing securities.

• The Toronto Stock Exchange (TSX) lists equities, some debt instruments that are convertible into a listed equity, income trusts, and exchange-traded funds.

• The TSX Venture Exchange lists equities and a few debenture issues.

• TSX Alpha Exchange offers trading in securities listed on the TSX and the TSX Venture Exchange.

• The Montréal Exchange trades all financial and equity futures and options listed for trading in Canada.

• ICE NGX Canada provides electronic trading, central counterparty clearing, and data services to the North American natural gas and electricity markets.

• The Canadian Securities Exchange lists equities of emerging companies.

• Cboe Canada is an exchange that provides listing services and facilitates trading in public companies, exchangetraded funds, Canadian Depositary Receipts™, special purpose acquisition companies, and closed-end funds. Approximately 15% of all volume traded in Canadian-listed securities trade through Cboe Canada.

• The Ontario web-based system where trades of unlisted securities are reported is called the Canadian Unlisted Board Inc. (CUB) system.

• Privately-owned computerized networks that match orders for securities outside of recognized exchange facilities. Also referred to as Proprietary Electronic Trading Systems (PETS). These is an alternative trading system.

FIXED-INCOME ELECTRONIC TRADING SYSTEMS

• CanDeal is a member of CIRO, and it is a joint venture between Canada’s six largest bank-owned investment dealers. It is operated by the TMX Group Limited and is recognized as both a debt ATS and an investment dealer. It offers institutional investors access to government securities and money market instruments.

• MarketAxess provides market data and a trading platform with access to multi-dealer competitive pricing for a wide range of corporate bonds and other types of fixed-income instruments. MarketAxess is a member of CIRO and operates in Ontario and Quebec.

• CBID, and CBID Institutional, is an ATS that operates two distinct fixed-income marketplaces: retail and institutional. The retail fixed-income marketplace is accessible by registered dealers on behalf of retail clients. The institutional fixed-income marketplace is accessible by registered dealers, institutional investors, governments, and pension funds.

• CanPX is a joint venture between several Canadian investment dealers and inter-dealer brokers (firms that facilitate trades between investment dealers). The CanPX system combines digital feeds from participating dealers to provide a composite display of real-time bid and offer quotations, in price and yield terms and with volume information. The service covers Government of Canada bonds and Treasury bills.

Canada’s public venture marketplace, the result of the merger of the Vancouver and Alberta Stock Exchanges in 1999 →TSX Venture Exchange