Topic 3 - The Share Market And The Corporation (Equity Markets)

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This article is a topic within the subject Capital Markets and Institutions.

Contents

Required Reading

Viney, (2009) Financial Institutions, Instruments and Markets, 6th Edition: McGraw-Hill, pp. 146-173.

The Nature Of A Corporation

[1] A corporation is a company that is a legal entity under Corporations law. Public corporations shares are traded on a formal stock exchange. Corporations are different to most other business forms for the following reasons:

  • Ownership claims are wide spread & easily transferable/tradeable & perpetual succession
  • Owners of public corporations do not affect day to day affairs of the company
  • Limited Liability (loss limited to amount invested) or partly paid shares of a non-liability firm, but forfeit the ownership

The objectives & policies are set by a board of directors, who are elected by shareholders at an AGM. They have a legal responsibility to ensure the corporation operates in shareholders’ best interests & appoint executive management to run day to day operations and reach objectives & policies. Management is responsible to the board that is responsible to the owners.

Advantages Of The Corporate Form

  • Limited Liability
  • Able to Obtain Large Amounts of Funds, for a relatively cheap cost - Liquidity of securities facilitates investment
  • Separation of ownership & control - Easily transferable ownership (deep & liquid market)
    • Appoint specialised management - greater effectiveness in planning/implementing strategic decisions
  • Perpetual Succession - The corporate form is unaffected by changes in management or ownership (Unlimited Life)
  • Suited to large-scale operations, access to a wider range of debt & equity sources of funds (need good credit rating)

Disadvantages Of The Corporate Form

  • Separation of ownership & control'
    • Conflict of interest between owners (principals) & management (agents), known as the agency problem
    • Managers may become short term orientated or maximise their own benefit rather than shareholders
  • Disclosure Requirements

Moderation

These disadvantages are moderated to some extent by:

  • Ability to Sell. Causes the price to fall
  • Board of Directors. Voting power. Can Dismiss Board.
  • Shareholder Meetings & Voting Rights. Proxy fight – group of shareholders solicit proxy votes to replace mgmt./board
  • Managerial Compensation. Stock options to align interests, performance related incentives
  • Managerial Labour Market. Disciplinary mechanism, bad managers won’t be hired, better performers will be promoted
  • Legal Restraints'. Legally required to act in the best interest of owners.
  • M&A. Shareholders can threaten to sell in hostile takeovers, a greater profit potential exists for poorly run companies
  • Rigorous Corporate Governance. Relationship between owners, board & management - clear responsibility & reporting structures need to be established to ensure the firms survival & the maximisation of shareholder value. They promote accountability & transparency.

It is important to note that a share is a financial asset, that is, a security that entitles a shareholder to share in the net profit of the company & to vote for the board of directors, & any resolutions put by the board to shareholders at general meetings.

The Securities Exchange

[2] A Securities Exchange is an organised & supervised market place where financial assets are traded. It is like any real market, for example Paddy’s market[3]. It requires accessibility, confidence & safety, attract sellers (lower listing fees), & provide liquidity. The overall objective of a market (exchange) is to attract liquidity to execute orders with reasonable speed at minimal cost & to find appropriate prices for customer’s - fair & orderly pricing discovery. To achieve this, the following must be considered:

  • Participants - Target market
  • Instruments - A wide or low range of instruments
  • Regulations - High or low
  • Technology & Protocols

Pricing Discovery is at the heart of exchange operations. Fair & orderly price discovery is essential to market trustworthiness.

Functions Of The Stock Market

Ultimately, it facilitates the flow of funds between surplus & deficit users. It does this by:

  • Providing a market in which publically listed companies can have their securities trade + Government securities
  • Allows listed companies to raise additional funds via the issue of securities (e.g. shares)
  • Providing investment opportunities for individual & institutional investors (insurance, superannuation, trusts etc.)

The principle functions of a modern stock exchange are:

  • Establishment of markets in a range of financial securities
  • Provision of a securities trading system (ASX Trade 24)
  • Operation of a clearing & settlements system (CHESS)
  • Regulation & monitoring of the integrity within the exchange’s market (ASX & ASIC)
  • Provision of a well informed market, to secure the confidence of all participants.

The SX performs primary/secondary, derivative, interest rate, trading & settlements, informational & regulatory role.

Market Efficiency

The principal determinant of market efficiency is the speed at which new information flows to the market, so that security prices can reflect the new information. The trading system, transactional & settlement system & market confidence in the integrity of the share market is important in effecting price discovery & hence the markets efficiency.

Primary And Secondary Market Roles

The Primary Market Role of a stock exchange is to facilitate the efficient & orderly sale of new financial securities (usually equity but also ‘trust units’ debt & govt. Securities). E.g. IPO’s, rights issues, placements & dividend reinvestment plans. Issues must be accompanied by a prospectus (terms & conditions of the issue). NB: Underwriters/Advisers help the corporation to list; Investors need to go through a broker (member of the exchange) for efficiency purposes.

In contrast, the Secondary Market facilitates trading in existing shares, no new funds are raised. An active, liquid & well organised secondary market increases the marketability/appeal of buying new shares in primary issues. In the secondary market, a corporation does not feature in the flow of funds & it has no direct impact on its cash flow.

FINS161231.jpg

The secondary market complements the primary market by enabling investors to trade securities. Only members of the exchange have the right to trade in these securities (brokers) & the price is determined by S/D which is affected by information. E.g. Investor puts order into a broker, who enters it into the SX’s securities trading system, which matches orders & facilitates the transfer of ownership & payment. [4] FINS161232.jpg

Equity Based Managed Products

[5] These products allow investors to gain a diversified exposure to a market via a single investment product rather than purchasing many securities.

  • Exchange Traded Funds - Gain access to a diversified portfolio of securities. E.g. iShares MSCI Australia 200 (ASX200)
  • Contracts for Difference - A contract listed on the exchange that is an agreement between a buyer & seller to exchange the difference in the value of a CFD. Can be based on a security, indices, currencies or commodities.
    • Difference in value = Contract value at the closing date less opening contract value
    • Provides tremendous leverage (only need a small deposit or initial margin)  High Risk & High Return
  • Real Estate Investment Trusts - Gain a diversified real estate portfolio which is not possible for the average investor
    • The units may be listed on the exchange & the type of property will be specified in the trust deed
  • Infrastructure Funds - Listed managed funds enabling investors to access investments in large infrastructure projects.
    • Pool a large amount of funds from many investors, invest in infrastructure, get returns (income or capital gain)
  • Derivatives

Derivative Market Role

[6] The securities exchange provides a market for trading equity-related derivative products. A Derivative is a financial security that derives its price from an underlying commodity or financial instrument that is available in the physical market . They allow investors the opportunity to manage or hedge risk exposure in their investment portfolio[7]. They include (options, warrants & futures). Derivative products are either:

  • Exchange Traded Contracts - Standardised financial contracts (terms are known) traded on a formal exchange
  • Over the Counter Contracts - Non Standardised, specific contracts negotiated between writer & buyer (less liquid)

3 Generic Types of Derivatives

[8]

  • Futurean exchange traded agreement to buy/sell a specified amount of a commodity at a price determined today for delivery or payment at a future date. They are standardised & traded through a futures exchange.More Info In Topic 10 - (Please Note That Only A Basic Understanding Is Needed Until Then)
  • WarrantsA financial instrument that conveys a right in the form of an option. Gives the right to buy (call) or sell (put) an underlying security at a particular price before a predetermined date. The warrant issue, authorised by a SX (e.g. bank) sets the terms & conditions. The warrant is then quoted & traded on the stock exchange
  • OptionThe right, but not the obligation to buy (call)/sell (put) a commodity or security at a predetermined exercise price. The buyer pays the premium to the option writer.More Info In Topic 11

NB: Hedging - a strategy that protects the investor from an identified risk exposure

Interest Rate Market Role

A lesser function of a stock exchange is the listing of debt issues of corporations, institutions & government. The interest rate market facilitates the listing of debt securities & the subsequent trading of the securities. An issuer of debt (directly into capital markets) must prepare a prospectus.

This role adds value to a debt issue (e.g. straight corporate bonds, floating rate notes, convertibles, preference shares) due to:

  • Transparency – Information about price, yield, maturity, credit rating of debt instruments
  • Easy of Entry – Electronic trading system facilitated buying/selling at minimum cost & time delay at current prices
  • Liquidity (standardised contract) – Quotation on the securities exchange provides access to a wider market

Trading & Settlement Roles

[9] The ASX uses, ASX Trade 24 - an integrated computer based trading system to trade all listed securities. Client orders are executed via broker’s computer (in order of price & time received). Buyers can specify a price or buy at the market price. When a buyer and seller agree on a price, the next phase is the settlement (transfer of ownership & funds). The ASX uses CHESS (Clearing House Electronic Sub Register System) to facilitate the settlement on transactions conducted via ASX24 (max of 3 days T+3). Although the order has been executed, there is still settlement risk (the other party may not have funds or ownership). A contract note is provided once the order is cleared. CHESS provides an electronic sub register system that records ownership of listed securities.

  • Settlement Risk - risk that one party to a financial transaction will not deliver value
  • CHESS Sponsor - Market participant that has access to CHESS (stockbroker)
  • Uncertificated Securities - Electronic record of share ownership, no certificate is issued
  • Contract Note - Document sent by broker to client detailing a share transaction

Information Role: Confidence & Integrity

Investor confidence in the ASX relies upon informational efficiency; current prices should reflect all available information. The ASX must facilitate the flow of information in order to ensure fair & orderly pricing. This is to create investor confidence so investors don’t shy away from the market.

The securities exchange has specific listing rules (that entities must comply with) for the provision of information, in particular continuous disclosure requirements, that are designed to ensure a well informed market. Firms must disclose price or value sensitive information, e.g. changes in financial forecasts, dividend declarations, takeover bids, and changes in director’s interest.

Regulatory Role: Confidence And Integrity

Regulation aims to ensure market participants have confidence in the integrity of market operations. Two main supervisors:

  • Australian Stock/Securities Exchange (ASX)
    • Ensure listed companies meet specified limited levels of performance & standards of information disclosure
      • Continuous disclosure requirements - help investors make informed decisions
      • Minimum requirements/tests must be met - ensuring good quality instruments. Otherwise delisted.
    • Prescribes appropriate behaviour of Broker Participants on the exchange - can sanction
    • Electronic Surveillance Systems to Monitor trading behaviour of Market Participants
    • National Guarantee Fund (NFG) compensates investors in the event of failure/misconduct by a stockbroker
  • Australian Securities Investment Commission (ASIC)
    • Supervises Corporation Law & markets in Australia - Insider trading
    • Responsible for market integrity & consumer protection across the financial system – investment, insurance & superannuation products
    • Supervises the ASX, addressing potential conflicts of interests as a publically listed corporation.

The Private Equity Market

[10] Private Equity is an alternative funding source for companies unable or not wanting to access equity capital through a public issue (minimum requirements). Generally, private equity is more risky but offers greater return. The source of funding is from large institutional investors - Superannuation funds, insurance - wanting to diversify. The funds are used for start-ups, expansions, recovery finance for distressed companies, management buyouts. The aim is to improve profitability to realise value via an IPO or to break the business up.

End

This is the end of this topic. Click here to go back to the main subject page for Capital Markets and Institutions.

References

Textbook refers to Viney, (2009) Financial Institutions, Instruments and Markets, 6th Edition: McGraw-Hill.

  1. Viney, (2009) Financial Institutions, Instruments and Markets, 6th Edition: McGraw-Hill, pp. 148-150
  2. Viney, (2009) Financial Institutions, Instruments and Markets, 6th Edition: McGraw-Hill, pp. 150-163
  3. Natalie Oh, ASB, UNSW
  4. Viney’s (2009) Financial Institutions, Instruments and Markets, 6th Edition: MCGRAW-HILL.
  5. Viney’s (2009) Financial Institutions, Instruments and Markets, 6th Edition: MCGRAW-HILL.
  6. Viney’s (2009) Financial Institutions, Instruments and Markets, 6th Edition: MCGRAW-HILL.
  7. Viney’s (2009) Financial Institutions, Instruments and Markets, 6th Edition: MCGRAW-HILL.
  8. Viney’s (2009) Financial Institutions, Instruments and Markets, 6th Edition: MCGRAW-HILL.
  9. Viney’s (2009) Financial Institutions, Instruments and Markets, 6th Edition: MCGRAW-HILL.
  10. Viney, (2009) Financial Institutions, Instruments and Markets, 6th Edition: McGraw-Hill, pp. 163-164
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