In short

What is meant with Capital Market?

It is the market for securities, where companies and government can raise long-term funds which can be traded easily. Capital market includes stock and bond market. Financial regulators oversee the protection of investors. Capital markets consist of primary markets, where new issues are sold to investors, and secondary markets, where trading takes place.

While the capital market as the name says deals in long term funds other financial markets such as the money market deal in short term assets or derivatives market as the name says deals in derivatives. Both the private and the public sectors provide market makers.

Substitution of banks via securities markets

There has been a transformation worldwide in the financial system. One feature of this is disintermediation, meaning that a sizable portion of saving funds flow directly to financial markets instead to banks. The interest in investing in the stock market, either directly or through mutual funds, has been an important component of this process.

Shares have become a large proportion of house holds' financial assets in many countries. Part of new household funds has gone directly to shares, but most funds have gone indirectly via institutions. like pension funds, mutual funds, hedge funds, insurance companies etc. In all developed economics or advanced developping countries the trend has been the same: saving has moved away from bank deposits to riskier securities of one sort or another.

Riskier saving requires an ability to manage increased risks and that is where institutions are coming in.

Many price movements are not due to new information. But there do exist stock market trends over certain periods. But changes in estimated risk, and use of certain strategies, such as stop-loss limits, cause financial markets to overreact in both directions.

Psychological factors may also contribute to stock price movements. People are predisposed to 'seeing' patterns, which may in reality not exist at all. A succession of good news may lead investors to overreact driving prices up.

Another phenomenon that works against an objective assessment is group thinking. It is not easy to stick to an opinion that differs markedly from a majority of the group, even if the single opinion might be in the end the right one.

Securities

What are securities? They are transferable interests representing financial value. They are categorized into debt or equity and bearer and registered securities.The uses of securities have changed over time, both for issuers and holders. Though the purpose of capital raising was the original one, its uses have expanded greatly.

Securities include shares of shares or mutual funds, bonds of any kind, options, derivatives, limited partnership units, and other formal investment instruments.

Here we are concentrating on shares and bonds.

Securities are an attractive option compared to bank loans, which tend to be relatively expensive and short term. Through securities, capital is provided by investors who purchase the securities. Governments will raise capital from securities if taxation and other income are insufficient to meet public expenditure.

Investors in securities may be retail, but the greatest part in terms of volume is by financial institutions acting on their own account, or on behalf of clients.

The basic purpose of the purchase of securities is investment to receive income and/or capital gain. The owner of a debt security is owed a debt by the issuer and is entitled to the payment of principal and interest. Debt securities are issued for a fixed term and redeemable at the end of that term. Government issues medium or long term debt securities, which normally carry a lower rate of interest than the corporate bonds.

Aspects of differentiation for straight bonds

collateral

in this group belong asset backed securities, collateralized debt or mortgage obligation, credit linked note, mortgage backed security and unsecured bond.

origin

can be corporate bond, government bond, Municipal bond
Coupon

van be fixed rate, floating rate, zero coupon, inflation indexed

The size of the worldwide “straight bond market' is estimated at $45trillion

Besides of the “straight bonds” other alternatives do exist.

Securitization

A financial technique that pools assets together and turns them into a tradeable security held by a special purpose vehicle (SPV). Financial institutions and businesses of all kinds use securitization to transfer cash-producing asset.

Through securitization a particular group of assets can be removed from the balance sheet. Residential mortgages for example, a debt owed to a bank, are also an exposure for the bank. Exposures restrict the amount of money a bank can lend and thus limits business expansion.

In a standard securitization the originator creates a pool of financial assets and then sells these assets to an SPV, that issues bonds backed by those assets. Thus the name asset-backed securities. Interest and principal payments depend on the cash flows generated by the assets of the underlying pool.

In securitization a bank maintains a residual interest and carries that on its balance sheet. The residual interest is the first piece to absorb losses if assets don’t perform. The bank will often remain agent for the buyer of the debts and gets a fee for this. The bank thus maintains the relationship with the original borrower while having only a small risk. While residential mortgages were the first assets to be securitized, non-mortgage related securitization nowadays may include also other financial assets, like credit card payments, trade receivables, leases, auto loans and student loans etc

Securitization is said to have reached a marketvolume of $6.6trillion.

Structured finance

Another way to raise funds from capital market is structured finance. It’s a “non standard” securitization arriving from “cash flow collateralized debt obligation” or “cash flow CDO.” Cash flow CDOs offer access to a diversified portfolio of credit risk in a single investment, providing risks/returns profiles that correspond to each investor’s choice.

Cash flow CDOs offer investor or asset manager and issuing party special benefits. The first party can achieve some protection from market value volatility. The second party can sell off portfolio credit risk, reduce regulatory capital requirements and lower funding costs.

Besides of “Cash flow CDOs” we know “market value CDOs”, which are managed to pay off liabilities through trading and sale of collaterals (eg shares) while Cash flow CDOs are receiving interest and principal payments from its collaterals.

The underlying assets of each CDO may be static or revolving and may consist of any form of debt asset.

The securities issued by collateralized debt obligations (CDO) are split into rated and unrated classes of bonds, rating depending from its priority of payments. Payments of interest and principal are first made to the most senior class and then to other classes, in the order of their subordination. Payments are made solely from the cash flows received from the underlying assets.

Senior bonds with first claim are usually rated high. Subordinated bonds (mezzanine) are usually rated lower as they have a subordinate claim on cash flows. The tranche, which occupies a first-loss position, is unrated and receives all of the residual interest and payment proceeds of the collateral. Its called equity CDO as it has a higher risk / return profile and a higher volatility of return than the underlying assets.

Cash flow CDOs can be arbitrage or balance sheet transactions. Arbitrage attempts to capture for “CDO equity” investors the spread between relatively high yielding though risky assets and lower yielding liabilities represented by the rated bonds.

Balance sheet transactions are motivated by the desire to remove loans or other assets from balance sheets

Synthetic

Some balance sheet transactions use credit derivatives to transfer the credit risk of assets from balance sheets to CDOs without selling assets. These structures or “synthetic CDOs” may be non-funded or partially funded. Synthetic CDOs have become very popular, especially in Europe where over 90% of the deals are synthetic, while in the US synthetic deals account for around 35% of arbitrage CDOs.

Market growth of CDO’s

First issued in late 1980s CDOs emerged in the 1990s as one of the fastest growing sectors of the asset-backed securities market. This growth reflects the increasing appeal of CDOs for asset managers and institutional investors.

According to estimates gross global CDO issuance of all types totalled USD157billion in 2004, USD 251billion in 2005 and is expected to reach USD290billion in 2006.

Hybrid securities

combine some of the characteristics of both debt and equity securities.Preference shares form such a class. If the issuer is liquidated, they carry the right to receive interest and/or a return of capital in priority to ordinary shareholders.

Equity warrants are another class. They are contractual entitlements to purchase shares on pre-determined terms.They are often issued together with bonds or existing equities, but are detachable from them and tradeable.

Convertibles are bonds which can be converted into shares. A convertible bond will have a lower coupon rate due to the ability of conversion even though normally at a premium to its market value.

Other convertible securities include exchangeable bonds -where the stock underlying the bond is different from that of the issuer, mandatory convertible securities which are short term securities with high yields convertible upon maturity into a variable number of common shares based on the stock price at maturity.

Key benefit of raising money by selling convertible bonds is a reduced cash interest payment.

Where are share securities traded?

The trading takes place at stock exchanges, which are either a corporation or a mutual organization providing facilities for brokers and traders. Stock exchanges also provide facilities for dividend payments, issue and redemption of securities. To be traded securities have to be listed.

Earlier there had to be a central location, but modern markets are to some extend electronic networks. Only members of stockexchanges are allowed to trade. Increasingly more and more stock exchanges are part of a global market

While the open outcry system, where the brokers meet on the floor, does still exist around the world, the future of stock trading seems to be electronically, especially for smaller orders.

In big bourses the open outcry system has been transformed into socalled “upstairs” trading, where the broker completes transactions with institutional players interested in the stock. Despite electronic trading the “upstairs” or personalized market in eg Paris completes nearly 65% of block trading volume, compared with 20% at NYSE.

Participants in the market

The earlier mostly individual investors have been replaced to quite some extend by "institutionalized"; buyers and sellers

Contribution of stock exchange markets to new capital

Global issuance of share and share related instruments totaled $505bn in 2004 up 29.8% year on year. IPOs were around 11% of the total.

Investment strategies

One of the many things people always want to know about the stock market is, "How do I make money?" While there are manifold approaches, the two basic methods are classified as fundamental or technical analysis. In fundamental analysis companies are evaluated by their financial results.

Contrary to that technical analysis studies price actions in markets through the use of charts and quantitative techniques. This technic attempts to forecast price trends regardless of the company's financial prospects.

Bond Market

Unlike the stock market the bond markets in most countries remain decentralized. This is due to the fact that the number of different securities outstanding is far larger. Because of the individuality of bond issues, and the lack of liquidity in many smaller issues, the majority of outstanding bonds are held by institutions. It is interesting to note that only 10% of bonds in the US are held by individuals.

Bonds are subject mainly to credit risk and interest rate risk. When a credit rating is lowered by a Credit Rating Agency its bond price will decrease. While this rarely affects the bond market as a whole, it can negatively affect other issuers when companies from the same industry are downgraded.

More detrimental to the larger bond market are interest rate increases or decreases. When interest rates increase, the value of existing bonds falls, since new issues pay a higher yield and vice versa.

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