Financial markets

Chapter 2
Literature Review

2.1. Definitions
2.1.1. Capital markets
There are various definitions on capital markets. According to Kidwell [1984], financial
markets can be classified on the basis of maturity of the financial claims that are traded.
Therefore, in this context, money markets trade in short-term debt instruments having maturity
of one year or less. Capital markets, on the other hand, describes the market that deals with
any long-term debt instrument or equity obligations having maturity greater than one year.
Kitchen [1986] has used the term “capital market” to include both securities market and
the money market. According to him securities market is the market dealing with government
bonds and debt and equity issued by corporations. Another researcher, Robbins, makes no
distinction between the securities and non-securities market and from the understanding of his
definition, capital market is the securities market.
M.B.Abbasi [1994] define capital market is as a set of institutions, processes and
individuals which facilitate the flow of society’s saving into productive investments.
Wijewardene [1993] also divides financial markets into the money market and the
capital market. The former deals with maturity of one year or less, while the later consists of
transactions with maturity of more than one year. In the capital market, he detailedly divides
into medium- and long-term, transactions with maturity between one and five years are
medium term, while those with maturity of more than five years fall into long-term. The capital
market can therefore be divided into submarkets:
• Loan market or the no-securities market, where the money is made available to the users
in the form of loan from financial intermediaries without creating a tradable security in the
process.
• Securities market, where money is acquired by the users by selling debt or equity
instruments to savers which may be tradable or non-tradable in the market.
According to view of Asian Development Bank (ADB), capital market as typically
defined include the portion of the financial system that provide medium- and long-term funds
for creating fixed assets (such as plant and machinery) used in the production of other goods.
In contrast, money markets provides short-term finance generally for working capital needs on
a loan basis for period of less than one year. Thus, money markets provide shot-term funds
for meeting fluctuating needs and must be paid relatively quick, and capital markets provide
long-term funds which can be used to make “capital investments”.
For the purpose of this research study, the definition given by the ADB will be used is
clear and precise.
2.1.2. Efficient capital market
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The purpose of capital market is to transfer funds between lenders (savers) and
borrowers (producers) efficiently. In an efficient capital market, prices fully and instantaneously
reflect all available relevant information. This means that when assets are traded, prices are
accurate signals for capital allocation.
Drake, P.S [1977] has done a great deal to operationalize the notion of capital market
efficiency. He defines three types of efficiency, each of which is based on a different notion of
exactly what type of information is understood to be relevant in the phrase “all prices fully
reflect all relevant information”.
1. Weak-form efficiency: no investor can earn excess returns by developing trading rules
based on historical price or return information. In other words, the information in past
prices or returns is not useful or relevant in achieving excess returns.
2. Semistrong-form efficiency: no investor can earn returns form trading rules based on any
publicly available information.
3. Strong-form efficiency: no investor can earn returns using any information whether publicly
available or not.
Allen, M [1991] has extended the definition of market efficiency. The market is said to
be efficient with regard to an information event if the information causes no portfolio changes.
The definition requires not only that there be no price change but also that there be no
transactions.
2.2. Structure capital market
According to ADB, the capital market consists of two segments: the non-securities
markets and the securities market. The non-securities markets provide non-negotiable
medium- and long-term debt funds through financial institutions such as development finance
institutions, commercial banks, and contractual savings institutions which mobilize savings
and then lend these mobilized funds directly to business, industry, and users of funds.
Securities markets provide medium- and long-term equity and debt funds in negotiable form
which are issued by corporations and governments, or through financial institutions such as
investment or merchant banks and venture capital firms, directly to individual and institutional
investors are then traded among different holders. Thus , investors in the securities markets
can sell their securities whenever they need funds, through equities they can participate in the
financial risk of the enterprise.
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Table 2.1: Organization of capital market [1]
Non-securities markets Securities markets
Instruments Loans
Mortgages
Leases
Sales and lease-back
Equity (shares and stocks)
Equity equivalents (convertible bonds or
debentures)
Debt securities (bonds or debentures)
Primary market Secondary market
Institutions Development banks
Specialized banks
Commercial banks
Saving banks
Insurance companies
Pension and employee
Provident funds
Leasing companies
Corporate
government issuers
Investment, merchant
banks
Brokers, dealers
Securities regulatory
bodies
Debenture trustees
Venture capital firms
Over the counter markets
Stock exchanges
Brokers, dealers
Clearance and settlement
agencies
Transfer agents and
mutual funds
Generally, the institutions and individuals that constitute the capital market may be
divided into two categories:
1. Participants: who are the ultimate savers and users of capital, as well as the financial
institutions and intermediaries that channel capital from savers to users.
2. Supporting and supervisory entities: Which are typically government bodies that facilities
and regulate the activities of the participants.
The main features of capital market are three fold:
• Collection and provision of capital for real investment, i.e. to fulfill the investment needs of
the company.
• Provide an opportunities to gain higher return through financial investment for investors,
i.e. provide a medium of investment.
• Provide higher liquidity, i.e. readily encashable and transactable investment instruments
for investors in the market.
2.3. Significance of capital market
2.3.1. Economic development and capital market
* Demand-following approach: The role of financial markets, largely comprising of
the capital market, in economic development has been an area of increasing interest for
development economics. This sector was initially through of as playing more or less a
passive role in economic development - “where enterprise leads finance follows”. The view
that growth in the financial sector is an outcome of the development in the real sector has
been explained that this approach places emphasis the demand side for financial services; as
the economy grows it generates additional and new demands for these services, which bring
about a supply response in the growth of the financial system. In this view, the lack of financial
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institutions in undeveloped countries is simply an indication of the lack of demand for their
services.
The more rapid the growth rate of real national income, the greater will be the demand
by enterprises for external funds and therefore financial intermediation, since under most
circumstances firms will be less able to finance expansion from internally generated
depreciation allowances and retained profits. The financial system can thus support and
sustain the leading sectors in the process of growth.
The nature of the pace of growth of financial sector depends on factors such as growth
rate real output and the commercialization and monetization of agriculture and other
subsistence sectors. The demand-following-supply response of the growing financial system is
presumed to come about more or less automatically i.e. the supply of entrepreneurs is highly
elastic and no constraint on the provision of favorable legal, institutional and economic
environment is envisaged.
* Supply-leading approach: This approach suggests the creation of financial
institutions and the supply of their assets, liabilities and other financial services in advance of
the demand for them, especially the demand of entrepreneurs in the modern growth - inducing
sectors. The supply-leading strategy has to simultaneously deal with the issue of transferring
resources from traditional sectors to modern sectors, and to promote and stimulate an
entrepreneurial response in these modern sectors. This strategy is considered to be most
suited to the countries where entrepreneuship is a major constraint on development. In the
process the top management of the financial institutions may ply the role of entrepreneurs in
industrial enterprises.
The supply-leading strategy is more effective during the initial phases of development
and induces growth in the real sector by financial means. The more backward the economy
relative to others, the greater the emphasis on the strategy of supply-leading finance. The use
of this strategy, however, should ensure that the use of resources, especially entrepreneurial
talents and managerial skills, and the costs of implicit or explicit subsidies should produce
sufficient benefits in the form of stimulating real economic development for this approach to be
justified.
Irrespective of which of the two strategies is practiced, the thrust of recent times is
focus on financial liberalization and encouragement of efficient markets through financial
deepening and elimination of fragmentation of markets to improve the process of mobilization
of financial savings as well as the efficiency of investment. This would help eliminate the
conditions of what M.B. Abbasi [1994] calls “financial repression” resulting from credit
rationing, subsidized credit and other factors responsible for distortions in the financial
markets.
2.3.2. Mobilization of savings
Mobilization of domestic savings - private and public is one of the three essential steps
involved in the process of capital formation; the two other steps being the channeling of
savings through a finance and credit mechanism and the act of investment itself. In Vietnam,
the level of domestic savings is still low. Sustained high growth rates will be critically
dependent on a significant increase in the level of domestic savings, both from the public and
the private sector. The savings rate is projected to increase from 17.0 to over 20.0 percent of
GDP during the projection period.
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The government is expected to contribute significantly to this increase with its own
savings; its efforts have already produced encouraging results in 1994. The scope for further
increase in public savings through increase in revenues may be limited in the future since the
share of revenue in GDP is already large. Further public savings will need to come from
expenditure restraints which can only be implemented through careful setting of priorities in
public spending.
Progress in the mobilization of savings will however depend on the maintenance of a
stable macroeconomic environment and the development of an appropriate incentive regime
for investment - including the strengthening of the legal framework, the financial system, and
the framework for the trade and investment.
2.3.3. Determinants of savings
* Financial repression: One of the major impediments to saving in developing
countries, according to M.B. Abbasi [1994], is the persistence of financial repression in these
economies. The intensity of financial repression in an economy is measured by the existence
of negative real rates of interest. The role of various factors leading to financial repression can
be judged from their contribution to widening the gap between real and normal interest rates
while interacting with ongoing inflation. The factors that contribute to financial repression
include taxation, usual restrictions on interest rates, heavy reserve requirements on bank
deposits, compulsory credit allocations etc. as they reduce the attractiveness of investment in
financial assets and holding claims on the domestic banking system.
* Income: Income, occupies the central place in determination of savings in the
economy. The amount of savings is determined by the absolute level of income as well as the
proportions of income saved out of each additional unit of income i.e., the marginal propensity
to save (MPS). The MPS should, according to the theory, increase with the increase in income
over time and across various income sections in the economy.
* Interest rates: The rates of interest is a major determinant of the demand of money
whereas the saving rate is only indirectly affected. A rise in the rate of interest reduces the
level of investment which result in the fall of the level of income and hence savings in the
economy. This indirect interaction implies a negative relationship between these two variables.
* Taxation: Most studies of the effects of taxation on saving show that government
savings increase with increased revenue taxation. However, several other studies [Please, S.,
1970] indicate that the increase in government savings is more than offset by a decrease in
the rate of private saving, while studies by Landan .L.[1980] found the reserve to be the case.
* Foreign aid: Studies conducted on the impact of foreign aid on savings have found
that foreign capital is a substitute for domestic savings. In other words, an increase in foreign
aid usually result in a decline in domestic savings or more accurately a part of the capital
inflow finances increased consumption.
* Export: Several studies have shown a positive relationship between savings and
exports. However, it is not clear whether this implies that the export sector has a higher
propensity to save than other sectors, or if it is the growth engendered by exports which is
responsible for the higher savings rates.
2.3.4. The role of financial intermediaries
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Financial intermediaries are defined as the “economic units whose principal function is
managing financial assets of other economic units - business concerns and individuals. Thus
they bring savers and borrowers together by selling securities to savers from money and
lending that money to borrowers” [Benton E. Gup, 1976].
UNIDO [21], has stressed the essential role that financial institutions have to play as
intermediaries and promoters of industrialization process. The following statements support
this claim.
• Financial institutions in less developed countries have to play an important role in the
process of economic development and they should be properly organized and oriented
towards the specific objectives they are expected to fulfill [Zolates, Xenophan, 1963].
• In order to ensure efficient and rational mobilization of savings and channeling of these
funds for the financing of the investment programs consistent with the development
objectives, financial institutions play a very important role, because they act as
intermediaries between surplus and deficit sectors in the country [Kivanc, Tarik, 1984].
• Economic development of any country depend on the contribution to growth of the financial
sector [World Bank, 1985].
Edwards [1987], has listed characteristics of successful economies and all successful
cases of economic resurgence which highlight the importance of finance and financial
institutions in industrial investment. They are:
1) Political acceptance of the importance of industry in the national economy;
2) The political will to act to create favorable financial circumstances and appropriate
institutions to help industry flourish;
3) An organization which acts as a financial ombudsman which, from a deep knowledge of
the circumstances of a particular industrial situation, can approve a company’s
investment plans (and frequently improving them in the process);
4) A financial system committed to the national success of its manufacturing industries;
5) Relatively cheap long-term loans for industry from the financial system;
6) The absence of any nonsensical theories about the ‘proper relation’ of debt to equity; and
7) A co-operative and practical approach by government, industry and banks to solve the
national economic problem.
It is widely recognized that during prosperous economic times there is always a rapid
increase in overall indebtedness, and during economic recessions there is always a slowdown
in the rate of growth of outstanding debt. The implication for financial intermediation is that the
greater the amount of spending financed externally through debt on equity issues, the greater
will be the role played by financial institutions. The term of financial institutions can be applied
as the central bank (State bank of Vietnam), commercial banks, investment and development
banks, finance companies, insurance corporation.
2.4. What is the securities market
2.4.1. Concept of securities market
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The concept of a securities market arises from three distinguishing principles. One is
the type of funds attracted to it. Funds moving through the securities market may include risk
averters, but the unique characteristic of this market is that it draws from investors who are
risk assumers and are therefore willing to provide capital to new growing ventures where the
chances of loss are marked by equal or greater opportunities for eventual gain. The second
principle of securities market is that the mechanism for moving its money flows involves
specialized institutions such as stock exchanges and securities dealers that have their own
procedures, technique of control and applicable legislation. The third principle refers to the
instruments used which are securities including stocks and bonds not ordinarily available in
other markets. The development of any capital market must give consideration to these three
aspects. Since its growth depends on the incentive embodied in the potential gains available
to risk assuming investors, uncertainty is an essential characteristic of the securities market
[Robbins, 1985].
2.4.2. Functions of securities market
As securities market has two closely interrelated parts: a new issue market where
corporations sell securities for the first time to the public which is termed as the primary
market and the secondary market or trading market where the securities, after they have been
initially issued, may be bought and sold among investors. each of these segments plays a part
in the overall contribution that the capital markets to a nation’s economy [Robbins, 1985].
The establishment of an efficient trading market is an essential precondition for a
thriving new issue market and any factor real or artificial, which tends to reduce the
marketability of securities or the investors confidence in the price making mechanism,
adversely affects the new issue market. This degree of efficiency, both of the trading and the
new issue market has a direct influence on the economic climate and potential of the country.
By providing a secondary market in securities the stock exchange not only epitomizes the free
enterprise system but acts a prerequisite for its survival and operation.
The primary market implies the very beginning stage of the securities market where
securities are issued by the issuers and sold to the investors and then the money flows to the
issuers from investors (buyers of the securities). This market characterized by the followings:
1. Secutalization process of the needed capital;
2. Process of the direct finance transforming money into the long-term capital.
The secondary market can be referred to as all types of markets where existing
securities are being traded between investors. The features of this market are as follows:
1. To get holding securities cashed;
2. Fair price determination of securities, free auction (perfect competition)
3. The fair price in the secondary market affects the issuing price in the primary market, two
markets are interdependent.
Securities Securities
Fund Fund
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Firm
Investors
Investor
Primary market Secondary market
Figure 2.1: Structure of the securities market [2]
An important aspect of the primary and secondary market is that they expose a
company seeking funds to the test of outside judgment, which is particularly important in
developing countries to ensure that the funds more along economic channels. Without capital
markets, ventures are ineligible for bank funds cannot be launched or must obtain their
financing from private sources. Therefore, due to bank bias a venture which has merit is killed
and economy suffers. If the reserve takes place where a potentially more useful outlets, and
economy suffers. In many developed capital markets, the judgment of investors, reflected in
the pricing mechanism of the market, has provided an effective means of discriminating the
values of different enterprises and of assessing their future worth to the national economy.
In addition to the financing, allocating and testing role, the securities market serve
other purposes. Once functioning properly, they are a significant source of savings, through
institutions such as mutual funds: this function has increased prominence due to inflationary
tendencies where individuals have being able to protect the capital value of at least a portion
of savings from being eroded by rising price levels. From the company’s point of view, the
market enables equity financing thereby reducing the risk of overly extended borrowing and
permitting the company’s to attain a better balanced capital structure between bonds and
stocks. Finally, by creating a objective basis for establishing prices, the securities market
facilitates the determination of valuation for taxation and mergers [Robbins, 1985].
2.4.3. Advantages of securities market
◊ A stock market enables companies to raise fresh capital both initially, by going public
(primary issues) and subsequently through secondary issues (rights or placements of
stocks) thus a stock exchange can provide additional capital for companies. Therefore,
company expansion takes place more readily.
◊ A stock market provides governments with an alternative means of selling bonds and
raising capital. The virtue of this depends on the ability of the government to use the funds
efficiently for the national economy.
◊ A stock market provides savers and financial institutions with a further outlet for their
funds. Investment in equities (and government stock unless held to maturity)is of course
investment in risky instruments. However investors have different risk taking capacities
and like to be offered a range of risks and a corresponding range of expected return. A
stock market enables investors to select a portfolio which gives a risk return combination
according to their liking. It enables them to diversify their investment and reduce risk. A
stock market by offering various returns, may be important to investors whose only
alternative is to place deposits and receive low repressed rates of interest. It can
therefore encourage savings and mobilization of funds. If the secondary market is active
investors have a market which is more liquid.
◊ A stock market provides a hierarchy of rates of return (and therefore of cost of capital)
between equities, corporate bonds and government stocks. Therefore firms and
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government rising new capital have to pay a rate of return which reflects both of rate of
return and alternative investors and risk associated with the undertaking. Therefore
allocation of capital is improved exante. This is important in capital markets which
otherwise repressed and when the cost of borrowing is not related either to the demand
for capital or risk of the investment.
◊ The stock market provides a vehicle for government corporations to go to public especially
with the privatization program worldwide.
◊ Stock market can bring foreign capital into a country from foreign portfolio investors
wishing to diversify internationally.
2.4.4. Disadvantages of securities market
The criticisms of stock markets are essentially the following:
◊ The encourage unequal distribution of wealth, by enabling those who are wealthy to invest
with a view to increasing their wealth, without working for it.
◊ Stock markets can encourage rash speculation both by individuals and institutions when
followed by collapse can lead to the ruin of both with consequent destabilizing effects on
the national economy. Wall street in late 1920’s, Hongkong in 1973.
◊ Stock markets can provide an opportunity for dishonest activity, such as conflict of
interest, market rigging insider dealing, issuing false or misleading prospectus, pushing
and selling overpriced or worthless stock.
◊ Although stock markets may allocate funds to the activities which are expected to show
the greatest financial profit, may not be the most profitable from a national point of view
because markets and prices are seriously distorted in many developing countries.
2.4.5. The supply of securities
Investors need a reasonable choice of both government securities and company so
that they can set up the type of portfolio they wish, and change it readily. This implies that
there must be a reasonable number of fairly large companies willing to make their shares
available to the public (Kitchen 1986).
Supply of securities could come from the state enterprises when they want to raise
debt by issues of bond s or debentures, also another source of supply is from the
privatization of state enterprises, where enterprises capital is raised by a public issue in the
primary securities market. Other sources of supply are the formation of new companies,
increases of capital of companies already public, private companies going public and
also in some instances joint ventures and wholly owned subsidiaries and companies
approved by Board of Investment in different countries (Robbins).
However, it must be stressed that in developing countries family owned companies
may be reluctant to dilute ownership and control. Also some private companies have found
ample opportunity for tax evasion which may not be available if they go to public. One way of
inducing private companies to go to public is for the broad of investment to offer additional
benefits such as tax reduction etc. for quoted companies.
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2.4.6. The demand for securities
The demand for shares depends on savings. A well functioning market requires a mix
of long term investors such as Insurance Companies, Pension funds, Investment trusts, Unit
trusts, dealers and short term investors (often individuals) which keep the market fluid. There
must therefore be substantial number of institutions which hold the savings of individuals and
individual investors [Kitchen 1986]. This in turn implies a reasonably widespread distribution of
wealth and income within a country, and a sizable middle class. Countries which have highly
skewed income and wealth distributions are unlikely to have the right mix of investors to keep
the market active and fluid. The success of the Malaysian and Singaporean stock exchanges
may be attribute partly to the large number of middle and lower middle class shareholders
[Darke 1977].
In addition to having and adequate level and distribution of wealth a country must
possess individuals willing to buy share. Investors need to be made aware of the stock
exchanges, of possible risks as well as of possible returns. This requires active, but
responsible, promotion on the part of the stock exchange authorities, investment trusts and
unit trusts and shareholders’ representative bodies.
At the same financial institutions need to be willing and able to buy shares. As Darke
(1977) has pointed out, institutions may need to be persuaded of the desirability of equity
investments; they may need to be freed from requirements to invest very heavily or even
entirely in government stocks.
The most important factor determining the willingness to buy and hold securities is the
elusive “investor confidence”. Investors need have confidence in the macroeconomics
performance of the economy (Market risk). Doubtful growth prospects and fears of inflation
are bad for stock markets, which perform badly under either worry. Investors need also to
have confidence in the firm whose shares they buy (specific risk). They need confidence in
the firm’s products and markets, its management and in its in integrity in disclosing
information. Finally they need to have confidence in the operation of the stock market and of
its members. Malpractice deter investor. They also need confidence in the accounting
standards required of the firm and in the auditing of the accountancy profession [Kitchen
1986].
Hopefully a direct interest in stocks would also be created by offering tax inducements
through the treatment of capital gains and dividend income [Robbins, 1985].
2.5. The instruments in the securities market
The generic term of for a wide variety of stocks and shares and bonds offered by
developed stock markets today is “securities”. They present what is known as capital of the
company. However when looking at the types of stocks and shares offered, it is usual to divide
the market into two: the bond market and equity market and other forms of a company’s risk
capital (Allen 1991).
2.5.1. Stocks
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