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1. Context & Essence

1.1. Learning outcomes

After studying this text the learner should / should be able to:

1. Understand the slot the equity market occupies in the financial system.

2. Be acquainted with the general terminology of the equity market.

3. Dissect the equity market definition into its elements.

4. Appreciate the statutory backdrop to equities and the equity market.

5. Know of the existence of equity derivative instruments.

1.2. Introduction

The purpose of this text is to provide an overview of the equity market and its role in the financial system. We start with a brief introduction to the financial system, and then contrast the equity market with the money and debt markets. A definition of the equity market is presented and dissected into its elements. The statutory backdrop to equities and the equity market is presented in brief and the equity derivatives are merely mentioned for the sake of completeness.

The following are the sections:

• The financial system in brief.

• The money and bond markets in a nutshell.

• Essence of the equity market.

• Statutory backdrop to shares and share market.

• Equity derivatives.

• Summary.

1.3. The financial system in brief

As seen in Figure 1, the financial system is essentially concerned with borrowing and lending. Lending occurs either directly to borrowers (e.g. equities held by an individual) or indirectly via financial intermediaries (e.g. an individual holds units and the unit trust holds as assets the liabilities of the ultimate borrowers). Although this is the main function, there are many related others as reflected in the following definition of the financial system:

The financial system is a set of arrangements / conventions embracing the lending and borrowing of funds by non-financial economic units and the intermediation of this function by financial intermediaries in order to facilitate the transfer of funds, to create additional money when required, and to create markets in debt and equity instruments (and their derivatives) so that the price and allocation of funds are determined efficiently.

simplified financial system Dissecting this definition reveals six essential elements:

Figure 1: simplified financial system Dissecting this definition reveals six essential elements:

• First: lenders (surplus economic units or supplies budget units) and borrowers (deficit economic units or deficit budget units), i.e. the non-financial economic units that undertake the lending and borrowing process. There are four groups of lenders and borrowers: household sector, corporate sector, government sector and foreign sector, and many members of these groups are lenders and borrowers at the same time.

• Second: financial intermediaries which intermediate the lending and borrowing process. They interpose themselves between the lenders and borrowers.

• Third: financial instruments, which are created to satisfy the financial requirements of the various participants; these instruments may be marketable (e.g. treasury bills) or non-marketable (e.g. participation interest in a retirement annuity).

• Fourth: the creation of money when demanded. Banks have the unique ability to create money by simply lending because the general public accepts bank deposits (= money) as a medium of exchange.

• Fifth: financial markets, i.e. the institutional arrangements and conventions that exist for the issue and trading (dealing) of the financial instruments.

• Sixth: price discovery, i.e. the price of equity and the price of money / debt (the rate of interest) are "discovered" (made and determined) in the financial markets. Prices have an allocation of funds function.

In this text on the equity market we will not cover money creation and the genesis of short-term interest rates (this takes place in the money market). We do cover the other elements briefly here as they form the context of the equity market. We begin with the financial intermediaries.

The financial intermediaries that exist in most countries are shown in Box 1 in categories. The individual intermediaries or categories are then presented in Figure 2 in terms of their relationship to one another.

BOX 1: FINANCIAL INTERMEDIARIES

MAINSTREAM FINANCIAL INTERMEDIARIES

DEPOSIT INTERMEDIARIES

Central bank (CB) Private sector banks

NON-DEPOSIT INTERMEDIARIES

Contractual intermediaries (CIs)

Insurers

Retirement funds

Collective investment schemes (CISs)

Securities unit trusts (SUTs) Property unit trusts (PUTs) Exchange traded funds (ETFs)

Alternative investments (AIs)

Hedge funds (HFs)

Private equity funds (PEFs)

QUASI-FINANCIAL INTERMEDIARIES (QFIs)

Development finance institutions (DFIs) Special purpose vehicles (SPVs) Finance companies Investment trusts / companies Micro lenders Buying associations

The financial instruments issued by the ultimate borrowers and the financial intermediaries are also shown in Figure 2. They can be categorised into:

• debt instruments

• deposit instruments (which are a variation of debt instruments)

• equity instruments.

Our focus is on the latter.

financial intermediaries & instruments / securities

Figure 2: financial intermediaries & instruments / securities

If we combine deposit instruments with debt instruments there are two financial markets: the debt and equity markets. They are depicted in Figure 3 together with the foreign exchange market. Note that:

• The money market and the bond market which together make up the debt market are also known as the interest-bearing market and the fixed-interest market. The terms interest-bearing and fixed-interest oppose the debt market from the equity market because the returns on shares are dividends and dividends are not fixed - they depend on the performance of companies.

• The debt and equity markets make up the capital market; called as such because companies access long-term or permanent capital in these markets.

• The foreign exchange (forex) market is not a financial market, but a conduit for foreign investors into local financial markets and for local investors into foreign financial markets.

To the debt and equity (and forex) markets we may add the derivative markets. Although lending and borrowing also do not take place in the derivative markets, they play an important role in the financial system in terms of enabling participants in the real economy to hedge (thereby creating stability in production).

Financial markets can be categorised into primary and secondary markets. The former is the market for the issue of new securities and the latter the market for the trading of securities that are already in issue. It will be apparent that non-marketable debt (NMD) instruments only have primary markets (e.g. a participation interest in a retirement fund) and that marketable debt (MD) instruments are issued in the primary markets and traded in the secondary markets (e.g. treasury bills).

financial markets

Figure 3: financial markets

Financial markets are either OTC (over the counter), such as the money market, or exchange driven, such as the equity market. Next we define the debt market which leads to a detailed description of the equity market.

 
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