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1.5.3. Market mechanism

The market mechanism is the structure, systems and conventions that exist to facilitate the issue and trading of shares. There are two types of market, i.e. the over the counter (OTC) market and the exchange-driven (and regulated) market. Most share markets around the world are exchange-driven markets.1

1.5.4. Issue (primary market)

Shares are issued by companies, which may be local or foreign (see Figure 4). In most countries shares issued by foreign companies are rare, and they are usually called inward-listed shares or foreign shares. The original shares of companies are unlisted shares and are issued to the founders of the companies (this is the primary market).

The directors of companies only list the shares (and issue new shares) when they have established a good profit record and are able to comply with the listing requirements of the exchange. The main motivation for listing the shares on an exchange is to have the mechanism to acquire further capital easily and at a good price.

1.5.5. Investing

equity issuers & investors

Figure 4: equity issuers & investors

The investors in (or holders of) equities are also depicted in Figure 4. In most countries all the ultimate lenders are holders of equity. The government holds equity in public enterprises. The foreign sector's involvement in the equity markets of countries differs widely. In some it is a large investor, while in others it is an insignificant investor. Generally speaking, the household sector is a small direct investor in equities; however, it is a large holder of equities via the investment vehicles.

All the mainstream financial intermediaries are investors in equities, with the exception of the central bank (and most of the QFIs). In most countries the largest holders of equities are the retirement funds (CIs), the long-term insurers (CIs), the securities unit trusts (CISs) and the exchange traded funds (CISs).

1.5.6. Trading (secondary market)

Trading in shares (i.e. secondary market broking and dealing) is a sizeable business in most financial markets. As noted earlier, the majority of secondary share markets are exchange-driven. The secondary equity market participants are:

• Members of share exchanges. The members (also called users in some markets) of share exchanges are usually separately-capitalised subsidiaries of the banks, smaller companies owned by participants and individuals (who then have unlimited liability). The generic name we use here for all the members is broker-dealers.

• Issuers of equity. Companies not only supply equity to the market, but they are, in many countries, permitted to purchase their own shares and hold them as "treasury stock" or cancel them.

• Investors. As we have seen, the investors include all the ultimate lenders and certain financial intermediaries. Of the latter the major participants are the retirement funds, the insurers, the exchange traded funds and the securities unit trusts. In some countries the foreign sector plays a major role.

• Speculators / arbitrageurs. These may be members of exchanges (the members that only deal for themselves) or non-members. Most of them trade intra-day in order to avoid settlement outlays. Their usefulness lies in increasing the turnover in the equity market, thereby contributing to efficient price discovery.

1.5.7. Permanent or semi-permanent capital of the issuers

Common shares and perpetual shares represent the permanent capital of a company. Preference shares (redeemable) and other forms of borrowing (for example bank overdraft facilities utilised in the case of smaller companies and the issue of bonds and commercial paper in the case of the larger companies) represent the semi-permanent capital of a company.

Permanent capital is the capital required to maintain the ongoing business of the company, to invest in plant and equipment and to hold the permanent core of inventories. The holders of common shares are rewarded by sharing in the profits of the company.

Redeemable preference shares are issued when temporary but medium-term funding is required. This medium-term funding is required in preference to bank loans. There are two main financial considerations (and inconveniences) in this regard:

• The uncertainty of obtaining funds at each rollover at maturity.

• The uncertainty of the rate of interest to be paid at each rollover date.

The ability to issue preference shares removes these uncertainties. The issuer has a fixed (i.e. a known) rate that is paid at known intervals and the funds are available for the full period required. Payments in some cases can be delayed (cumulative preference shares).

1.6. Statutory backdrop to shares and share market

Shares are issued by companies and companies are regulated under a statute (in most countries called the Companies Act). This statute defines a company and there are usually two types: private and public. Only the latter may be listed.

Most countries' statutes relating to companies also define / cover the following issues in respect of shares and the share market:

• Equity share capital (issued share capital and shares).

• Definition of share (a share in the share capital...).

• Register of shareholders.

• Transfer of shares.

• Dividends and reserves.

• Increase, decrease, conversion, consolidation, subdivision cancellation of shares.

• Payments to shareholders.

• Uncertificated securities.

• Preference shares.

• Letter of allocation and rights offer.

• No offer for subscription to public without prospectus.

• No offer for sale to the public without prospectus.

• Matters to be stated in prospectus.

• Underwritten issues of shares.

• Voting rights of shareholders.

• Power of directors to issue share capital.

A share (usually called stock) exchange is licensed under a statute and this statute usually lays out the conditions for self-regulation which includes the skeleton of the Rules and Directives under which the members of the exchange operate.

1.7. Equity derivatives

In the many equity markets of the world there exist vibrant markets for the derivative instruments that have been created for the purpose of transferring interest rate risk / transforming assets and liabilities. The derivative instrument types are depicted in broad terms in Figure 5.

derivative instruments / markets

Figure 5: derivative instruments / markets

In the equity derivative markets we find:

• Forwards.

• Futures.

• Options:

- options on "physicals"

- equity warrants.

• Swaps:

- equity-bond swaps.

• Hybrids:

- options on futures

- swaptions.

1.8. Summary

There are two types of equity: common shares and preference shares. Equity represents the permanent or semi-permanent capital of the issuers (companies).

The equity market can be described as the mechanism / conventions that exist for the issue (primary market) of, investing in, and the trading (secondary market) of, equity instruments.

The statutory backdrop of equities and the equity market are the statutes that regulate companies and the share exchange. Most regulators embrace the concept of exchange self-regulation.

1.9. Bibliography

Blake, D, 2000. Financial market analysis. New York: John Wiley & Sons Limited.

Faure, AP, 2007. The equity market. Cape Town: Quoin Institute (Pty) Limited.

Mayo, HB, 2003. Investments: an introduction. Mason, Ohio: Thomson South Western.

McInnes, TH, 2000. Capital markets: a global perspective. Oxford: Blackwell Publishers.

Mishkin, FS and Eakins, SG, 2000. Financial markets and institutions. Reading, Massachusetts: Addison Wesley Longman.

Pilbeam, K, 1998. Finance and financial markets. London: Macmillan Press.

Reilly, FK and Brown, KC, 2003. Investment analysis and portfolio management. Mason, Ohio: Thomson South Western.

Reilly, FK and Norton, EA, 2003. Investments. Mason, Ohio: Thomson South Western.

Rose, PS, 2000. Money and capital markets (international edition). Boston: McGraw-Hill Higher Education.

Santomero, AM and Babbel, DF, 2001. Financial markets, instruments and institutions (second edition). Boston: McGraw-Hill/Irwin.

Saunders, A and Cornett, MM, 2001. Financial markets and institutions (international edition). Boston: McGraw-Hill Higher Education.

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