CAPITAL MARKET FINANCING AND RISK MANAGEMENT 6 Capital market financing refers to the financing of long-term fund especially from the capital market. Capital market refers to the long-term market composed of equity and bond markets. Risk management means the identification of risks and selection thereof and ways and means as to reduce risks. The major approaches to manage risk are: risk avoidance, loss prevention and control, risk retention and risk transfer.
Against this background, the present UNIT#SIX includes the following aspects : 1) Capital Market and Its Role (Lesson: 1) 2) Long-term Financing – Internal and External (Lesson: 2) 3) Equity Financing and Preferred Stock Financing (Lesson: 3) 4) Debt Financing (Lesson: 4) 5) Lease Financing (Lesson: 5) 6) Hybrid and Derivative Types of Financing (Lesson: 6) 7) Valuation of Bonds, Common Stock and Preferred Stock (Lesson:7) 8) Financial Risk Management (Lesson: 8) 9) Hedging and Insurance. (Lesson: 9) School of Business Blank Unit-6 Page-408 Bangladesh Open University Lesson–1: Capital Market and Its Role After attentively reading the lesson 1, you should be able- To understand the definition & characteristics of capital market. To know the various components of capital market To discuss the functions of capital market: Stock market and Bond Market. To compare the capital market with financial and money markets.
To understand the nature of perfect capital market. And To realize the role of capital market in the industrial and hence the economic development of a developing country. Definition and Characteristics of Capital Market Capital market refers to a place where long-term supply of funds is Capital market available as well as procurement of those funds is made. That is, capital refers to a place market is the origin of long-term funds of all types, whether, equity where long-term stock, preferred stock and bonds securities.
That is, capital market deals supply of funds are with capital market securities like treasury notes or bonds, municipal available as well as procurement of bonds, corporate bonds, mortgage & equity securities namely common those funds are stock and preferred stock. It is through capital market that the personal as made. well as institutional savings are converted into investment. That is why the capital market is formed in coordination with the savers and investors.
A capital market may be called an ideal capital market when the supplies A capital market of capital according to the needs of industrial enterprises are guaranteed. may be called an It should also be organized, transparent and efficient in order become an ideal capital market ideal one. An ideal capital market should have the following when the supplies of characteristics: capital according to the needs of i) Adequate number of individual and institutional investors; industrial ii) Existence of various competitors and auxiliary organizations enterprises are namely stock exchanges, investment banks, broker firms etc. iii) Liquidity benefits through sufficient transactions in the indirect market.
iv) Expected transparency and reasonableness in dealings and contracts v) Proper supervisory organization like stock exchange commission in order to control the functioning of capital market vi) Transactions of various types of securities like stock, equity and preferred, bond and other securities. vii) To have a clear cut conception of the investors and savers about the functioning and administration of capital market with presence of skilled entrepreneurs and professionals. Fundamentals of Financial Management Page-409 School of Business Components of Capital Market Since capital market is formed in coordination with the investors and The various savers, hence the main elements of capital market are - components of capital market may be grouped into i) Saving banks; ii) Investment banks; iii) Finance companies depositors and non depository financial iv) Development Financial Institutions (DFI) v) Commercial banks, vi) institutions. Stock exchanges; vii) Leasing companies; viii) Credit units, ix) Mutual funds; x) Insurance companies and xi) Pension funds.
The various components of capital market may be grouped into depositors and non depository financial institutions which are shown in the following chart : Chart - 1 : Showing Various Components of Capital Market Components Depository Non - depository Finance Companies Commercial Banks DFIs Credit U Savings Banks Stock Exchanges Investment Leasing Companies Banks Credit Unions Mutual Funds Pension Funds Insurance Companies A brief discussion of each of the above components of capital market is given below: i) Commercial Banks Commercial banks are those, which accept deposits from the individuals, organizations and governments in one hand and lend funds to the parties, on the other. In aggregate, they are the most dominant depository institutions in any country. They collect the scattered savings of the country; then create investible funds and lastly, mobilize the same into productive investments. Unit-6 Page-410 Bangladesh Open University ii) Saving Banks Like commercial banks, savings banks also accumulate the scattered savings of the country and then create investible funds and lastly channelise these funds into productive investments.
Most savings banks are mutual in nature. iii) Investment Banks Investment banks are those, which under write shares and debentures of corporate firms and deal in capital market through trading various transactions. They also create securities & provide institutional financing. iv) Credit Unions Credit union differs from commercials savings banks in that they (a) are not profit oriented and (b) restrict their business to the main members only.
They use most of their funds to provide loans to their members. v) Finance Companies Most finance companies obtain funds by issuing securities and then lend the funds to individuals and small businesses. vi) DFIS DFIS play the significant role as the source of long-term funds mainly for the corporate firms. They supply fixed capital to the investors for investment in fixed capital expenditures.
They also perform the underwriting functions relating to shares and debentures of the corporate firms. vii) Stock Exchange Stock exchange means any body comprising of individuals organizations whether incorporated or not, constituted for the purpose of assisting and controlling of buying, selling or dealing in securities. In its primary market, funds are obtained by issuing shares, stocks and securities of the firms, individuals and government. viii) Leasing Companies Leasing companies are the easiest sources of financing fixed assets requirements of the corporate firms, individuals and other organizations.
ix) Mutual Funds Some of the mutual funds concentrate their investments in capital market securities such as stocks or bonds. In this way, they provide funds for long-term investments by the investors. Fundamentals of Financial Management Page-411 School of Business x) Insurance Companies Insurance companies receive premium in exchange for insurance policies and use these funds to purchase a variety of securities. Thus, they invest the proceeds received from insurance in stocks and bonds.
xi) Pension funds Many companies, corporations and government organizations and agencies offer pension plans to their employers their employers or both periodically contribute funds to such plans. The funds contributed are invested in securities until they are withdrawn by the employees upon their retirement. Functions of Capital Market : Stock Market & Bond Market Generally speaking, Before discussing the functions of capital market, it is essential to the capital markets classify the capital market, since the functions differ in terms of the types may be broadly of the market. Generally speaking, the capital markets may be broadly classified into two classified into two types namely stock market and bond market.
Stock types namely stock market may be again of two types namely common stock market and market and bond market. preferred stock market. Bond market may also be of three types namely corporation bond market, Treasury bond markets and municipal bond market. Therefore, the broad type functions of capital market are discussed in the following sub-sections.
Functions of Stock Market i. Providing adequate permanent floor for performing transactions in common stock or preferred stock. As a result, rate of selling and buying stocks and liquidity and transferability of invested stocks increases along with increasing in the stability in stock prices. Ensuring adequate volume of trade leading to liquidity.
Providing reasonable level of fairness in deal making of trading. Allowing the determination of actual transfer prices of stock on the basis of corporate firms’ present and future profitability; since the market helps creating competitive stock market. Helps increasing the transparency, accuracy and safety of transactions by following certain norms and disciplines while allowing trading. Ensuring arrangement of investment in productive sectors of the economy after accumulating surplus money of the individuals and organizations.
Helps equitable distribution of capital in any specific industry, factory etc. Protecting the interests of the investors. Unit-6 Page-412 Bangladesh Open University ix. Helps government in framing policy in the interests of the investors and industrial growth x.
Registering and monitoring stock prices and xi. Providing adequate instruments and technical aids for prompt and smooth trading. Functions of Bond Market i. They allow the individuals as well as the organizations to raise the requisite long-term funds by selling their bonds.
They help investors having surplus funds to make investments in the purchase of bonds and thereby earning returns. They play the vital role in proper functioning of the capitalistic economy where they serve to charnel funds from severs to borrowers. They can provide an important allocative function by channeling the funds to productive investors. They can render corporate advisory services.
Money Market, Capital Market Vs Financial Market i) Financial Market The term financial market is used to describe the place where investors The term financial with surplus capital provide their surplus capital to those who are in need market is used to of capital. This may be done directly, such as a person borrowing from a describe the place friend/ relative, or financial intermediaries such as banks, mutual funds, where investors with insurance companies may facilitate this process. Similar to financial surplus capital provide their institutions, financial markets allow for the suppliers and demanders of surplus capital to funds to deal with each other. Therefore, financial market facilitates the those who are in needs of investors having surplus capital and borrowers who are need of need of capital.
ii) Money Market A money market is one which deals in short term securities of a A money market is maximum period of one year. It is a market where dealers purchase and one which deals in sell securities. The examples of short term securities are commercial short term securities paper, treasury bills and bankers acceptances. Money market is one of of a maximum the components of financial market.
period of one year. iii) Capital Market A capital market is one that deals in long-term securities. The examples A capital market is of long-term securities are shares and bonds of corporations, long term one that deals in government bonds and debentures of companies and corporations. The long-term securities.
capital market is one of the important components of financial market. A capital market may be either equity market or bond market. Fundamentals of Financial Management Page-413 School of Business Nature of Perfect Capital Market A perfect capital market imposes more stringent conditions. The A perfect capital market imposes following are the attributes of a perfect capital market: more stringent conditions.
* No entry barriers Any one can participate in the market. Thus the suppliers or users of funds can enter the market and deal with each other. * Large number of buyers and sellers Perfect competition in the market is ensured by the presence of large number of buyers and sellers of securities. * Divisibility of financial assets Financial assets are divisible and therefore, affordable investments are made by all participants.
* Absence of transaction costs There are no transaction costs. Participants can buy and sell securities with ease and without many costs. * No tax differences Ideally, there are no taxes. There should not be any tax distortions.
One set of investors should not be favored over others. * Free trading Any one is free to trade in securities in the capital market. There should not be government restrictions on trading. An efficient capital market is perfect if the above mentioned conditions are fully satisfied.