Things you have to know about share markets

[Blog #2 on financial markets]

A major segment of financial markets is the capital market. This consists of the equity, or share, market; and the money and bond markets. We are first going to look at the share market and what it means for safe investing.


The share market
The terms shares, equities or stocks are used interchangeably to describe marketable financial instruments of listed companies quoted and traded on a financial exchange (or stock exchange). These shares represent ownership by investors of the productive assets of listed companies. A stock exchange facilitates the raising of share capital by companies (borrowers) in the primary share market, and the trading of these shares in the secondary share market by investors (lenders).

Companies could source finance through the issuance of share capital or debt (borrowed funds). Share capital is raised through the issuance of shares, while debt is raised through the issuance of debentures and corporate bonds, or the incurrence of loans. The fundamental difference between shares and bonds is that shareholding represents co-ownership in contrast to bondholders being creditors.

Bondholders in their capacity as creditors (lenders of money) of the private company issuing debt are entitled to regular interest payments and repayment of principal at maturity. An investment in bonds delivers a steady cash flow in the form of interest receipts, and bondholders' prior claim on company assets make bonds more safe investing than shares. In normal circumstances, the lower level of risk associated with investments in bonds compared to shares should result in a lower level of return on bonds than on shares.

Shareholders in their capacity as co-owners of the company are entitled to share in profit by way of dividend payments (payments out of profits after tax and other prior claims) and in capital gains or losses (capital appreciation and depreciation). This depends on the market's assessment of the company as reflected by changes in market prices (the ruling share price at the time of the last recorded transaction) of listed shares.


In contrast to bonds, shares have no fixed maturity. Furthermore, shareholders can dispose of listed shares at current market prices in the secondary share market on a stock exchange.

Different classes of share
Listed companies can usually issue different types or classes of share to raise capital. the differentiation between the two main classes of share is based on shareholder priority in terms of rights to the distribution ot earnings (a company's net income or net profit during a specific period). The distribution of earnings to preference shares ranks higher than ordinary shares. This means that the dividends on preference shares have to be paid before dividends on ordinary shares are paid. Ordinary shares are the most widely used type of share. The dividends paid on ordinary shares can be in excess of dividends on preference shares, but the dividend payment remains uncertain, reflecting the higher degree of risk associated with dividends on ordinary shares relative to preference shares.

The two main characteristics of ordinary shares can be summarised as:

• the right to residual claim of income and assets after all prior claims - means that investors bear the full risk of the company and share in the profits by way of dividends only if profits are made after all other payments such as interest on debt and dividends on preference shares,
• limited liability - means that, at worst, shareholders can only lose the capital invested (may not really be considered as safe investing).

Other types of ordinary share are nonvoting ordinary shares, deferred ordinary shares, bearer shares, and nil-paid letters - these are not discussed here.

The primary and secondary share markets
The share market can be categorised as either the primary market (where newly issued shares are offered), or the secondary market where subsequent trading takes place. Borrowers raise share capital in the primary market and investors trade these shares at current market prices in the secondary market.

Issuing activity in the primary market determines the size of the pool of shares available for trade in the secondary market, whereas transactions in the secondary market determine the tradability (the ease with which shares can be traded), marketability (buying and selling shares without an impact on the price), and liquidity (ability to convert shares into cash or to purchase shares at short notice) of the pool of shares, and assist in the price formation process.

The secondary share market can be disaggregated into four markets:

• the formal market where listed shares on a stock exchange (the licensed formal exchange) are traded;
• the over-the-counter (OTC) market, an unlicensed informal market for the trading of shares;
• trades in listed shares off exchange; and
• direct trades between buyers and sellers without the intermediation of brokers.

The trade-off between demand and supply for shares influences the determination of the share prices. Issuers of share capital are also in competition with borrowers and investors in the bond market and other asset markets. Changes in investors' preferences for certain asset classes (financial and non-financial assets such as shares, bonds. cash, real estate etc.) also affect the availability of funding in the primary share market. Switching between asset classes by investors reflects investors' ever-changing assessment of expected risks and returns as market conditions change.