Capital Markets
Capital Markets are venues in which those with excess cash, or investors, provide money to those who need it, such as corporations, governments, and municipalities (the “issuer”). In exchange for cash provided, investors will have a claim on the cash flow generated by the Issuer.
If the claim is such that the investor will receive a fixed return regardless of the performance of the company, it’s called bond. But if the claim is a ‘residual claim’, meaning that the investor will receive whatever cash left after everyone else is paid, then it’s called stock.
Accordingly, there are two major types of capital markets: Stock Market and Bond Market. While stock markets have centralized venues (for example, New York Stock Exchange), bond markets are mostly decentralized with many transactions occurring over the counter (OTC). This is why the transparency and liquidity in the bond markets are less. The major buyers of the bonds are large institutional investors such as pension funds and insurance companies.
The transaction of transferring cash from investors to the issuer is called “buying” stock or bonds. Basically, the investor pays cash and in exchange, they will receive a physical or digital certificate of bond or stock. The venue that has processed the transaction will arrange for the certificate to be issued to the investor.
Stocks
Stock ownership means having ownership in a company, which is sometimes expressed as having residual ownership (or being entitled to the residual cash flows). Residual ownership means that an investor is entitled to the pro-rata share of all of the company’s assets (and cash distributions) after all other parties interacting with the company (e.g., lenders and creditors) are paid. This is a good thing if the company is growing because while the liabilities are fixed, the assets are growing and leaving the stock owners with the excess cash.
To illustrate this point, think of a company that has $1000 worth of assets and $500 worth of liabilities ($400 loan and $100 payable to suppliers). As the owner (or stockholder), you are entitled to $1000-$500 = $500, which is the money that is left if we sell assets for $1000 and pay the bank and suppliers. Now, think that the company’s sales are good and they generate $800 cash. Keeping everything else the same, we have $1000+$800= $1800 worth of assets. Now, our residual share is $1800 - $500 = $1300. In other words, our ownership increased from $500 to $1300, which is a 260% gain.
Some of the most famous venues for buying and selling stocks are:
NYSE (New York Stock Exchange)
NASDAQ (National Association of Securities Dealers Automated Quotations)
London Stock Exchange (The oldest stock exchange that is still in operation)
Korea Stock Exchange (Index: KOSPI)
Frankfurt Stock Exchange (Index: DAX)
Japan Exchange Group (Index: NIKKEI or NIK)
Hong Kong Stock Exchange (Index: Hang Seng Index)
Shanghai Stock Exchange (Index: SSE Composite Index)
Singapore Exchange (Index: SGX)
A company can be listed on two or more stock exchanges. For example, Toyota is listed on the following stock exchanges, as per Toyota’s website.
Japan: Tokyo, Nagoya, Fukuoka, Sapporo
Overseas: New York, London
Stock exchanges operate in local time. Therefore, when Japan’s markets open, New York stock exchanges are closed. But even when the markets are closed, a lot of activities between the brokers and dealers happen during premarket and after-hour sessions. This is why the price could close at $10 but the next day when it opens, it will be $12. The open price sometimes is influenced by the activities in other markets. Let’s say, some news breaks out in Japan about Toyota during the time the markets are open which impacts the price favorably. The next morning, when traders in New York see that, they react as well and put their orders in premarket sessions which will drive prices up or down.
Bonds
Bond ownership means that investors lend money to corporations, organizations, or governments. Each bond has certain characteristics, such as term (1-year, 2-year, 10-year, etc.), coupon rate (interest rate), payment frequency, etc.
Where to buy bonds? Many brokers who also have online services allow investors to buy bonds through their platforms. There is no centralized location for bond exchange.
What are the bonds’ specifics and features?
The most prominent categories of bonds are government bonds, municipal bonds, and corporate bonds.
Corporate bonds, in turn, can be classified into Investment Grade (Baa rating and above; high-quality) and High Yield bonds (lower quality, including junk bonds).
Other features include callable, puttable, floating coupon, and inflation-projected bonds.
TIPS (Treasury Inflation-Protection Securities) are bonds issued by the US government with coupons that adjust higher/lower with CPI. These bonds are specifically valuable in inflationary periods. The UK equivalent of TIPS is called “Index-Linked Gilts”. Gilts is a common name used in the UK and a few commonwealth countries for government bonds. Please note that there is no ‘free lunch’ in financial markets, and if there is favorable optionality attached to a bond, then it’s usually reflected in the price.
Bonds can also be callable, meaning that the issuer will repay the investors the money they have invested and cancel the bonds. This usually happens when interest rates are falling, so it’s more beneficial for issuers to cancel older bonds with higher interest rates and issue new ones with lower interest rates. Many of the corporate bonds are callable, so we need to bear in mind that quite often we can’t take advantage of favorable bond rates, because they get called.