STOCK MARKETS

1. INTRODUCTION
The capital market is the market for long-term finance. In it, investors hand over money today in
exchange for promises of money far in the future. The long delay in repayment magnifies the two basic
problems of lending. First, it increases risk: the longer the time to repayment, the greater the opportunity
for the borrower to misbehave. Second, it reduces liquidity: the longer the time to repayment, the less
important is repayment itself as a source of liquidity. Much of what goes on in today’s capital market
can be understood in terms of these two basic problems and of the market’s attempts to deal with them.

There are two types of capital markets:

the primary market – the market for new long-term securities. The need to control borrower behavior
lies behind much of this activity.

the secondary market – the market for trading existing issues. It is the secondary market that provides
investors in long-term securities with liquidity. The key considerations are provision of liquidity, price
discovery efficiency and trading costs.

Long-term finance and its difficulties

In most years, capital expenditure is a little higher than available internal funding. On average, though,
only a small part of total investment is financed through the capital market.

These numbers raise two intriguing question: Why do corporations borrow so little in the capital
market?

Incentive problems between stockholders and managers

Managers who also own a company have every incentive to maximize its value: they gain all the
benefits. However, when a significant part of the equity is owned by outsiders, the managers’ incentives
change.

Managers with a reduced equity stake in the company do not work as hard. They treat themselves to
costly perks. They pursue growth for its own sake, even when growth does not bring higher profits.
They do so because larger companies pay their managers more and provide greater opportunities for
promotion.
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Managers with a small equity stake may also be overcautious. A risky project with a high expected
payoff may look very attractive to the stockholders. However, from the point of view of managers, it
may look much less attractive. If the project succeeds, the stockholders get all or most of the benefits. If
it falls, the stockholders may take a loss, but the managers stand to lose more – their jobs.

If managers are so prone to following their own interests rather than those of the stockholders, why
don’t the stockholders monitor them more closely? The main reason is a free-rider problem. Typically,
the ownership of large corporations is diffuse. It is divided among millions of stockholders, none of
whom has a substantial stake in the company. An individual stockholder who takes the trouble to
monitor incurs all the costs but enjoys only a fraction of the benefits. Most of the benefits of his work go
to other stockholders, who bear none of the costs of monitoring.

Board of directors, although supposed to represent the shareholders have more incentives to please the
managers than to please the millions of anonymous stockholders they are supposed to represent.
Moreover, monitoring is hard work. Acquiring the necessary expertise and information involves effort.
Why bother? Why not simply accept managers’ assurances that all is well?

Incentive problems between debt holders and owners

There is an alternative source of long-term finance that avoids many of the problems of the equity
contract – the debt contract. However, the debt contract has incentive problems of its own. Once debt is
issued, the borrower finds risky projects more attractive. If the project succeeds, the borrower gets all
the benefits. If it fails and the company becomes insolvent, the debt holders share in the loss.

Debt holders clearly have an interest in monitoring the borrower to prevent this sort of behavior. Unlike
stockholders, however, debt holders have no formal right to interfere in the running of the company. As
long as the borrower continues to make the required payments on the debt, there is nothing debt holders
can do.

Therefore, the time to impose conditions is before the loan is made. This is done with loan covenants
written into the bond indenture. Typical covenants limit the issuing of additional debt, restrict the
payment of dividends, and establish conditions – in addition to actual default – under which the debt

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must be repaid immediately. Monitoring compliance with the terms of the indenture again involves a
free-rider problem. The solution is to appoint a trustee – a disinterested third party – to monitor
compliance with the debt contract and, if necessary, to represent the debt holders in court.

Despite these arrangements, the ability of debt holders to control borrower behavior is limited. There is
no way to prohibit by covenant all the different ways a borrower can misbehave. Moreover, covenant
restrictions have their cost. The reduce the freedom of the borrower to do things that might be in the debt
holders’ interest. For example, a covenant may prevent additional borrowing that could fund a promising
project that would increase the likelihood of repaying the original loan.

The main sanction available to debt holders – forcing the borrower into bankruptcy – is of limited value.
The bankruptcy process involves substantial legal costs and disrupts the company’s operations, both of
which reduce the potential payoff to debt holders.

Some implications of the incentive problems

Capital markets have developed a variety of ways to address these incentive problems. However, even
with the best solutions the capital market can offer, the incentive problems remain.

Potential providers of long-term finance fully understand the nature of these problems. If the potential
for abuse is too high, they simply will be unwilling to provide the funds. If they do provide the funds,
they will demand a high return to compensate them for the risks. Of course, some companies are more
likely to misbehave than others. But it is hard for investors to tell “bad” companies from “good” ones.
Bad companies will do their best to look like good companies, so they can raise funds more cheaply. As
a result, investors will assume the worst and demand a high return from all companies.

The potential for incentive problems grows with the degree of manager discretion. If a company’s assets
are concrete and relatively easy to monitor – as they are for railroads, utilities, and resource extraction –
the company will find it easier to raise funds in the capital market. If its assets are easily diverted to
risky projects and the value of those projects is hard to evaluate – as is the case with trading companies,
resource exploration, and industries that do extensive research and development – it may find it hard or
even impossible to raise funds in the capital market.

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The high cost of raising funds in the capital market is the reason corporations borrow so little there,
relying instead on internal funds. Internal funds are a particularly attractive alternative for “good”
companies, because it is they who find the cost of raising funds in the capital market excessively high.
Of course, such adverse selection will only worsen investors’ experience in the capital market and make
it even costlier for corporations to raise funds there.

2. INSTRUMENTS
The basic instruments of the capital market are shares, bonds and preference shares.

Shares of a company can be divided into two categories

1. Ordinary (common) shares
2. Preference shares

Ordinary shares
Ordinary shares represent the ownership position of a company. The holder of ordinary shares are called
shareholders of stakeholders, these are legal owners of the company. Ordinary shares are the source of
permanent capital since they do not have a maturity date. For the capital contributed by shareholders by
purchasing shares, they are entitled to dividends but the amount or rate of dividend is not fixed, it is
decided by the company’s board of directors. An ordinary share is therefore a variable income security.
Being the owner of the company, shareholders bear the risk of ownership and are therefore entitled to
dividends after the claims of others have been satisfied and similarly when the company is wound up.
They can exercise their claims on assets after the claim of other suppliers of capital have been met.

Authorized share capital represents the maximum amount of capital which a company can raise from
shareholders. A company can however change its authorized share capital by altering its memorandum
of association. The portion of the authorized share capital which has been offered to shareholders is
called issued share capital. Subscribing share capital represents that part of the issued share capital
which has been accepted by shareholders. The amount of subscribed share capital paid up by
shareholders to the company is called paid up share capital. Ordinary shares are long term sources of
capital to a company.

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Characteristics of ordinary shares
1. Claim on income:
Ordinary shareholders have a residual claim. i.e they have a claim to the residual income, which is
earning available for ordinary shareholders, after paying expenses, interest charges taxes preference
dividend, if any. This income may be split into two parts: dividend and retained earnings. Dividends are
immediate cash flows to shareholders. Retained earnings are re-invested in the business and
shareholders stand to benefit in future in the form of the firm’s enhanced dividend and capital gain.

2. Claim on assets:
Ordinary shares also have a residual claim on the company’s assets in the case of liquidation, liquidation
can occur on account of business failure or sale of business. Out of the realized value of assets, first the
claim of debt holders, then preference shares are satisfied, and the remaining balance, if any is paid to
ordinary shareholders. The claims of ordinary shareholders may generally remain unpaid.

3. Right to control
Control in the context of a company means the power to determine its policies. The company’s major
policies are approved by the board of directors while the day to day operations are carried out by
managers appointed by the board. Ordinary shareholders have the legal power to elect directors on the
board of directors. If the board fails to protect their interest, they can replace directors.

4. Voting rights:
Ordinary shar5eholders are required to vote on a number of important matters. The most significant
proposals include:
 Election of directors at the annual general meeting (AGM)
 Change in the memorandum and articles of association

Shareholders may vote in person or by proxy. A proxy gives a designated person a right to vote on
behalf of shareholder at the company’s AGM

5. Pre-emptive rights:
This right entitles a shareholder to maintain his proportionate share of ownership in the company. The
law grants shareholders the right to purchase new shares in the same proportion as their current

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ownership. If a shareholder owns 1% of company’s ordinary shares, he has a pre-emptive right to buy
1% of ordinary shares issued. A shareholder may decline to exercise this right.

6. Limited liability:
The liability of ordinary shareholders is limited to the amount of investment in shares. If a shareholder
has already fully paid the issue price of shares purchased, he has nothing more to contribute in the event
of a financial distress or liquidation.

Pros and cons of equity (common shares) financing

Advantages to the company:

1) Permanent capital: They are not redeemable; therefore the company has no liability for cash
outflow associated with its redemption. It is a permanent capital and is available for use as
long as the company goes

2) Borrowing base: Equity capital increases the company’s financial base and thus its
borrowing limit. By issuing ordinary shares, the company increases its financial capability.

3) Dividend payment discretion: A company is not legally obliged to pay dividend. Therefore
in times of financial difficulties, it can reduce or suspend payments of dividends

Disadvantages

1. Costs: shares have a higher cost because:

 Dividends are not tax deductible as are interest payments
 Floatation costs on ordinary shares are higher than those on debit

2. Risk: since they are riskier from an investor’s point of view as there is uncertainty regarding
dividends and capital gains, they therefore require a relative higher rate of return.
3. Earnings dilution: if the profit does not increase immediately in proportion to the increase in the
number of ordinary shares, then the issue of new ordinary shares dilutes the existing shareholders
earnings.

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4. Ownership dilution:- issuance of new ordinary shares may dilute the ownership and control of
the existing shareholders. While shareholders may have pre-emptive rights to retain their
proportionate ownership. They may not have funds to invest in ordinary shares

Fixed interest securities

Under fixed interest securities we have debentures and bonds which provide loan capital to the
company. A debenture is a long term promise note for raising loan capital and is issued by a
company in return for payment of interest and principle as stipulated, bonds on the other hand are
issued mostly by public sector companies.

Debentures
These are long term fixed income, financial securities. The purchasers of debentures are called
debenture holders. These are creditors to the firm. The par value of a debenture is the face- value
appearing on the debenture certificate.

Characteristics:
1. Interest rate/ fixed income: the interest rate is fixed and known, it is called the contractual rate of
interest. It is a percentage of the par value of the debentures that will be paid out periodically in
the form of interest. Payment of interest is legally binding on the company. Debenture interest is
deductible for computing the company’s corporate tax. However it is taxable in the hands of a
debenture holder.
2. Maturity: debentures are issued for a specific period of time. The maturity of a debenture
indicates the length of time until the company redeems (returns) the par value to debenture
holders and terminates the debentures.
3. Redemption: debentures are mostly redeemable; they are generally redeemed on maturity.
4. Debenture or debenture trust deed: - this is a legal agreement between the company issuing
debentures and the debenture trustees who represent the debenture holders. The responsibility of
the trustee is to protect the interest of debenture holders by ensuring that the company fulfills the
contractual obligations. The indenture provides the specific terms of the agreement, including a
description of debentures, rights of debenture holders, rights of the issuing company and the
responsibility of trustee.

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 5. Security:- debentures can either be secured or unsecured. A debenture can be secured by a charge
on the present and future assets of the company or it may not be protected by any security, in this
case it is known as un unsecured or naked debenture
6. Claim on assets and income:- debenture holders have a claim on the company’s earnings prior to
that of the shareholders, debenture interest has to be paid before paying any dividend to
preference and ordinary shareholders. A company can be forced to bankruptcy if it fails to pay
interest to debenture holders. In liquidation the debenture holders have a claim on assets prior
that of shareholders. However secured debenture holders will have priority over the unsecured
debenture holders.

Advantages and disadvantages

Advantages
1. Less costly: - a) investors consider debentures as a relatively less risky investment alternative and
therefore requires a lower rate of return.
b) Interest payments are deductible and therefore this reduces the tax liability of the company
borrowing.
2. No ownership dilution:- debenture holders are creditors not owners and therefore have no voting
rights.
3. Fixed payment of interest: - debenture holders do not participate in the extra ordinary earnings of the
company. Payments are limited to interest
4. Reduced real obligation: during period of high inflation, debenture issue benefits the company. Its
obligation of paying the interest and principle which are fixed

Disadvantages
1. Obligatory payments:- payment of interest and principle is a legal obligation, failure to which can
lead to liquidation,
2. Cash outflow-: principal must be paid on maturity and therefore at some point it involves substantial
cash outflow.
3. Restrictive covenant:- the debenture may contain restrictive covenant which may limit the
company’s operating flexibility in future.

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Preference shares
A preference share is often considered to be a hybrid security since it has many features of both ordinary
shares and fixed income securities.
It is similar to an ordinary share in that;-
a) The non-payment of dividends does not force the company to insolvency
b) Dividends are not deductible for tax purposes.
c) It has no fixed maturity date:

It is similar to a debenture in that:-

a) Dividend rate is fixed
b) Preference shares do no share in the residual earnings.
c) Preference shareholders have claims on income and assets prior to ordinary shares.
d) They usually do not have voting rights.

Characteristics:-
1. Claims on income:- preference share is a senior security as compared to ordinary share. It has a
prior claim on the company’s income in the sense that the company must pay first preference
dividend before paying ordinary dividend. It also has a prior claim in the company’s assets in the
event of liquidation. The preference share claim is honored after that of a debenture but before that
or ordinary shares. Thus in terms of risks, a preference share is less risky than an ordinary share.
2. Fixed dividend:- the dividend rate is fixed and is expressed as a percentage of the par value.
Preference share is a fixed income security because it provides a constant income to investors.
Preference dividends are not tax deductible.
3. Cumulative dividends:- all past unpaid preference dividend must be paid before any ordinary
dividends are paid.
4. Redemption: - preference shares can either be redeemable or perpetual (irredeemable) the
redeemable preference shares have a maturity date.
5. Voting rights-: preference shareholders generally do not have voting rights and they cannot
participate in extra ordinary profits earned by the company
6. Convertibility-: preference shares may be issued convertible or non-convertible, a convertible
preference shares allows preference shareholders to convert their shares fully or partly, into ordinary
shares at a specified price during given period of time

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3 THE MARKET FOR NEW ISSUES

Underwriting corporate securities

New issues of securities must be sold to investors. How this is done differs from country to country and
has changed over the years. New issues may be sold directly to investors by the issuer, or distributed by
brokers for a commission, or sold through an underwriter that buys up the whole issue for distribution.
The issue may be distributed through networks of brokers, through financial institutions (primarily
banks), through public advertising, or even by salesmen going door to door. Most new issues of
corporate securities are sold through underwriters and distributed through stockbrokers.

Underwriters provide investors with some assurance of the quality of the securities they sell.
Underwriters are obliged to exercise due diligence in uncovering the facts and in making them known to
the purchasers of securities. Investors can, and do, sue to recover losses if they believe the underwriter
has been negligent or dishonest.

The main incentive for due diligence, however, is not legal liability but reputation. An underwriter that
acquires a reputation for selling lemons will find it hard to sell future issues. Because of the
underwriter’s poor reputation, its clients will have to pay a high yield on their securities (sell them at a
low price). This means that good issuers will avoid such an underwriter.

Pricing is particularly important for initial public offerings (IPOs). These are issues of stock by
companies that are selling equity for the first time (companies “going public”). The problem with IPOs
is that there is no market price to provide guidance on the value of the stock; the underwriter has to
decide on the appropriate price below their “fair” value. Among the explanations that have been
suggested, some focus on the information problem. Under pricing enhances the reputation of both
underwriter and issuer. If the stock does well after it is issued, the underwriter will find it easier to sell
other IPOs and the issuer will find it easier to sell secondary issues.

The underwriter negotiates a price with the issuer and then buys the whole issue at that price with the
intention of reselling it, at a higher price, to the public. This arrangement has two advantages for the
issuer. It removes the uncertainty about the amount of funds the issue will raise and it relieves the issuer
of the considerable transactions costs of marketing the issue. Underwriters typically form syndicates to
provide the necessary finance and to spread the risk.

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Having purchased the issue, the underwriters sell it off to investors. This process takes time and, as we
shall see, involves risks. Underwriters often commit themselves to repurchasing from investors the
securities they underwrite (at the market) in order to enhance their liquidity. This makes the securities
more attractive and easier to sell in the first place.

Private placements
Rather than being sold to the public at large – a public issue – securities can be sold privately to a few
large institutions and wealthy individuals – a private placement. In early capital markets, private
placements predominated. However, as methods of underwriting and distributing public issues steadily
improved private placement diminished in importance.

4. THE SECONDARY MARKET

A good secondary market is less important for short-term securities. They mature quickly, so normal
repayment turns them into cash soon enough. Over the short life-time of a money market security, its
value is unlikely to vary very much. There is little time for drastic changes in the circumstances of the
issuer, and because of its short duration, the price of the security is not very sensitive to changes in
interest rates.

With long-term securities, the situation is very different. Repayment is far in the future (for bonds) or
nonexistent (for stock): the secondary market is the only way to turn them into cash. There is plenty of
time for the circumstances of the issuer to change, so it is important to be able to unload securities, or to
acquire them, rapidly to benefit from new information.

We can divide the secondary market into wholesale and retail parts. The wholesale market is the market
in which professionals, including institutional investors, trade with one another. Transactions are usually
large. The retail market is the market in which the individual investor buys and sells securities.

The wholesale market for corporate equities is conducted on a number of exchanges as well as over the
counter (OTC). The wholesale market for bonds is principally an OTC market. The market for the
smaller issues is “thin.” Volume in these issues is small, and few dealers find it worthwhile to make a
market. Because of the lack of competition and of the high fixed costs of making a market, bid-ask
spreads are large.

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Assessment of stock markets
They are assessed on four key aspects:
 Provision of liquidity
 Price discovery - three forms of price efficiency
 Allocative efficiency
 Trading costs efficiency

Types of orders
Market order – transact at best available terms
Limit orders – an order to transact only at specified prices
Buy limit order – Buy if price is X or below
Sell limit order – Sell if price is Y or greater

Stock market indices

A stock market index is the composite value of a group of secondary market-traded stocks. Eg NSE All
share index, NSE 20 share index, Dow Jones Industrial Average, S&P 500 Index, NASDAQ Composite
Index. They are usually price or value weighted.

5. PLAYERS IN THE STOCK MARKET

Exchange
The Stock Exchange is a market that deals in the exchange of securities issued by publicly quoted
companies and the Government. The major role that the stock exchange has played, and continues to
play in many economies is that it promotes a culture of thrift, or saving. The very fact that institutions
exist where savers can safely invest their money and in addition earn a return, is an incentive to people
to consume less and save more.

Secondly, the stock exchange assists in the transfer of savings to investment in productive enterprises as
an alternative to keeping the savings idle. It should be appreciated that in as much as an economy can
have savings, the lack of established mechanisms for channeling those savings into activities that create
wealth would lead to mis-allocation or waste of those savings. Therefore, even if a culture of saving
were to be encouraged, the lack of developed financial markets may lead to economic stagnation.

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Thirdly, a robust stock market assists in the rational and efficient allocation of capital, which is a scarce
resource. The fact that capital is scarce means systems have to be developed where capital goes to the
most deserving user. An efficient stock market sector will have the expertise, the institutions and the
means to prioritise access to capital by competing users so that an economy manages to realise
maximum output at least cost. This is what economists refer to as the optimum production level. If an
economy does not have efficient financial markets, there is always the risk that scarce capital could be
channeled to non-productive investments as opposed to productive ones, leading to wastage of resources
and economic decline.

Fourthly, stock markets promote higher standards of accounting, resource management and transparency
in the management of business. This is because financial markets encourage the separation of owners of
capital, on the one hand, from managers of capital, on the other. This separation is important because we
recognise that people who have the money may not necessarily have the best business ideas, and people
with the best ideas may not have the money. And because the two need each other, the stock exchange
becomes the all-important link. To give a practical example, if an entrepreneur has a bright business idea
and lacks the money, he can approach the Nairobi Stock Exchange, float shares and raise the capital he
needs to turn his idea into a business. The shareholders will then appoint directors and management to
run the company on their behalf. This arrangement benefits both parties because the manager of capital,
who is the entrepreneur, gets access to capital to turn his idea into a reality, while the owners of capital,
who are the shareholders, get a return on their investment without having to report for work at that
company.

Fifthly, the stock exchange improves the access to finance of different types of users by providing the
flexibility for customization. This is made possible as the financial sector allows the different users of
capital to raise capital in ways that are suited to meeting their specific needs. For example, established
companies can raise short term finance through commercial paper; small companies can raise long term
capital by selling shares; the Government and even municipal councils can raise funds by floating
various types of bonds as an alternative to foreign borrowing.

Sixthly, and very important, is that the stock exchange provides investors with an efficient mechanism to
liquidate their investments in securities. The very fact that investors are certain of the possibility of
selling out what they hold, as and when they want, is a major incentive for investment as it guarantees
mobility of capital in the purchase of assets.

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There are many others less general benefits which stock exchanges afford individuals, corporations
and even the Government.
1. The mobilization of savings for investment in productive enterprises as an alternative to putting
savings in bank deposits, purchase of real estate and outright consumption.
2. The growth of related financial services sector e.g. insurance, pension and provident fund
schemes which nurture the spirit of savings.
3. The check against flight of capital which takes place because of local inflation and currency
depreciation.
4. Encouragement of the divorcement of the owners of capital from the managers of capital; a very
important process because owners may not necessarily have the expertise to manage capital
investment efficiently.
5. Encouragement of higher standards of accounting, resource management and public disclosure
which in turn affords greater efficiency in the process of capital growth.
6. Facilitation of equity financing as opposed to debt financing. Debt financing has been the
undoing of many enterprises in both developed and developing countries especially in
recessionary periods.
7. Improvement of access to finance for new and smaller companies. This is now possible on the
Alternative Investments Market Segment (AIMS). This can also be realised through Venture
Capital institutions which are fast becoming key players in financing small businesses.
8. Encouragement of public floatation of private companies which in turn allows greater growth
and increase of the supply of assets available for long-term investment.
The establishment of an efficient stock market is, therefore, indispensable for any economy that is keen
on using scarce capital resources to achieve economic growth.

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