The share market is part of the capital market (= the market for long-term capital). The capital market is the market in which prime borrowers are able to access long-term and/or permanent funding. A note is required: we also use the term "borrowers" for the issuers of shares because shares includes preference shares which in many markets are redeemable. As we have shown, strictly speaking, an ordinary share represents part-ownership and not a debt of a company.
We define the share market as:
The share market is the mechanism / conventions that exist for the issue of, investing in, and the trading of marketable share instruments that represent the permanent or semi-permanent capital of the issuers (companies).
If this definition is dissected, we arrive at the following key words:
• Market mechanism.
• Issue (primary market).
• Trading (secondary market).
• Permanent or semi-permanent capital of the issuers. Each of these key words will be explained briefly.
Shares are issued by companies in terms of the statute that regulates them (usually called the Companies Act) and there are two types:
• Ordinary shares (also called common shares or common stock) that represent the permanent capital of companies; they have no maturity date (as such they are much like perpetual bonds).
• Preference shares (also called preferred shares or preferred stock). These shares may be redeemable (i.e. have a fixed maturity date), redeemable at the option of the issuer or non-redeemable (have no maturity date). The latter are sometimes called perpetual preference shares.
Shares pay dividends, as opposed to bonds and money market instruments that pay interest. Dividends on preference shares are usually fixed-rate dividends and they have preference over dividends on ordinary shares (explained in more detail later).
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.
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).
Figure 4: issue of shares
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 a mechanism to acquire further capital easily and at a good price.
The investors in (or holders of) shares are also depicted in Figure 4. In most countries all the ultimate lenders are holders of shares. The government holds shares in public enterprises. The foreign sector's involvement in the share 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 shares; however, it is a large holder of shares via the investment vehicles.
All the mainstream financial intermediaries are investors in shares, with the exception of the central bank (and most of the QFIs). In most countries the largest holders of shares are the retirement funds (CIs), the long-term insurers (CIs), the securities unit trusts (CISs), the exchange traded funds (CISs) and hedge funds (HFs).
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 share market participants are:
• Members of share exchanges. The members (also called users in some markets) of share exchanges are usually separately-capitalized subsidiaries of the banks, smaller companies owned by participants and individuals. The generic name we use here for all the members is broker-dealers.
• Issuers of shares. Companies not only supply shares 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, the hedge 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 share market, thereby contributing to efficient price discovery.
Permanent or semi-permanent capital of the issuers
Common shares and perpetual preference shares (and perpetual bonds) represent the permanent capital of a company. Preference shares (redeemable) and other forms of borrowing (for example bank overdraft facilities utilized 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 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).
Having briefly covered the debt and share markets we are able to present an illustration of the local financial markets: see Figure 5.
Figure 5: local financial market