How Complex is the Financial Market? – A Tale of the Two Horsemen.

AUTHOR: AKOREDE SAMUEL OMOTAYO

INTRODUCTION

Have you ever wondered what Shares and Bonds means? Perhaps you have heard or read about financial terms like securities, derivatives and the stock exchange, and you wonder what they mean. Don’t worry, you are not alone! The financial market (FM) and its attending terminologies are as complex as they sound, but all you need is a basic understanding – and the complex becomes simple. In the first of its series, this article sets out in simple sentences, whatEquity and Debt securities are and what makes the financial market significant.

The Financial Market in a Nutshell

Think of the financial market as a place where buying and selling of SECURITIES takes place.Like individuals, companies and governments need money to function – we call them issuers. The banks and brokers which help them to get money are intermediaries. And the source of this money are big financial institutions, like pension funds and insurance companies, called institutional investors. In exchange for the money from institutional investors, the companies and governments issue securities. The intermediaries (banks and brokers) distributes these securities to institutional investors and make a market (trade) in them so that institutional investors may buy and sell the securities at any time they want to.

Source of the Money

How does this concern me? you may ask. Or of what significance is the financial market? The answer is simple. The source of the money traded in the financial market is from you and me. There are three main types of institutional investors; insurance companies, pension funds and wealth managers. When you take out an insurance policy, you pay-in premiums. Insurance companies takes your premium and invest the premiums in the markets in order to meet claims out of the investment returns.

Likewise, pension funds take in contributions from monthly salaries or wages (with contributions from employers), and invest that money to yield returns in order to provide pensions for when employees retire. Wealth managers (hedge-funds, asset managersetc.) take in money from individuals and invest it on their behalf in the markets. But how is this money traded?

Securities – the two horsemen of the financial market.

Don’t be alarmed by the sub-topic. The “two horsemen” is a mere representation for Equity securities and Debt Securities which are the two main types of securities traded in the markets. A third class is Derivatives which is not discussed in this article. By definition, a security is a trade-able financial asset, and the country’s regulatory structure determines what qualifies as a security. As mentioned above, Companies and Governments are issuers of securities, and they issue them in exchange for money.

You may wonder, how are the securities different, and of what importance? It’s simple.

Equity securities is the term for shares or sometimes stocks, and is issued only by companies (governments cannot issue shares). When individuals and investors put money into a company and in return get a share, they become shareholders. The significance of this is that shareholders are part-owners of a company, which gives you certain rights – such as in the making of decisions – depending on the class or type of share purchased. As a company makes profit, it pays its shareholders dividends out of those profits. The place where a share is traded (bought and sold) is called the stock market, and information about the prices of shares and the volume to be traded are publicised by the stock exchange to all market participants via data providers such as Bloomberg and Reuters.

Debt Securities is the term for Bonds and loans. Unlike Shares, both the government and companies can take out loans and issue bonds. With loans, the borrower (company or government) is lent a sum of money, called principal, and pays interest on that amount until the loan is repaid in full. The catch for the lender, is that he gets his money back in full, plus interest. Commercial banks are often lenders – which usually raise the money from our deposits, failing which they borrow money from each other on the interbank market. Bondswork in similar ways, but are traded on the capital market as opposed to banking market where loans are traded. Think of bonds as Bigger loans. The holder of the Bond is the lender (Creditors, bondholder etc.), the issuer of the bond is the borrower (debtor), the interest on the bond is called a coupon, and when the bond comes a close is called maturity. A fortiori, the issuer must repay the principal on the bond’s maturity. When a company issue bonds – It’s called corporate bonds. Government bonds have different names depending on the jurisdictions (FGN Bonds – Nigeria, Treasuries – US, and Gilts – UK) and where it is traded (e.g. Eurobonds are traded internationally). Similarly, short term bonds – called treasury bills in Nigeria – works the same way.

Debt-or-Shares?

You may ask, what is the effect of a debt or equity security? Again, this is simple. The catch in buying shares is that you become a part owner and have certain rights on how the business is being run. Also, when a company is profitable, the share price increases (appreciates), which means you get higher dividends or more profits if you realise your investment by selling the shares. The downside is that when the company becomes insolvent, the shareholders may likely lose their investment; and their shares become valueless, as their interests ranks below the creditors (debtholders).

The catch in debt securities however is that, although you are not entitled to dividends and is not a part-owner of the company, the interest of a debtholder (either by bond or loans) ranks above those of the shareholders when the company becomes insolvent and liquidators are appointed to distribute the remaining assets and money. This means that the investment of debtholders is more secure, in the advent of liquidation.

Concluding thoughts

The financial markets might seem confusing, but at their heart they exist to bring institutions and people together so money flows to where it is needed most. Companies need money to hire, invest and grow. Governments need money for capital projects like nuclear plants and bridges. Individuals need to save their money and make profits from doing so. In the end… it’s a win-win situation for everyone, and all we need is to ride with the two-horsemen!

Adapted from Christopher Stoakes’ “Know the City” 2015/2016.
Akorede Samuel Omotayo is a First Class LLB graduate of Bangor University, UK and a candidate of the Freshfields Stephen Lawrence Scholarship Scheme. He also holds a BA (Hons) in Philosophy, Ekiti State University, and is presently preparing for his Bar I due to start June 2018.