Financial Institutions, Instruments and Markets

8th edition
Instructor's Resource Manual
Christopher Viney and Peter Phillips

Chapter 4
The share market and the corporation
Learning objective 4.1: understand the structure of a corporation and identify advantages and
disadvantages of being a publicly listed corporation

Members of the board of directors of a corporation are elected by

shareholders at a general meeting.

The board determines the objectives and policies of the firm, and
appoints executive managers, who are responsible for managing the
day-to-day business operations and reporting back to the board.

With a limited liability company, the liability of a shareholder is limited

to the fully paid issue price of the shares.

With a no liability company a shareholder holding any partly paid

shares cannot be forced to make further payment, but may forfeit the
shares.

Advantages of the corporate form of business include access to a large

pool of equity funds through the stock market, the separation of
ownership (shareholders) and control (managers), the continuity of
business operations, the ability to conduct large-scale operations and
the opportunity for investors to hold a diversified share portfolio.

A potential disadvantage of the corporate form is the agency problem,

whereby managers may try to run the business for their own benefit
rather than for the shareholders benefit.

The board of directors should establish strong corporate governance

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practices to ensure accountability and transparency.

Learning objective 4.2: consider the origins and purpose of a stock exchange

Theoriginsofstockexchangesdatebackto1553inEngland.

Today,stockexchangescompetewithintheinternationalmarketswherethereare
continuousflowsofinformation.

Astockexchangefacilitatesthelistingofcorporationsandthequotationandbuyingand
sellingoflistedsecurities.

Anexchangeoperatesasecuritiestradingsystemandatransactionsettlementsystem.

Stockexchanges,andregulators,seektomaintaintheefficiencyandintegrityofthe
market.

Learning objective 4.3: understand the primary market role of a stock exchange through which
corporations raise new funding

Theprimarymarketroleofastockexchangerelatestotheissueofnewsecuritiesby
listedcorporationsorotherentities.

Thelistingofanewcompanyisknownasafloatoraninitialpublicoffering(IPO).

Themainformofequityissuedbyacorporationistheordinaryshare(commonstock).

Primarymarketissuesofordinarysharesraiseequitycapitalforcorporations.Equity
capitalistypicallyusedtoenableafirmtogrow.

Shareholdersmayreceivedividendsand/orcapitalgains(orlosses).

Existingcorporationsmayissueadditionalequitythroughrightsissues,placementsand
dividendreinvestmentschemes.

Astockexchangemayalsolistdebtinstruments,unitsinpublictrustsandderivative
products.

Anissueofequityordebttothepublicrequiresthepreparationofaprospectus.

The ASX, as at 3 April, had 2183 listed corporations and was ranked 8th in the MSCI
global index ranking.

Learning objective 4.4: discuss the secondary market role of the stock exchange through which
existing securities are bought and sold
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Thesecondarymarketroleprovidesamarketstructureforthebuyingandsellingof
existinglistedsecurities.

Buyandsellordersarelodgedthroughastockbrokerthathasaccesstotheexchanges
tradingandsettlementplatforms.

Secondarymarkettransactionsdonotraiseadditionalequityfortheoriginalissuing
corporationtheyareatransferofownershipforvalue.

Marketliquidityistheratioofturnovertomarketcapitalisation.Adeepandliquidmarket
encouragesinvestors.

Marketcapitalisationisthenumberofissuedsharesmultipliedbytheshareprice.

Learning objective 4.5: examine the managed products (exchange traded funds, contracts for
difference, real estate investment trusts and infrastructure funds) and derivative products
(options, warrants and futures contracts) roles of a stock exchange

Stockexchangesmaylistarangeofmanagedproductsandderivativeproducts.These
standardisedproductsareknownasexchangetradedcontracts.

Exchangetradedfunds(ETF)usuallyinvestinabasketofsecuritieslistedonthelocalor
internationalexchanges,foreigncurrenciesorcommodities.ETFsprovideaccesstoa
diversifiedportfolioofsecurities.

Acontractfordifference(CFD)isanagreementtoexchangethenetdifferenceinvalue
betweenthestartdateandtheclosedateofaCFD.TheCFDisbasedonaspecified
security.OnlyadepositispaidinitiallythereforetheCFDishighlyleveraged(increased
risk).

Arealestateinvestmenttrust(REIT)issuesunitsinthetrustinordertoraisefundsto
purchaseproperty,includingindustrial,hotelsandleisure,retailandoffice.Assets
generaterentalincomeand(hopefully)capitalgains.

Infrastructurefundsenableinvestorstogainaccesstolargescaleinfrastructureprojects,
suchasutilities,transport,materialshandlingandcommunicationsfacilities.

Anoptioncontractgivesthebuyertheright,butnottheobligation,tobuy(calloption)or
sell(putoption)aspecifiedsecurityatapredeterminedpriceanddate.Thewriterofthe
optionreceivesapremiumpaymentfromtheoptionbuyer.

Anequitywarrantgivestheholdertherighttobuy(orsell)theunderlyingsecurityata
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specifiedpriceonorbeforeanominateddate.Stockexchangeslistawiderangeof
warrantcontracts.

Afuturescontractisanagreementbetweentwopartiestobuy(orsell)aspecified
commodityorfinancialinstrumentataspecifieddateinthefuture.Thevalueofthe
futurescontractmovesasthepriceoftheunderlyingassetinthephysicalmarketmoves.
Settlementmaybefordeliveryoftheasset,orcash.

Learning objective 4.6: examine the interest rate market role of a stock exchange

Corporationsfundtheiroperationsfromacombinationofequityanddebt.

Debtissuesmaybelistedonastockexchangeandprovideinvestorswithtransparency,
liquidityandeaseofentryandexit.

Astraightcorporatebondisafixedinterestsecuritythatpaysaperiodiccoupon.The
principalisrepaidatmaturity.Asecuredbondisknownasadebenture;anunsecured
bondasanunsecurednote.Astheinterestrateisfixed,thevalueofthebondwillchange
asinterestratesinthecurrentmarketchange.

Afloatingratenote(FRN)isacorporatebondthatpaysavariablecouponratewhichwill
bebasedonapublishedreferencerate.

Aconvertiblenoteisahybridsecuritythatpaysafixedinterestrateandincludesan
optiontoconvertthenoteatafuturedateintoordinaryshares.

Apreferenceshareisahybridsecuritythatpaysafixeddividend.Ithasanoptionat
maturitytoredeemtocashorconverttoordinarysharesataspecifiedprice.

Learning objective 4.7: explain the electronic trading (ASX Trade) and settlement (CHESS)
platforms used for share-market transactions by the Australian Securities Exchange (ASX)

Tosupporttheprimarymarketandsecondarymarketroles,anexchangemustprovide
tradingandsettlementplatforms.Majorexchangesusehighspeed,robusttechnologybasedsystems.

ASXusesASXTradewhichisanintegratedsystemthatallowsthestockexchangeto
tradealllistedsecurities.ASXTrade24facilitatesglobaltradinginderivativecontracts.

AuthorisedstockbrokershaveaccesstotheASXplatforms.Investorslodgebuyandsell
orderswiththeirstockbroker,generallyusingtheinternet.
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Thebrokerwillissueacontractnotewhichprovidesfulldetailsofthetransaction.

SettlementwillnormallyoccurinT + 3businessdayswhentransferofownershipand
financialsettlementwillbeprocessedthroughCHESS.

CHESSwillissueaholdingstatementontheuncertificatedshareholding.

Learning objective 4.8: recognise the importance of information flows to the efficiency and
integrity of stock exchanges

Sharepricesmoveasdemandandsupplyforshareschange.Demandandsupplychange
asaresultofnewinformationcomingtothemarket.

Stockexchangelistingrulesrequirecontinuousdisclosureofinformationthatmayimpact
uponinvestmentdecisionsandshareprices.Thisisinadditiontoprescribedreporting
requirements,suchthelodgingofperiodicfinancialstatements.

Astockexchangewillmonitorinformationflowstoensurethemarketisfullyinformed
inordertomaintaintheintegrityandconfidenceinthemarket.

Learning objective 4.9: identify the principal regulators that affect the behaviour of participants
in the Australian share market

Eachnationstateisresponsiblefortheregulationandsupervisionofitsownstock
exchanges.Usuallythisroleissharedbetweengovernmentappointedregulatory
authoritiesandtheactualexchangeitself.

InAustralia,theAustralianSecuritiesandInvestmentsCommission(ASIC)has
responsibilityforthesupervisionofrealtimetradinginthedomesticlicensedmarkets.

ASICisresponsibleforenforcementoflawsagainstmisconduct,andthesupervisionof
financialserviceslicenceholders.

ASICmaintainsanintegratedsurveillancesystem.Breachesofrulesareenforcedbya
disciplinarypanel.

ASXalsomonitorscontinuousdisclosurethroughitsowncompliancesubsidiary.Itmay
imposepenalties,suspendordelistacorporationandforwardaformalreporttoASICfor
furtheraction.

TheReserveBank(RBA)monitorsthelicensedclearingandsettlementplatformsand
systemsinordertoensurefinancialstabilityandreducesystemicriskinthefinancial
system.
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Learning objective 4.10: explain the structure and purpose of the private equity market
Privateequityisanalternativesourceofequityfundingforacompany.
Privateequitymaybeprovidedforstartupcompanies,businessexpansionforexisting
companies,recoveryfinanceforcorporationsinfinancialdifficultyormanagementbuy
outs.
Specialistprivateequityfundsobtainthemajorityoftheirfundsfrominstitutional
investors.
Privateequityfundingisusuallyregardedasahigherriskinvestment.
Theprincipalobjectivesofprivateequityfundsmaybetoimprovecompanyperformance
inpreparationforanIPO,orthebreakupofacompanysothatthecomponentpartsmay
besoldseparately.

Essay questions
1. Thepubliclylistedcorporationisviewedasoneofthemostimportantinnovationsinthe
historyofeconomicandfinancialdevelopment.Outlinetheadvantagesanddisadvantages
ofthepubliclylistedcorporation.(LO 4.1)

A publicly listed corporation is a legal entity formed under the provisions of the Corporation
Law of a nation-state, and listed on a formal stock exchange.

Shares can be readily bought and sold in the market without directly affecting the continuing
existence of the business.

The liability of shareholders for the debts of the business is limited to the value of their
shareholding.

Large amounts of equity funding can be obtained more easily through access to the stock market.

Investors may be willing to purchase shares in the knowledge that the stock exchange provides
an active secondary market for the future sale of those shares.

Shareholders can reduce the risks of share ownership by holding a diversified portfolio of share
investments.

The separation of ownership (shareholders) and control (managers) means that the corporation
can choose specialised and skilled personnel to run the business.

The corporate form allows for continuity in the activities of the business. The death or
bankruptcy of a shareholder will not impact the existence of the business.
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The corporate form is almost essential for large-scale undertakings. Corporations gain access to a
larger and wider range of equity and debt sources of funds.

The separation of ownership and control enables the corporation to plan and implement strategic
decisions more effectively.

The cost advantages of large-scale production are a further benefit of the corporate form of
business organisation.

There are important disadvantages. Foremost among these is the separation of ownership and
control. The distance between the managers who run the day-to-day operations of the company
and the shareholders who own the company has increased significantly since the early days of
capitalism.

At the beginning, the major owners were often the managers of the company. However,
management now rests in the hands of technical experts while the shareholders maintain a distant
presence with little control over the operating decisions that are made within the firm. This
separation of ownership and control can lead to direct conflicts of interest between managers and
shareholders.

2. Freelancer Ltd is one of the newest public companies to list on the Australian Securities
Exchange. Identify and discuss the rights, roles and responsibilities of Freelancers
shareholders, board of directors and executive management now that it is a publicly listed
company. (LO 4.1)

A publicly listed corporation is a legal entity formed under the provisions of the Corporations Law
and listed on a formal stock exchange. Freelancer Ltd is required to comply with the relevant
legislation and the listing rules of the ASX.

A shareholder has a right to vote in the affairs of the corporation, in particular vote on resolutions
put to a general meeting of the company.

Shareholders elect the board of directors of a corporation.

Shareholders, as owners of a company, do not have a right to participate directly in the day-today operation and management of the business.

The objectives and policies of a corporation are determined by a board of directors.

Directors have a legal responsibility to ensure that the corporation operates in the best interests
of the shareholders.
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The board of directors appoints an executive management group that is responsible for achieving
specified objectives and policies through the management of the day-to-day financial and
operational affairs of the company.

Executive management is responsible to the board of directors. The board of directors reports to
shareholders.

3. (a) Briefly explain the concept of corporate governance within the context of a corporation.

Corporategovernancerelatestotherelationshipsthatshouldexistbetweentheshareholdersofa
company,theboardofdirectorsandexecutivemanagement.

Acompanymustimplementcorporategovernanceprocessesthatputpoliciesandproceduresin
placetoensurethataccountabilityandtransparencybecomeanintegralpartofthecorporate
culture.

Clearresponsibilityandreportingstructuresneedtobeestablishedtofacilitatethelongterm
survivaloftheorganisationandthemaximisationofshareholdervalue.

(b) What is the relationship between corporate governance and the so-called agency problem?
(LO 4.1)

The maximisation of shareholder value presumes the board of directors will establish appropriate
objectives and policies and that management will implement strategies that seek to increase the
value of the organisation.

Agency theory considers the potential problems that may arise from the separation of ownership
and control of a corporation.

Managers control the day-to-day operation of the business and may not necessarily act in the best
interests of the shareholders.

For example, managers may maximise their own benefits at the expense of the shareholder, such
as increasing staff levels for prestige and power, extending management remuneration schemes,
increasing sales at the expense of profitability and sustainability.

The board of directors must implement policies that align the interests of management with those
of the shareholders.

Corporate governance policies seek, in part, to address potential agency problems.

4. Most developed or developing countries seek to establish modern and efficient stock
exchanges.
(a) Identify and discuss the five principal functions of a modern and efficient stock exchange.

The establishment of markets in a range of financial securitiesthis includes the primary and
secondary markets in equity (ordinary shares); listed debt securities (preference shares,
convertible notes, subordinated debt); and derivatives (options, warrants, futures).

The provision of a securities trading systemmost modern and efficient stock exchanges have
implemented electronic trading systems, for example the ASX Trade platform used by the ASX.
Buy/sell orders are placed into ASX Trade by authorised brokers. The system matches orders and
executes the trade.

Operation of a clearing and settlements systemglobal competitive forces require exchanges to

settle stock transactions within T+3 days. This time line may be reduced even further as systems
become even more efficient. The system used by the ASX is known as CHESS. CHESS
instantaneously records the transfer of ownership and facilitates the financial settlement of a
transaction thus removing the possibility of settlement risk.

Regulation and monitoring of the integrity of the exchanges marketsthe efficiency and
integrity of the market is important. The ASX has its own set of listing rules. The exchange
monitors the behaviour of listed companies and authorised brokers, and is able to apply penalties
including delisting a company or revoking the licence of a broker.

Provision of a well-informed market to secure the confidence of all participantsthe price of a

share is a function of available information about that stock; changes in the current price will be
in response to new information coming into the market that will have an impact on the future
performance of the listed entity. Clearly it is essential that continuous disclosure of material
information must be advised to the exchange immediately.
(b) Why is it important to maintain modern and efficient stock exchanges? (LO 4.2)

Stock exchanges are highly competitive, both within their home country and within the
international markets.

A stock exchange provides a market where companies may become listed corporations

Corporations listed on a stock exchange are the principal drivers of economic growth within
a country.

The stock exchange facilitates efficient access to large amounts of equity funding that is
essential for a corporation. This includes the listing of ordinary shares, hybrid and debt
securities.

A modern and efficient stock market, incorporating a deep and liquid primary and secondary
market, encourages investors to provide investment capital to corporations.

If the investment capital is used wisely by corporations, this should lead to prosperity for the
company and its shareholders, plus increased economic growth.

The efficiency of a stock market is a measure of how quickly new information is absorbed by
the market and reflected in changes in share prices.

5. Discuss why a strong primary market is important for economic growth within a country
and explain how each of the main participants in the primary issue of securities interact
with each other during the share issuance process. (LO 4.3)

A stock exchange facilitates the flow of funds, firstly, through the primary market issue and,
secondly, the secondary market trading of existing securities.

The primary market role of the stock exchange is to facilitate the raising of capital by publicly
listed corporations through the issue of new equity based securities to investors.

The primary market issue of new equity is the source of capital funds for the corporation; these
funds allow the maintenance and growth of a business.

Primary market issues facilitate the process of conversion of savings to investment, which
theoretically leads to an accumulation of capital capacity, economic growth, increased
production and higher levels of employment.

The interaction of the main participants in the securities issuance process is depicted in Figure
4.1. Corporations occupy the central position in the process, receiving funds from the issuance of
securities. Underwriters and advisors guide corporations through the issuance process and funds
flow through brokers from individuals, institutions and overseas investors with surplus funds to
invest. The process is facilitated by a stock exchange.

6. (a) Discuss the secondary market role of a stock exchange and its importance to the
corporation. Illustrate your answer by using examples.

The secondary market role of a share market is to provide an organised and efficient market
where existing listed securities may be bought and sold at current market prices.
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The current market price should reflect the performance outcomes and forecast prospects of
individually listed companies within the context of the relevant industry sector, and the domestic
and global economies.

An efficient share market facilitates transfer of ownership amongst investors and enhances
liquidity in listed securities.

Securities initially issued through the primary market may be subsequently traded through the
stock market as a secondary market transaction.

Secondary market transactions will include a range of securities listed on the exchange,
including ordinary shares, rights issues, preference shares, instalment receipts, debentures and
notes.

Economic growth derives from primary market investment; however a successful primary
market requires the support of a deep and liquid secondary market.

An active secondary market encourages investors to purchase new securities because the
investors are confident they will be able to sell those securities in the future in the secondary
market quickly at the current market price.
(b) What is meant by the liquidity of the share market? Explain why liquidity in the

secondary market is important both to shareholders and to the corporation. (LO 4.4)

Liquidity in the share market relates to the ability of the holder of a security to buy or sell listed
securities without unduly disturbing the current market price of the shares being traded.

The standard measure of share market liquidity is the ratio of the value of turnover to market
capitalisation. Market capitalisation is calculated by multiplying the number of shares on issue
by their current market price.

Liquidity in the secondary market for shares encourages investors to initially purchase new
issues by corporations. Shareholders are confident that shares may be easily and quickly sold
without incurring a capital loss as a direct result of the sale transaction (capital loss/gain may
result from other factors such as company performance outcomes).

A liquid share market provides advantages to both the investor (shareholder) and the corporation
in that it facilitates the raising of long-term capital while providing short-term liquidity to the
investor.

7.(a)Asastockbroker,youhavebeenapproachedbyaclientseekingtoestablishadiversified
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portfolioofdomesticshares.Afteridentifyingtheclientsinvestmentneeds,yourecommend
theclientuseanexchangetradedfund(ETF)toachieveherinvestmentobjectives.Explain
totheclienthowanETFwillachievetheobjectiveofadiversifiedshareportfolio.

Exchangetradedfunds(ETF)offeredthroughastockexchangesuchastheASXinvestina
basketofsecuritieslistedontheASX,securitieslistedonaninternationalstockexchange,
foreigncurrenciesorcommodities.

InvestorspurchaseunitsinanETF.

Theinvestorsgainadiversifiedportfolioofsharesbecausethefundmanagerofanequity
basedETFseekstotracktheperformanceofabenchmarkstockexchangeindex,for
example,theS&P/ASX200.

ThefundsraisedfromthesaleofunitsintheETFareusedtopurchaseasecurities
portfoliothatreplicatesthespecifiedindex.Forexample,theETFwouldholdallorthe
majorityofsharesincludedintheS&P/ASX200index.

UnitsinanETFareboughtandsoldthroughastockexchangeexactlythesameasordinary
sharesoflistedcorporationsareboughtandsold.

(b)Theclientalsowishestogainaninvestmentexposuretotheinternationalsharemarkets.Is
itpossibletouseETFstoachievethisobjective?Explain. (LO 4.5)

Aninvestorisabletogainanexposuretotheinternationalsharemarketsbypurchasingan
appropriateETF;forexample,theiSharesS&P500givesexposuretotheUSmarkets,while
iSharesS&PEurope350providesexposuretomajorEuropeancorporationslistedona
numberofEuropeanexchanges.

8. Asanexperiencedinvestor,youareawarethatacontractfordifference(CFD)canbeused
togainaleveragedexposuretotheindividualshares,aspecifiedsharemarketindex,
foreigncurrenciesandcommodities.
(a) ExplainhowaCFDisstructured.

Acontractfordifference(CFD)isacontractlistedonastockexchangethatisan
agreementbetweenaCFDbuyerandsellertoexchangethedifferenceinthevalueofa
CFD.
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ThedifferenceinvalueiscalculatedbysubtractingthevalueoftheCFDcontractatthe
startdatefromthevalueofthecontractattheclosedate.

TheCFDmaybebasedonanominatedsecuritylistedonalocalorinternationalstock
exchange,stockexchangeindices,foreigncurrenciesorcommodities;forexample,aCFD
maybebasedonSantosLimitedshareslistedontheASX.ThevalueoftheCFDisdirectly
correlatedwiththevalueoftheunderlyingSantossharesatthestartandclosedated
specifiedintheCFDcontract.

(b) Describetheimpactofleverageonthistypeofinvestment. (LO 4.5 )

ACFDprovidesahighlevelofleverageforaninvestorasthebuyerofaCFDonlypaysa
depositorinitialmargin;thatis,theinvestordoesnotpaythefullvalueoftheunderlying
shares.

Thismeansthataninvestormaybeabletotakeamuchlargerexposuretothemarketinthat
moreoftheunderlyingsecuritycanbeboughtorsoldbecausefullpaymentisnotrequired

AninvestormayuseaCFDtogolonginarisingmarket,orgoshortinafallingmarket.

However,therisksassociatedwithleveragearemuchhigherasthefullgainorlossassociated
withtheunderlyingsecuritywillbemadewhentheCFDisclosedout.

Aninvestorneedstounderstandtheupsideandthedownsideriskassociatedwithaleveraged
investmentwithaCFD;forexample,ifaninvestorbelievesthatmarketisgoingtorisethen
theinvestormaydecidetobuyaCFD,thatis,takealongposition.Iftheunderlyingsecurity
oftheCFDrisesthentheinvestorwillmakeaprofit,butifthesecurityfallsinvaluethe
investorwillmakealoss.

9. TwomanagedinvestmentproductsofferedthroughtheASXarerealestateinvestment
trusts(REIT)andinfrastructurefunds.Identifyandbrieflydescribethemainfeaturesof
eachoftheseproducts. (LO 4.5)
1. Arealestateinvestmenttrust(REIT):

ThemanagerofaREITpurchasespropertyandholdstheassetswithinatrust.

UnitsintheREITmaybelistedonastockexchangeandtradedthesameasordinary
sharesinlistedcorporations.

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Asinvestorsarebuyingunitsinthelistedtrust,theygainaccesstoadiversifiedrealestate
portfoliothatotherwisewouldnotbepossiblefortheaverageinvestor;forexample,an
investormaypurchaseunitsworth$10000inaREITwhereas,withthatsmallamount,
theinvestorcouldnotpurchasepropertydirectly.

ThetypeofpropertyheldinaREITwillbespecifiedinthefund'strustdeedandmay
includeindustrial,hotelandleisure,retailandofficeproperties.

Investorsmaybenefitfrombothcapitalgainsonthepropertyassetsplusrentalincome
generatedbytheproperties.

UnitsinalistedREITaremuchmoreliquidthantheunderlyingproperty;thatis,itis
easiertoselltheunitsthanitistoquicklysellthepropertyheldinthetrust.

2. Infrastructurefunds:

Aninfrastructurefundisamanagedfundthatmaybelistedonastockexchangeand
enablesinvestorstogainaccesstoinvestmentopportunitiesinlargescaleinfrastructure
projectssuchastollroads.

Infrastructureprojectsarenormallymultimilliondollarprojectsandthereforebeyond
theinvestmentcapacityoftheaverageinvestor.

Theinfrastructurefundgathersacceptsfundsfromalargenumberofinvestorstocreatea
significantpooloffunds.Thisenablesthefundmanagertotheninvestinthesetypesof
projectsorassets.

Returnstoinvestorsmaytaketheformofcapitalgainsandincomegeneratedfromthe
project.Forexample,apowerstationwillgenerateincomefromgeneratingandselling
electricitytoconsumers.

Otherinfrastructureassetsincludeutilities,transport,materialhandlingand
communicationfacilities.

10. Three equity-based derivative products that may be offered through a stock exchange are
an options contract, an equity warrant and a futures contract. Briefly explain the main
features of each of these products. Why might an investor use these products? (LO 4.5)

A derivative is a financial security that derives its price from an underlying commodity or
instrument, for example a share listed on a stock exchange.

Derivatives traded on a stock exchange are standardised exchanges traded contracts.

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Derivatives are designed to facilitate the management of risk exposures; for example, an investor
might hedge the risk that a share price may fall by implementing a strategy to lock in the current
share price using a derivatives contract.

An option contract gives the buyer of the option the right, but not the obligation, to buy (sell) at a
predetermined price at or by a predetermined date. A call option is the right to buy; a put option
the right to sell. The buyer of the option will pay a premium to purchase the contract from the
option writer. The contract price is the exercise or strike price.

An equity call warrant gives the warrant holder the right to buy the underlying security (shares)
at a particular price, on or before a predetermined date. A put warrant gives the right to sell. A
warrant issuer is a third party, such as a bank, authorised by a stock exchange to write warrant
contracts.

A futures contract is an agreement to buy or sell a specified commodity or instrument at a

predetermined price and date. The value of a futures contract moves as the value of the
underlying security changes in the physical market.

11. Woodside Petroleum Limited is considering issuing debentures in the capital markets and
having the debt debentures quoted on the fixed interest market of the ASX.
(a) As the chief financial officer for Woodside you have been invited to explain the issue to a
group of investors. Prepare a list and explain the advantages to both Woodside and the
potential investor in having the debentures listed?

Transparencythe stock exchange keeps the markets informed

Ease of entry and exita deep and liquid market using electronic trading (ASX Trade)
and settlement systems (CHESS)

Liquidityexistence of price makers and a large pool of investors

Listing increases the corporate image and profile in the financial markets

The receipt of a known income stream, being interest coupons

An investment option for surplus funds

A strategic investment option to manage interest rate risk exposures

An opportunity to diversify an investment portfolio.

(b) Briefly describe the main characteristics of a debenture. (LO 4.6)

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A debenture is a corporate bond that pays a regular periodic interest payment (coupon)
and the principal is repaid at maturity.

The debenture is a secured security with a fixed and floating charge over the assets of the
issuer.

A debenture may be a straight corporate bond that pays a fixed interest coupon or a
floating rate notes that pays a variable interest rate based on a published reference rate.

12.

(a)UsingtheexampleofthetradingandsettlementplatformsusedbytheASX,explain

theprocesswherebyoneinvestorplacesabuyorderfor1000RioTintoLimitedsharesand
anotherinvestorplacesasellorderfor1000RioTintoLimitedshares;bothordersat
marketprice. (LO 4.7)

The ASX operates a technology based trading platform (ASX Trade) and a settlements systems
(Clearing House Electronic Sub-Register SystemCHESS).

If stockbrokers received orders to buy RIO shares and another to sell RIO shares, the
stockbrokers initiate buy/sell orders of their clients by entering the orders into the ASX Trade
platform.

ASX Trade matches buy and sell orders and initiates the transaction.

Under the CHESS arrangements shareholders no longer receive and hold a share certificate, but
rather hold uncertificated securities, being an electronic record of shareholdings.

The buying and selling of shares is facilitated by a CHESS sponsor such as a stockbroker.

The current CHESS arrangements require settlement of a share transaction to occur in three days
(T + 3).

The combination of ASX Trade and CHESS form the basis of the ASXs strategy to remain an
efficient and competitive international stock exchange.

(b) Within the context of the above Rio Tinto share transaction, define and provide examples
of the following: (LO 4.7)

uncertificated sharesownership of stock listed on an exchange is recorded electronically,

for example the ASX no longer issues actual share certificates

share contract noteadvicesentfromastockbrokertoaclientconfirmingthefulldetailsofa

buyorselltransactionthathasbeencarriedoutbythebrokeronbehalfoftheclient.Includes

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detailsofthestock,thedate,thenumberofshares,thepricepershare,feesandcharges,total
costandsettlementdate

settlement riskthe probability that one party to a buy/sell transaction will not fulfil their
contractualobligations.Forexample,deliveryofthestockandtransferofownershipmayoccur,
butfinancialsettlementdoesnoteventuate.

T + 3 business daysused to describe settlement of a share transaction when transfer of

ownershipandvaluewilloccuronthetransactiondayplusthreedays.

13. (a) It may be argued that information is the life-blood of an efficient stock market. Explain
this proposition.

Listed corporations raise their equity funds and part of their debt funds through the issue of
securities on a stock exchange.

Investors purchase these securities because they have confidence in the operation of the primary
and secondary markets on the exchange.

The current price of a security reflects all known information relevant to that stock.

The stock price will change in response to new information coming to the market.

Therefore, the efficiency at which information is provided to the market and the speed at which it
is absorbed will directly affect the pricing of listed securities.

(b) Within the context of the ASX, explain the requirements and purpose of continuous
reporting.

Once an entity is, or becomes, aware of any information concerning the corporation that a
reasonable person would expect to have a material effect on the price or value of the entitys
securities, the entity must immediately tell the ASX that information.

The Corporations Act states that a reasonable person would consider information to be material
if it would be likely to influence persons who commonly invest in securities in deciding whether
or not to subscribe for, or buy or sell, the securities.

The purpose of continuous reporting is to ensure all market participants are quickly and
accurately fully informed so that appropriate investment decisions may be made.

(c) Identify, using examples, five different pieces of information that are regarded as being
material and therefore should be reported to the stock exchange. (LO 4.8)
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Answerswillincludeaselectionofthefollowing:

achangeinthecorporationsfinancialforecastsorexpectations

theappointmentofareceiver,manager,liquidatororadministrator

atransactionforwhichtheconsiderationpayableorreceivableisasignificantproportionofthe
writtendownvalueoftheentitysconsolidatedassets

arecommendationordeclarationofadividendordistribution

noticeofatakeoverbid,oranintentiontobuybackissuedshares

aproposaltorestructurethecapitalbaseofthecorporation

anintentiontoissueequityoptions,orvarytheexercisepriceonexistingoptions

thenoticeofgeneralmeetingsofshareholders,includingmotionstobeputtothemeetingand
theoutcomesofthosemotions

anychangeofaddressofthecorporateofficeortheshareregistry

achangeinthechairperson,directorsandauditors

copiesofanydocumentsforwardedtoshareholders

disclosureofdirectorsinterests

arecommendationordecisionthatadividendordistributionwillnotbedeclared

undersubscriptionsoroversubscriptionstoanissue

acopyofanyfinancialdocumentslodgedwithanoverseasstockexchangeorotherregulator
whichisavailabletothepublic.

14. Outline the regulatory structure and the responsibilities of the main supervisors of market
integrity and market participant's behaviour in Australian stock exchanges. (LO 4.9)
InAustralia,theAustralianSecuritiesandInvestmentsCommission(ASIC)hasresponsibilityfor
thesupervisionofrealtimetradinginthedomesticlicensedmarkets.
ASICisresponsibleforenforcementoflawsagainstmisconduct,andthesupervisionoffinancial
serviceslicenceholders.
ASICmaintainsanintegratedsurveillancesystem.Breachesofrulesareenforcedbya
disciplinarypanel.
ASXalsomonitorscontinuousdisclosurethroughitsowncompliancesubsidiary.Itmayimpose
penalties,suspendordelistacorporationandforwardaformalreporttoASICforfurtheraction.
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 TheReserveBank(RBA)monitorsthelicensedclearingandsettlementplatformsandsystemsin
ordertoensurefinancialstabilityandreducesystemicriskinthefinancialsystem.
15. The private equity market is an alternative source of equity funding for business. Explain
how this market typically operates. (LO 4.10)

Private equity funding is usually provided to higher risk companies that often do not have
adequatecollateralorprofitperformancetoattractinvestorswithinthenormalsharemarketor
bankingsourcesoffunds.

Privateequitymarketfundingisusuallydirectedtowards:
startup funds for new companies to allow the business to develop its products and

services
o

businessexpansionfundsthatallowacompanytogrowthecurrentbusinessoperations

recoveryfinanceforcompaniesthatarecurrentlyexperiencingfinancialdifficulty

managementbuyoutfinancingwheretheexistingcompanymanagersseektobuythe
existingbusinessfunded,inpart,withprivateequity.

Themajorityofprivateequityisprovidedthroughfundsthatareestablishedforthispurpose;
thatisthefundsspecialiseinseekingoutandanalysingpotentialprivateequityopportunitiesor
targets.

WithinAustralia,themajorprovidersoffundsfortheprivateequityfundsaresuperannuation
fundsandlifeinsuranceoffices.Theseinstitutionalinvestorsseektoincreasetheoverallreturn
ontheirlargeinvestmentportfoliosbyincludingaproportionofhigherriskinvestments.

Theinvestmenthorizonofprivateequityinvestorsisoftenforlessthanfivetosevenyears.

Asprivateequityhaslimitedliquidity,thatis,itcannotbesoldthroughthesharemarket,a
principalobjectiveofprivateequityinvestorsistosignificantlyimprovetheprofitperformance
ofthecompanysothatthecompanycanbelistedonastockexchangethroughaninitialpublic
offering(IPO).

Alternatively,theinvestorsmayseektobreakupthecompanyandsellthecomponentpartsin
ordertoachieveareturnoninvestment.

Privateequityfundingtendstogrowintimesofsustainedeconomicgrowth.Ontheotherhand,
intimesofaneconomicdownturn,newprivateequityfundingmayfallsignificantly.

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FINANCIAL NEWS CASE STUDY

In Chapter 4 we discussed private equity and the role of private equity firms in the financial
markets. It may come as a surprise to some to learn that a private equity firm, BlackRock, is
the largest investor in the world with approximately $15 trillion of assets under its direct or
indirect control. The rise of BlackRock generated some interesting media commentary. The
following article from The Economist provides a number of insights into BlackRock and the
surprisingly multifaceted nature of the biggest company in the private equity business.
Ask conspiracy theorists who they think really runs the world, and they will probably point
to global banks, such as Citigroup, Bank of America and JPMorgan Chase. Oil giants such as
Exxon Mobil and Shell may also earn a mention. Or perhaps they would focus on the consumergoods firms that hold billions in their thrall: Apple, McDonalds or Nestl.
One firm unlikely to feature on their list is BlackRock, an investment manager whose name
rings few bells outside financial circles. Yet it is the single biggest shareholder in all the
companies listed above. It owns a stake in almost every listed company not just in America but
globally. (Indeed, it is the biggest shareholder in Pearson, in turn the biggest shareholder in The
Economist.) Its reach extends further: to corporate bonds, sovereign debt, commodities, hedge
funds and beyond. It is easily the biggest investor in the world, with $4.1 trillion of directly
controlled assets (almost as much as all private-equity and hedge funds put together) and
another $11 trillion it oversees through its trading platform, Aladdin.
Established in 1988 by a group of Wall Streeters led by Larry Fink, BlackRock succeeded in
part by offering 'passive' investment products, such as exchange-traded funds, which aim to
track indices such as the S&P 500. These are cheap alternatives to traditional mutual funds,
which often do more to enrich money managers than clients (though BlackRock offers plenty of
those, too). The sector continues to grow fast, and BlackRock, partly through its iShares brand,
is the largest competitor in an industry where scale brings benefits. Its clients, ranging from
Arab sovereign-wealth funds to mom-and-pop investors, save billions in fees as a result.
The other reason for its success is its management of risk in its actively managed portfolio.
Early on, for instance, it was a leader in mortgage-backed securities. But because it analysed
their riskiness zipcode by zipcode, it not only avoided a bail-out in the chaos that followed the
collapse of Lehman, but also advised the American Government and others on how to keep the
financial system ticking in the darkest days of 2008, and picked up profitable money20

management units from struggling financial institutions in the aftermath of the crisis.
Other peoples money
Compared with the many banks which are flourishing only thanks to state largesse,
BlackRocks successbased on providing value to customers and paying attention to detailis
well-deserved. Yet when taxpayers have spent billions rescuing financial institutions deemed too
big to fail, a 25-year-old company that has grown so vast so quickly sets nerves jangling.
American regulators are therefore thinking about designating BlackRock and some of its rivals
as 'systemically important'. The tag might land them with hefty regulatory requirements.
If the regulators concern is to avoid a repeat of the last crisis, they are barking up the wrong
tree. Unlike banks, whose loans and deposits go on their balance-sheets as assets and liabilities,
BlackRock is a mere manager of other peoples money. It has control over investments it holds
on behalf of otherswhich gives it great influencebut it neither keeps the profits nor suffers
the losses on them. Whereas banks tumble if their assets lose even a fraction of their value,
BlackRock can pass on any shortfalls to its clients, and withstand far greater shocks. In fact, by
being on hand to pick up assets cheaply from distressed sellers, an unleveraged asset manager
arguably stabilises markets rather than disrupting them.
But for regulators that want not merely to prevent a repeat of the last blow-up but also to
identify the sources of future systemic perils, BlackRock raises another, subtler issue, concerning
not the ownership of assets but the way buying and selling decisions are made. The $15 trillion
of assets managed on its Aladdin platform amount to around 7 per cent of all the shares, bonds
and loans in the world. As a result, those who oversee many of the worlds biggest pools of
money are looking at the financial world, at least in part, through a lens crafted by BlackRock.
Some 17 000 traders in banks, insurance companies, sovereign-wealth funds and others rely in
part on BlackRocks analytical models to guide their investing.
Aladdins genius
That is a tribute to BlackRocks elaborate risk-management models, but it is also
discomfiting. A principle of healthy markets is that a cacophony of diverse actors come to
different conclusions on the price of things, based on their own idiosyncratic analyses. The
value of any asset is discovered by melding all these different opinions into a single price. An
ecosystem which is dominated by a single line of thinking is not healthy, in politics, in nature or
in markets. Such groupthink in finance is a recipe for booms (when everyone wants to buy the
same thing) and busts (when they all rush to sell). Though Aladdin advises clients on investment
decisions rather than making them, it inevitably frames how they think of market risk.
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The last crisis had many causes. One of them, which perhaps lay behind all the others, was
that investors stopped thinking critically about what they were buying. Too many decided to
trust credit-rating agencies, which assured them, for example, that packages of American
subprime mortgages were extremely unlikely to default. BlackRocks models are no doubt better
than the clunkers put out by Moodys or Standard & Poors up to 2008: the firms relative recent
success has proved that. But too many investors relying on a single model spreads an unhealthy
orthodoxy and is likely to make the markets more volatile than they otherwise would be.
That is probably not a serious systemic risk, for it will be self-limiting: the more money
follows BlackRock, the more money there is to be made betting against it. The real danger is for
investors. The more they rely on BlackRocks analysis, the smaller the upside when it gets things
right and the greater the downside when it gets things wrongas, one day, it eventually will.
Until then BlackRocks single-minded focus on mastering risk is to be commended. If its peers in
the financial world had taken the same approach in the run-up to 2008, much of the chaos of the
past five years would have been averted.
SOURCE: The Rise of BlackRock, The Economist, 7 December 2013.

DISCUSSION POINTS

'BlackRock is not just a private equity firm.' Discuss this statement with reference to
BlackRocks Aladdin trading platform.
Those people who have heard of BlackRock associate it with private equity or the
purchase of ownership stakes in companies. Although BlackRock has a substantial
private equity business, the bulk of the assets that it indirectly oversees are associated
with its Aladdin trading platform.

BlackRock controls more assets than almost all other private equity firms and hedge
funds combined. Discuss the implications of the market dominance of BlackRock.
High levels of market dominance or concentration are a long-standing concern for
regulators. The idea that some financial institutions are too big to fail stems from their size
and market position. BlackRocks size and market dominance almost certainly place it in
the too big to fail category. However, BlackRock is not a bank and is not exposed to losses
on the assets that trade through Aladdin. It also has an enviable record of prudent risk
management.
22

The size of the Aladdin trading platform means that many investors frame their view
of the markets through a lens provided by BlackRock. Should regulators be
concerned about BlackRocks dominance and the systematic risk it may create?
The size of BlackRocks Aladdin platform is only a concern if it has the potential to create a
systemic risk. The author of the article implies that BlackRock provides a lens through
which many other funds managers view the markets. Of course, large numbers of investors
moving in the same direction may be cause for concern if it exacerbates market volatility.
However, funds managers no doubt complement the BlackRock view with their own
research. As such, one must be careful not to overstate the matter.

Does the size of the Aladdin trading platform have any implications for the
information role that markets perform?
This goes to the previous point. Market prices that reflect a single dominant opinion may
not fully reflect the true state of affairs. However, the incentive for funds managers to seek
out relevant information and form their trades based on their analysis of that information
remains intact.

True/False questions
1. FTheagencyproblemreferstoaconflictofinterestarisingbetweentheCEOandtheboardof
directors.
2. FTheAustraliansharemarketisrelativelysmallandrankswelloutsideofthetop10globalshare
markets.
3.TShareholderdissatisfactioncanbereflectedorsignalledbypricemovementsinthecompanys
shares.
4. TShareoptionshavebeenapopularcomponentofmanagementcompensationpackages
designedtominimisepotentialagencyproblems.
5. FItisnotpossibletoraisesignificantamountsofcapitalbyundertakinganinitialpublicoffering
ofsharesontheASX.
6. FThemarketcapitalisationofacorporationiscalculatedbymultiplyingthenumberofshareson
issuebythecurrentsharepriceanddividingtheresultbyanappropriatediscountrate.
7. FAphysicalmarketisdefinedasaformalexchangeinwhichderivativeproductsaretraded.

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8. TAnexchangetradedfund(ETF)providesaninvestorwiththeopportunitytogainexposuretoa
diversifiedshareportfolio.
9. TThemaintypeofassetheldinaREITmanagedfundisproperty.
10.FInfrastructurefundsarenormallyestablishedbythegovernmenttoensurebasicservicesare
providedtothecommunity.
11.FThewriterofanoptionhastheright,butnottheobligation,tobuyorsellasecurityata
predeterminedpriceanddate,onpaymentofapremiumtotheoptionbuyer.
12.TAstraightcorporatebondisalongtermdebtsecuritythatpaysaperiodicfixedratecoupon
andrepaysthefacevalueatmaturity.
13.FApreferencesharegivestheshareholderarighttopurchaseadditionalsharesinacorporation
atapredeterminedpriceanddate.
14.FAnuncertificatedsecurityisissuedbytheASXtoashareholderwhentheoriginalshare
certificatehasbeenmisplaced.
15.FThepaperbasedCHESSsystemforvaluesettlementandtransferofownershipofsharesmean
thatfinalsettlementtakes,onaverage,sevendaystocomplete.
16.TAnessentialroleofastockexchangeistoensurethatmarketparticipantsareimmediately
informedofmaterialchangestoalistedcompanysoperations.
17.FTheASXcurrentlyhasagovernmentprotectedmonopolyasastockexchangeinAustralia.
18.TASIChasresponsibilityforthesupervisionofrealtimetradingontheASX.
19.FTheprivateequitymarkethasgrownrapidlyandisnowalmostaslargeasthestockexchange.
20.FTheGFChadverylittleimpactonglobalequitymarkets,butratheritmainlyimpactedglobal
economicgrowth.

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