14
Capital Markets
Chapter
McGraw-Hill/Irwin
Copyright © 2008 by The McGraw-Hill Companies, Inc. All rights reserved.
Chapter Outline
• Capital market and securities.
• Fund raisers in the capital markets.
• The three-sector economy of the United
States.
• Physical and electronic markets.
• Rapid adjustment of prices as an indication
of efficiency.
• Security legislation.
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Security Markets
• Consist of various government bonds and
corporate common stocks.
• The markets are influenced by variables like:
– Interest rates
– Investor confidence
– Economic growth
– Global crisis, etc.
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Types of Security Markets
• Money markets
– Short-term markets comprising of securities with
maturities of one year or less.
• Include Treasury bills, commercial paper, negotiable
certificates of deposits.
• Capital markets
– Long-term markets consisting of securities
having maturities greater than one year.
• Include bonds, common stock, preferred stock, and
convertible securities.
• These securities comprise a firm’s capital structure.
14-4
International Capital Markets
• Has played an important role over the last
decade due to various factors:
– Collapse of the Iron Curtain in the early 1990s.
– Reunification of Germany.
– Implementation of a competitive and tariff-free
market in Europe at the start of 1993.
– Establishment of NAFTA in 1994.
– Economic growth of the Asian countries.
– Establishment of the European Monetary Union
(EMU) in 1999.
14-5
International Capital Markets as a
Source of Funds
• An opportunity for companies to raise debt
capital at the lowest cost.
• Many list their common stock around the
world to:
– Increase liquidity for the stockholders.
– Provide opportunities for the potential sale of
new stock in foreign countries.
• About 5.1% of foreign investment has been
invested in government securities.
14-6
Competition for Funds in the U.S.
Capital Markets
• Securities available in the capital market:
– The federal government
– Government agencies
– State governments
– Local municipalities.
• Investors must choose among corporate and
noncorporate securities with the desire to:
– Maximize returns for any give level of risk.
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Government Securities
• U.S. government securities - treasury
– Manages the federal government’s debt in order
to balance the flow of funds.
– Sells short- or long-term securities to finance
shortfalls or retires in case of surplus.
• State and local securities
– Municipal securities or tax-exempt offerings
– Investors - high marginal tax brackets.
– Supported by revenue-generating projects.
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Government Securities (cont’d)
• Federally sponsored credit agencies
– Government units issuing securities on a
separate basis from those sold by the U.S
Treasury.
– Includes:
•
•
•
•
Federal Home Loan Banks (FHLB).
Federal National Mortgage Association (Fannie Mae).
Farm Credit Banks.
Student Loan Marketing Association.
14-9
Corporate Securities
• Corporate bonds
– Debt instruments having a fixed life and to be
repaid at maturity.
– As bonds come due and are paid off, the
corporation normally replaces this debt with new
bonds.
• Preferred stock
– Least used of all long-term securities, since the
dividend is not tax-deductible to the corporation.
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Corporate Securities (cont’d)
• Common stock
– Sold by companies desiring new equity capital.
– Either sold as a new issue in an initial public
offering (IPO) or as a secondary offering.
– Treasury stock: When a company purchases its
own stock – availability of surplus cash.
14-11
Internal Sources of Funds
• Include retained earnings and cash flow
added back from depreciation.
– Composition of internal funds is a function of:
•
•
•
•
Corporate profitability
The dividends paid
The resultant retained earnings
The depreciation tax shield firms avail.
14-12
Depreciation and Retained Earnings
for Internal Financing
14-13
Flow of Funds through the Economy
14-14
The Supply of Capital Funds
• Household sector - major supplier of funds.
• Indirect investments:
– Household savings generated by wages.
– Transfer payments from the government.
– Wages and dividends from the corporations.
• These are funneled to financial intermediaries.
• Diverse financial institutions channel funds into
commercial banks, mutual savings banks, and credit
unions.
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Suppliers of Funds to Credit Markets
(Year-end 2004)
14-16
The Role of the Security Markets
• The capital markets are divided into many
functional subsets.
– Each specific market serves a certain type of
security.
• Secondary trading:
– The security trades in appropriate markets – not
original offering.
– Provides liquidity to investors and keeps the
prices competitive.
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The Role of the Security Markets
(cont’d)
• Security markets provide liquidity by:
– Enabling corporations to raise funds by selling
new issues of securities.
– Allowing investor to sell them with relative ease
and speed.
• Corporations and government units would
not be able to raise large amounts of capital
for economic growth – without markets.
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The Organization of Security
Markets
• Security markets structuring has changed
because of:
– Technological advances which include:
• Mergers or alliances between exchanges.
• Transformation of member exchanges into public
companies.
• Elimination of trading on the exchange floor.
– Changes in decimalization of price quotes
impacting the:
• Efficiency of markets
• Profitability
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The New York Stock Exchange
• Is the largest and most important of all global
stock exchanges
– Comprises of thousands of huge companies
whose shares are listed on the NYSE.
– Brokers meet to buy and sell securities through
a bid (buy price) and ask (sell price) market,
called an auction market.
• They are registered members of the exchange.
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Listing Requirements
• Listing requirements are stringent and include:
– Minimum standards for earnings and net tangible
assets.
– Market value of publicly held shares.
– Number of common shares owned by the public.
– Monthly trading volume.
• Firms pay the exchange for:
– Initial listing fee.
– Annual listing fees - shares outstanding.
– Additional fees - number of shares traded per year.
14-21
Listing Stocks on a Stock Market
• Benefits of listing stocks on the stock
market:
– Providing liquidity to owners.
– Allowing the company a more viable means of
raising external capital for growth and
expansion.
14-22
Decimalization
• SEC mandated the switch from fractions to
decimals.
– To make quotations more readable and
understandable for the investing public.
– Some complaints include loss of profits.
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Electronic Trading
• Electronic markets have a good chance of
dominance due to the:
– Speeds.
– Efficiency.
– Low cost execution.
• Floor trading and electronic trading is
currently the norm.
14-24
National Association for Security
Dealers Automated Quotation
• NASDAQ:
– Divides its markets into national and small
capitalization markets.
– Oversees the local OTC markets as well as the
OTC Bulletin board market.
– Is the largest screen-based market in the United
States.
• Over 30% of the NASDAQ Index consists of
technology stocks.
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The American Stock Exchange
(AMEX)
• Owned by NASDAQ, operating separately.
– Has about 800 companies listed on it.
– Listings are less stringent compared to the
NASDAQ National Market.
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Regional Stock Exchanges
• Exist outside of New York.
• Trade primarily in issues of large national
companies.
• Allowed to trade with companies on the New
York Stock Exchange.
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Foreign Exchanges – Global Stock
Markets
14-28
Electronic Communication Network
(ECN)
• Electronic trading systems that automatically
buy and sell orders at specified prices.
– Also known as alternative trading systems (ATS).
– Has SEC approval to be fully integrated into the
national market system.
– Can choose to act as broker, dealer, or an
exchange.
– Lowers the cost of trading.
– Advantage: can trade 24 hours a day
– Disadvantage: undertakes risk of after hour markets.
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National Association of Securities
Dealers (NASD)
• World’s largest private-sector regulator of
financial services.
• Responsible for regulating brokers and
dealers on all domestic markets.
• The law requires that every securities firm
doing business with the American public
must register with the NASD.
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Market Efficiency
• Markets in general are efficient when:
– Prices adjust rapidly to new information.
– There is a continuous market, in which each
successive trade is made at a price closer to the
previous price.
– The market can absorb large dollar amounts of
securities without destabilizing the prices.
• The important variable affecting efficiency is
the certainty of income stream.
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Market Efficiency (cont’d)
• Fixed income securities with known
maturities have a reasonably efficient
markets.
– The most efficient is that of the U.S. government
securities.
– Corporate bond markets are reasonable to a
degree.
– Common stocks market has been supported
through decimalization, ECNs etc.
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The Efficient Market Hypothesis
• Weak form
– Past price information is unrelated to future
price.
– Trends cannot be predicted and taken
advantage of by investors.
• Semi-strong form
– Prices currently reflect all public information.
• Strong form
– All information, both private and public is
immediately reflected in stock prices.
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Regulation of the Security Markets
• Organized securities markets are regulated
by the:
– Securities and Exchange Commission (SEC)
– Self-regulation of the exchanges.
• Three laws govern the sale and trading of
securities with a primary purpose:
– To protect unwary investors from fraud and
manipulation.
– To make markets more competitive and
transparent.
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Securities Act of 1933
• Important features include:
– All offerings except government bonds and bank stocks to be
sold in more than one state to be registered with the SEC.
– The registration statement is to be filled 20 days in advance of
the date of sale and must include detailed corporate
information.
– The SEC does not certify the fairness of a price but only the
information seems to be accurate.
– All new issues of securities must be accompanied by a
prospectus containing the same information appearing in the
registration statement.
– Officers of the company and other experts preparing the
prospectus or the registration statement could be sued for
penalties and recovery of realized losses in case of
discrepancies in information.
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Securities Exchange Act of 1934
• Some of the important features include:
– Guidelines for insider trading preventing them from taking
quick advantage of information resulting in short-term gains.
– The Federal Reserve’s Board of Governors responsible for
setting margin requirements to determine the quantity of
credit.
– Manipulation of securities by conspiracies among investors
was prohibited.
– SEC given control over the proxy procedures of corporations.
– The SEC required that certain reports be filled periodically, for
its regulation of companies traded on the market.
– All security exchanges to register with the SEC.
14-36
Securities Acts Amendments of 1975
• Major focus: to direct the SEC to supervise the
development of a national securities market.
– Assumed that any national market would extensively use
computers and electronic communication devices.
– Prohibited fixed commissions on public transactions and
prohibited banks, insurance companies and other
financial institutions from buying stock exchange
membership to save commission costs.
– The Intermarket Trading system, computerization
demonstrated by the ECNs and a more competitive
structure has now been observed.
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Sarbanes-Oxley Act of 2002
• Not directly related to security trading.
• Features include:
– Authorization of an independent private-sector board to
oversee the accounting profession.
– Creation of new penalties and long prison terms for
corporate fraud and document destruction.
– Restrictions on accounting firms from providing
consulting services to audit clients, and other similar
provisions.
– The act holds corporate executives legally accountable
for the accuracy of their firm’s financial statements.
– It requires the CEO, along with the CFO, to sign off
documents, making the monitoring a very serious
business
14-38