Capital Markets

14Chapter

Copyright © 2011 by The McGraw-Hill Companies, Inc. All rights reserved.McGraw-Hill/Irwin

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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 a myriad of securities from government bonds to corporate common stock

• Influenced by variables like:– Interest rates– Investor confidence– Economic growth– Global crises

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Types of Security Markets

• Money markets– Short-term markets comprising of securities with

maturities of one year or less• Treasury bills, commercial paper, negotiable

certificates of deposits

• Capital markets– Long-term markets consisting of securities

having maturities greater than one year• Bonds, common stock, preferred stock, convertible

securities• These securities comprise a firm’s capital structure

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International Capital Markets

• Emerged as a result of:– Adoption of basic principles of capitalism– Global privatization– Reduced telecommunication costs– Continuing development of international “free trade”

• Establishment of NAFTA in 1994• CAFTA reduces trade barriers• The six original members of EU abolished internal tariffs in

1968• WTO strives to further liberalize international trade• Eurozone and embrace the euro, the official currency for the 16

Eurozone countries

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2008 Total Dollar Trading Volume on Ten Largest Equity Markets

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International Capital Markets as a Source of Funds

• An opportunity for companies to raise debt and equity 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 3.8% of foreign investments ($885 billion) has been invested in government securities

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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 given 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

• Federally sponsored credit agencies– Governmental units issuing securities on a

separate basis from those sold by U.S. Treasury– Includes:

• Federal Home Loan Banks (FHLB)

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Government Securities (cont’d)

• Federal National Mortgage Association (Fannie Mae)• Federal Home Loan Mortgage Corporation (Freddie

Mac)• Farm Credit Banks• Student Loan Marketing Association (Sallie Mae)• Federal Agricultural Mortgage Corporation, (Farmer

Mac)

• State and local securities– Municipal securities or tax-exempt offerings

• Purchased by investors in high marginal tax brackets• Supported by revenue-generating projects

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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

• 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: A company purchases its own stock – No maturity date

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Internal versus External Sources of Funds

• Internally generated funds include retained earnings and cash flow added back from depreciation– Composition of internal funds is a function of:

• Corporate profitability• Dividends paid• Resultant retained earnings• Depreciation tax shield firms avail

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Internally Generated Funds: Depreciation and Retained Earnings

• The figure shows the relative importance of depreciation (provided 77%) and retained earnings (provided 23%) in providing internal financing

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The Supply of Capital Funds

• Household sector - major supplier of funds• Indirect investments:

– Household savings generated by wages and dividends

• Are funneled to financial intermediaries that, in turn, make investments in the capital markets

• Purchase mutual fund shares, invest in life insurance, or participate in private pension plans

– Diverse financial institutions channel funds into commercial banks, mutual savings banks, and credit unions

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Flow of Funds Through the Economy

• Three-sector economy, consisting of:– Households ( the major supplier of funds for investment)– Business (net demander of funds)– Government (net demander of funds)

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Suppliers of Funds to Credit Markets (September 2008)

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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

among all kinds of investors– Provides liquidity to investors and keeps the

prices competitive among alternative security investments

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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 the Security Markets

• Security markets structuring has changed because of: – Technological advances which include:

• The rise of electronic communication networks (ECNs)

• Mergers or alliances between exchanges• Transformation of membership-owned organizations

to public companies• Acquisition of leading ECNs by the traditional

exchanges

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Traditional Organized Exchanges

• Either national or regional, both structured in similar fashion

• Exchanges have had a central trading location to buy and sell securities

• Each stock trades at a physical location, a trading post, on exchange’s trading floor

• Brokers are registered members of exchanges• NYSE is the largest of all traditional exchanges

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Regional Exchanges

• Began by trading securities of local firms

• Trading on these exchanges are primarily done in nationally known companies

• Trading in same companies common between NYSE and regionals like Chicago Stock Exchange

• More than 90 percent of companies traded on the Chicago Stock Exchange also listed on the NYSE – referred to as “dual trading”

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Listing Requirements

• A firm’s securities can be traded on an exchange if company meets listing requirements and has been approved by board of governors of that exchange

• All exchanges have minimum requirements that must be met before trading occurs in company’s common stock

• Are most restrictive at NYSE

• Are less restrictive at NASDAQ

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Electronic Communication Networks (ECNs)

• Electronic trading systems that automatically buy and sell orders at specified prices– Also known as alternative trading systems (ATSs)– Have SEC approval to be fully integrated into the

national market system– Can choose to either act as a broker-dealer or as an

exchange– Do not have an exchange floor or physical trading posts– Lower the cost of trading– Forced organized security exchanges to make

significant changes in their operations and structure

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The New York Stock Exchange

• In 2006, NYSE merged with a large ECN and became a public company– Comprises of thousands of huge companies whose

shares are listed on the NYSE– Specialists (employed by member firms) meet to buy

and sell securities through a bid and ask market, called an auction market

– In addition to acquiring Archipelago, NYSE merged with Euronext (the largest European exchange)

– NYSE acquired American Stock Exchange in 2008

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The NASDAQ Market

• NASDAQ:– Was considered an OTC market prior to 2006

– Recognized as a national securities exchange by the SEC from August 1, 2006

– All trades are done electronically – no trading floor and no specialists

– Largest exchange in the U.S by dollar trading volume

– Known for trading technology and listing of many of the world’s largest technology companies

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The NASDAQ Market (cont’d)

– Created SuperMontage, electronic trading system that integrates trading process with limit orders, time stamps for receipt of orders, multiple quotes, etc.

– Acquired the largest ECN called INET, and later BRUT

– Created more speed and price efficiency in order executions

– Divides its markets into national and small cap issues

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Foreign Exchanges

• As a sign of growing importance of international capital markets– Many large U.S. international companies trade

on foreign stock exchanges– Many foreign companies trade on the NYSE

• The following slide presents lists members of the World Federation of Exchanges most of which are flourishing with growing volume

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World Federation of Exchanges Members (2006)

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Other Financial Exchanges

• Future exchanges have grown• Corporations use futures markets to hedge

against changing:– Interest rates– Commodity prices– Weather or inadequate rain etc.

• CME Group is one of the largest future exchanges

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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 reasonably efficient markets– The most efficient is that for U.S. government

securities– Corporate bond markets are reasonable to a

degree

• Common stocks market has been supported through decimalization, ECNs, and online brokerages

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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

• Semistrong 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– The Securities Act of 1933– The Securities Exchange Act of 1934– The Securities Acts Amendments of 1975

• Primary purpose:– To protect unwary investors from fraud and

manipulation– To make markets more competitive and transparent

• The Sarbanes-Oxley Act of 2002 also provides additional protection for investors

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Securities Act of 1933

• Deals with regulation of new issues of securities• 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 date of sale and must include detailed corporate information

– The SEC does not certify the fairness of a price, but only that 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

• Deals with trading in the securities markets• 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 quantity of credit

– Manipulation of securities by conspiracies among investors was prohibited

– SEC given control over the proxy procedures of corporations– SEC required that certain reports be filled periodically, for its

regulation of companies traded on the markets– All security exchanges to register with the SEC

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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,

also 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 monitoring a very serious business