Chapter Capital Markets

14
McGraw-Hill/Irwin Copyright © 2011 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 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 14-31
 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 14-32
 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
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