Capital Markets

1. Capital Markets 14

2. 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.

3. 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.

4. 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.

5. 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.

6. 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.

7. 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.

8. 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.

9. 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.

10. 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.

11. 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.

12. 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.

13. Depreciation and Retained Earnings for Internal Financing

14. Flow of Funds through the Economy

15. 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.

16. Suppliers of Funds to Credit Markets (Year-end 2004)

17. 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.

18. 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.

19. 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

20. 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.

21. 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.

22. 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.

23. 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.

24. 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.

25. 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.

26. 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.

27. 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.

28. Foreign Exchanges – Global Stock Markets

29. 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.

30. 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.

31. 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.

32. 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.

33. 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.

34. 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.

35. 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.

36. 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.

37. 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.

38. 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