Capital Markets (Chapter 14)

1. Capital Markets(Chapter 14) • Financial Markets and Institutions • Sources of Funds for Corporations • Security Exchanges and OTC • Market Indices • Efficient Market Hypothesis • Regulation of Security Markets

2. FINANCIAL MARKETS • Money Markets (Short-Term) • Treasury Bills • Negotiable CDs • Bankers’ Acceptances • Commercial Paper • Capital Markets (Long-Term) • Common Stock • Bonds • Preferred Stock • Convertible Securities

3. Financial Markets (Continued) • Primary Markets • New Issues • Secondary Markets • Outstanding Issues • Spot Markets • Price today - Delivery today • Futures Markets • Price today - Delivery in the future.

4. DERIVATIVES MARKETS • A derivative is any security whose value is derived from the price of some other underlying security. • Some examples of derivatives • Put and call options • Futures contracts • Zero coupon bonds • Can be used to increase risk (e.g., options) • Can also be rather low in risk (e.g., zero coupon government bonds)

5. FINANCIAL INSTITUTIONS • Many Different Financial Intermediaries • Investment Bankers • Commercial Banks • Savings & Loan Associations • Credit Unions • Pension Funds • Life Insurance Companies • Mutual Funds • Financial Service Corporations • Offers a diversified list of financial services (banking, insurance, etc. - e.g., Citigroup, Prudential)

6. Sources of Funds for Corporations • External Sources:(About 60% of total sources during the 1990s) • Bonds – Largest source of external financing. • Preferred Stock – Least used external source compared to bonds and common stock. • Common Stock • Internal Sources: (About 40% of total sources during the 1990s) • Retained Earnings – Increases in highly profitable years. • Cash Flow from Depreciation – Increases as a percentage of internal sources generated during years of low profitability.

7. SECURITIES MARKETS • New York Stock Exchange (NYSE) • American Stock Exchange (AMEX) • Regional Exchanges • Foreign Exchanges • Over-The-Counter Markets

8. New York Stock Exchange (NYSE) • Largest and most important of all exchanges. • Number of members (seats) - exceeds 1,300 • Commission Brokers - About half of the members - (Buy and sell orders placed by the public). Merrill Lynch is an example. • Specialists – A substantial number of the members (each stock is assigned to a specialist). • In addition to stock, there are hundreds of bonds listed on the NYSE. • Stringent listing requirements in terms of earnings, assets, number of shares outstanding, etc.

9. AMERICAN STOCK EXCHANGE (AMEX) • The “other” national exchange. • Dollar volume of trading is only a small percentage of that on the NYSE. • Listing requirements are less stringent than the NYSE

10. REGIONAL EXCHANGES • Chicago, Pacific, Philadelphia, Boston • About 90% of the stocks are dually listed on the NYSE • Composite Transactions • In the Wall Street Journal, dually listed stocks on the regional exchanges are reported on the NYSE or AMEX.

11. OVER-THE-COUNTER MARKETS(Unlisted Securities) • Several thousand stocks are actively traded. • Supervised by the NASD (National Association of Securities Dealers) • NASDAQ (Automated Quotations) • Biggest Companies - National Market List • Others - Supplemental Lists • Merged with the AMEX in 1998 (NASDAQ – Amex Market Group) • Referred to as a screen-based market (no physical location – trading via computers.)

12. OVER-THE-COUNTER MARKETS(Continued) • Most bonds are traded OTC. In fact, U.S. Govt issues make OTC the largest securities market of all in total dollars. NYSE, however, is the largest for stocks. • Online Trading Systems • Electronic Communications Networks (ECNs) • Instinet is the largest.

13. MARKET INDICES • Dow Jones Industrial Average • 30 large widely held companies • S&P 500 • 500 large-cap companies • NASDAQ • More than 5000 companies • Many high tech stocks • Wilshire 5000 • Includes more than 7000 U.S. equity securities

14. MARKET INDICES(Continued) • Russell 2000 • A widely used “small stock” index. • Numerous International Indices • Many “specialized” indices • Utilities • Banks • Etc.

15. Equilibrium and Disequilibrium in the Stock Market Expected Return Appropriate Risk/Return Tradeoff Underpriced Overpriced In Equilibrium Risk

16. Efficient Market Hypothesis • The Hypothesis in General: Securities are always in a state of equilibrium. They are neither undervalued nor overvalued. • Weak Form of the Hypothesis: Security prices fully reflect past market data (e.g., prices, volume, odd lots, etc.) • Semistrong Form of the Hypothesis: Security prices fully reflect all publicly available information. • Strong Form of the Hypothesis: Security prices fully reflect all information (public and insider). • Empirical Evidence: With some exceptions, markets tend to be fairly efficient in the weak and semistrong sense, but definitely inefficient in the strong sense.

17. Regulation of Security Markets • Securities Act of 1933 • Provide full disclosure of information regarding new issues of securities (primary market) • Securities Exchange Act of 1934 • Created the Securities and Exchange Commission • Regulates trading in the securities markets (secondary market) • Controls insider trading • Securities Acts Amendments of 1975 • Develop a central market place (national securities market)