Capital Markets
The capital markets are made up of securities that have a life of one year or longer (often much longer).
The primary participants raising funds in the capital markets are the U.S. Treasury; other agencies of the federal, state, and local governments; and corporations. The United States is a three-sector economy in which households, corporations, and governmental units allocate funds among themselves.
Securities markets consist of organized exchanges and over-the counter markets.
Security markets are considered to be efficient when prices adjust rapidly to new information.
Security legislation is intended to protect investors against fraud, manipulation, and illegal insider trading.
Money and Capital Markets
Money market: Short-term market for securities maturing in a year or less. Capital market: Long-term market for securities with maturities greater than one year. More often, companies search all capital markets including world markets for capital at the lowest cost.
International Capital Markets
Competition for low cost funding is worldwide. Money flows between countries include U.S. investment abroad and foreign investments in the U.S. See Table 14-1.
Competition for Funds in the U.S. Capital Market
Government Securities
Corporate Securities
Government Securities
Long-term financing of the U.S. is no longer a major issue as the government reached a surplus in 1998 and is projected to continue in this situation for the next decade. Large amounts of long-term capital in the United States have been supplied by foreigners. Foreign investors have been attracted by the relatively high interest rates and political stability available in the United States.
Government Securities
Federally sponsored credit agencies, charged with funding the large numbers of federal programs, issue securities in the capital markets. Agencies such as the Federal National Mortgage Association, the Federal Home Loan Banks, the Farm Credit Banks, has varied widely but has been rising in percentage terms as the U.S. Treasury has no need to finance large deficits by selling U.S. government securities.
State and local municipalities are usually required by law to balance their budgets so their borrowing is often shortterm or project related. The interest paid on these issues is exempt from federal income tax.
Corporate Securities
• New issues of corporate securities have been predominantly bonds in recent years. Bonds are more widely used to raise capital when interest rates are low. • Though very similar to debt, the lack of the tax deductibility of preferred stock dividends has constrained the popularity of preferred stock issues. • New issues of common stock mushroomed in the late 1990s as the dot.com craze swept the IPO market.
The majority of internally generated funds are not included in reported earnings. Funds from operations but not included in reported earnings through the depreciation process provide the primary "source" of internal funding. Although the percentage between retained earnings and depreciation varies based on profits and capital spending patterns.
FIGURE 14-1 Internally generated funds: Depreciation and retained earnings
PPT 14-1
PPT 14-2
FIGURE 14-2 Flow of funds through the economy
PPT 14-3
FIGURE 14-3 Suppliers of funds to credit markets
The Role of the Security Markets
Securities markets aid the allocation of capital between the sectors of the economy and the financial intermediaries. Security markets enable the demanders of capital to issue securities by providing the necessary liquidity for investors in two ways:
a. Corporations are able to sell new issues of securities rapidly at fair competitive prices. b. The markets allow the purchaser of securities to convert the securities to cash with relative ease.
The Organization of the Security Markets
Several national and regional exchanges provide a centrally located auction market for buyers and sellers of securities who use the services of brokers having representatives on the floor of the exchanges.
The primary exchanges are the New York Stock Exchange (NYSE) and the American Stock Exchange (AMEX) which merged with NASDAQ in 1998.
Exchanges of lesser importance include the Midwest, Pacific, Detroit, Boston, Cincinnati, and PBW (Philadelphia, Baltimore, and Washington) exchanges. Ninety percent of the volume on these regional Exchanges is from dually traded stocks on the NYSE.
New York Stock Exchange (NYSE)
The NYSE accounts for approximately 80 percent of the dollar volume of all listed stock traded in the U.S.
To be listed on the NYSE, firms must meet certain minimum requirements pertaining to earnings power, level of assets, market value and number of shares of publicly-held common stock, and the number of shareholders. Beginning in August 2000, U.S. security markets started trading in decimals rather than fractions. The impact of this move by the SEC is still being scrutinized.
The global nature of capital markets is evidenced by the increasing volume and security listings on stock markets around the world. The Tokyo stock exchange is the largest in the world and companies such as Intel, IBM, and McDonald's trade there and on the Frankfurt stock exchange.
Likewise, many foreign companies trade on the NYSE. As more companies trade on exchanges around the world in multiple time zones, the easier it will be for trading to be continuous for 24 hours per day.
• Finance In Action: Long Term Capital Management LP- The Collapse of a Hedge Fund One of the most significant events in the capital markets during the 1990s was the near collapse of Long Term Capital when Russia defaulted on their sovereign debt. To make matters more intense for the academic community, two Nobel Laureates, Myron Scholes and Robert Merton, were involved with the firm. No matter how smart you are, you can make mistakes if you misjudge your risks or take too many risks. Markets are not always rational and when markets become perverse, even smart people can lose money.
• Corporations that do not meet listing requirements or choose not to be listed on the exchanges are traded in the over-thecounter market (OTC).
– 1. The OTC market is a national network of dealers linked by computer display terminals, telephones, and teletypes. – 2. OTC dealers own the securities they trade and seek to earn a profit from their buying and selling, whereas brokers receive a commission as an agent of the buyer or seller of securities.
– 3. The National Association of Securities Dealers (NASD) which supervises the OTC market has divided the OTC market into groups: a. The National Market List is composed of the largest OTC companies. b. The National List includes smaller firms centered in one state or city. c. The Supplemental List includes very small developmental companiesand closely held firms with very few shares available for trading – 4. Due to the lower prices of OTC stocks, the dollar volume of exchange listed stocks is larger. Due to the great amount of debt securities traded OTC, however, the OTC market is the largest market for all security transactions in total dollars.
• Electronic Communications Networks (ECNs) are electronic trading systems that match, buy and sell orders at specified prices. ECNs lower the cost of trading by creating better execution, more price transparency and by allowing “after hours trading.”
Market Efficiency
• A. Criteria of Efficiency
– 1. Rapid adjustment of prices to new information – 2. Continuous market; successive prices are close – 3. Market is capable of absorbing large dollar amounts of securities without destabilizing the price.
• B. The more certain the income stream, the less volatile price movements will be and the more efficient the market will be. • C. Screen based trading systems versus floor trading is becoming a trend that most observers would agree increase market efficiency.
Market Efficiency
• D. The efficiency of the stock market is stated in three forms.
– 1. Weak form: Past price information is unrelated to future prices, trends cannot be predicted and taken advantage of by investors. – 2. Semi-strong form: Prices reflect all public information. – 3. Strong form: Prices reflect all public and private information.
Market Efficiency
• E. A fully efficient market, if it exists, precludes insiders and large institutions from making profits from security transactions in excess of the market in general. • F. The efficiency of the market is debatable but most would agree that the movement is toward greater efficiency.
Regulation of the Security Markets
• Organized securities markets are regulated by the Securities and Exchange Commission (SEC) and through selfregulation. The OTC market is regulated by the National Association of Securities Dealers (NASD).
Four major laws govern the sale and trading of securities.
1. Securities Act of 1933: This act was a response to abuses present
in the securities markets during the Wall Street "Crash" era. Its purpose was to provide full disclosure of all pertinent investment information on new corporate security issues.
2. The Securities Exchange Act of 1934 created the Securities and
Exchange Commission (SEC) and empowered it to regulate the securities markets.
3. The Securities Acts Amendments of 1975 directed the SEC to
supervise the development of a national securities market, prohibited fixed commissions on public transactions, and prohibited financial institutions and insurance companies from buying stock exchange memberships to save commission costs.
4. The Sarbanes-Oxley Act of 2002 authorized an independent
private-sector board to oversee the accounting profession. The act was in response to the many accounting frauds perpetrated on investors by companies such as Enron, World Com, and Tyco.
PPT 14-4
TABLE 14-3 Global stock markets
Chapter 14 - Outline
Capital Markets vs. Money Markets Government Securities Corporate Securities Organized Stock Exchanges Over-the-Counter Market Regulation of the Securities Markets