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;
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
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
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
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
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
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.
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 short-
term or project related. The interest paid on these issues
is exempt from federal income tax.
• 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
• New issues of common stock mushroomed in
the late 1990s as the dot.com craze swept the
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.
Internally generated funds:
Depreciation and retained earnings
Flow of funds
Suppliers of funds to
The Role of the Security Markets
Securities markets aid the allocation of capital
between the sectors of the economy and the
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
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
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
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-the-
counter 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
– 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
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
• 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.
• 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
– 2. Semi-strong form: Prices reflect all public
– 3. Strong form: Prices reflect all public and
• 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
• F. The efficiency of the market is
debatable but most would agree that the
movement is toward greater efficiency.
Regulation of the Security
• Organized securities markets are
regulated by the Securities and Exchange
Commission (SEC) and through self-
regulation. The OTC market is regulated
by the National Association of Securities
Four major laws govern the sale and trading of
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
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.
Global stock markets
Chapter 14 - Outline
Capital Markets vs. Money
Organized Stock Exchanges
Regulation of the Securities