Chapter 14

Capital Markets

By

Md. Shahedur Rahaman Chowdhury

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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 various government bonds and corporate common stock

• The markets are influenced by variables like:– Interest rates– Investor confidence– Economic growth– Global crises, etc.

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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

• Have played an important role over the last decade due to various factors:– The Soviet Union disbanded in 1991– China has moved along a capitalistic course for several

decades– Central and Eastern European countries “privatized”

many of their state industries during the 1990s– Continuing development of international “free trade”

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International Capital Markets (cont’d)

– 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– Euro still considered second most important international

currency– Value of “euro cash” in circulation now exceeds value of

dollars in circulation worldwide

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2006 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 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 3.7% of foreign investment 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)• Farm Credit Banks• Student Loan Marketing Association

• State and local securities– Municipal securities or tax-exempt offerings– Investors - 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

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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

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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• The dividends paid• The resultant retained earnings• The depreciation tax shield firms avail

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Internally Generated Funds: Depreciation and Retained Earnings

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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

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Flow of Funds Through the Economy

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Suppliers of Funds to Credit Markets (September 2007)

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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 – not

original offering– Provides liquidity to investors and keeps the

prices competitive

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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 member exchanges into 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

• Historically, exchanges have central trading location, securities bought & sold in auction market by brokers acting as agents for buyers & sellers

• Each stock trades at a physical location, trading post, on exchange’s trading floor

• Brokers are registered members of exchanges

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Regional Exchanges

• Began by trading securities of local firms• Also listed on national exchanges but continued to

be traded on regionals• Trade primarily done in nationally known

companies• Trading in same companies common between

NYSE and regionals like Chicago Stock Exchange — dual trading

• More than 90 percent of companies traded on the Chicago Stock Exchange also listed on the NYSE - 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

• NYSE - biggest exchange, generates most dollar volume in large companies, listing requirements are most restrictive

• NASDAQ has less restrictive listing requirements than NYSE

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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 act as broker-dealer or an exchange– 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 meet to buy and sell securities through a bid

and ask market, called an auction market• They are registered members of the exchange

– In addition to acquiring Archipelago, NYSE merged with Euronext

– NYSE acquired American Stock Exchange in 2008

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The NASDAQ Market

• NASDAQ:– Was once considered an OTC market– All trades done electronically– Second largest exchange in the U.S.– Currently owns 30% of London Stock Exchange– 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 capitalization markets

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World Federation of Exchanges Members (2006)

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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, etc.

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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

Q

End

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Q & A

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Thank You.

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