978-1259277160 Chapter 14 Lecture Note

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Capital Markets

Author’s Overview

This chapter on capital markets is basic to the understanding of the flow of funds through the

economy and the relationship of capital markets to corporate bonds, stocks, and preferred stock.

Students often view bonds as uninteresting and unimportant securities, so special emphasis has

been placed on them to show their dominant positions as a source of external capital. The

instructor may wish to emphasize that corporations operate in competitive capital markets with

government units.

Although much of this chapter is descriptive, it reinforces the concepts of risk and return and

wealth maximization by describing the markets that create wealth and either reward or penalize

the investor for assuming risk. The allocation of capital in a capitalistic economy is crucial to

the understanding of our economic system, and the instructor will wish to point out the role of

the securities markets in this allocation process.

Also, the role of international capital markets should be stressed. The collapse of Asian

currencies during 1997 and 1998 and the Russian government debt default are examples of how

the international markets are linked as well as the collapse of Argentina in 2002. The Financial

Crisis that began in 2007 and continued into 2013 affected economies worldwide. Housing

prices fell in the U.S. and Europe, and unemployment rose to very high levels. Commercial

banks had to be recapitalized, and many European countries were in economic trouble and had

to be supported by the European Union and the International Monetary Fund. The Dow Jones

Industrial average fell by more than 50 percent but recovered all of its losses by August of

2013. Markets and currencies were affected by the turmoil in the Middle East. There is much to

discuss about how international markets are linked.

Markets are now dominated by electronic communication networks (ECNs) rather than

traditional floor trading. Changes in our market structure will continue to be motivated by

competition and technology and striving for low-cost leadership and transaction speed between

competitive markets.

We have taken the opportunity to include a section on market efficiency. There is a discussion

of efficiency in the more traditional sense of liquidity, stability, and continuity, and this is

linked with the concept of the efficient markets hypothesis in the weak, semi-strong and strong

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forms. The important matter of securities market regulation is also covered in the chapter.

Chapter Concepts

LO1. The capital markets, both domestic and foreign, are made up of securities that have a

life of one year or longer (often much longer).

LO2. 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.

LO3. The United States is a three-sector economy in which households, corporations, and

governmental units allocate funds among themselves.

LO4. Securities markets consist of physical and electronic markets.

LO5. Security markets are considered to be efficient when prices adjust rapidly to new

information.

LO6. Security legislation is intended to protect investors against fraud, manipulation, and

illegal insider trading.

Annotated Outline and Strategy

Perspective 14-1: Though this is a descriptive chapter, the institutional relationships are

important to students who have had limited experience with capital markets.

I. Introduction

A. Money market: Short-term market for securities maturing in a year or less.

B. Capital market: Long-term market for securities with maturities greater than one

year.

C. More often, companies search all capital markets including world markets for

capital at the lowest cost.

II. International Capital Markets

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A. Competition for low cost funding is worldwide.

B. Important developments in international capital markets include NAFTA (1994);

creation of the European Monetary Union and European Central Bank (1999);

the growth of the World Trade Organization (WTO) with the admission of

Russia in 2012 as one of the 160 member countries; and the rise of China as the

world’s second largest economic power.

C. The economic development of emerging markets has increased the size of these

markets as a percentage of the world’s publicly traded capital.

D. Money flows between countries include U.S. investment abroad and foreign

investments in the U.S.

PPT Leading World Equity Markets: (Figure 14-1)

III. Competition for Funds in the U.S. Capital Market

Perspective 14-2: Explain that finding financial capital is a competitive game. Companies

compete among themselves, the federal government, and state governments.

A. Government Securities

1. The U.S. Treasury borrows both long-term and short-term debts to cover

budget deficits. When budget surpluses exist, as they did in 1998, the

government reduces its net borrowing.

2. 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.

3. 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.

4. 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.

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B. Corporate Securities

1. 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.

2. Though very similar to debt, the lack of the tax deductibility of preferred

stock dividends has constrained the popularity of preferred stock issues.

3. New issues of common stock occur when a company needs to raise more

new capital than can provided by retained earnings.

4. The majority of internally generated funds are not included in reported

earnings. Depreciation tax shields provide a substantial source of

internal funding. The percentage relationship between retained earnings

and depreciation varies over time based on profits and capital spending

patterns, but depreciation is usually a very substantial source of

internally generated funds.

PPT Internally generated funds: Depreciation and retained earnings

(Figure 14-2)

IV. The Supply of Capital Funds

PPT Flow of Funds through the Economy (Figure 14-3)

Finance in Action: The World’s Biggest Exchange: Hatched from an Egg?

This box describes the formulation and evolution of the futures market. What began as a

marketing technique to guarantee prices on eggs and butter has become the largest

exchange in the world (The CME Group) trading over 1.2 quadrillion dollars each year.

A. Business and government have been net demanders of funds and the household

sector the major supplier of funds in our three-sector economy.

B. Household sector savings are usually channeled to the demanders of funds

through financial institutions such as commercial banks, savings and loans,

mutual savings banks, and credit unions. See Figure 14-2 for the major suppliers

of U.S. credit market funds.

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C. Other intermediaries in the flow-of-funds process include mutual funds, pension

plans, and insurance firms.

D. The Role of the Security Markets

1. Securities markets aid the allocation of capital between the sectors of the

economy and the financial intermediaries.

2. 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.

Perspective 14-3: Explain that financial markets are continually changing over time as

technology advances.

V. The Organization of the Security Markets

A. In addition to the traditional national and regional securities exchanges which

provide a centrally located auction market for buyers and sellers, the

globalization of markets and investments is fueling the need for electronic

communication networks (ECNs) to improve efficiency and lower trading costs.

B. Traditional Organized Exhanges

1. The primary U.S. exchanges are the New York Stock Exchange (NYSE)

and NASDAQ.

2. Regional Exchanges of lesser importance include the Chicago, Boston,

Cincinnati, and Philadelphia exchanges. Ninety percent of the volume on

these regional Exchanges is from dually traded stocks on the NYSE.

3. For a firm to sell its stock on one of these exchanges, it must meet the

listing requirements of that exchange.

C. Electronic Communications Networks (ECNs)

1. Electronic trading systems that use computers to automatically match

buy and sell orders.

2. ECNs lower the cost of trading by creating better execution, more price

transparency and by employing “after hours trading.” Most ECNs have

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been granted “Exchange” status by the Securities and Exchange

Commission.

3. Once thought to be in competition with the traditional exchanges, many

are now owned by the established exchanges.

D. New York Stock Exchange (NYSE)

1. The NYSE is the largest and most important global stock exchange.

2. 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.

See the web exercise at the end of the chapter.

3. Beginning in August 2000, U.S. security markets started trading in

decimals rather than fractions. Market-makers generally prefer the wider

spreads guaranteed with fractions, but investors appear to have benefited

from decimalization.

4. In 2005, the NYSE purchased Archipelago, an electronic communication

network (ECN) that competed with traditional floor trading. It was

argued that ECNs will eventually dominate floor trading due to greater

efficiency and in fact they have.

5. In 2006, the NYSE merged with Euronext in order to expand its

international scope.

6. In 2012 the Intercontinental Exchange (ICE) agreed to buy the

NYSE-Euronext Exchange, and as of July 2013 received permission from

the European Union and the U.S. and now owns the NYSE.

E. The NASDAQ Market – NASDAQ is a purely electronic market with no central

location.

1. The NASDAQ market is a national network of dealers.

2. 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 NASDAQ market includes the National Market, which includes

larger firms of national interest, and the Small-Cap Market for smaller

companies, many of which are of regional interest.

F. Numerous stock exchanges operate outside the United States. These exchanges

trade stocks in of companies in their own domestic market, as well as stocks of

large U.S. companies. Many foreign stocks are also traded in U.S. markets.

G. The National Association of Securities Dealers (NASD) regulates brokers and

dealers in all U.S. markets. The NASD writes rules governing broker and dealer

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behavior and polices its members.

H. Foreign Exchanges

1. These are shown in Table 14-1.

I. Other Financial Exchanges

1. Consist mostly of futures, commodity and options exchanges.

VI. 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.

Finance in Action: Dark Pools – Market Efficiency or a Question of Ethics.

This box discusses a dark pool where trading occurs between institutional investors usually in

blocks of 10,000 to 100,000 shares. Dark pools work much like ECNs but the trades do not

show up on the consolidated tape for other market makers to observe. Theses are not public

exchanges and so critics complain they lack transparency or price discovery. Hedge funds and

mutual fund managers use these dark pools to hide their trades from competitors.

D. The Efficient Market Hypothesis has 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.

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

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movement is toward greater efficiency.

VII. Regulation of the Security Markets

A. 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 Dealers (NASD).

B. Major laws govern the sale and trading of securities as well as reporting

standards.

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.

5. In 2010 Congress passed the Dodd-Frank: Wall Street Reform and

Consumer Protection Act. This is the most comprehensive financial

reform legislation since the Great Depression. This act impacts banks,

hedge funds, derivatives, credit cards, mortgages, and other financial

products. It is an extremely complex law, and as of late 2015 it had many

rules that were not yet defined and put into action.

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