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.
LO2. The primary participants raising funds in domestic capital markets are the U.S. Treasury;
other agencies of the federal, state, and local governments; and corporations.
LO4. Securities markets consist of physical and electronic markets.
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LO5. Security markets are considered to be efficient when prices adjust rapidly to new
information.
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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
II. International Capital Markets
A. Competition for low-cost funding is worldwide.
B. Important developments in international capital markets include NAFTA (1994);
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
PPT Domestic Market Capitalization (Millions of USD) (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
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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
2. Federally sponsored credit agencies, charged with funding the large numbers
3. State and local municipalities are usually required by law to balance their
1. New issues of corporate securities have been predominantly bonds in recent
2. Though very similar to debt, the lack of the tax deductibility of preferred
stock dividends has constrained the popularity of preferred stock issues.
4. The majority of internally generated funds are not included in reported
earnings. Depreciation tax shields provide a substantial source of internal
PPT Internally Generated Funds—Corporate Profits, Dividends, and
Retained Earnings (Figure 14-2 Panels A & B)
IV. The Supply of Capital Funds
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 around $1 quadrillion each year.
PPT Flow of Funds through the Economy (Figure 14-3)
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
D. The role of the security markets
1. Securities markets aid the allocation of capital among 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:
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 that 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 exchanges
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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,
3. For a firm to sell its stock on one of these exchanges, it must meet the listing
2. ECNs lower the cost of trading by creating better execution and more price
3. Once thought to be in competition with the traditional exchanges, many are
now owned by the established exchanges.
D. The 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
3. In 2006, the NYSE merged with Archipelago, an electronic communication
5. In 2012 the IntercontinentalExchange (ICE) agreed to buy the NYSE
Euronext Exchange.
E. The NASDAQ market—NASDAQ is a purely electronic market with no central
location.
1. The NASDAQ market is a national network of dealers.
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buyer or seller of securities.
3. The NASDAQ market includes the National Market, which includes larger
F. Numerous stock exchanges operate outside the United States. These exchanges trade
stocks 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.
1. Foreign exchanges are shown in Table 14-1 on p. 455. World markets by
geographic region are shown in Table 14-2 on page 466.
PPT World Markets by Geographic Region (Table 14-2)
G. Other Financial Exchanges
1. Consist mostly of futures, commodity, and options exchanges.
VI. Market Efficiency
A. Criteria of efficiency
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
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3. Strong form: Prices reflect all public and private information.
F. 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.
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
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 was a response to abuses present in the securities
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
4. The Sarbanes-Oxley Act of 2002 authorized an independent private-sector
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since the Great Depression. This act impacts banks, hedge funds, derivatives,