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The Function of Securities Markets
Securities Markets:
Definition: Financial marketplaces for stocks and bonds.
Primary Functions:
Assist businesses in finding long-term funding to finance capital needs.
Provide private investors a place to buy and sell securities such as stocks and bonds.
Types of Securities Markets
Primary Markets:
Definition: Handle the sale of new securities.
Secondary Markets:
Definition: Handle the trading of securities between investors, with the proceeds of the sale going to the seller.
Initial Public Offering (IPO):
Definition: The first public offering of a corporation’s stock.
The Role of Investment Bankers
Investment Bankers:
Definition: Specialists who assist in the issue and sale of new securities.
Institutional Investors:
Definition: Large organizations, such as pension funds or mutual funds, that invest their own funds or the funds of others.
Stock Exchanges
Stock Exchange:
Definition: An organization whose members can buy and sell (exchange) securities for companies and investors.
Over-the-Counter (OTC) Market:
Definition: Exchange that provides a means to trade stocks not listed on the national exchanges.
NASDAQ:
Definition: A nationwide electronic system that communicates over-the-counter trades to brokers.
NYSE Overview
New York Stock Exchange (NYSE):
Historical Context: Once the largest floor-based exchange in the world; now operates primarily on electronic networks.
Observation: The exchange floor appears deserted compared to past busy days.
Securities Regulations
Securities and Exchange Commission (SEC):
Definition: A federal agency responsible for regulating various exchanges.
Creation: Founded in 1934 through the Securities and Exchange Act.
Purpose: Established guidelines to prevent insider trading.
Prospectus:
Definition: A condensed version of economic and financial information that a company must file with the SEC before issuing stock; must be sent to prospective investors.
Insider Trading
Definition:
Buying or selling a stock on the basis of company information not available to the investing public.
Hypothetical Examples:
Provided to illustrate legal vs. illegal insider trading.
Top Stock Exchanges
List of Key Stock Exchanges:
New York Stock Exchange
NASDAQ
Euronext
Shanghai Stock Exchange
Japan Exchange Group
Shenzhen Stock Exchange
Hong Kong Exchanges
National Stock Exchange of India
London Stock Exchange Group
Foreign Stock Exchanges
Definition: Investors can buy securities from companies worldwide, and foreign investors can invest in U.S. securities.
How Businesses Raise Capital by Selling Stock
Stocks:
Definition: Shares of ownership in a company.
Stock Certificate:
Evidence of stock ownership, specifying the company name, number of shares, and type of stock issued.
Dividends:
Definition: Part of a firm’s profits distributed to stockholders as cash payments or additional shares.
Advantages of Issuing Stock
Key Advantages:
Stockholders are owners and are not obligated to be repaid.
No legal obligation to pay dividends.
Improves a firm’s balance sheet as stock does not create debt.
Disadvantages of Issuing Stock
Key Disadvantages:
Stockholders vote for the board of directors, possibly altering control of the firm.
Dividends are paid from after-tax profits and are not tax-deductible.
Need to keep stockholders happy can influence managerial decisions.
Common and Preferred Stocks
Common Stock:
The basic form of ownership in a firm, conferring voting rights and profit-sharing through dividends.
Rights of holders include:
Vote on board of directors and critical company issues.
Share in profits through dividends (if declared).
Purchase new common stock shares before others.
Preferred Stock:
Grants preference in dividends and claims on assets over common stockholders.
Characteristics:
No voting rights.
Can be callable, convertible, or cumulative.
Initial Public Offerings (IPOs)
Example:
Bausch + Lomb raised approximately $630 million from its IPO.
Importance: Illustrates the appeal of stock issuance for financing growth.
How Businesses Raise Capital by Issuing Bonds
Bond Definition:
A corporate certificate indicating that a person has lent money to a firm.
Key Terms:
Principal: The face value of the bond.
Maturity Date: The date by which the issuer must repay the principal to the bondholder.
Bond Interest
Interest Payments:
Payment the issuer makes to bondholders for borrowed money, referred to as the coupon rate.
Rates depend on:
Government rates, economic conditions, issuing company reputation, and competitor rates.
Bond Rating Agencies:
Assess the creditworthiness of a corporation’s bond issues (e.g., Moody's, Standard & Poor's, Fitch).
Bond Ratings
Examples of Ratings:
Aaa/AAA: Highest quality, lowest default risk.
C: Lowest grade.
Advantages of Issuing Bonds
Key Advantages:
Bondholders are creditors, not owners, and typically have no voting rights.
Interest on bonds is tax-deductible.
Temporary funding source, eventually repaid.
Callable bonds can be repaid before maturity.
Disadvantages of Issuing Bonds
Key Disadvantages:
Increases debt, potentially affecting market perceptions.
Legal obligation to pay interest; non-payment can lead to legal action.
Face value due at maturity.
Types of Bonds
Unsecured Bonds (Debenture Bonds):
Not backed by specific collateral.
Secured Bonds:
Backed by collateral such as property or assets.
Special Bond Features
Sinking Fund:
Reserve account for retiring part of the bond principal before maturity.
Callable Bonds:
Can be paid off by the issuer before the maturity date.
Convertible Bonds:
Allow bondholders to convert bonds into shares of common stock.
How Investors Buy Securities
Stockbroker:
Registered representative serving as a market intermediary to buy and sell securities.
Responsibilities include placing orders and negotiating prices.
Investing through Online Brokers:
Examples: Charles Schwab, Interactive Brokers, Fidelity.
Offer online trading services, often with low or zero trading fees.
Robo-Advisors:
Automated tools using algorithms to make investment suggestions.
Choosing the Right Investment Strategy
Criteria for Selecting Investment Options:
Investment risk
Yield
Duration
Liquidity
Tax consequences
Five Questions to Ask Before Investing
Is the seller licensed?
Is the investment registered?
How do the risks compare with potential rewards?
Do you understand the investment?
Where can you turn for help?
Average Returns on Investments
Investment Returns:
Stocks: 12.8%
International Stocks: 5.3%
Real Estate: 4.2%
Gold: 8.5%
Bonds: 1.4%
1-Year CDs: 1.7%
Reducing Risk through Diversification
Diversification:
Definition: Buying various investment alternatives to spread the risk.
Benefits include decreased chance of total loss.
Fiduciary:
Act in clients’ best interests; must disclose potential conflicts of interest.
Perceptions of the Market
Market Terminology:
Bulls: Investors who believe prices will rise.
Bears: Investors who expect prices will decline.
Capital Gains: The positive difference between purchase and sale prices of a stock.
Selecting Stocks
Types of Stocks:
Blue-chip stocks
Growth stocks
Income stocks
Penny stocks
Orders for Buying/Selling Stocks:
Market Order: Buy/sell immediately at the best available price.
Limit Order: Buy/sell at a specific price, if available.
Bear Market Examples
Significant Declines in S&P 500:
January 2022 to October 2022: 25% drop
February 2020 to March 2020: 34% drop
2007 to 2009: 56% drop
2000 to 2002: 51% drop
1987 to 1988: 34% drop
1973 to 1974: 49% drop
1968 to 1970: 36% drop
Stock Splits
Definition:
An action giving stockholders multiple shares for each one owned.
Result: No change in ownership structure or immediate investment value.
Buying Stock on Margin
Definition:
Purchasing stocks by borrowing part of the purchase cost.
Margin: Portion of the purchase paid with investors’ own money.
Margin Call: A broker's request for the investor to cover losses.
Understanding Stock Quotations
Key Information in Stock Quotes:
Highest and lowest price for the day
High and low over the past 52 weeks
Dividend paid
Dividend yield
Ratios such as price/earnings ratio
Earnings per share
Number of shares traded
Overview of NASDAQ
NASDAQ Price Wall:
Continuously updates stock prices and trading volumes.
Initially catered to small companies, now competes with NYSE for new listings.
Financial News and Research Sites
Top Sources:
Financial Times
Forbes
The Economist
Fortune Magazine
The Motley Fool
TheStreet
MarketWatch
Investing in Bonds
Maturity:
Selling a bond before maturity may result in selling at a discount or premium.
Bond prices inversely related to interest rates.
Risk Assessment:
Conducted by bond rating organizations; higher risk typically attracts higher interest rates.
High-Risk (Junk) Bonds
Junk Bonds:
High-risk, high-interest bonds with elevated default rates.
Investing in Mutual Funds and ETFs
Mutual Funds:
Organizations that buy stocks/bonds and sell shares to the public.
Pool investors' money and buy according to fund objectives.
Index Funds: Designed to track market indices.
Fees and Charges for Mutual Funds
Load Funds:
Charge a commission to buy or sell shares.
No-Load Funds:
Do not charge commissions.
Open-End Funds:
Accept investments from any interested investor.
Closed-End Funds:
Limit the number of shares; no new investors once the target number is met.
Exchange-Traded Funds (ETFs)
Definition:
Collections of stocks traded on exchanges; function like individual stocks.
Can be bought/sold any time during the trading day.
Comparison of Investment Types
Investment | Degree of Risk | Expected Income | Possible Growth (Capital Gain) |
|---|---|---|---|
Bonds | Low | Secure | Little |
Preferred Stock | Medium | Steady | Little |
Common Stock | High | Variable | Good |
Mutual Funds | Medium | Variable | Good |
ETFs | Medium | Variable | Good |
Who Owns Mutual Funds?
Ownership Data:
2023: 116 million individual U.S. investors
2022: 115.3 million
2021: 102.6 million
2020: 102.5 million
2015: 90.9 million
2010: 93 million
1997: 61.7 million
Varieties of ETFs
Types of ETFs:
Traditional: Include U.S. stocks and investment-grade bonds.
Niche: Focus on specific sectors or classes like healthcare.
Exotic: Invest in volatile sectors, e.g., commodities or emerging technologies.
Test Preparation Questions
TestPrep 1:
What are the two primary purposes of a securities exchange?
What does NASDAQ stand for? How does this exchange work?
What government agency oversees the securities industry? What is a prospectus?
TestPrep 2:
Name at least two advantages and disadvantages of issuing stock as equity financing.
What are the major differences between common stock and preferred stock?
TestPrep 3:
Why are bonds considered a form of debt financing?
What does it mean if a firm issues a 7% debenture bond due in 2030?
Explain the difference between an unsecured and secured bond.
TestPrep 4:
What is the key advantage of investing through online brokers? What is the primary disadvantage?
What are three key factors to remember in establishing your investment strategy?
What is the primary purpose of diversifying investments?
What is the major benefit of investing with a fiduciary?
TestPrep 5:
What is a stock split? Why do companies sometimes split their stocks?
What does buying stock on margin mean?
What are mutual funds and ETFs? How are they different?
What is a load and no-load mutual fund?
What is the key benefit to investors in investing in a mutual fund or ETF?
Test Preparation Questions Answers
What are the two primary purposes of a securities exchange?
Assist businesses in finding long-term funding to finance capital needs.
Provide private investors a place to buy and sell securities such as stocks and bonds.
What does NASDAQ stand for? How does this exchange work?
NASDAQ stands for National Association of Securities Dealers Automated Quotations. It is a nationwide electronic system that communicates over-the-counter trades to brokers. It initially catered to small companies but now competes with NYSE for new listings, continuously updating stock prices and trading volumes on its "Price Wall."
What government agency oversees the securities industry? What is a prospectus?
The Securities and Exchange Commission (SEC) is the federal agency responsible for regulating various exchanges, founded in 1934 through the Securities and Exchange Act to prevent insider trading.
A prospectus is a condensed version of economic and financial information that a company must file with the SEC before issuing stock; it must be sent to prospective investors.
Name at least two advantages and disadvantages of issuing stock as equity financing.
Advantages:
Stockholders are owners and are not obligated to be repaid.
There is no legal obligation to pay dividends.
Issuing stock improves a firm’s balance sheet as stock does not create debt.
Disadvantages:
Stockholders vote for the board of directors, possibly altering control of the firm.
Dividends are paid from after-tax profits and are not tax-deductible.
The need to keep stockholders happy can influence managerial decisions.
What are the major differences between common stock and preferred stock?
Common Stock: The basic form of ownership in a firm, conferring voting rights and profit-sharing through dividends. Holders have the right to vote on the board of directors and critical company issues, share in profits through dividends (if declared), and purchase new common stock shares before others.
Preferred Stock: Grants preference in dividends and claims on assets over common stockholders. Preferred stockholders typically have no voting rights and can be callable, convertible, or cumulative.
Why are bonds considered a form of debt financing?
Bonds are considered a form of debt financing because they represent a loan made by an investor to a borrower (typically a corporation or government). The issuer of the bond has a legal obligation to repay the principal (face value) at a specified maturity date and to make periodic interest payments to the bondholder.
What does it mean if a firm issues a 7% debenture bond due in 2030?
If a firm issues a 7% debenture bond due in 2030, it means the firm has borrowed money from investors. The "7%" is the coupon rate, meaning the firm will pay 7% of the bond's face value as interest to bondholders annually until the maturity date. "Debenture bond" specifies that it is an unsecured bond, not backed by specific collateral. "Due in 2030" means the principal amount borrowed must be repaid to the bondholders by the year 2030.
Explain the difference between an unsecured and secured bond.
Unsecured Bonds (Debenture Bonds): These are not backed by specific collateral. Their repayment relies solely on the general creditworthiness and financial stability of the issuing company.
Secured Bonds: These are backed by specific collateral, such as property or assets. In case of default by the issuer, bondholders have a claim on the specified collateral.
What is the key advantage of investing through online brokers? What is the primary disadvantage?
Key Advantage: Online brokers often offer low or zero trading fees, making investing more accessible and cost-effective for individual investors.
Primary Disadvantage: Online brokers typically provide less personalized advice and support compared to full-service stockbrokers, requiring investors to be more self-reliant in their investment decisions.
What are three key factors to remember in establishing your investment strategy?
Investment risk
Yield
Duration
Liquidity
Tax consequences
(Any three of these are applicable).
What is the primary purpose of diversifying investments?
The primary purpose of diversifying investments is to spread the risk by buying various investment alternatives, thereby decreasing the chance of total loss.
What is the major benefit of investing with a fiduciary?
The major benefit of investing with a fiduciary is that they are legally obligated to act in their clients’ best interests and must disclose any potential conflicts of interest.
What is a stock split? Why do companies sometimes split their stocks?
A stock split is an action by a company that gives stockholders multiple shares for each one owned. For example, in a 2-for-1 split, a stockholder with 100 shares would receive an additional 100 shares, bringing their total to 200. This results in no change in the overall ownership structure or the immediate investment value for the shareholder.
Companies sometimes split their stocks to make shares more affordable and liquid, attracting more investors who might be deterred by a high per-share price. It can also signal confidence in the company's future growth.
What does buying stock on margin mean?
Buying stock on margin means purchasing stocks by borrowing part of the purchase cost from a broker. The portion of the purchase paid with the investor's own money is called the margin. This strategy can amplify returns but also magnify losses.
What are mutual funds and ETFs? How are they different?
Mutual Funds: Organizations that pool investors' money to buy stocks and bonds or other securities, and then sell shares in the fund to the public. They buy and sell according to the fund's stated objectives.
ETFs (Exchange-Traded Funds): Collections of stocks or other assets that are traded on exchanges, functioning like individual stocks. Unlike mutual funds, ETFs can be bought and sold any time during the trading day at market prices, similar to individual stocks.
Difference: Mutual funds are typically priced once a day after the market closes, whereas ETFs are continuously traded throughout the day on stock exchanges, offering more liquidity and intra-day trading flexibility.
What is a load and no-load mutual fund?
Load Funds: Mutual funds that charge a commission or sales fee when investors buy or sell shares.
No-Load Funds: Mutual funds that do not charge commissions for buying or selling shares.
What is the key benefit to investors in investing in a mutual fund or ETF?
The key benefit to investors in a mutual fund or ETF is diversification. By pooling money, these funds invest in a wide range of securities, spreading risk across multiple assets and reducing the impact of poor performance by any single security.