The Securities Market
Securities markets are financial marketplaces where stocks and bonds are issued and traded. They serve two important functions: they help businesses obtain long-term funding for capital needs, and they give investors a place to buy and sell securities.
This chapter examines how securities markets operate, how firms raise money by issuing stocks and bonds, and how individual investors can evaluate investment choices.
Primary and Secondary Markets
Securities markets are divided into primary markets and secondary markets.
- Primary markets handle the sale of new securities. When a corporation sells stock to the public for the first time, the sale is called an Initial Public Offering (IPO).
- Secondary markets handle the trading of securities among investors after those securities have already been issued. In these transactions, the proceeds generally go to the investor who sells the security rather than to the company that originally issued it.
Investment Bankers and Institutional Investors
Investment bankers are specialists who assist in the issue and sale of new securities. They can help companies obtain regulatory approval, arrange underwriting, and sell securities to investors.
Institutional investors are large organizations such as pension funds and mutual funds that invest their own funds or the funds of others. Because of the size of their investments, institutional investors can be important participants in securities markets.
Stock Exchanges and Electronic Markets
A stock exchange is an organization whose members can buy and sell securities on behalf of companies and individual investors. The chapter also distinguishes the over-the-counter (OTC) market, which provides a way to trade securities that are not listed on national exchanges.
NASDAQ is described in the chapter as an electronic network linking securities dealers so they can exchange securities electronically. Modern securities trading is heavily electronic, even when an exchange also has a traditional trading-floor identity.
The Securities and Exchange Commission
The Securities and Exchange Commission (SEC) is the federal agency responsible for regulating securities markets. The chapter connects the SEC with the Securities Exchange Act of 1934 and with efforts to improve fairness and disclosure in securities markets.
A prospectus is a condensed presentation of economic and financial information that a company must file before issuing securities and provide to prospective investors. The chapter also emphasizes that securities laws prohibit illegal insider trading based on important nonpublic information.
Stocks: Ownership in a Corporation
Stocks represent shares of ownership in a company. A stock certificate is evidence of stock ownership. Stockholders are owners rather than creditors, so the company does not repay their investment in the same way it repays a loan.
Dividends are portions of a firm's profits that may be distributed to stockholders as cash or additional shares. A corporation is not legally required to pay dividends simply because it has issued stock.
Advantages and Disadvantages of Issuing Stock
Advantages
- Stockholders are owners, so the firm does not have to repay their investment as debt.
- There is no legal obligation to pay dividends.
- Issuing stock can strengthen the balance sheet because it does not create additional debt.
Disadvantages
- Stockholders may have voting rights and can influence the board of directors.
- Issuing additional shares can change the control of the company.
- Dividends are paid from after-tax profits and are not tax-deductible.
- Management may feel pressure to satisfy shareholder expectations.
Common and Preferred Stock
Common stock is the most basic form of corporate stock. Common stockholders generally have the right to vote for the board of directors and may share in profits when dividends are approved.
Preferred stock gives owners preference in receiving dividends before common stock dividends are distributed. Preferred stock may also have special features such as being callable, convertible, or cumulative.
Bonds: Borrowing from Investors
A bond is a certificate indicating that an investor has lent money to a corporation or government. Unlike stockholders, bondholders are creditors rather than owners and do not vote on corporate matters.
The principal, also called face value or par value, is the amount the issuer promises to repay. Interest is the payment the issuer makes to compensate bondholders for the use of their money.
Advantages and Disadvantages of Issuing Bonds
Advantages
- Bondholders are creditors rather than owners, so issuing bonds does not give them voting control.
- Bond interest is generally treated as a tax-deductible business expense.
- Bonds are a temporary source of financing and are repaid at maturity.
- Some bonds can be repaid before maturity if they contain a call provision.
Disadvantages
- Bonds increase the firm's debt.
- Interest payments are legal obligations.
- Failure to make required payments can lead to legal action.
- The face value of the bond must be repaid at maturity.
Bond Ratings and Classes
Bond ratings help investors evaluate default risk. Higher ratings generally indicate lower expected default risk, while lower ratings indicate greater risk. Bonds rated in the speculative range may be referred to as junk bonds.
The chapter distinguishes two broad classes of corporate bonds:
- Secured bonds are backed by collateral such as land or equipment.
- Unsecured bonds, also called debenture bonds, are not backed by specific collateral.
How Investors Buy Securities
A stockbroker is a registered representative who acts as a market intermediary and buys and sells securities for clients. Investors can also use online brokerage services to buy and sell stocks and bonds.
Before selecting an investment, the chapter recommends considering five important criteria:
- Investment risk
- Yield
- Duration
- Liquidity
- Tax consequences
Investment Objectives and Diversification
Investors should establish objectives before choosing securities. Possible objectives include long-term growth, income, maintaining available cash, and protection from inflation.
Diversification means purchasing several different types of investments in order to spread risk. Rather than placing all funds into one company, industry, or asset class, a diversified investor may combine stocks, bonds, mutual funds, international investments, and cash or savings.
Bulls and Bears
A bull is an investor who believes stock prices are likely to rise. A bear is an investor who expects stock prices to decline. These terms describe expectations about the direction of the securities market rather than particular investment products.
Ways Investors May Classify Stocks
Investors may choose stocks according to different objectives and company characteristics. The chapter identifies examples such as:
- Blue-chip stocks
- Growth stocks
- Income stocks
- Penny stocks
A capital gain is the positive difference between the price paid for a stock and the price received when the stock is later sold.
Stock Splits
A stock split gives stockholders two or more shares for each share they previously owned. A split changes the number of shares and the price per share, but it does not immediately change the investor's total ownership value or the firm's ownership structure.
Companies may split stock to reduce the price per share and make the shares appear more accessible to investors.
Buying Stock on Margin
Buying on margin means borrowing part of the purchase price of a stock from a brokerage firm. Margin increases purchasing power, but it also increases risk.
If the value of the securities falls, an investor may receive a margin call requiring additional cash or securities. The brokerage firm may also sell securities to repay the loan. Because borrowed money is involved, an investor can lose more than the amount originally contributed.
Stock Quotations and Investment Research
Stock quotations provide information about securities prices, trading activity, and other market data. The PowerPoint also emphasizes using multiple financial news and research sources when evaluating investments rather than relying on a single source or an unverified tip.
Understanding Bond Prices and Yields
A bond's par value is the amount the investor receives if the bond is held to maturity. The market price is the price investors currently place on the bond. A bond selling below par sells at a discount; a bond selling above par sells at a premium.
The coupon rate is the stated interest rate in the bond agreement. For example, a $1,000 bond with a 9 percent coupon rate pays $90 in annual coupon interest.
The current yield compares annual coupon interest with the bond's current market price:
Current Yield = Annual Coupon Interest ÷ Current Market Price
The yield to maturity (YTM) considers the interest payments and the difference between the price paid for the bond and the amount received at maturity.
Premiums, Discounts, and Interest-Rate Risk
The chapter provides useful rules for understanding bond yields:
- If a bond sells at a premium: Coupon Rate > Current Yield > YTM.
- If a bond sells at a discount: Coupon Rate < Current Yield < YTM.
- If a bond sells at par: Coupon Rate = Current Yield = YTM.
Bond market prices also respond to changing interest rates. In general, when market interest rates rise, existing bond prices fall; when market interest rates fall, existing bond prices rise. This creates interest-rate risk for investors who may sell a bond before maturity.
Mutual Funds and Exchange-Traded Funds
A mutual fund is an organization that pools investors' money, purchases stocks and bonds according to the fund's purpose, and sells shares in that investment portfolio to the public.
An exchange-traded fund (ETF) is a collection of securities that trades on a securities exchange more like an individual stock. Mutual funds and ETFs can give investors access to diversified portfolios without requiring them to purchase each individual security themselves.
The price per share of a mutual fund is commonly referred to as its net asset value (NAV).
Stock Market Indicators
Market indexes help investors follow broad changes in stock prices. The Dow Jones Industrial Average is an index based on 30 selected companies. The chapter also identifies the S&P 500 as a broader measure of market performance.
These indicators do not show what every individual stock is doing, but they provide a convenient summary of general market movement.
Market Turmoil and Program Trading
The securities markets have experienced periods of sharp increases and declines. The PowerPoint uses historical examples such as the 1929 crash, the 1987 decline, the dot-com downturn, the financial crisis beginning in 2008, and the major market declines associated with COVID-19 in 2020.
Program trading uses computer instructions to trigger trades when specified market conditions occur. Following major market disruptions, exchanges developed mechanisms such as trading curbs and circuit breakers to slow or temporarily halt trading during extreme market movements.
Putting Chapter 19 Together
Securities markets connect businesses that need long-term financing with investors who want opportunities for income, growth, and diversification. Companies can raise equity by issuing stock or raise debt by issuing bonds. Investors must then consider risk, return, liquidity, time horizon, diversification, taxes, and market conditions when deciding which securities fit their objectives.
The central lesson is that securities offer opportunities, but they also involve risk. Sound investing begins with clear objectives, careful research, diversification, and an understanding of how stocks, bonds, funds, and securities markets work.