1. Chapter 14
Capital Markets
By
Md. Shahedur Rahaman
Chowdhury
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2. 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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3. 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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4. 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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5. 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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6. 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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7. 2006 Total Dollar Trading Volume
on Ten Largest Equity Markets
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8. 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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9. 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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10. 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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11. 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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12. 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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13. 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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14. 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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15. Internally Generated Funds:
Depreciation and Retained Earnings
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16. 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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17. Flow of Funds
Through the Economy
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18. Suppliers of Funds to Credit Markets
(September 2007)
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19. 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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20. 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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21. 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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22. 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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23. 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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24. 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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25. 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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26. 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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27. 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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28. 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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29. World Federation
of Exchanges Members (2006)
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30. 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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31. 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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32. 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
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33. End
Q
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34. Q&A
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35. Thank You.
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