SECURITIES MARKETS

The primary function of a securities market—whether or not it has a physical location—is to bring together buyers and sellers of securities.

Securities markets can be classified by whether they are involved in original sales or resales of securities, and by whether or not they involve a physical trading location.

Primary and Secondary Markets

When a security is first issued, it is sold in the primary market. This is the market in which new issues are sold and new capital is raised. So it is the market whose sales directly benefit the issuer of the securities.

There are three ways to raise capital in the primary market. The first is the direct sale, in which the investor purchases, say, stock directly from the issuer. Many venture capital firms invest in small, growing businesses in this way. Also, many corporations sell securities directly to large investors, such as pension funds. By doing so, the issuer can tailor the features of the security (such as maturity) to suit the desires of the investor. This type of selling is referred to as private placement.

A second method is through financial institutions, which are firms that obtain money from investors in return for the institution’s securities and then invest that money. For example, a bank issues bank accounts in return for depositors’ money and then loans that money to a firm.

Besides banks, firm such as mutual funds and pension funds operate as financial institutions.

The third method for primary market transactions operates through investment bankers, who buy the securities issued by corporations and then sell those securities to investors for a higher price. This process of buying shares from the issuer and reselling them to investors is called underwriting. For example, Kraft Foods’ 2001 offering of newly issued common shares was underwritten by a syndicate of 15 underwriters, including Credit Suisse First Boston, Salomon Smith Barney, Deutsche Banc Alexander Brown, and J. P. Morgan. The offering raised $8.7 billion, with Kraft Foods receiving over $8.4 billion:

The three methods of raising capital in the primary market are illustrated in Exhibit 2.1. We discuss the underwriting of securities and the role of investment bankers.

A secondary market is one in which securities are resold among investors. No new capital is raised and the issuer of the security does not benefit directly from the sale. Trading takes place among investors.

Investors who buy and sell securities on the secondary markets may obtain the services of stock brokers, individuals who buy or sell securities for their clients.

We can use the market for college textbooks to illustrate the difference between primary and secondary markets. Suppose one of your instructors decides to use this book, Financial Management and Analysis, as the class text. The instructor notifies the school bookstore, which buys copies of the text from the publisher, John Wiley & Sons, and then puts them up for sale at a somewhat higher price than was paid. You then buy your new copy of this book from the bookstore. The market for new books, in which you, the publisher, and the bookstore have operated as buyer, seller, and intermediary, respectively, is a primary market. 

The bookstore has acted as a sort of textbook “investment banker,” but most of the money invested in the book has gone to the issuer (the publisher).

The bookstore received a profit for performing as an intermediary, a facilitator of the transaction between you and the publisher. The publisher would have been hard put to sell to each member of the class individually.

At the end of the term you may wish to sell your used copy of Financial Management and Analysis. You can sell it directly to a friend who is about to take the course, or you can sell it back to the bookstore for resale to another student. Both these transactions take place in the secondary textbook market, because the publisher (the issuer) is not a party to them.

If a firm can raise new funds only through the primary market, why should financial managers be concerned about the secondary market on which the firm’s securities trade? Because investors may not be interested in buying securities that are not liquid—that they could not sell at a fair price at any time. And the secondary markets provide the liquidity.

For example, suppose IBM wants to issue new common shares to pay for its expansion program; investors would not be willing to buy such shares if they could not expect to sell them on the secondary market should the need arise. IBM counts on the existence of a healthy secondary market to entice investors to buy its new stock issue.

Exchanges and Over-the-Counter Markets

There are two types of secondary securities markets: exchanges and over-the-counter markets. Exchanges are actual places where buyers and sellers (or their representatives) meet to trade securities. Examples are the New York Stock Exchange and the Tokyo Stock Exchange.

Over-the-counter (OTC) markets are arrangements in which investors or their representatives trade securities without sharing a physical location.

For the most part, computer and telephone networks are used for this purpose. These networks are owned and managed by the market’s members. An example is the Nasdaq system, which is operated by the National Association of Securities Dealers (NASD).

Exchanges may be privately owned, as are those in the United States and the United Kingdom. Privately owned exchanges are managed by their owners, or members (typically brokerage firms), who may pay hundreds of thousands of dollars for the privilege of owning a seat (a membership) on the exchange. Private exchanges are self-regulated; that is, they determine the rules and regulations that must be followed by their members, by traders, and by companies whose securities are listed, or accepted for trading, on the exchange.

Exchanges may be owned and operated by banks or banking organizations, as are many European exchanges—those in Luxembourg and Germany, for example. If the exchanges are owned by the banking institutions,these institutions then control both the primary and secondary markets for securities. Both bank-owned and privately owned exchanges are, of course, subject to regulation by the countries in which they are located.

Finally, there are state-controlled exchanges, such as those in France, Belgium, and several Latin American countries. These are generally the most restrictive exchanges and are characterized by stringent listing standards, especially for foreign companies.

There are two types of pricing systems for securities: the pure auction and the dealer market. In the pure auction process, investors wanting to buy or sell shares of stock submit their bids through their brokers, who relay these bids to a centralized location, where bids are matched and the transaction is executed. The party that does the matching is referred to as the specialist. For each stock in the market, there is only one matchmaker, one specialist. In a dealer market, individual dealers buy and sell shares of stock, trading with individuals and other dealers.

We refer to these dealers as market makers since they “make” a market in the stock, providing liquidity to the market. In a dealer market, there may be many dealers for a given stock. Though a market can use either or some combination of the two systems, exchanges tend to use the auction process and over-the-counter markets use a dealer market.

Markets in the United States Governments provide no guarantees regarding securities. However, through legislation and regulation of markets, transactions, and transactors, the U.S. government has attempted to guard against fraudulent practices and manipulative behavior on the part of market participants.

The federal organization charged with the regulation of U.S. financial markets is the Securities and Exchange Commission (SEC). The SEC is a federal agency that administers federal securities laws and was established by the Securities and Exchange Act of 1934. The SEC consists of five members, each appointed by the President of the United States for a term of five years. The SEC carries out the following activities:

■Issues rules that clarify securities laws or trading procedure issues.

■Requires disclosure of specific information.

■Makes public statements on current issues.

■Oversees self-regulation of the securities industry by the stock exchanges and professional groups such as the National Association of Securities Dealers.

Major federal legislation is listed in Exhibit 2.2; in addition, the states have all passed laws that reinforce or extend federal legislation.

Money Markets

Money market securities are not traded in a physical location; rather these securities are traded over-the-counter through banks and dealers that are networked together by telephone and computer lines. These

intermediaries bring together buyers and sellers from around the world. In the United States, most trading is centered around large banks (called money center banks) located in the major financial centers of the country.

Many banks and dealers specialize in specific instruments, such as commercial paper or bankers’ acceptances.

Equity Markets

In the United States, there are two national stock exchanges: (1) the New York Stock Exchange (NYSE), commonly called the “Big Board,” and (2) the American Stock Exchange (AMEX or ASE), also called the “Curb.” National stock exchanges trade stocks of not only U.S. corporations but also non-U.S. corporations. In addition to the national exchanges, there are regional stock exchanges in Boston, Chicago (called the Midwest Exchange), Cincinnati, San Francisco (called the Pacific Coast Exchange), and Philadelphia. Regional exchanges primarily trade stocks from corporations based within their region.

The major OTC market in the United States is Nasdaq (the National Association of Securities Dealers Automated Quotation System), which is owned and operated by the NASD (the National Association of Securities Dealers). The NASD is a securities industry self-regulatory organization (SRO) that operates subject to the oversight of the SEC. Nasdaq is a national market. During 1998, Nasdaq and AMEX merged to form the Nasdaq–AMEX Market Group, Inc., each maintaining their respective markets and forming a large market that takes advantage of both the floor-based market structure and the OTC market structure.

The NYSE is the largest exchange in the United States, with approximately 2,800 companies’ shares listed and dominates other markets in terms of the value and volume of shares traded. The AMEX is the second largest national stock exchange in the United States, with more than 750 issues listed for trading. Nasdaq has a greater number of listed stocks (4,200) but with much less market capitalization than the NYSE.

According to the Securities Act of 1934 (see Exhibit 2.2), there are two categories of traded stocks. The first is exchange traded stocks, which are also called listed stocks. The second is OTC stocks, which are also non-exchange traded stocks and are, thereby, by inference, nonlisted.

However, as we will describe later in this chapter, certain Nasdaq stocks have listing requirements (the Nasdaq National Market and the Nasdaq Small Capitalization Market). Thus, a more useful and practical categorization of these categories is as follows:

■Exchange listed stocks (national and regional exchanges).

■Nasdaq listed OTC stocks.

■Non-Nasdaq OTC stocks.

Stock Exchanges

Stock exchanges are formal organizations, approved and regulated by the Securities and Exchange Commission (SEC). They are made up of members who use the exchange facilities and systems to exchange or trade listed stocks. These exchanges are physical locations where members assemble to trade. Stocks that are traded on an exchange are said to be listed stocks. That is, these stocks are individually approved for trading on the exchange by the exchange. To be listed, a company must apply and satisfy requirements established by the exchange for minimum capitalization, shareholder equity, average closing share price, and other criteria. Even after being listed, exchanges may delist a company’s stock if it no longer meets the exchange requirements.

To have the right to trade securities or make markets on an exchange floor, firms or individuals must become a member of the exchange, which is accomplished by buying a seat on the exchange. The number of seats is fixed by the exchange and the cost of a seat is determined by supply and demand of those who want to sell or buy seats. In early 2001, there were 1,366 seats on the NYSE.

Two kinds of stocks are listed on the five regional stock exchanges: 

(1) stocks of companies that either could not qualify for listing on one of the major national exchanges or could qualify for listing but chose not to list; and (2) stocks that are also listed on one of the major national exchanges. The latter are called dually listed stocks. The motivation of a company for dual listing is that a local brokerage firm that purchases a membership on a regional exchange can trade their listed stocks without having to purchase a considerably more expensive membership on the national stock exchange where the stock is also listed.

Alternatively, a local brokerage firm could use the services of a member of a major national stock exchange to execute an order, but in this case it would have to give up part of its commission.

The regional stock exchanges compete with the NYSE for the execution of smaller trades. Major national brokerage firms have in recent years routed such orders to regional exchanges because of the lower fee they charge for executing orders or better prices, as we will discuss later.

OTC Market

The OTC market is called the market for unlisted stocks. As explained previously, technically while there are listing requirements for exchanges, there are also listing requirements for the Nasdaq National and Small Capitalization OTC markets. Nevertheless, exchange traded stocks are called listed, and stocks traded on the OTC markets are called unlisted.

There are three parts to the OTC market: two under the aegis of NASD (the Nasdaq markets) and a third market for truly unlisted stocks, the non-Nasdaq OTC markets.

The Nasdaq stock market is the flagship market of the NASD. Nasdaq is essentially a telecommunication network that links thousands of geographically dispersed, market-making participants. Nasdaq is an electronicquotation system that provides price quotations to market participants on Nasdaq listed stocks. Although there is no central trading floor, Nasdaq has become an electronic “virtual trading floor.” Some 535 dealers, known as market-makers, representing some of the world’s largest securities firms, provide competing bids to buy and offers to sell Nasdaq stocks to investors.

The Nasdaq stock market has two broad tiers of securities: (1) the Nasdaq National Market and the Small Capitalization Market. Newspapers contain separate sections for these two tiers of stocks (sections labeled the “Nasdaq National Market” and the “Nasdaq Small Capitalization Market”). The Nasdaq National Market is the dominant OTC market in the United States.

Whereas the Nasdaq stock markets are the major parts of the U.S. OTC markets, the vast majority of the OTC issues (about 8,000) do not trade on either of the two Nasdaq systems. There are two types of markets for these stocks. The securities traded on these markets are not listed; that is, they have no listing requirements. The first of these two non-Nasdaq OTC markets is the OTC Bulletin Board (OTCBB), sometimes called simply the Bulletin Board. It includes stocks not traded on NYSE, AMEX, or Nasdaq. The second non-Nasdaq OTC market is the Pink Sheets that are published weekly. In addition, an electronic version of the Pink Sheets is updated daily and disseminated over market data vendor terminals. Pink Sheet securities are often pejoratively called penny stocks.

Alternative Trading Systems

It is not necessary for two parties to a transaction to use an intermediary.

That is, the services of a broker or a dealer are not required to execute a trade. The direct trading of stocks may take place between two customers without the use of a broker. A number of proprietary alternative trading systems (ATSs) are operated by the NASD members or member affiliates. These ATSs are for-profit “broker’s brokers” that match investor orders and report trading activity to the marketplace via Nasdaq or the third market. In a sense, ATSs are similar to exchanges because they are designed to allow two participants to meet directly on the system and are maintained by a third party who also serves a limited regulatory function by imposing requirements on each subscriber.

Broadly, there are two types of ATSs: electronic communications networks and crossing networks. Electronic communications networks (ECNs) are privately owned broker-dealers that operate as market participants within the Nasdaq system. They display quotes that reflect actual orders and provide institutions and Nasdaq market-makers with an anonymous way to enter orders. Instinet was the first ECN. Crossing networks are systems developed to allow institutional investors to cross trade—that is, match buyers and sellers directly—typically via computer.

These networks are batch processes that aggregate orders for execution at prespecified times.

Stock Market Indicators

Stock market indicators have come to perform a variety of functions, from serving as benchmarks for evaluating the performance of professional investors to answering the question “How did the market do today?” Thus, stock market indicators (indexes or averages) have become a part of everyday life.

The most commonly quoted stock market indicator is the Dow Jones Industrial Average (DJIA). Other stock market indicators cited in the financial press are the Standard & Poor’s 500 Composite (S&P 500), the New York Stock Exchange Composite Index (NYSE Composite), the Nasdaq Composite Index, and the Value Line Composite Average (VLCA). Other stock market indicators include the Wilshire stock indexes and the Russell stock indexes, which are followed primarily by institutional money managers.

In general, market indexes rise and fall in fairly similar patterns.

Although the correlation is high, the indexes do not move in exactly the same ways at all times. The differences in movement reflect the different ways in which the indexes are constructed. Three factors enter into that construction: the universe of stocks represented by the sample underlying the index, the relative weights assigned to the stocks included in the index, and the method of averaging across all the stocks.

Some indexes represent only stocks listed on an exchange. Examples are DJIA and the NYSE Composite, which represent only stocks listed on the Big Board. By contrast, the Nasdaq Composite Index includes only stocks traded over the counter. A favorite of professionals is the S&P 500 because it contains both NYSE-listed and OTC-traded shares.

Each index relies on a sample of stocks from its universe, and that sample may be small or quite large. The DJIA uses only 30 of the largest corporations, while the NYSE Composite includes every one of the NYSE listed shares. The Nasdaq Composite Index also includes all shares in its universe, while the S&P 500 has a sample that contains only 500 of the more than 8,000 shares in the universe it represents.

The stocks included in a stock market indicator must be combined in certain proportions, and each stock must be given a weight. The three main approaches to weighting are these: (1) weighting by the market capitalization of the stock’s company, which is the value of the number of shares times price per share; (2) weighting by the price of the stock; and (3) equal weighting for each stock, regardless of its price or its firm’s market value. With the exception of the Dow Jones averages (such as the DJIA) and the VLCA, all of the most widely used indices are market-value weighted. The DJIA is a price-weighted average, and the VLCA is an equally weighted index.

Stock market indicators can be classified into three groups: (1) those produced by stock exchanges based on all stocks traded on the exchanges; (2) those produced by organizations that subjectively select the stocks to be included in indices; and (3) those where stock selection is based on an objective measure, such as the market capitalization of the company. The first group includes the New York Stock Exchange Composite Index, which reflects the market value of all stocks traded on the exchange. Although it is not an exchange, the Nasdaq Composite Index falls into this category because the index represents all stocks tracked by the Nasdaq system.

The three most popular stock market indicators in the second group are the Dow Jones Industrial Average, the Standard & Poor’s 500, and the Value Line Composite Average. The DJIA is constructed from 30 of the largest blue-chip industrial companies. The companies included in the average are those selected by Dow Jones & Company, publisher of the Wall Street Journal. The S&P 500 represents stocks chosen from the two major national stock exchanges and the over-the-counter market.

The stocks in the index at any given time are determined by a committee of Standard & Poor’s Corporation, which may occasionally add or delete individual stocks or the stocks of entire industry groups. The aim of the committee is to capture present overall stock market conditions as reflected in a very broad range of economic indicators. The VLCA, produced by Value Line, Inc., covers a broad range of widely held and actively traded NYSE, AMEX, and OTC issues selected by Value Line.

In the third group, we have the Wilshire indexes produced by Wilshire Associates (Santa Monica, California) and Russell indexes produced by the Frank Russell Company (Tacoma, Washington), a consultant to pension funds and other institutional investors. The criterion for inclusion in each of these indexes is solely a firm’s market capitalization. The most comprehen- sive index is the Wilshire 5000, which currently includes more than 6,500 stocks, up from 5,000 at its inception. The Wilshire 4500 includes all stocks in the Wilshire 5000 except for those in the S&P 500. Thus, the shares in the Wilshire 4500 have a smaller capitalization than those in the Wilshire 5000. The Russell 3000 encompasses the 3,000 largest companies in terms of their market capitalization. The Russell 1000 is limited to the largest 1,000 of those, and the Russell 2000 has the remaining smaller firms.

Does it matter in which market a corporation’s securities are traded? Yes and no. It is desirable to have your 

securities traded in a market where there is sufficient activity so that an investor who wants to buy or sell the security can do so readily. Therefore, the marketability that the market provides to the security is important. The more easily a security can be bought and sold, the less its marketability risk, which is the risk than an owner will not be able to sell the security when he or she wants to sell it. Investors are willing to take a lower return when the marketability risk is lower, allowing the corporation to raise additional funds at a lower cost. Therefore, firms want to list their stocks in a market that provides marketability for the stock.

Bond Markets

Almost all bond trading takes place in OTC markets, with the remainder (around 1%) occurring mainly on the New York Stock Exchange Fixed Income Market and the American Stock Exchange. The bond trading that does take place on exchanges consists primarily of small orders, whereas bond trading in the OTC market is for larger—sometimes huge—blocks of bonds, purchased by institutional investors.

Within the OTC market, large banks and large trading firms “make a market” in bonds; that is, they connect buyers with sellers. They negotiate directly with large bond investors such as pension funds, insurance companies, and corporations, and are connected through a computerized network.

As with the stock market, there are bond market indexes that are followed by investors. The wide range of bond market indexes available can be classified as broad-based bond market indexes and specialized bond market indexes. The three broad-based bond market indexes most commonly used by institutional investors are the Lehman Brothers U.S.

Aggregate Index, the Salomon Smith Barney (SSB) Broad Investment- Grade Bond Index (BIG), and the Merrill Lynch Domestic Market Index.

There are more than 5,500 issues in each index. The specialized bond market indexes focus on one sector of the bond market or a subsector of the bond market. Indexes on sectors of the market are published by the three firms that produce the broad-based bond market indexes. Non brokerage firms have created specialized indexes for sectors.

Options and Futures Markets

The first formal options market was the Chicago Board Options Exchange (CBOE), begun in 1973. Soon after, several exchanges introduced options contracts to their “product lines.” Now options are traded on such exchanges as the CBOE, the Chicago Board of Trade (CBOT), the Pacific  Stock Exchange, the Philadelphia Stock Exchange, and the American Stock Exchange. As an indicator of the growing interest in options, we note that the dollar value of options traded annually on the CBOE now exceeds the value of the stocks traded annually on the AMEX. Options are traded on both exchanges and in the over-the-counter market, with most of the recent growth in the over-the-counter market.

Futures contracts are traded on (among others) the CBOT, the Chicago Mercantile Exchange, the Mid-America Commodity Exchange, and the New York Futures Exchange. Some futures markets specialize in certain contracts, either by preference or by state law. For example, the International Petroleum exchange specializes in petroleum products such as crude oil and gas oil. However, most commodities exchanges deal with a variety of futures contracts.

Like the equity markets, options and futures markets are subject to state and federal regulations (to different degrees), as well as to self-regulation by the markets themselves.

Efficient Markets

Investors do not like risk and they must be compensated for taking on risk—the larger the risk, the more the compensation. But can investors earn a return on securities beyond that necessary to compensate them for the risk? In other words, can investors earn an abnormal profit on the secondary markets? Can they beat the market? The answer is “maybe.”

An efficient market is a market in which asset prices rapidly reflect all available information, and the securities markets in the United States are typically thought of as being highly efficient. This means that all available information is already impounded in a security’s price, so investors should expect to earn a return necessary to compensate them for their opportunity cost, anticipated inflation, and risk. That would seem to preclude abnormal profits. But according to at least one theory, there are several levels of efficiency: weak form efficient, semi-strong form efficient, and strong form efficient.

In the weak form of market efficiency, current securities prices reflect all past prices and price movements. In other words, all worthwhile information about previous prices of the stock has been used to determine today’s price; the investor cannot use that same information to predict tomorrow’s price and still earn abnormal profits.

Empirical evidence shows that the securities markets are at least weak-form efficient. In other words, you cannot beat the market by using information on past securities prices.

In the semi-strong form of market efficiency, the current market prices of securities reflect all publicly-available information. So if you trade on the basis of publicly-available information, you cannot earn abnormal profits. This does not mean that prices change instantaneously to reflect new information, but rather that information is impounded rapidly into the prices of securities.

Empirical evidence supports the idea that U.S. securities markets are semi-strong form efficient. This, in turn, implies that careful analysis of securities and issuing firms cannot produce abnormal profits.

In the strong form of market efficiency, stock prices reflect all public and private information. In other words, the market (which includes all investors) knows everything about all securities, including information that has not been released to the public.

The strong form implies that you cannot make abnormal profits from trading on inside information, where inside information is information that is not yet public.7 This form of market efficiency is not supported by the evidence. In fact, we know from recent events that the opposite is true; gains are available from inside information.

As pointed out above, U.S. securities markets are essentially semistrong efficient. This means that investors can, for the most part, expect securities to be fairly priced. So when a firm issues new securities, it should expect investors to pay a price for those shares that reflects their value. This also means that if new information about the firm is revealed to the public (for example, concerning a new product), the price of the stock should change to reflect that new information.

But a semi-strong efficient market also means that an investor can make abnormal profits through trading using information not known to the public. Such trading tends to distort the prices of affected securities and thus to harm at least some investors. For that reason, and because investigators found evidence of such trading during the corporate merger mania of the 1980s, existing anti-insider trading legislation has recently been strengthened and reinforced. Strengthening such legislation tends to ensure the fairness of securities prices.

In essence, it is illegal for any person with an agency relationship to a firm to benefit financially through non-public information obtained as a result of that relationship. This does not mean that executives of a corporation cannot buy and sell shares of the firm. Trading by insiders (members of the board of directors and the employees of the firm) is legal if it is not motivated by the use of non-public information. What it does mean is that insiders cannot use inside information to make their personal investment decisions; doing so would be illegal insider trading. As another example, an investment banker who is negotiating the merger of two corporations cannot legally purchase the stock of those corporations knowing that the market prices will rise when news of the merger is made public.