CHAPTER 20
I. THE FUNCTION OF
SECURITIES MARKETS.
LEARNING GOAL 1.
Examine the functions of securities markets and investment bankers.
A. Securities
markets serve TWO MAJOR FUNCTIONS:
1. To help
businesses find LONG-TERM FUNDING.
2. To give
investors a place to BUY AND SELL INVESTMENTS such as stocks and bonds.
B. BENEFITS OF
SECURITIES MARKETS.
1. BUSINESSES
BENEFIT by obtaining the capital they need to finance beginning operations,
expand their businesses, or buy goods and services.
2. INVESTORS
BENEFIT by having a convenient place to buy and sell stocks, bonds, mutual
funds, and other investments.
C. Securities
markets are divided into TWO MARKETS:
1. PRIMARY MARKETS
handle the sale of NEW SECURITIES.
a. Corporations
only make money on the sale of their securities once, when they are first bought
on the primary market.
b. After that the
secondary market handles the trading of securities between investors.
c. However,
companies can offer additional shares of stock in the future to raise
additional capital.
2. SECONDARY
MARKETS handle the trading of securities between investors; the proceeds of the
sale go to the investor selling the stock, not to the corporation.
D. THE IMPORTANCE
OF LONG-TERM FUNDING.
1. Many new
companies start without sufficient capital.
2. Businesses
normally prefer to meet long-term financial needs by using retained earnings or
by borrowing from a lending institution.
3. If such forms
are not available, the company may be able to raise capital by issuing
corporate bonds or selling stock.4. These forms of debt or equity financing is
not available to all companies.
E. THE ROLE OF
INVESTMENT BANKERS.
1. INVESTMENT
BANKERS are specialists in assisting in issuing and selling of new securities.
2. Investment
bankers also UNDERWRITE NEW ISSUES of bonds or stocks, buying the en tire bond
or stock issue then selling the issue to investors.
3. INSTITUTIONAL
INVESTORS are large investors such as pension funds, mutual funds, insurance
companies, and banks.
II. DEBT FINANCING
THROUGH SELLING BONDS.
LEARNING GOAL 2.
Compare the advantages and disadvantages of companies selling bonds and
identify the classes and features of bonds.
A. THE LANGUAGE OF
BONDS.
1. A BOND is a
corporate certificate indicating that a person has loaned money to a firm.
2. INTEREST is the
payment the issuer of the bond makes to the bondholders to pay for use of the
borrowed money.
a. The BOND
INTEREST RATES may be called the bond's COUPON RATE, a term from when bonds
were issued as bearer bonds and the holder was considered the owner.
b. Today bonds are REGISTERED,
and changes in ownership are recorded.
c. The interest
rate paid on a bond varies based on factors such as the going interest rate for
bonds.
d. Bonds are also
rated in terms of their risk by independent firms such as Standard and Poor's
and Moody's Investor Services.
3. PRINCIPAL is the
face value of a bond.
4. MATURITY DATE is
the date the issuer of bond must pay the principal of the bond to the
bondholder.
B. ADVANTAGES AND
DISADVANTAGES OF SELLING BONDS.
1. ADVANTAGES OF
BONDS INCLUDE:
a. BONDHOLDERS are
creditors, not owners and HAVE NO VOTE on corporate affairs.
b. Interest paid on
bonds is TAX-DEDUCTIBLE.
c. Bonds are a
TEMPORARY SOURCE OF FUNDING; they are eventually repaid and the debt obligation
eliminated.
2. DISADVANTAGES OF
BONDS INCLUDE:
a. Bonds are an
INCREASE IN DEBT.
b. Interest on
bonds is A LEGAL OBLIGATION.
c. The face value
of the bonds MUST BE REPAID on the maturity date.
C. DIFFERENT
CLASSES OF BONDS.
1. UNSECURED BONDS
are not supported by any collateral.
a. Unsecured bonds
are usually referred to as DEBENTURE BONDS.
b. Debenture bonds
are issued only by well- respected firms with excellent credit ratings.
2. SECURED BONDS
are backed by some tangible asset that is pledged to the bondholder if interest
or principal is not paid; THEY INCLUDE:
a. MORTGAGE BONDS,
secured by company assets such as land and buildings, are the most common form
of secured bond.
b. COLLATERAL TRUST
BONDS are backed by stock and held in trust by a bank.
c. EQUIPMENT TRUST
BONDS are backed by equipment the company owns, such as trucks or aircraft.
D. SPECIAL BOND
FEATURES.
1. Companies often
establish a sinking fund to ensure that funds are available to repay
bondholders on the maturity date.
2. A SINKING FUND
is a bond provision that requires the issuer to pay off, on a periodic basis,
some part of the bond issue before its final maturity.
3. A CALL PROVISION
is a clause in a bond that gives the issuer of the bond the right to retire the
bond before its maturity.
4. A CONVERTIBLE
BOND is one that can be converted into shares of common stock in the issuing
company.
III. EQUITY
FINANCING THROUGH SELLING STOCK.
LEARNING GOAL 3.
Compare the advantages and disadvantages of issuing stock and outline the
differences between common and preferred stock.
A. EQUITY FINANCING
is the obtaining of funds through the sale of ownership in the corporation.
B. LEARNING THE
LANGUAGE OF STOCK.
1. STOCKS are
shares of ownership in a company.
2. A STOCK
CERTIFICATE is evidence of stock ownership, often held electronically.
3. PAR VALUE is an
arbitrary dollar amount printed on the front of a stock certificate.
a. Some states
require par value as a basis for the state's incorporation fees.
b. Most companies
issue NO-PAR STOCK.
4. DIVIDENDS are a
part of the firm's profits that may be distributed to shareholders as either
cash payments or additional shares.
C. ADVANTAGES AND
DISADVANTAGES OF ISSUING STOCK.
1. ADVANTAGES OF
ISSUING STOCK IN CLUDE:
a. Stockholders
investment NEVER HAS TO BE REPAID.
b. There is NO
LEGAL OBLIGATION to pay dividends to stockholders, so profits can be invested
back in the business.
c. Selling stock
can IMPROVE THE CONDITION OF THE FIRM'S BALANCE SHEET since no debt is
incurred.
2. DISADVANTAGES OF
ISSUING STOCK INCLUDE:
a. Stockholders
have the RIGHT TO VOTE and can alter the direction of the firm.
b. Dividends are
PAID OUT OF PROFIT AFTER TAXES and are not tax exempt.
c. Management
decision making is often tempered by THE NEED TO KEEP STOCKHOLDERS HAPPY.
D. ISSUING SHARES
OF PREFERRED STOCK.
1. PREFERRED STOCK
gives its owners preference in the payment of dividends and an earlier claim on
assets if the company is liquidated. It does not include voting rights.
2. PREFERRED STOCK
DIVIDENDS DIFFER FROM COMMON STOCK DIVIDENDS in several ways:
a. The PAR VALUE is
the basis for the dividend the firm is willing to pay.
b. The dividend is
FIXED.
c. If dividends are
paid, dividends on preferred stock must be paid in full before any common stock
dividends can be paid.
3. SIMILARITIES
BETWEEN PREFERRED STOCK AND BONDS.
a. Both have a face
(or par) value, and both have a fixed rate of return.
b. Preferred stock
are rated by Standard amp; Poor and Moody's just like bonds.
c. Both increase in
market value, but stock generally increases at a higher percentage than bonds.
4. SPECIAL FEATURES
OF PREFERRED STOCK.
a. Preferred stock
could be CALLABLE, meaning a company could require preferred stockholders to
sell back their shares.
b. Preferred stock
could also be CONVERT IBLE.
c. Preferred stock
could be CUMULATIVE; that is, the missed dividends can be accumulated if they
are not paid.
E. ISSUING SHARES
OF COMMON STOCK.
1. COMMON STOCK is
the MOST BASIC FORM of ownership of firms.
2. Common stock
includes the RIGHTS:
a. To vote for
board of directors and on important issues.
b. To share in the
firm's profits through dividends if declared by the firm's board of directors.
3. Due to the
PRE-EMPTIVE RIGHT, common stockholders have the first right to purchase any new
shares of common stock.
IV. STOCK
EXCHANGES.
LEARNING GOAL 4.
Identify the various stock exchanges and describe how to invest in securities
markets and choose among different investment strategies.
A. A STOCK EXCHANGE
is an organization whose members can buy and sell (exchange) securities for the
public.
1. Brokerage firms
purchase memberships or SEATS on the exchanges.
2. The limited
number of seats pushed the average price of a seat on the NYSE to $1.3 million
in 1997.
3. Stock exchanges
operate in cities such as Paris, London, Sydney, Buenos Aires, and Tokyo.
4. The listings of
foreign firms on the NYSE have tripled in the past five years.
B. U.S. EXCHANGES.
1. The LARGEST
STOCK EXCHANGE in the U.S. is the NEW YORK STOCK EXCHANGE.
2. The
second-largest U.S. exchange is the AMERICAN STOCK EXCHANGE (AMEX), which lists
about 1000 common and preferred stocks.
3. There are
SEVERAL REGIONAL EXCHANGES in Chicago, San Francisco, Philadelphia, Boston,
Cincinnati, Spokane, and Salt Lake City that deal with regional issues.
C. THE
OVER-THE-COUNTER (OTC) MARKET.
1. The
OVER-THE-COUNTER (OTC) MARKET provides a means to trade stocks not listed on
the national securities exchanges.
2. The nationwide
electronic system that communicates OTC trades to brokers is called NATIONAL
ASSOCIATION OF SECURITIES DEALERS AUTOMATED QUOTATION SYSTEM (NASDAQ.)
3. Originally, the
over-the-counter market dealt with small firms that could not qualify for
listing on the two nation exchanges.
4. Today, firms
such as Intel and Microsoft have their stock traded on the OTC market because
the trades are done electronically.
D. SECURITIES
REGULATIONS.
1. The SECURITIES
ACT OF 1933 protects investors by requiring full disclosure of financial
information by firms selling new stocks or bonds.
2. The SECURITIES
AND EXCHANGE COMMISSION (SEC) is the federal government agency that has
responsibility for regulating the various exchanges.
a. Companies
trading on the national ex changes must register with the SEC and provide
annual updates.
b. Companies must
follow established specific guidelines when issuing stock.
3. A PROSPECTUS is
a condensed version of financial information prepared for the SEC that must be
sent to purchasers.
4. INSIDER TRADING
involves the use of knowledge or information that a person gains through his or
her position that allows him or her to benefit from fluctuations in stock
prices.
a. The term INSIDER
has been broadened to include anyone with information about a security not
available to the general public.
b. Penalties for
insider trading can include fines or imprisonment.
V. HOW TO INVEST IN
SECURITIES MARKETS.
A. A STOCKBROKER is
a registered representative who works as a market intermediary to buy and sell
securities for clients.
B. HOW TO BUY
STOCKS OR BONDS.
1. An investor
contacts a stockbroker and gives the order.
2. The stockbroker
calls a member of the stock exchange who represents the firm for which the
broker works.
3. That member goes
to the place where the bond or stock is traded and negotiates a price.
4. The completed
transaction is reported to the broker and then to the investor.
5. Large brokerage
firms have an automated order system.
6. The same
procedure is followed if you want to sell stocks and bonds.
7. The broker can
also be a source of information about what stocks or bonds meet your
objectives.
8. However, you can
learn about and follow stocks or bonds on your own.
C. INVESTING
ON-LINE.
1. Investors can
use ON-LINE TRADING SERVICES to buy and sell stocks and bonds.
2. These trading
services are less expensive than regular stockbroker commissions.
3. They are
targeted primarily at investors who are willing to do their own research and
make their own investment decisions.
D. CHOOSING THE
RIGHT INVESTMENT STRATEGY.
1. Investment
objectives change over the course of a person's life.
2. You should
consider FIVE CRITERIA FOR SELECTING AN INVESTMENT VEHICLE:
a. INVESTMENT RISK,
the chance that an investment and all its yield will be worth less at some
future time.
b. YIELD, the
percentage return on an in vestment, such as interest or dividends.
c. DURATION, or the
length of time assets are committed.
d. LIQUIDITY, how
quickly one can get back invested funds when desired.
e. TAX
CONSEQUENCES, how the investment will affect investors' tax situation.
VI. INVESTING IN
BONDS.
LEARNING GOAL 5.
Analyze the opportunities bonds offer as investments.
A. Bonds are a
rather SAFE INVESTMENT.
1. U.S. GOVERNMENT
BONDS are backed by the full faith and credit of the federal government.
2. MUNICIPAL BONDS
offered by local governments often have advantages such as tax-free interest.
B. If you purchase
a corporate bond, you do not have to hold it until maturity because bonds are
bought and sold daily on major exchanges.
1. However, you are
not guaranteed to get the face value of the bond.
2. if your bond
does not have attractive features, you may be forced to sell your bond at a
DISCOUNT, less than the face value.
3. If your bond is
highly valued, you may be able to sell it at a PREMIUM, above the face value.
4. Bond prices
generally fluctuate with current market interest rates.
C. Standard amp;
Poor's and Moody's Investor Service provide information that RATES various
corporate and
government bonds as to their degree of RISK to investors.
VII. INVESTING IN
STOCK AND MUTUAL FUNDS.
LEARNING GOAL 6.
Explain the opportunities stocks and mutual funds offer as investments and the
advantages of diversifying investments.
A. STOCK
INVESTMENTS provide an opportunity for investors to share in the success of
emerging or expanding companies.
1. As owners,
however, stockholders can also lose money if a company does not do well.
2. The market price
of common stock is very dependent on the overall performance of the
corporation.
3. Stock investors
are often called BULLS and BEARS depending upon their perceptions of the
market.
a. BULLS are investors
who believe that stock prices will rise.
b. BEARS are
investors who expect stock prices to decline.
4. INVESTMENT
OPPORTUNITIES IN STOCK.
a. GROWTH STOCKS
are stocks of corporations whose earnings are expected to grow faster that
other stocks or the overall economy.
b. INCOME STOCKS
are stocks that offer a high dividend yield (i.e. public utilities.)
c. BLUE CHIP STOCKS
are stocks of high-quality companies.
d. PENNY STOCKS are
stocks that sell for less than $1, and are considered very risky investments.
B. BUYING STOCK:
MARKET AND LIMIT ORDERS.
1. MARKET ORDERS
are instructions to a broker to buy stock at the best price obtainable in the
market now.
2. LIMIT ORDERS are
instructions to a broker to purchase stock at a specific price.
C. STOCK SPLITS.
1. Companies and
brokers prefer to have stock purchases conducted in ROUND LOTS, purchases of
100 shares at a time.
2. A STOCK SPLIT is
the issue of two or more shares for every share of stock outstanding.
3. The advantage to
the company is that it may be ABLE TO SELL MORE SHARES at lower prices.
4. The advantage to
shareholders is that the DEMAND FOR THE STOCK MAY BE GREATER.
D. INVESTING IN
MUTUAL FUNDS.
1. A MUTUAL FUND is
an organization that buys and stocks and bonds and then sells shares in those
securities to the public.
2. The BENEFIT is
that you CAN BUY GET OWNERSHIP OF MANY DIFFERENT COMPANIES that you could not
afford to invest in individually-it helps you diversify.
3. Mutual funds are
the BEST WAY FOR SMALL INVESTORS TO BEGIN.
a. Very
conservative funds invest only in government securities or secure corporate
bonds.
b. Others
specialize in high-tech firms, foreign companies, precious metals, and other
investments with greater risk.
c. Some mutual
funds even invest exclusively in socially responsible companies.
4. You can buy most
funds directly and save any fees.
a. A NO-LOAD FUND
is one that charges no commission to buy or sell its shares.
b. A LOAD FUND
would charge a commission to investors to buy into the fund.
c. OPEN-END FUNDS
will accept the investments of any interested investors.
d. CLOSED-END FUNDS
offer a specific number of shares; once issued, no further investors are
admitted.
5. Mutual funds
offer the small investor a way to spread the risk of stock ownership.
E. DIVERSIFYING
INVESTMENTS.
1. DIVERSIFICATION
means buying several different investments to spread the risk.
2. By diversifying
investments, the investor decreases the chance of losing everything.
3. This strategy is
often called a PORTFOLIO STRATEGY.
VIII. INVESTING IN
HIGHER-RISK INVESTMENTS.
LEARNING GOAL 7.
Discuss the high risk involved in junk bonds, buying stock on margin, and
commodities.
A. Some investors
like safer investments-others want to take more market risk.
B. INVESTING IN
HIGH RISK BONDS.
1. JUNK BONDS are
high-risk, high-interest bonds.
2. Standard amp;
Poor's and Moody's consider junk bonds as non-investment-grade bonds because of
their high risk and high default rates.
3. If the company
can't pay off the bond, the investor is left with nothing more than paper. In
other words, junk.
C. BUYING STOCK ON
MARGIN.
1. BUYING ON MARGIN
is the purchase of stocks by borrowing some of the purchase cost from the
broker.
2. MARGIN is the
amount of money the investor must have in the stock; the Federal Reserve sets
MARGIN RATES (discussed in detail in Ch. 21.)
3. A MARGIN CALL
requires the investor to come up with more money to cover any losses.
D. INVESTING IN
COMMODITIES.
1. Investors
willing to speculate in COMMODITIES hope to profit from the rise and fall of
prices of items such as coffee, wheat, pork bellies, petroleum, and other
'commodities' that are scheduled for delivery at a given date in time.
a. Trading in
commodities demands skill.
b. About 75 to 80%
of the investors who speculate in commodities lose money in the long run.
2. A COMMODITY
EXCHANGE specializes in the buying and selling of precious metals and
agricultural goods such as wheat, cattle, sugar, silver, gasoline, and foreign
currencies.
a. The Chicago
Board of Trade (CBOT) is the largest commodity exchange.
b. The Chicago
Mercantile Exchange is the second largest.
c. Commodity
exchanges operate like stock exchanges where members of the exchange meet on
the exchange's floor to transact deals.
d. But all
transactions for a specific commodity take place in a specific trading area, or
'PIT.'
3. FUTURE MARKETS
involve the purchase and sale of goods for delivery some time in the future.
IX. UNDERSTANDING
INFORMATION FROM SECURITIES MARKETS.
LEARNING GOAL 8.
Explain securities quotations listed in the financial section of a newspaper,
how the Dow Jones Averages affect the market.
A. A wealth of
investment information is available in daily newspapers and various magazines.
B. UNDERSTANDING
BOND QUOTATIONS.
1.
Government-issued bonds are covered in The Wall Street Journal in a table
called Treasury Issues.
2. These issues are
traded on the over-the-counter market.
3. The PRICE is
quoted as a PERCENTAGE OF THE FACE VALUE.
4. The easiest way
to buy bonds is to invest in a BOND MUTUAL FUND.
C. UNDERSTANDING
STOCK QUOTATIONS.
1. The Wall Street
Journal lists stock quotations from the New York Stock Exchange, the American
Stock Exchange, and the NASDAQ over-the-counter markets.
2. STOCK QUOTATIONS
tell you many things:
a. Figure 20-7
shows the information on the New York and American Stock Exchanges.
b. Stocks are
quoted in sixteenths of a dollar.
c. Preferred stocks
are identified by the letters PF following the abbreviate company name.
3. STOCK QUOTES
SHOW:
a. The highest and
lowest price the stock has sold for over the past 52 weeks.
b. The abbreviated
company name and the company's stock symbol.
c. The last
dividend per share paid.
d. The stock's
dividend yield (the return expected.)
e. The P/E ratio
(price to earnings ratio.)
f. Number of shares
traded that day in 100s.
g. The stock's
high. low, and closing price for the day.
h. The net change
in the stock's price from the previous day.
D. UNDERSTANDING
MUTUAL FUND QUOTATIONS.
1. Figure 20-8
shows The Wall Street Journal's listing of mutual funds.
2. The quotation
shows:
a. The funds' name.
b. The fund's NET
ASSET VALUE (NAV), the market value of the mutual fund's portfolio divided by
the number of shares outstanding.
c. The sale price
(the net asset value plus charges and fees.)
d. The net change
in the NAV from the previous day's trading.
3. It is also
simple to change your investment objectives with mutual funds.
E. THE DOW JONES
AVERAGES.
1. The DOW JONES
INDUSTRIAL AVERAGE is the average cost of 30 specific industrial stocks; it is
used to give an indication of the direction of the market over time.
a. Charles Dow
began measuring stock averages in 1884 when he added together prices of 11
important stocks and divided the total by 11 to get an average.
b. The Dow was
broadened in 1982 to include 30 stocks.
c. New stocks are
substituted on the Dow when deemed appropriate.
2. Critics argue
that the SAMPLE IS TOO SMALL to get a good statistical representation and that
it is BIASED IN FAVOR OF BLUE CHIP STOCKS.
3. Many investors
prefer to follow stock indexes like the Standard amp; Poor's 500 that tracks a
broader mix.
F. THE STOCK MARKET
SLIDES OF 1987 AND 1997.
1. The stock market
dropped 508 points on October 19, 1987.
a. On that day the
stock market suffered the largest one-day drop in history.
b. In just
six-and-a-half hours, the market lost a half-trillion dollars.
2. WHAT CAUSED THE
CRASH?
a. Many reasons can
be given, but one of the most common is 'PROGRAM TRADING' which is the process
of giving your computer instructions to automatically sell if the price of your
stock dips to a certain price.
b. On Black Monday
computers issued sell orders that caused many stocks to fall.
3. On October 27,
1997 the Dow fell 554 points due to fears of economic problems in Asian
markets.
a. The 1997 plunge
was the first test using new 'CIRCUIT BREAKERS,' rules adopted in the wake of
the crash of 1987.
b. If the market
fell 350 points, the circuit breakers would kick on and halt trading for a half
hour.
4. WHAT LESSONS CAN
BE LEARNED FROM THE SLIDES OF 1987 AND 1997?
a. Be ready for
volatility.
b. We live in a
global market and all nations' economies and markets are tied together.
c. Be diversified.
d. Don't gamble
borrowed money.
e. Take a long-term
perspective.