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.