Foundations of Financial Management: An Analysis (part 54)

“Bills travel through the mail at twice the speed of checks.” 

— Steven Wright

Capital Markets (Part B)

by

Charles Lamson

The Supply of Capital Funds

In a three-sector economy, consisting of business, government, and households, the major supplier of funds for investment is the household sector. Corporations and the federal government have traditionally been net demanders of funds. Figure 2 diagrams the flow of funds through our basic three sector economy.

Figure 2 Flow of funds through the economy

As households receive wages and transfer payments from the government and wages and dividends from corporations, they generally save some portion of their income. Their savings are usually funneled to financial intermediaries that, in turn, make investments in the capital markets with the funds received from the household sector. This is known as indirect investment. The types of financial institutions that channel funds into the capital markets are specialized and diverse. Funds may flow into commercial banks, mutual savings banks, and credit unions. Households may also purchase mutual fund shares, invest in life insurance, or participate in some form of private pension plan or profit sharing. All these financial institutions act as intermediaries; they help make the flow of funds from one sector of the economy to another very efficient and competitive. Without intermediaries, the cost of funds would be higher, and the efficient allocation of funds to the best users at the lowest cost would not occur.

The Role of the Security Markets

Security markets exist to aid the allocation of capital among households, corporations, and governmental units, with financial institutions acting as intermediaries. Just as financial institutions specialize in their services and Investments, so are the capital markets divided into many functional subsets, with each specific market serving a certain type of security. For example, the common stocks of some of the largest corporations are traded on the New York Stock Exchange, whereas government securities are traded by government security dealers and the over-the-counter markets. 

Once a security is sold for the first time as an original offering, the security trades in its appropriate market among all kinds of investors. This trading activity is known as secondary trading, since funds flow among investors, rather than to the corporation. Secondary trading provides liquidity to investors and keeps prices competitive among alternative security investments. It is very important to the functioning of the financial markets.

Security markets provide liquidity in two ways. First, they enable corporations to raise funds by selling new issues of securities rapidly at fair, competitive prices. Second, they allow the investor who purchases securities to sell them with relative ease and speed and thereby turn the paper asset into cash. Ask yourself the question, "Would I buy securities if there were no place to sell them?" You would probably think twice before committing funds to an illiquid investment. Without markets, corporations and governmental units would not be able to raise the large amounts of capital necessary for economic growth.

The Organization of the Security Markets

The structure of the security markets has changed drastically in the last years of the twentieth century and the first two decades of this century, and it is expected to continue evolving into global electronic markets. These changes include mergers or alliances between exchanges, the transformation of member exchanges into public companies, and the elimination of trading on the exchange floor. Other changes such as decimalization of price quotes have impacted the efficiency of the markets and their profitability. Many of the changes are being driven by technology, which is creating low-cost competition for the traditional markets such as the New York Stock Exchange.

In the section we present the current organization of the markets and provide an update of significant events of the last few years. We divide the security market into organized exchanges and over-the-counter markets. Each will be examined separately.

The Organized Exchanges

Organized exchanges are either national or regional in scope. Each exchange has a central location where all buyers and sellers meet in an auction market to transact purchases and sales. Buyers and sellers are not actually present on the floor of the exchange but are represented by brokers who act as their agents. These brokers are registered members of the exchange.

The New York Stock Exchange (NYSE) and the American Stock Exchange (AMEX) are national exchanges and each is governed by an elected board of directors, of whom half are public directors and the other half industry representatives. Although the Chicago and Pacific Coast exchanges are the largest of the so-called regional stock exchanges, they trade primarily in issues of large national companies. Some of the smaller exchanges, such as Boston and Cincinnati, are more Regional in the sense that many of the companies listed on them are headquartered or do their principal business in the region in which the exchange is located. These smaller exchanges account for a very small percentage of trading in listed securities (Block & Hirt, 2005, p. 424).

While the AMEX is a national market, it is quite small compared to both NASDAQ and the New York Stock Exchange. While the AmEx is a stock exchange with a central location, NASDAQ is a screen-based market. Screen-based means there is no physical location, but trading is based on computers and other communication media.

The regional exchanges can trade common stock in the same companies that are traded on the New York Stock Exchange. This dual trading accounts for over 90 percent of the stocks traded on the Chicago and Pacific regional exchanges. A consolidated tape reports the prices and volume of all shares listed on the NYSE and traded on the regional exchanges, NASDAQ, and the NYSE.

In addition to the consolidated tape there is the Intermarket Trading System (ITS), which is an electronic communications network which links nine markets---NYSE, AMEX, Boston, Chicago, Cincinnati, Pacific and Philadelphia stock exchanges, the Chicago Board Options Exchange, and the NASDAQ. The ITS was created in 1978 in response to the Securities Amendments Act of 1975 (p. 425). Because the consolidated tape and ITS both make all trade in these markets visible to all market participants, prices are more competitive and efficient and liquidity is improved.

*MAIN SOURCE: BLOCK & HIRT, 2005, FOUNDATIONS OF FINANCIAL MANAGEMENT, 11TH ED., PP. 422-425*

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