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16.7: Securities Markets

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    6. How do securities markets help firms raise funding, and what securities trade in the capital markets?

    Stocks, bonds, and other securities trade in securities markets. These markets streamline the purchase and sales activities of investors by allowing transactions to be made quickly and at a fair price. Securities are investment certificates that represent either equity (ownership in the issuing organization) or debt (a loan to the issuer). Corporations and governments raise capital to finance operations and expansion by selling securities to investors, who in turn take on a certain amount of risk with the hope of receiving a profit from their investment.

    Securities markets are busy places. On an average day, individual and institutional investors trade billions of shares of stock in more than 10,000 companies through securities markets. Individual investors invest their own money to achieve their personal financial goals. Institutional investors are investment professionals who are paid to manage other people’s money. Most of these professional money managers work for financial institutions, such as banks, mutual funds, insurance companies, and pension funds. Institutional investors control very large sums of money, often buying stock in 10,000-share blocks. They aim to meet the investment goals of their clients. Institutional investors are a major force in the securities markets, accounting for about half of the dollar volume of equities traded.

    Types of Markets

    Securities markets can be divided into primary and secondary markets. The primary market is where new securities are sold to the public, usually with the help of investment bankers. In the primary market, the issuer of the security gets the proceeds from the transaction. A security is sold in the primary market just once—when the corporation or government first issues it. The Blue ApronIPO is an example of a primary market offering.

    Later transactions take place in the secondary market, where old (already issued) securities are bought and sold, or traded, among investors. The issuers generally are not involved in these transactions. The vast majority of securities transactions take place in secondary markets, which include broker markets, dealer markets, the over-the-counter market, and the commodities exchanges. You’ll see tombstones, announcements of both primary and secondary stock and bond offerings, in the Wall Street Journal and other newspapers.

    The Role of Investment Bankers and Stockbrokers

    Two types of investment specialists play key roles in the functioning of the securities markets. Investment bankers help companies raise long-term financing. These firms act as intermediaries, buying securities from corporations and governments and reselling them to the public. This process, called underwriting, is the main activity of the investment banker, which acquires the security for an agreed-upon price and hopes to be able to resell it at a higher price to make a profit. Investment bankers advise clients on the pricing and structure of new securities offerings, as well as on mergers, acquisitions, and other types of financing. Well-known investment banking firms include Goldman Sachs, Morgan Stanley, JP Morgan, Bank of America Merrill Lynch, and Citigroup.

    A stockbroker is a person who is licensed to buy and sell securities on behalf of clients. Also called account executives, these investment professionals work for brokerage firms and execute the orders customers place for stocks, bonds, mutual funds, and other securities. Investors are wise to seek a broker who understands their investment goals and can help them pursue their objectives.

    Brokerage firms are paid commissions for executing clients’ transactions. Although brokers can charge whatever they want, most firms have fixed commission schedules for small transactions. These commissions usually depend on the value of the transaction and the number of shares involved.

    Online Investing

    Improvements in internet technology have made it possible for investors to research, analyze, and trade securities online. Today almost all brokerage firms offer online trading capabilities. Online brokerages are popular with “do-it-yourself” investors who choose their own stocks and don’t want to pay a full-service broker for these services. Lower transaction costs are a major benefit. Fees at online brokerages range from about $4.95 to $8.00, depending on the number of trades a client makes and the size of a client’s account. Although there are many online brokerage firms, the four largest—Charles Schwab, Fidelity, TD Ameritrade, and E*Trade—account for more than 80 percent of all trading volume and trillions in assets in customer accounts.11 The internet also offers investors access to a wealth of investment information.


    Competition Causes Online Fees to Drop

    With the U.S. stock market reaching an all-time high in 2017, private investors continue to look for ways to get in or stay in the market without paying exorbitant fees to execute their own trades. Historically, fees associated with buying and selling stocks have been high and considered one reason why investors sought alternatives via online trading platforms offered by firms such as Fidelity, Charles Schwab, TD Ameritrade, and E*Trade. With advances in technology, including the use of artificial intelligence, the costs associated with handling stock trades has dropped dramatically over the last decade, and investors are looking for the best possible deal.

    With competition from companies such as Robinhood, a start-up app that offers $0 fees for stock trades, online trading firms have rushed to reduce their fees to attract more overall business, and a price war has ensued. Fidelity and Charles Schwab lowered their fees for online stock and exchange-traded funds to $4.95; Ameritrade and E*Trade reduced their fees from $9.99 to $6.95.

    So how will these firms continue to make money? They believe that lowering the price of entry for trading stocks will allow them to “sweep up” customer assets—meaning firms have an opportunity to attract new customers who not only will take advantage of low trading fees but will be interested in other financial products offered by these investment companies. Some of the other services being touted by online trading firms include loaning money to investors to buy stock and cross-selling customers on wealth management services and other investment products.

    According to some industry analysts, one downside to matching competitors’ low fees could be a strategy of consolidation within the online trading industry. Unless firms can increase their overall business by reaching out to current customers and potential ones, some may be forced to join up with competitors.

    Critical Thinking Questions

    1. From a business standpoint, do you think the “almost-free” trading fees make sense? Explain.
    2. What can online trading firms do to increase their overall business, particularly when it comes to attracting new investors?

    Sources: Simone Foxman, “The Future Price of Investing: Zilch,” Bloomberg Businessweek,, October 31, 2017; Evelyn Chang, “Robinhood, Trading App for Millennials, Still Betting on Stocks over Bitcoin,” CNBC,, October 10, 2017; Taylor Tepper, “You Probably Have the Wrong Idea When It Comes to Investments. Let’s Fix That,”, July 19, 2017; Trevor Hunnicutt and Tim McLaughlin, “Brokerages’ Race to Zero Fees Points to a Bigger War to Come,” Reuters,, February 27, 2017.

    Investing in Bonds

    When many people think of financial markets, they picture the equity markets. However, the bond markets are huge—the Securities Industry and Financial Markets Association (SIFMA) estimates that the global bond market is nearly $88 trillion. In the United States, companies and government entities sold about $2 billion in new bond issues in 2016. Average daily trading volume exceeded $760 billion, with U.S. Treasury securities accounting for more than 60 percent of the total.12

    Bonds can be bought and sold in the securities markets. However, the price of a bond changes over its life as market interest rates fluctuate. When the market interest rate drops below the fixed interest rate on a bond, it becomes more valuable, and the price rises. If interest rates rise, the bond’s price will fall. Corporate bonds, as the name implies, are issued by corporations. They usually have a par value of $1,000. They may be secured or unsecured (called debentures), include special provisions for early retirement, or be convertible to common stock. Corporations can also issue mortgage bonds, bonds secured by property such as land, buildings, or equipment. Approximately $1.5 trillion in new corporate bonds were issued in 2016.13

    In addition to regular corporate debt issues, investors can buy high-yield, or junk, bonds—high-risk, high-return bonds often used by companies whose credit characteristics would not otherwise allow them access to the debt markets. They generally earn 3 percent or more above the returns on high-quality corporate bonds. Corporate bonds may also be issued with an option for the bondholder to convert them into common stock. These convertible bonds generally allow the bondholder to exchange each bond for a specified number of shares of common stock.

    A photograph shows Elon Musk.
    Exhibit 16.5 Elon Musk and his electric car company, Tesla, issued high-yield junk bonds in August 2017 and raised nearly $1.8 billion to help finance the production and launch of Tesla’s new Model 3. Tesla has spent billions of dollars in its efforts to develop electric cars in the past few years. What are the risks and rewards of buying junk bonds? (Credit: Steve Jurvetson/ flickr/ Attribution 2.0 Generic (CC BY 2.0))

    U.S. Government Securities and Municipal Bonds

    Both the federal government and local government agencies also issue bonds. The U.S. Treasury sells three major types of federal debt securities: Treasury bills, Treasury notes, and Treasury bonds. All three are viewed as default-risk-free because they are backed by the U.S. government. Treasury bills mature in less than a year and are issued with a minimum par value of $1,000. Treasury notes have maturities of 10 years or less, and Treasury bonds have maturities as long as 25 years or more. Both notes and bonds are sold in denominations of $1,000 and $5,000. The interest earned on government securities is subject to federal income tax but is free from state and local income taxes. According to SIFMA, a total of $1.7 trillion U.S. treasuries were issued in 2016, down 20 percent from 2015.14

    Municipal bonds are issued by states, cities, counties, and other state and local government agencies. Almost $445.8 billion in municipal bonds were issued in 2016.15 These bonds typically have a par value of $5,000 and are either general obligation or revenue bonds. General obligation bonds are backed by the full faith and credit (and taxing power) of the issuing government. Revenue bonds, on the other hand, are repaid only from income generated by the specific project being financed. Examples of revenue bond projects include toll highways and bridges, power plants, and parking structures. Because the issuer of revenue bonds has no legal obligation to back the bonds if the project’s revenues are inadequate, they are considered more risky and therefore have higher interest rates than general obligation bonds.

    Municipal bonds are attractive to investors because interest earned on them is exempt from federal income tax. For the same reason, the coupon interest rate for a municipal bond is lower than for a similar-quality corporate bond. In addition, interest earned on municipal bonds issued by governments within the taxpayer’s home state is exempt from state income tax as well. In contrast, all interest earned on corporate bonds is fully taxable.

    Bond Ratings

    Bonds vary in quality, depending on the financial strength of the issuer. Because the claims of bondholders come before those of stockholders, bonds are generally considered less risky than stocks. However, some bonds are in fact quite risky. Companies can default—fail to make scheduled interest or principal payments—on their bonds. Investors can use bond ratings, letter grades assigned to bond issues to indicate their quality or level of risk. Ratings for corporate bonds are easy to find. The two largest and best-known rating agencies are Moody’s and Standard & Poor’s (S&P), whose publications are in most libraries and in stock brokerages. Table 16.2 lists the letter grades assigned by Moody’s and S&P. A bond’s rating may change if a company’s financial condition changes.

    In addition to stocks and bonds, investors can buy mutual funds, a very popular investment category, or exchange-traded funds (ETFs). Futures contracts and options are more complex investments for experienced investors.

    Mutual Funds

    Suppose that you have $1,000 to invest but don’t know which stocks or bonds to buy, when to buy them, or when to sell them. By investing in a mutual fund, you can buy shares in a large, professionally managed portfolio, or group, of stocks and bonds. A mutual fund is a financial-service company that pools its investors’ funds to buy a selection of securities—marketable securities, stocks, bonds, or a combination of securities—that meet its stated investment goals. Each mutual fund focuses on one of a wide variety of possible investment goals, such as growth or income. Many large financial-service companies, such as Fidelity and Vanguard, sell a wide variety of mutual funds, each with a different investment goal. Investors can pick and choose funds that match their particular interests. Some specialized funds invest in a particular type of company or asset: in one industry such as health care or technology, in a geographical region such as Asia, or in an asset such as precious metals.

    Mutual funds are one of the most popular investments for individuals today: they can choose from about 9,500 different funds. Investments in mutual funds are more than $40 trillion worldwide, of which U.S. mutual funds hold more than $19 trillion. About 94 million individuals, representing 55 percent of all U.S. households, own mutual funds.16 Mutual funds appeal to investors for three main reasons:

    Moody’s and Standard & Poor’s Bond Ratings
    Moody’s Ratings S & P Ratings Description
    Aaa AAA Prime-quality investment bonds: Highest rating assigned; indicates extremely strong capacity to pay.
    Aa, A AA, A High-grade investment bonds: Also considered very safe bonds, although not quite as safe as Aaa/AAA issues; Aa/AA bonds are safer (have less risk of default) than single As.
    Baa BBB Medium-grade investment bonds: Lowest of investment-grade issues; seen as lacking protection against adverse economic conditions.
    Ba B BB B Junk bonds: Provide little protection against default; viewed as highly speculative.
    Caa Ca C CCC CC C D Poor-quality bonds: Either in default or very close to it.


    • They are a good way to hold a diversified, and thus less risky, portfolio. Investors with only $500 or $1,000 to invest cannot diversify much on their own. Buying shares in a mutual fund lets them own part of a portfolio that may contain 100 or more securities.
    • Mutual funds are professionally managed.
    • Mutual funds may offer higher returns than individual investors could achieve on their own.

    Exchange-Traded Funds

    Another type of investment, the exchange-traded fund (ETF), has become very popular with investors. ETFs are similar to mutual funds because they hold a broad basket of stocks with a common theme, giving investors instant diversification. ETFs trade on stock exchanges (most trade on the American Stock Exchange, AMEX), so their prices change throughout the day, whereas mutual fund share prices, called net asset values (NAVs), are calculated once a day, at the end of trading. Worldwide, ETF assets in 2016 were more than $3.5 trillion, with the U.S. ETF market accounting for 73 percent of the global market.17

    Investors can choose from more than 1,700 ETFs that track almost any market sector, from a broad market index such as the S&P 500 (described later in this chapter), industry sectors such as health care or energy, and geographical areas such as a particular country (Japan) or region (Latin America). ETFs have very low expense ratios. However, because they trade as stocks, investors pay commissions to buy and sell these shares.

    Futures Contracts and Options

    Futures contracts are legally binding obligations to buy or sell specified quantities of commodities (agricultural or mining products) or financial instruments (securities or currencies) at an agreed-on price at a future date. An investor can buy commodity futures contracts in cattle, pork bellies (large slabs of bacon), eggs, coffee, flour, gasoline, fuel oil, lumber, wheat, gold, and silver. Financial futures include Treasury securities and foreign currencies, such as the British pound or Japanese yen. Futures contracts do not pay interest or dividends. The return depends solely on favorable price changes. These are very risky investments because the prices can vary a great deal.

    Options are contracts that entitle holders to buy or sell specified quantities of common stocks or other financial instruments at a set price during a specified time. As with futures contracts, investors must correctly guess future price movements in the underlying financial instrument to earn a positive return. Unlike futures contracts, options do not legally obligate the holder to buy or sell, and the price paid for an option is the maximum amount that can be lost. However, options have very short maturities, so it is easy to quickly lose a lot of money with them.


    1. Distinguish between primary and secondary securities markets. How does an investment banker work with companies to issue securities?
    2. Describe the types of bonds available to investors and the advantages and disadvantages they offer.
    3. Why do mutual funds and exchange-traded funds appeal to investors? Discuss why futures contracts and options are risky investments.

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