The Structure and Operation of U.S. Security Markets - Financial Management

As discussed earlier, capital markets are usually classified as either primary or secondary markets.New securities are issued in the primary markets, and the firms issuing these securities receive the proceeds from their sale, thus raising new capital. Outstanding securities are traded in the secondary markets, where owners of these securities may sell them to other investors. The corporations whose securities are traded in the secondary markets do not share in the proceeds from these sales.

Although primary and secondary markets are separate, they are closely related. Smoothly functioning secondary markets aid the primary markets, because investors tend to be more willing to purchase new securities when they know they can sell them in the secondary market. In fact, the potential liquidity available in the secondary markets may make investors more willing to accept slightly lower returns on their investments, thereby lowering the cost companies have to pay for their funds.

Security Exchanges and Stock Market Indexes

Secondary markets can be classified as either listed security exchanges or over -the-counter (OTC) markets. Listed security exchanges operate at designated places of business and have requirements governing the types of securities they can list and trade. The OTC security markets do not have centralized places of business but rather exist as networks of security dealers connected by a communications system of telephones and computer terminals that allow the dealers to post the prices at which they are willing to buy and sell various securities.

Listed Security Exchanges

The New York Stock Exchange, sometimes called the Big Board, was founded in 1792 and is the largest stock exchange in the United States. Over 2,000 common and preferred stocks and over 800 bonds are listed on the NYSE. For a company’s stock to be listed and traded on the NYSE, the company must meet certain minimum requirements with regard to the number of shares of stock outstanding, the number of shareholders, the geographical distribution of shareholders, the value of assets, the market value of shares, and the net income level. As a result, the NYSE tends to list the stock of larger firms.

The NYSE is composed largely of security firms that purchase memberships, or seats. The cost of these seats varies, depending on the securities industry outlook. The other major organized national exchange is the American Stock Exchange, which, like the NYSE, is located in New York City. The companies listed on the AMEX are smaller on average than those listed on the NYSE.

In addition to the national exchanges, there are a number of regional exchanges located around the country. The largest are the Chicago Exchange, the Pacific Exchange, and the Philadelphia, Boston, and Cincinnati exchanges. In general, regional exchanges list stocks of companies located in their geographical areas. Many large companies are listed on both the NYSE and one or more regional exchanges. Trading activities on the NYSE and the major regional exchanges are listed together and reported in the financial press as the NYSE Composite Transactions.

Over-the-Counter Markets

Securities not listed on exchanges are said to be traded “over the counter.” In general, these include stocks of small and relatively unknown companies, although a growing number of large companies, such as Microsoft, many bank and insurance company stocks, a majority of corporate bonds and preferred stocks, and most U.S.Treasury and municipal bonds are traded in OTC markets. Security firms that deal in OTC securities and actually carry inventories in certain stocks play an important role in the smooth functioning of OTC markets, and they are said to “make a market” in the securities they inventory.

On each business day, The Wall Street Journal contains price quotations on OTC stocks having some national interest. These quotations are from NASDAQ, the automated quotation system of the National Association of Security Dealers. This system has helped to integrate more fully the OTC market at the national level.

Stock Market Indexes

Stock market indexes give a broad indication of how the stock market or a segment of it performed during a particular day. The most frequently quoted stock market index is the Dow Jones Industrial Average (DJIA), which is based on the stock prices of 30 large, well -established industrial corporations.5 The DJIA is calculated by adding the prices of the 30 stocks and dividing by a number that reflects prior stock dividends and splits.When a radio announcer says “The market was up five points today,” the announcer means the DJIA was up five points.

The Dow Jones Transportation Average is based on 20 major railroad, airline, and trucking stocks, and the Dow Jones Utility Average is derived from 15 major utility stocks. The DJIA is combined with the transportation and the utility averages to form the Dow Jones Composite Average.

The Standard & Poor’s 500 Stock Price Index (S&P 500), another frequently quoted stock market index, is significantly broader than the DJIA. It is compiled from the stock prices of 400 leading industrial firms, 20 transportation firms, 40 utilities, and 40 financial institutions. The S&P 500 is a market value weighted index. This means, for example, that a stock whose total market value is $2 billion influences the index twice as much as a stock whose total market value is $1 billion. we provides a listing and data on major stock market indexes.

Regulation of the Security Markets

Both the individual states and the federal government regulate the securities business. Beginning with Kansas in 1911, each of the 50 states (with the exception of Delaware) has passed so -called blue sky laws. The term blue sky came about when some risky securities were called nothing more than “pieces of blue sky.” In spite of these state laws, many investors received incomplete and even fraudulent security information during the 1920s.

This fact, combined with the 1929 stock market crash and the general reform spirit of the 1930s, led to the enactment of two principal pieces of security legislation the Securities Act of 1933 and the Securities Exchange Act of 1934 and the establishment of the

Securities and Exchange Commission (SEC).

This federal legislation has been aimed primarily at ensuring full disclosure of security information. In addition to regulating the disclosure of information in new security offerings and setting disclosure requirements for nearly all firms whose shares trade publicly, the SEC also regulates “insider” trading. Any time a director, officer, or major stockholder that is, an “insider” of a large corporation trades in that corporation’s securities, the trade must be reported to the SEC.

This information is available to the public and is used by some investors in deciding which stocks to buy or sell. This reporting requirement attempts to prevent insiders from trading securities secretly on the basis of private information. Insider trading is examined further in the “Market Efficiency” and “Ethical Issues” sections later in the chapter.

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