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As indicated in Section 1.1, firms offer two basic types of securities to investors. Debt securities are contractual obligations to repay corporate borrowing. Equity securities are shares of common stock and preferred stock that represent noncontractual claims to the residual cash flow of the firm. Issues of debt and stock that are publicly sold by the firm are then traded on the financial markets. The financial markets are composed of the money markets and the capital markets. Money markets are the markets for debt securities that will pay off in the short term (usually less than one year). Capital markets are the markets for long-term debt (with a maturity at over one year) and for equity shares. The term money market applies to a group of loosely connected markets. They are dealer markets. Dealers are firms that make continuous quotations of prices for which they stand ready to buy and sell money market instruments for their own inventory and at their own risk. Thus, the dealer is a principal in most transactions. This is different from a stockbroker acting as an agent for a customer in buying or selling common stock on most stock exchanges; an agent does not actually acquire the securities. At the core of the money markets are the money market banks (these are large banks mostly in New York), government securities dealers (some of which are the large banks), and a large number of money brokers. Money brokers specialize in finding short-term money for borrowers and placing money for lenders. The financial markets can be classified further as the primary market and the secondary markets. The Primary Market: New IssuesThe primary market is used when governments and corporations initially sell securities. Corporations engage in two types of primary market sales of debt and equity: public offerings and private placements. Most publicly offered corporate debt and equity come to the market underwritten by a syndicate of investment banking firms. The underwriting syndicate buys the new securities from the firm for the syndicate's own account and resells them at a higher price. Publicly issued debt and equity must be registered with the United States Securities and Exchange Commission (SEC). Registration requires the corporation to disclose all of the material information in a registration statement. The legal, accounting, and other costs of preparing the registration statement are not negligible. In part to avoid these costs, privately placed debt and equity are sold on the basis of private negotiations to large financial institutions, such as insurance companies and mutual funds, and other investors. Private placements are not registered with the SEC. Secondary MarketsA secondary market transaction involves one owner or creditor selling to another. It is therefore the secondary markets that provide the means for transferring ownership of corporate securities. Although a corporation is only directly involved in a primary market transaction (when it sells securities to raise cash), the secondary markets are still critical to large corporations. The reason is that investors are much more willing to purchase securities in a primary market transaction when they know that those securities can later be resold if desired. DEALER VERSUS AUCTION MARKETS There are two kinds of secondary markets: dealer markets and auction markets. Generally speaking, dealers buy and sell for themselves, at their own risk. A car dealer, for example, buys and sells automobiles. In contrast, brokers and agents match buyers and sellers, but they do not actually own the commodity that is bought or sold. A real estate agent, for example, does not normally buy and sell houses. Dealer markets in stocks and long-term debt are called over-the-counter (OTC) markets. Most trading in debt securities takes place over the counter. The expression over the counter refers to days of old when securities were literally bought and sold at counters in offices around the country. Today, a significant fraction of the market for stocks and almost all of the market for long-term debt have no central location; the many dealers are connected electronically. Auction markets differ from dealer markets in two ways. First, an auction market or exchange has a physical location (like Wall Street). Second, in a dealer market, most of the buying and selling is done by the dealer. The primary purpose of an auction market, on the other hand, is to match those who wish to sell with those who wish to buy. Dealers play a limited role. TRADING IN CORPORATE SECURITIES The equity shares of most of the large firms in the United States trade in organized auction markets. The largest such market is the New York Stock Exchange (NYSE), which accounts for more than 85 percent of all the shares traded in auction markets. Other auction exchanges include the American Stock Exchange (AMEX) and regional exchanges such as the Pacific Stock Exchange. In addition to the stock exchanges, there is a large OTC market for stocks. In 1971, the National Association of Securities Dealers (NASD) made available to dealers and brokers an electronic quotation system called NASDAQ (which originally stood for NASD Automated Quotation system and is pronounced "naz-dak"). There are roughly two times as many companies on NASDAQ as there are on NYSE, but they tend to be much smaller in size and trade less actively. There are exceptions, of course. Both Microsoft and Intel trade OTC, for example. Nonetheless, the total value of NASDAQ stocks is much less than the total value of NYSE stocks.
There are many large and important financial markets outside the United States, of course, and U.S. corporations are increasingly looking to these markets to raise cash. The Tokyo Stock Exchange and the London Stock Exchange (TSE and LSE, respectively) are two well-known examples. The fact that OTC markets have no physical location means that national borders do not present a great barrier, and there is now a huge international OTC debt market. Because of globalization, financial markets have reached the point where trading in many investments never stops; it just travels around the world. Exchange Trading of Listed StocksAuction markets are different from dealer markets in two ways. First, trading in a given auction exchange takes place at a single site on the floor of the exchange. Second, transaction prices of shares traded on auction exchanges are communicated almost immediately to the public by computer and other devices. The NYSE is one of the preeminent securities exchanges in the world. All transactions in stocks listed on the NYSE occur at a particular place on the floor of the exchange called a post. At the heart of the market is the specialist. Specialists are members of the NYSE who make a market in designated stocks. Specialists have an obligation to offer to buy and sell shares of their assigned NYSE stocks. It is believed that this makes the market liquid because the specialist assumes the role of a buyer for investors if they wish to sell and a seller if they wish to buy.
ListingStocks that trade on an organized exchange are said to be listed on that exchange. In order to be listed, firms must meet certain minimum criteria concerning, for example, asset size and number of shareholders. These criteria differ from one exchange to another.
NYSE has the most stringent requirements of the exchanges in the United States. For example, to be listed on NYSE, a company is expected to have a market value for its publicly held shares of at least $100 million. There are additional minimums on earnings, assets, and number of shares outstanding. The listing requirements for non—U.S. companies are somewhat more stringent. As The Real World box on this page discusses, listed companies also face significant costs arising from disclosure requirements. Table 1.3 (on p. 17) gives the market value of NYSE-listed stocks and bonds.
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