2 Securities Markets
What are Securities Markets?
Securities markets play an important role in the modern business world, and a basic understanding of markets, especially the stock market (Video 2.1), will help you better understand business news and current events.
Watch Video 2.1: How Does the Stock Market Work? for an overview of the stock market. Closed captioning is available. Click HERE to read a transcript.
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.
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, and they aim to meet the investment goals of their clients. Institutional investors control very large sums of money and are a major force in the securities markets.
What Is a Public Company?
The term public company can be defined in various ways. There are two commonly understood ways in which a company is considered public: first, the company’s securities trade on public markets; and second, the company discloses certain business and financial information regularly to the public.
Companies are subject to public reporting requirements if they:
- Sell securities in a public offering, such as an initial public offering (IPO) (Video 2.2)
- Allow their investor base to reach a certain size, which triggers public reporting obligations
- Voluntarily register with the Securities and Exchange Commission (SEC)
Watch Video 2.2: What is an IPO? to learn more about what it means to “go public” through an IPO. Closed captioning is available. Click HERE to read a transcript.
Public companies must keep their shareholders informed on a regular basis by filing periodic reports and other materials with the SEC. The SEC makes these documents publicly available without charge on its EDGAR website.
Following are reports that may be filed by U.S.-based public companies; click the name of each report type in the interactive list below to learn more:
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.
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.
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.
Secondary Markets
When we think of stock markets, we are typically referring to secondary markets, which handle most of the securities trading activity. The two segments of the secondary markets are broker markets and dealer markets. The primary difference between broker and dealer markets is the way each executes securities trades. Securities trades can also take place in alternative market systems and on foreign securities exchanges.
Broker Markets
The broker market consists of national and regional securities exchanges that bring buyers and sellers together through brokers on a centralized trading floor. In the broker market, the buyer purchases the securities from the seller through the broker.
The oldest and most prestigious broker market is the New York Stock Exchange (NYSE), which has existed since 1792. Often called the Big Board, it is located on Wall Street in downtown New York City.[1] As of early 2023, the NYSE listed the shares of 2,385 companies, including 578 foreign companies, and had a total market capitalization of $24.6 trillion in mid-2022.[2] Major companies such as IBM, Coca-Cola, AT&T, Procter & Gamble, Ford Motor Co., and Chevron list their shares on the NYSE. Companies that list on the NYSE must meet stringent listing requirements and annual maintenance requirements.
Until relatively recently, all NYSE transactions occurred on the vast NYSE trading floor. Each of the companies traded at the NYSE is assigned to a trading post on the floor. When an exchange member receives an order to buy or sell a particular stock, the order is transmitted to a floor broker at the company’s trading post. The floor brokers then compete with other brokers on the trading floor to get the best price for their customers.
In response to competitive pressures from electronic exchanges, the NYSE created a hybrid market that combines features of the floor auction market and automated trading. Its customers now have a choice of how they execute trades.
Dealer Markets
Unlike broker markets, dealer markets do not operate on centralized trading floors but instead use sophisticated telecommunications networks that link dealers throughout the United States. Buyers and sellers do not trade securities directly, as they do in broker markets. They work through securities dealers called market makers, who make markets in one or more securities and offer to buy or sell securities at stated prices. A security transaction in the dealer market has two parts: the selling investor sells his or her securities to one dealer, and the buyer purchases the securities from another dealer (or in some cases, the same dealer).
The largest dealer market is the National Association of Securities Dealers Automated Quotation system, commonly referred to as NASDAQ. The first electronic-based stock market, the NASDAQ is a sophisticated telecommunications network that links dealers throughout the United States. The NASDAQ lists more companies than the NYSE, but the NYSE still leads in total market capitalization. The NASDAQ’s sophisticated electronic communication system provides faster transaction speeds than traditional floor markets.
The securities of many well-known companies trade on the NASDAQ. Examples include Amazon, Apple, Costco, Comcast, JetBlue, Microsoft, and Starbucks. The stocks of most commercial banks and insurance companies also trade in this market, as do most government and corporate bonds. As of early 2023, 3,629 companies were listed on the NASDAQ, including 864 foreign companies.[3]
Bonds
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. Corporations can also issue mortgage bonds, bonds secured by property such as land, buildings, or equipment.
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.
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.
Municipal bonds are issued by states, cities, counties, and other state and local government agencies. 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). Table 2.1 lists the letter grades assigned by Moody’s and S&P. A bond’s rating may change if a company’s financial condition changes.
| 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. |
Mutual Funds and ETFs
In addition to stocks and bonds, investors can buy mutual funds, a very popular investment category, or exchange-traded funds (ETFs).
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 appeal to investors for three main reasons:
- 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 (Video 2.3) because they hold a broad basket of stocks with a common theme, giving investors instant diversification. ETFs trade on stock exchanges, 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. ETFs tend to have low expense ratios, but because they trade as stocks, investors may pay commissions to buy and sell ETF shares.
Watch Video 2.3: Mutual Funds vs. ETFs to learn more about these two popular securities, how they are similar, and how they differ. Closed captioning is available. Click HERE to read a transcript.
Regulation of Securities Markets
Both state and federal governments regulate the securities markets. The states were the first to pass laws aimed at preventing securities fraud. But most securities transactions occur across state lines, so federal securities laws are more effective. In addition to legislation, the industry has self-regulatory groups and measures.
Securities Legislation
Congress passed the Securities Act of 1933 in response to the 1929 stock market crash and subsequent problems during the Great Depression. It protects investors by requiring full disclosure of information about new securities issues. The issuer must file a registration statement with the Securities Exchange Commission (SEC), which must be approved by the SEC before the security can be sold.
The Securities Exchange Act of 1934 formally gave the SEC power to regulate securities exchanges. The act was amended in 1964 to give the SEC authority over the dealer markets as well. The amendment included rules for operating the stock exchanges and granted the SEC control over all participants (exchange members, brokers, dealers) and the securities traded in these markets.
The 1934 act also banned insider trading, the use of information that is not available to the general public to make profits on securities transactions. Because of lax enforcement, however, several big insider trading scandals occurred during the late 1980s. The Insider Trading and Fraud Act of 1988 greatly increased the penalties for illegal insider trading and gave the SEC more power to investigate and prosecute claims of illegal actions. The meaning of insider was expanded beyond a company’s directors, employees, and their relatives to include anyone who gets private information about a company.
Other important legislation includes the Investment Company Act of 1940, which gives the SEC the right to regulate the practices of investment companies (such as mutual funds managed by financial institutions), and the Investment Advisers Act of 1940, which requires investment advisers to disclose information about their background. The Securities Investor Protection Corporation (SIPC) was established in 1970 to protect customers if a brokerage firm fails, by insuring each customer’s account for up to $500,000.
In response to corporate scandals that hurt thousands of investors, the SEC passed new regulations designed to restore public trust in the securities industry. It issued Regulation FD (for “fair disclosure”) in October 2000. Regulation FD requires public companies to share information with all investors at the same time, leveling the information playing field. The Sarbanes-Oxley Act of 2002 has given the SEC more power when it comes to regulating how securities are offered, sold, and marketed.
Self-Regulation
The investment community also regulates itself, developing and enforcing ethical standards to reduce the potential for abuses in the financial marketplace. The Financial Industry Regulatory Authority (FINRA) oversees thousands of brokerage firms and more than 624,000 registered brokers.[4] It develops rules and regulations, provides a dispute resolution forum, and conducts regulatory reviews of member activities for the protection and benefit of investors.
In response to “Black Monday”—October 19, 1987, when the Dow Jones Industrial Average plunged 508 points and the trading activity severely overloaded the exchange’s computers—the securities markets instituted corrective measures to prevent a repeat of the crisis. Now, under certain conditions, circuit breakers stop trading for a 15-minute cooling-off period to limit the amount the market can drop in one day. Under revised rules approved in 2012 by the SEC, market-wide circuit breakers kick in when the S&P 500 Index drops 7 percent (level 1), 13 percent (level 2), and 20 percent (level 3) from the prior day’s closing numbers.[5]
Global Trading and Foreign Exchanges
Improved communications and the elimination of many legal barriers are helping the securities markets go global. The number of securities listed on exchanges in more than one country is growing. Foreign securities are now traded in the United States. Likewise, foreign investors can easily buy U.S. securities.
Stock markets also exist in foreign countries: more than 60 countries operate their own securities exchanges. NASDAQ ranks second to the NYSE, followed by the London Stock Exchange (LSE) and the Tokyo Stock Exchange. Other important foreign stock exchanges include Euronext (which merged with the NYSE but operates separately) and those in Toronto, Frankfurt, Hong Kong, Zurich, Australia, Paris, and Taiwan.[6]
Why should U.S. investors pay attention to international stock markets? Because the world’s economies are increasingly interdependent, businesses must look beyond their own national borders to find materials to make their goods and markets for foreign goods and services. The same is true for investors, who may find that they can earn higher returns in international markets.
Chapter Review
Optional Resources to Learn More
 |
Articles |
| “Market Capitalization: How Is It Calculated and What Does It Tell Investors?” https://www.investopedia.com/terms/m/marketcapitalization.asp | |
 |
Videos |
| “The Stock Market” https://youtu.be/ZCFkWDdmXG8 | |
 |
Websites |
| Corporate Finance Institute https://corporatefinanceinstitute.com/resources/ | |
| How Stock Markets Work https://www.investor.gov/introduction-investing/investing-basics/how-stock-markets-work | |
| Investopedia https://www.investopedia.com/financial-term-dictionary-4769738 |
Chapter Attribution
This chapter incorporates material from the following sources:
Chapter 16 of Gitman, L. J., McDaniel, C., Shah, A., Reece, M., Koffel, L., Talsma, B., & Hyatt, J. C. (2018). Introduction to business. OpenStax. https://openstax.org/books/introduction-business/pages/16-introduction. Licensed with CC BY 4.0.
Investor.gov. (n.d.). Public companies. https://www.investor.gov/introduction-investing/investing-basics/how-stock-markets-work/public-companies. This content is in the public domain.
Media Attributions
Video 2.1: Ted-ED. (2019, April 29). How does the stock market work? [Video]. YouTube. https://youtu.be/p7HKvqRI_Bo
Video 2.2: CNBC. (2018, May 3). What is an IPO? [Video]. YouTube. https://youtu.be/l4HMCr5roAM
Video 2.3: Wall Street Journal. (2016, February 8). Mutual funds vs. ETFs: Which is right for you? [Video]. YouTube. https://youtu.be/Es3vXJ7GoV8
- Statista Research Department. (2023, May 22). Comparison of the number of listed companies on the New York Stock Exchange (NYSE) and Nasdaq from 2018 to 1st quarter 2023, by domicile. Statista. https://www.statista.com/statistics/1277216/nyse-nasdaq-comparison-number-listed-companies/ ↵
- Kenton, W. (2022, August 31). New York Stock Exchange (NYSE): Definition, how it works, history. Investopedia. https://www.investopedia.com/terms/n/nyse.asp ↵
- Statista Research Department. (2023, May 22). Comparison of the number of listed companies on the New York Stock Exchange (NYSE) and Nasdaq from 2018 to 1st quarter 2023, by domicile. Statista. https://www.statista.com/statistics/1277216/nyse-nasdaq-comparison-number-listed-companies/ ↵
- FINRA. (n.d.). About FINRA. Retrieved August 14, 2023, from https://www.finra.org/about ↵
- Guzman, Z., & Koba, M. (2016, January 7). When do circuit breakers kick in? CNBC explains. CNBC. https://www.cnbc.com/2015/08/24/when-do-circuit-breakers-kick-in-cnbc-explains.html ↵
- Statista (n.d.). Stock exchanges - statistics & facts. Statista. Retrieved October 27, 2023, from https://www.statista.com/topics/1009/global-stock-exchanges/#topicOverview ↵
Investment certificates that represent either equity (ownership in the issuing organization) or debt (a loan to the issuer).
Funds provided in exchange for a share of ownership in a business.
Borrowing funds that must be repaid, usually with interest.
Investment professionals who are paid to manage other people’s money.
A company that is subject to public reporting requirements and whose securities trade on public markets.
Process by which a company lists its ownership shares on a public stock exchange.
The SEC is an independent federal agency, established pursuant to the Securities Exchange Act of 1934, whose mission is "to protect investors, maintain fair, orderly, and efficient markets, and facilitate capital formation."
The securities market where new securities are sold to the public.
The securities market where old (already issued) securities are bought and sold, or traded, among investors; includes broker markets, dealer markets, the over-the-counter market, and the commodities exchanges.
Firms that act as intermediaries, buying securities from corporations and governments and reselling them to the public.
The process of buying securities from corporations and governments and reselling them to the public; the main activity of investment bankers.
A person who is licensed to buy and sell securities on behalf of clients.
Consists of national and regional securities exchanges that bring buyers and sellers together through brokers on a centralized trading floor. The NYSE is a broker market.
The oldest and most prestigious broker market, which has existed since 1792 and is located on Wall Street in downtown New York City.
In contrast to broker markets, buyers and sellers do not trade securities directly. Instead they work through securities dealers called market makers, who make markets in one or more securities and offer to buy or sell securities at stated prices. A security transaction in the dealer market has two parts: the selling investor sells his or her securities to one dealer, and the buyer purchases the securities from another dealer (or in some cases, the same dealer). The NASDAQ is a dealer market.
The first and largest electronic stock market, which is a sophisticated telecommunications network that links dealers throughout the United States.
Long-term debt obligations (liabilities) of corporations and governments.
Also called face amount or face value. This is equal to the principal amount that the issuer will repay at the end of the bond term or maturity date.
Bonds secured by property such as land, buildings, or equipment.
High-risk, high-return bonds often used by companies whose credit characteristics would not otherwise allow them access to the debt markets.
Bonds that allow the bondholder to exchange each bond for a specified number of shares of common stock.
Bonds issued by states, cities, counties, and other state and local government agencies.
Letter grades assigned to bond issues to indicate their quality or level of risk; assigned by rating agencies such as Moody’s and Standard & Poor’s (S&P).
A financial-service company that pools investors’ funds to buy a selection of securities that meet its stated investment goals.
A security similar to a mutual fund; holds a broad basket of stocks with a common theme but trades on a stock exchange so that its price changes throughout the day.
The use of information that is not available to the general public to make profits on securities transactions.
Procedures for coordinated cross-market trading halts if a severe market price decline reaches levels that may exhaust market liquidity. These procedures, known as market-wide circuit breakers, may halt trading temporarily or, under extreme circumstances, close the markets before the normal close of the trading session.
