The Capital Markets

Selling securities to investors in the various capital markets provides the means for corporations, governments and government agencies to satisfy their need for capital, thus providing investors the opportunity to profit by trading capital for securities, which are transferable claims on the assets of the entity that originally sold the securities. More specifically, securities are financial assets that are transferable claims on the real assets of the issuer of the securities. The capital markets, a.k.a. securities markets, consist of the primary capital markets where securities are first sold to institutional investors and the various stock, bond and commodities exchanges where securities are subsequently traded.

There are two primary types of securities: debt and equity. Equities include common stock and preferred stock. Debt securities include bonds, convertible bonds, commercial paper, short-term government debt and certificates of deposit. A third type of security, derivatives, derive their value from some underlying asset that may be another security, a tangible asset, the option to buy or sell an asset at a predetermined price or a contract to buy or sell an asset at a predetermined price. However, derivatives are not used as a means for raising capital, rather, they are typically used as a means of hedging, financial engineering or speculating.

Mutual funds are securities comprised of pools of other securities that may be debt, equities or derivatives. With the exception of commodities funds, mutual funds typically restrict their use of derivatives to hedging. Commodities funds use derivatives extensively to either model an index or to model a portfolio of their own design, thus eliminating the unnecessary expense and inconvenience of actually taking possession of the commodities in their portfolios.

Corporations, government agencies and municipal governments raise capital by selling their securities in the primary capital markets to institutional investors. After this initial sale the securities are traded in the secondary capital markets, which is where individual investors buy and sell securities. The U.S. Treasury sells its securities directly to institutional and individual investors. After it's initial sale, Treasury debt also is sold in the secondary market. CDs also are sold directly to institutional and individual investors.

Nearly all U.S. equities are traded on one of the three U.S. stock exchanges: The New York Stock Exchange, the American Stock Exchange and the NASDAQ. These exchanges and the lesser-known exchanges make up the secondary market for equities, which serve both individual and institutional investors.

The New York and American stock exchanges are physical auction-type exchanges where securities are traded at bid and asked prices and liquidity is provided by specialists who make up any imbalances between buy and sell orders. The specialists provide liquidity by keeping inventories of the stocks in which they specialize and by setting the bid price to maintain a balance between supply and demand (i.e., sell orders and buy orders). When a balance can't be maintained, they absorb any excess sell orders and add to their inventories or sell from their inventories to cover excess buy orders. The bid-ask spread is the market specialists' profit, which compensates them for providing liquidity to these capital markets.

The NASDAQ, which stands for National Association of Securities Dealers Automated Quotation System, was formed in 1971 by the National Association of Securities Dealers (NASD) then subsequently sold in 2000 and 2001, at which time it became The NASDAQ Stock Market. The NASDAQ also operates on a bid-ask basis but it is a fully automated electronic system. Liquidity is provided to this capital market by brokerages who act as dealers that fulfill the same function as the specialists on the physical exchanges. The dealers are said to make a market in the stocks in which they specialize and are thus known as market makers. They, too, are compensated for this service by the bid-ask spread.

Mutual fund shares are sold and redeemed by the fund companies and an exact balance is maintained between sales and redemptions by issuing or dissolving shares, thus there is no need for secondary capital markets for these securities. Individuals can deal directly with the mutual fund companies or through a discount or full-service broker. In the case of no load mutual funds, there will never be a charge for purchases or redemptions, but trades made through a discount brokerage may be subject to a transaction fee and trades made through a full-service brokerage will always be subject to a transaction fee.

Individuals can buy and sell Treasury bonds through the U.S. Treasury's Treasury Direct service, which is the Treasury's exclusive capital market. Individuals must trade corporate and municipal bonds through a brokerage in one of the secondary capital markets. Mutual funds and other institutional investors can purchase corporate and municipal bonds in the primary market and have more options than individuals for trading existing issues of all types of bonds.

Whenever the need for capital arises, corporations, governments and government agencies will return to the capital markets to sell more debt and/or equity securities. Occasionally, corporations will use excess cash to buy back a portion of their outstanding common stock or callable bonds, or issue new debt when interest rates drop and use the proceeds to "call back" their older, higher interest callable bonds. When high-interest bonds are called and replaced with bonds that have a lower coupon, the companies' cost of capital is decreased assuming there is no concurrent change in the company's capital structure. There are a number of opinions as to what effect these actions could have on a company's stock under various scenarios. That issue is beyond the scope of this subsection.

The U.S. Federal Reserve Board of Governors' Federal Open Market Committee (FOMC) will from time to time buy Treasury debt in the capital markets as part of its monetary policy. By purchasing Treasury debt on the open market, the Fed increases the money supply. This is usually done to decrease interest rates and stimulate the economy. It also is done to ward off deflation, which is extremely rare. So rare, indeed, that it hasn't happened since the Great Depression, although we were close, by some accounts, in the early and late 2000s and looking at a distinct possibility in the early 2010s. Increasing the money supply for any reason other than to keep pace with ordinary economic expansion is inflationary, so there needs to be a good reason to do it, like reviving a faltering economy or countering deflation.