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Lesson Explainer: Stock Market Economics

In this explainer, we will learn how to identify stocks and bonds and characterize the role of the stock market in a country’s economy.

As economies around the world are growing in size and complexity, the stock market is becoming increasingly important, not only to the national economy, but also for personal finance. Attracted by high potential return on investments, many individuals today put their money in the stock market rather than in commercial banks. To satisfy the investors’ interest in the stock market, many newspapers dedicate special sections to the stock market. Larger stock market events can be occasionally seen in the front pages of newspapers, since they affect everyone in the economy. This raises the following question: Why is the stock market so important in today’s economy?

To answer this question, let us begin by discussing the most fundamental function of the stock market, which is to provide financial resources to the firms in the economy. Firms in the economy require a lot of resources to begin their production or to increase the scale of their existing production. In some cases, the firms can afford to use their own cash reserve or a portion of their profits from existing production to fund new developments. However, this is not always possible. Often, expanding the scale of production to meet the needs on a national or an international level requires very large sums of money. Hence, firms need a way to raise capital, that is, to acquire money needed for their developments.

We recall that firms can raise capital by borrowing from commercial banks. Commercial banks function as financial intermediaries between savers and borrowers by collecting deposits from savers and making loans to borrowers. Firms can apply for loans from commercial banks, which they need to repay with interest at a later date. Interest rates for these loans are based on many different factors, including the firm’s creditworthiness. Part of these interest payments is used to cover the defaulted loans, so banks need to assign higher interest rates on loans with higher default risk to account for the possibility of not recovering the full amount. If the default risk is excessive, commercial banks may also reject the firm’s loan application.

From the firm’s perspective, higher interest rates reduce the benefit of borrowing from commercial banks, even when their loan applications may be approved. A firm may need to raise capital for a long-term or a risky project, for which commercial banks would assign high interest rates. This makes it more difficult for firms to make profit after paying interest. Hence, firms turn to individual investors who may be willing to lend their money for these projects. If the firms are successful, these investors can reap the benefits directly from the firms without going through commercial banks.

Firms can raise capital from individual large-scale, or institutional, investors who can finance their projects. An institutional investor is a person who makes investment decisions with other people’s (clients’) money, while a large-scale investor is an individual investor with a large pool of money. To borrow money from these investors, the firms need to convince each investor that their projects will be successful and that the investor can profit from participating in the firm’s new projects. Sometimes, these investors are given rights to participate in the firm’s management since the return of their investment depends on the firm’s success. By borrowing directly from these investors, the firms can avoid the need to go through commercial banks to access new capital.

While these agreements and investment decisions can be made without a legal system in place, it is then difficult for all parties involved to trust that the other parties will fulfill their end of the deal. This uncertainty will likely cause investors to hesitate before entrusting large amounts of money to these firms. In this regard, the stock market serves as a mediator between firms and investors by providing this marketplace. The stock market itself does not refer to a physical marketplace, but the term encompasses the entire framework, including all its participants, regulations, and buildings, which together create a marketplace where firms can raise capital by selling their financial contracts, called securities. Mainly, there are two types of securities that are issued and traded in the stock market: stocks and bonds. Both stocks and bonds allow the firm to raise capital in the stock market.

In our first example, we will consider how private firms can raise capital for new investments.

Example 1: Raising Capital

Which of the following is not a possible source of new capital for private firms?

  1. A stock
  2. A commercial bank
  3. A bond
  4. The central bank
  5. An investor

Answer

Recall that capital is the money a firm requires to pay for new developments. In some cases, this capital can originate from the firm’s own cash reserve or profits from the firm’s other ongoing projects, but this is not the case here, since the question requires “new” capital.

Let us consider each of the given options and determine whether it is a possible source of new capital for private firms.

  1. A stock is a financial instrument, that is, a security, issued by a firm in the stock market. Issuing stocks allows private firms to raise capital from investors. Hence, a stock is a possible source of new capital for private firms.
  2. A commercial bank can make loans to firms, which the firms need to repay with interest. Hence, a commercial bank is a possible source of new capital for private firms.
  3. A bond, like a stock, is a security issued by a firm in the stock market, allowing the firm to raise capital from investors. Hence, a bond is a possible source of new capital for private firms.
  4. The central bank does not deal with private firms, but its customers are restricted to the government and other banks. Hence, the central bank is not a possible source of new capital for private firms.
  5. Firms can raise capital from institutional or large-scale investors who can afford to finance their projects. To do so, the firms need to convince each investor why they can be entrusted with the money and how the firms plan to return their profits to the investors. Hence, an investor is a possible source of new capital for private firms.

Option D, the central bank, is not a possible source of new capital for private firms.

We have mentioned that the shared function of stocks and bonds is to allow firms to raise capital from investors in the stock market. However, stocks and bonds are two very different securities. Let us consider the characteristics of these securities.

A stock entitles its holders, called shareholders, to a fractional “ownership” of the firm, where the percentage of ownership is proportional to the number of outstanding stock shares. This “ownership” does not literally mean that shareholders own the firm, which would include its physical properties and liabilities, but it refers to specific legal rights. To protect shareholders from the firm’s liabilities, stock-issuing firms, or corporations, are given legal status as individuals, allowing the firms to have their own assets as well as bank accounts. Hence, the corporation’s liability is on the corporation itself rather than its owners, and the firm’s assets are seized and sold to repay its debts when it fails to meet its obligations. This legal framework protects shareholders from the firm’s liabilities.

Shareholder’s rights can be divided into voting rights and cash flow rights. Voting rights, also known as control rights, allow shareholders to participate indirectly in the management of the firms by voting on a number of important decisions. For instance, shareholders can vote for the firm’s new directors, while the nominations are made by more significant stakeholders known as the board of directors. Elected directors are then legally obligated to represent shareholders’ interest in the management of the firm and are subject to lawsuits for violations. Additionally, shareholders can vote on matters involving fundamental changes to the firm, including mergers (i.e., consolidating two different firms into one firm) or liquidation (i.e., selling the corporation’s assets to pay for outstanding debts).

Cash flow rights entitle shareholders to portions of the firm’s profits. We know that a firm’s profits are returned to its owners as income. Since shareholders are legal owners of the firm, the firm’s profits are distributed evenly among shareholders in proportion to the number of shares held. There are two different ways of distributing profits. First, firms can distribute their profits to shareholders directly in cash payments known as dividends. The amount of dividends paid depends on the number of shares held as well as the firm’s profits during an accounting period. However, not all corporations pay profits as dividends. Another method of distributing profits is through reinvestment, which is an indirect method of returning profits to shareholders by increasing the value of each stock share. In reinvestment, corporations invest their profits to expand their operations, rather than paying them out as dividends, so that their future stock prices will increase. Since shareholders own these shares, their elevated prices would reflect the firm’s profits. The following diagram represents the cash flow involved in the stock security between investors and firms.

Since shareholders “own” a fraction of the firm, they also share a portion of the firm’s risks. Unlike in the case of loans, the firm is not obligated to repay the original investment to shareholders, nor does the firm pay interest on the raised capital. Also, stocks do not have predetermined terms, which makes them good securities for firms interested in financing long-term projects. The ability to raise long-term capital as well as the absence of liabilities are the benefits of stock as a security. However, when a firm issues stocks, its original owners, or founders, forfeit a portion of their ownership of the firm. The firm’s profits as well as decision-making powers are shared proportionately with the shareholders. While a firm’s original owners may purchase back their own stock shares to regain control of the firm, this repurchase often is done at a much higher price compared to the initial sale. Hence, a decision to issue stocks should be made after careful consideration since it is not easily reversed. While the loss of control and profit sharing are disadvantages of issuing stock, shared ownership can also be an advantage since it distributes the firm’s risk to the shareholders.

In our next example, we will consider shareholders’ rights.

Example 2: Understanding Shareholders’ Rights

Which of the following are rights of shareholders?

  1. Participation in the firm’s management
  2. The firm’s physical assets
  3. Recovery of the original stock price
  4. A portion of the firm’s profits
  5. A portion of the firm’s debts

Answer

Recall that a stock entitles shareholders to a fractional “ownership” of the firm proportional to the number of outstanding stock shares. However, this “ownership” does not literally mean that shareholders own the firm, including its physical assets and liabilities. Instead, shareholder’s ownership rights are divided into voting rights and cash flow rights.

Let us consider each option to determine whether it describes a shareholder’s right.

  1. Voting rights provide shareholders their rights to participate in the firm’s management. In particular, shareholders can elect the firm’s directors, who then must serve the shareholders’ collective interest. Shareholders can also vote on matters concerning fundamental changes in the firm’s structures, such as mergers and liquidation. Hence, participation in the firm’s management is one of the shareholder’s legal rights.
  2. While shareholders are fractional “owners” of the firm, it does not mean that they own the firm’s physical properties, such as the office building and equipment. Shareholders’ rights as owners are restricted to voting rights and cash flow rights, which does not include their rights to the firm’s physical assets. Hence, the firm’s physical assets are not part of shareholders’ legal rights.
  3. Unlike in the case of loans, firms do not have to repay the amount of capital raised through issuing stocks. Shareholders carry a portion of the firm’s risk because their investment may be diminished if the firm does not succeed. In such cases, shareholders may lose a part or all of their original investment. Hence, recovery of the original stock price is not a part of shareholders’ legal rights.
  4. Cash flow rights entitle shareholders to a portion of the firm’s profits. Profits can then be distributed either as dividends, which are direct cash payments to shareholders, or as reinvestment, which is indirectly reflected in the increased stock price. Hence, sharing in a portion of the firm’s profits is one of the shareholder’s legal rights.
  5. While shareholders “own” a portion of the firm, they are not liable to the firm’s debts. If the firm is unable to repay its debts, its assets must be sold off to pay for the debts. But for the shareholders, while they may be affected by decreased or diminished stock prices, their personal properties are not at risk to be sold off to cover the firm’s obligations. Hence, sharing in a portion of the firm’s debts is not a part of shareholders’ legal rights or obligations.

Options that correctly describe the rights of shareholders are option I, which describes the shareholder’s voting rights, and option IV, which describes the shareholder’s cash flow rights.

Let us now discuss the characteristics of bonds. A bond is a security through which an entity can borrow from investors in the stock market. A bond issuer can be a firm, in which case it is a corporate bond, or it can be a government, in which case it is a municipal (local) or treasury (national) bond. In this lesson, we will only discuss the characteristics of corporate bonds. Corporate bonds are sold in units of a standard face value, or par value, which is the amount owed by the firm at the end of a specified period, which is the maturity date. The proceeds from the sale of these bonds are how firms can borrow directly from investors in the stock market rather than take loans from commercial banks. Like in the case of bank loans, the firm is obligated to repay its debt plus interest. Unlike bank loans, these long-term debt securities are tradable in the stock market.

Interest payments on bonds are generally delivered through coupons, which are periodic cash payments to bondholders resembling stock dividends. While stock dividends depend on the firm’s profits, bond coupons are constant payments in each payment period. The following diagram represents the cash flow involved in the bond security between investors and firms.

Together with the coupon payments, the real interest rate on bonds also depends largely on the bond’s price when it is first sold. If investors in the stock market consider the firm to be risky, their bonds will be priced lower than their face value, which means that the firm will receive less money for their bond compared to what they will owe at the end of the bond’s term. Since the firm needs to pay back the bond’s face value regardless of its market price, a lower market price means that the firm is essentially paying a higher interest rate on the loan.

Let us consider benefits of issuing bonds to raise capital. Generally, firms can obtain lower interest rates on capital when issuing bonds compared to taking loans from commercial banks. Lower interest rates mean more profits for the firms, which makes bonds more attractive than bank loans. Additionally, bond issuers only need to make periodic coupon payments, and the face value is only due at the end of the bond’s term. In comparison, most bank loans require repayment throughout the loan’s term, which makes it more difficult for firms to take full advantage of the borrowed amount. The ability to postpone the full repayment to the end of the term makes the bond an attractive security to raise capital for long-term projects.

Unlike shareholders, bondholders are not owners of the firm and they cannot intervene in the firm’s management. Instead, bondholders are creditors, that is, lenders, to the firm, and the firm is obligated to repay the bond’s face value as well as coupons. When the firm, or corporation, cannot meet these obligations, bankruptcy is declared, which is a legal statement indicating that the firm cannot fulfill its obligations. In the event of bankruptcy, the corporation’s assets are seized and put on sale, and the proceeds from the sale are distributed to the bondholders before any shareholders are compensated. If the proceeds exceed the amount of liabilities, any excess is then distributed among the shareholders.

In our next example, we will consider legal rights of bondholders.

Example 3: Legal Rights of Bondholders

Which of the following does not correctly describe a legal right of bondholders?

  1. Bondholders have priority over shareholders in a firm’s assets in case of bankruptcy.
  2. Bondholders have the right to share in the firm’s profits.
  3. Bondholders have a right to interest payments.
  4. Bondholders have the right to recover the face value of a bond at the end of its term.

Answer

Recall that a bond is a security that allows firms to borrow directly from investors in the stock market. Bonds are essentially loans, although they differ from bank loans in the repayment structure. Let us consider each option to determine whether or not it correctly describes legal rights of bondholders.

  1. When the firm is unable to make coupon payments during the term or return the bond’s face value at the end of the term, it needs to declare bankruptcy. Upon this declaration, the firm’s assets are sold off to meet its obligations first to its creditors, who are the bondholders. Shareholders, who are owners of the firm, only receive compensation if there is excess funds remaining after the bondholders’ rights are met. Hence, this option correctly describes bondholders’ legal rights.
  2. Bondholders are creditors to the firm and are entitled to the repayment of the debt plus interest. However, bondholders do not have any direct claim toward the company’s profits. While the company’s profits mean that it is more likely to be able to fulfill its debt obligations, bondholders still will not receive any additional payments due to profits. Hence, this option incorrectly describes bondholders’ legal rights.
  3. Bondholders are entitled to regular interest payments on the firm’s debts, which are paid in the form of coupons. These payments must be fulfilled regardless of the firm’s profits, or bankruptcy of the firm must be declared. Hence, this option correctly describes bondholders’ legal rights.
  4. Bond issuers must deliver the bond’s debt, which is represented by its face value, to the bondholders at the end of the bond’s term. Repayment of the bond’s face value completes the firm’s obligation toward its creditors. Hence, this option correctly describes bondholders’ legal rights.

Option B, the right to share in the firm’s profits, is not one of the bondholders’ legal rights.

We can summarize the characteristics of stocks and bonds in the following table.

Point of ComparisonStocksBonds
DefinitionA stock entitles its holders, called shareholders, a fractional “ownership” of the firm, where the percentage of ownership is proportional to the number of outstanding stock shares.A bond is a security through which an entity can borrow from investors in the stock market. A bond issuer can be a firm, in which case it is a corporate bond, or it can be a government.
OwnershipShareholders “own” a fraction of the firm. They also share a portion of the firm’s risk.Bondholders are not owners Of the firm and they cannot intervene in the firm’s management. Instead, bondholders are creditors, that is, lenders, to the firm.
BenefitsShareholders indirectly participate in firms’ management (voting rights) and are entitled to portions of the firms’ profits (cash flow rights), which are known as dividends.Interest payments on bonds are generally delivered through coupons, which are periodic cash payments to bondholders. In addition, bondholders get the face value of the bond at the maturity date.

Let us consider how these securities are issued and traded in the stock market.

The stock market can be divided into primary and secondary markets. The primary market, also known as the issuance market, is the marketplace where securities are first issued and sold. Like the term stock market, primary market does not refer to a physical building, but rather it refers to the framework, together with investors, borrowers, and intermediaries involved in issuing and selling of the securities. Securities are first offered for sale through the primary market, from which the firms raise their capital. The initial public offering, or IPO, is a major component of the primary market where firms offer their stock for sale for the first time.

The primary market is heavily regulated, and the issuance of securities such as stocks and bonds involves lengthy processes, requiring approval from the government agency overseeing the stock market. Here, investment banks assist the firms through a process called underwriting. The term underwriting is commonly used when someone takes on the risk involved in financial agreements, such as loans, in exchange for a fee. In the primary market, this term refers to a specific process in accordance with the country’s laws. Security underwriting is generally performed by a group of investment banks called the syndicate banks. To begin the underwriting process, the syndicate banks survey large-scale and institutional investors within their networks to gauge their interest in purchasing the firm’s securities. Based on the level of interest as well as the firm’s risk, the underwriters determine the price of each share to be offered at the IPO. Underwriters also guarantee the sale of a certain number of shares at this price and are obligated to purchase any unsold shares themselves. In this way, underwriters take on the risk of issuing these securities.

Regular investors cannot buy securities at the primary market. Participants in the primary market are limited to firms, investment banks, institutional and large-scale investors. Regular investors can buy these securities that had already been issued and purchased through the secondary market, which is also known as the exchange market. Large-scale investors, institutional investors, and underwriters who purchased securities from the primary market can liquidate (sell) their shares in the secondary market to convert them to money. Typically, shares are sold at higher prices in the secondary market, leaving profits to underwriters for compensation of their risk. While the primary market mainly serves as a place for firms to raise capital through issuing securities, the secondary market provides a marketplace for regular investors to buy or sell securities.

Besides the apparent distinction in their roles, the primary and secondary markets differ significantly in regard to how the prices of securities are determined. In primary markets, securities are priced by the underwriters, and buyers such as institutional or large-scale investors purchase the securities at the predetermined price. In secondary markets, securities are priced by the market mechanism, that is, supply and demand. If the amount of securities offered for sale exceeds the amount buyers in the market demand, the price of the security will decrease. Conversely, if investors want to buy more securities than what is currently offered for sale, the security’s price will increase. This market mechanism causes the prices of securities to be volatile, especially when new information such as the company’s quarterly performance reports is released. Generally, bond prices are more stable than stock prices since bondholders are guaranteed the return of the bond’s face value as well as coupon payments.

Like the primary market, the secondary market is heavily regulated. The government agency regulating the stock market closely supervises trading activities and places restrictions on the types of securities traded in the market. Generally, security trading happens within physical buildings in centralized locations known as trading floors, of which the New York Stock Exchange (NYSE) is the largest in terms of the size of trading activities. Trading floors have restricted access that limits admissions to specialized individuals such as financial brokers, and average investors need to place their orders through brokers. Brokers are financial intermediaries, generally working for investment banks, who carry out transactions of securities on behalf of their clients. Brokers charge a fee for each transaction, which is usually a flat fee per transaction.

Securities not meeting regulations are traded more informally through the Over-the-counter (OTC) market, which is not a physical place. The OTC market is a decentralized marketplace where traders directly perform transactions with each other without going through brokers. The OTC market provides a trading network for traders but does not mediate transactions.

In the next example, we will consider the components of the stock market.

Example 4: Functions of the Secondary Market

Which of the following does not accurately describe a function of the secondary market?

  1. Brokers carry out transactions of securities in the secondary market on behalf of their clients.
  2. A government agency oversees trading activities in the secondary market.
  3. Investors can buy or sell securities through the secondary market.
  4. Most trading of the secondary market occurs within physical buildings to which access is restricted.
  5. Firms can issue new securities through the secondary market.

Answer

Recall that the stock market is a marketplace where securities such as stocks and bonds are issued and traded. The primary market is where securities are issued and sold initially to large-scale investors and underwriters, and the secondary market is where these securities can be sold or bought by average investors.

Let us consider each option to determine whether it correctly describes the function of the secondary market.

  1. For average investors, it is difficult to buy or sell their securities directly in the secondary market, especially in the physical buildings, that is, trading floors, where most of the trading that occurs is restricted to authorized individuals. Hence, financial brokers, who usually work for investment banks, buy or sell their clients’ securities in trading floors. Hence, this option correctly describes a function of the secondary market.
  2. The secondary market is heavily regulated, and a specialized government agency closely watches trading activities for any sign of foul play. The agency also sets and enforces policies, restricting types of assets that can be traded in the secondary market. Hence, this option correctly describes a function of the secondary market.
  3. This is the main role of the secondary market, as mentioned above. Regular investors can buy or sell their securities in the secondary market according to the regulations set by the government agency. For this role, the secondary market is also known as the exchange market. Hence, this option correctly describes a function of the secondary market.
  4. The vast majority of trading in the secondary market occurs within trading floors, which are centralized physical locations with restricted access. Only authorized individuals, such as financial brokers, can enter the trading floors to conduct their trades. Hence, this option correctly describes a function of the secondary market.
  5. Firms can only issue new securities through the primary market. The role of the secondary market is limited to trading already-issued securities. Hence, this option does not describe a function of the secondary market.

Option E, issuance of new securities, is not a function of the secondary market.

Let us discuss the functions of the stock market in a nation’s economy. The primary role of the stock market is to help firms raise capital directly from investors. While there are many secondary effects of the stock market, this is the main reason the stock market exists. In particular, firms can obtain funds for riskier or longer-term projects in the stock market, while such loans would be difficult to obtain from commercial banks. The stock security has additional benefits of sharing the firm’s risk with the shareholders, and the bond security has benefits of lower interest rates and flexible repayment structure. Firms invest the raised capital to increase the scale of their production or to begin new production. Collectively, capital raised through the stock market leads to economic growth since the firms in the economy can produce more goods and services.

While the primary role of the stock market mentioned above is to benefit the firms, the stock market also benefits the investors by providing a stable and reliable marketplace for them to purchase securities. Securities traded in the stock market typically offer a higher rate of return on investments compared to interest rates from commercial banks. However, this higher rate may not be realized if the firm’s performance does not meet expectations or if the firm is facing times of economic instability. Investing in the stock market accompanies the risk of losing the investment, while deposits in saving accounts in commercial banks are guaranteed by the nation’s central bank. Despite the risk, many investors are attracted by the overall faster growth rate of money through the stock market.

The stock market also provides a place, that is, the secondary market, where investors can easily sell their securities. In other words, the stock market gives securities liquidity, that is, the ability to easily convert an asset into money. Typically, investors can only sell their securities within the trading hours, which is when the trading floors are open. Within trading hours, security holders can request their brokers to sell any number of their shares. Today, most of these orders are submitted through the Internet, and transactions are almost instantaneous due to the high volume of trade in the stock market. For this reason, holding securities is almost as versatile as having the money in a bank deposit.

The stock market, through its regulations, provides guarantees for financial obligations of all parties involved. Security buyers must pay for the security, and sellers must deliver their security to buyers without delay. Firms must also uphold their responsibilities for each security they issue. Additionally, the stock market supervises each trade to ensure that investors are complying to the rules rather than cheating the system to achieve personal gains. These regulations and guarantees of financial obligations work together to make the stock market more reliable for everyone. This reliability makes investing money in the stock market more appealing, which benefits the overall economy.

Lastly, activities in the stock market serve as indicators for the health of the national economy. The stock market regularly reports details on the prices of securities as well as the volume of trades. When considering data from the stock market, we should keep in mind that the stock market’s activities are largely driven by people’s speculations rather than real economic events. This is why certain types of announcements by the government or by companies can cause abrupt changes in stock prices as well as peaks in trading volume. Nevertheless, data from the stock market can provide useful insights into the state of economic health when used in combination with other indicators such as GDP or GNI. In particular, when a nation’s economy is experiencing an anomaly, the prices of securities fluctuate wildly, which then captures the public’s attention in front pages of newspapers.

In our final example, we will consider the role of the stock market.

Example 5: Understanding Functions of the Stock Market

Which of the following is not an essential function of the stock market in contemporary economies?

  1. Directing savings to invest in legitimate channels
  2. Ensuring the prices of securities do not fluctuate irregularly
  3. Providing a stable and open market for transactions between savers and borrowers
  4. Providing liquidity to securities
  5. Providing rules and guarantees for the completion of transactions of securities

Answer

The stock market is a place where securities such as stocks and bonds are issued and traded. These securities are used by firms as ways to raise capital so that they can increase their capacities for production. Apart from this primary role, the stock market also plays significant roles in a nation’s economy. Let us consider each option and determine whether it correctly describes the stock market’s roles.

  1. The stock market serves the investors by providing a venue for them to purchase securities. These securities, while riskier than bank deposits, often result in higher return on their investments. In other words, the stock market directs these savings to legitimate channels by providing securities for investors. Hence, this option correctly describes one of the functions of the stock market.
  2. Prices of securities fluctuate frequently, especially in the secondary market, where these prices are purely controlled by the market mechanism, that is, supply and demand. The stock market does not control or ensure these prices since then the prices would not be determined by the market mechanism. Excessive fluctuations in the prices of securities is often a symptom of economic instability, rather than an underlying illness. Rather than controlling the symptom, the government needs to identify the underlying condition that causes the tumults in the stock market. Hence, this option incorrectly describes the functions of the stock market.
  3. This is in fact the primary role of the stock market. The stock market provides a place for transactions between savers (or investors) and borrowers (or firms). In particular, these transactions are done through the primary market, where firms raise capital by selling their securities to underwriters and large-scale investors. Hence, this option correctly describes one of the functions of the stock market.
  4. Recall that liquidity is the ability to easily convert an asset into money. The stock market, particularly the secondary market, provides liquidity to securities by offering investors a safe and reliable place to sell them. These sales are typically done by financial brokers working in trading floors, but investors can easily order the sale of their shares by the Internet. Hence, this option correctly describes one of the functions of the stock market.
  5. Through heavy regulations, the stock market makes sure that all parties involved carry out their obligations. This involves the obligation for the buyers to pay for the securities, for the sellers to deliver the securities, and also for the firms to uphold their obligations for each security they issue. These regulations make the stock market more reliable for the investors. Hence, this option correctly describes one of the functions of the stock market.

Option B, ensuring the prices of securities do not fluctuate irregularly, is not a function of the stock market.

Let us finish by recapping a few important concepts from this explainer.

Key Points

  • The stock market is a place where securities such as stocks or bonds are issued and traded.
  • A stock is a security that entitles its holders, shareholders, to a fractional ownership of the firm. The ownership rights are as follows:
    • Voting rights allow shareholders to participate indirectly in the management of the firms by voting on a number of important decisions, such as the election of new directors or making fundamental changes to the firm such as mergers and liquidation.
    • Cash flow rights entitle shareholders to a portion of the firm’s profits. The firm’s profits are returned as dividends or reinvestment.
  • A bond is a security that allows firms to borrow directly from individual investors. Firms are obligated to pay periodic interest payments, known as coupons, and return the bond’s face value at the end of the term.
  • If a firm cannot make coupon payments or return the face value of bonds, it must declare bankruptcy. During bankruptcy, the firm’s assets are seized and sold to pay for its obligations.
  • The stock market is divided into the primary and secondary markets.
    • The primary market, also known as the issuance market, is the marketplace where securities are first issued and sold.
      • The initial public offering, or IPO, is a major component of the primary market where firms offer their stock for sale for the first time.
      • Investment banks assist the firms through their underwriting, which refers to the process of raising capital through selling the firm’s securities.
      • The primary market is not open to regular investors. Its participants are restricted to underwriters, investment banks, and large-scale and institutional investors.
    • The secondary market, also known as the exchange market, is the marketplace where securities are traded.
      • Most of the trading occurs in trading floors, which are restricted to authorized financial brokers. Brokers fulfill trades for regular investors for a fee.
      • The secondary market is heavily regulated.
      • Over-the-counter (OTC) market is an informal market outside of trading floors where many securities, including those not meeting regulations, are traded.
  • The stock market serves the following functions in an economy:
    • The primary market provides firms a venue to raise capital through issuing securities.
    • The secondary market provides investors a legitimate channel for their investments.
    • The secondary market provides liquidity, that is, the ability to easily convert financial assets (securities) into money.
    • Through regulations, the stock market provides a reliable marketplace for all parties.
    • Activities in the stock market serve as indicators for the state of the health of the national economy.

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