Financial Markets

Corporations dominate our economy in part because they have ready access to finan-cial markets. Financial markets provide funds to firms for investment in produc-tive assets. Besides furnishing funds for corporate investment, financial markets also provide investors with opportunities to put their savings to work. By coordinating the savings activities of individuals and the investment needs of corporations, financial markets play a key role in the economic development of our country. In this section, we describe the basic attributes of financial markets and continue our discussion of market efficiency.

Financial Securities, Transferability, and Liquidity As we begin our study of financial markets, we focus on stocks and bonds—the most com- mon financial securities issued by corporations. There are many more types of financial securities than stocks and bonds—every year new financial instruments are introduced. As with physical goods, these securities have value; however, their value derives from the rights attached to their ownership rather than from their physical attributes.

The most important of these rights is the claim a security gives an investor to the cash flows of the issuing corporation. The nature of these financial claims varies with the type of security. Recall from Chapter 1 that some are fixed claims, such as bonds or loans, and others, such as common stock, are residual claims. Bondholders lend money to the cor- poration and in return receive a series of interest payments as well as repayment of the amount originally lent, the principal amount. Interest payments are typically scheduled to be made twice a year for the life of a bond. At the bond’s maturity date, the corporation repays the principal. A bondholder may sell a bond prior to maturity, receiving whatever the market price is for the bond at that time. Once a bond is sold, the new owner receives the remaining interest and principal payments.

Corporations have a legal obligation to make interest and principal payments as sched- uled in the bond indenture contract. The borrowing corporation makes a bond inden- ture contract with a trustee, usually a bank or trust company. The indenture obligates the borrowing company to comply with a set of predetermined conditions that the trustee monitors on behalf of the lenders. The indenture conditions typically include maintaining certain levels of liquidity and limit additional borrowing, the sale of significant assets, and the payment to shareholders of large cash dividends. The objective of these constraints is to help ensure that bondholders will receive their promised interest and principal pay- ments in full and on time. Failure to make the contractual payments can force a company into bankruptcy.

After a company pays bank loans, commercial paper, lines of credit, and all other fixed or contractual obligations, the remaining cash flows belong to shareholders. Since share- holders have a claim to what is leftover, they are referred to as residual claimants. The

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