Firms that want to raise capital have a choice between attracting debt or equity. The main difference between these financing forms is that debt holders have a contract that states that their claims must be paid in full before the firm can make payments to equity holders. Equity holders are entitled to the rest of the company after the debt holders are paid off. Therefore equity is often referred to as a residual claim. Equity markets, also known as stock markets, are markets where different types of equity are traded. The most common forms of equity are common stocks and preferred stocks. The term common stock is reserved for stock that does not have a special preference in either dividend payments or in bankruptcy. Preferred stock has preference over common stock in dividends and/or bankruptcy.
Equity markets are generally divided into primary and secondary markets. The primary market is where the securities are first offered to the general public. This takes place in the form of a so-called Initial Public Offering (IPO). There is abundant evidence that IPOs are under-priced. This means that the offer price of the shares is, on average, lower than the market price at the end of the first trading day. In 2003 Jay Ritter overviewed evidence on underpricing for thirty-eight countries and found that the average first day returns vary between 5.4 percent for Denmark and 256.9 percent for China. The average first day returns for the United States were 18.4 percent. After the initial public offering, shares can be traded in public secondary markets. These markets can either be organized as an exchange or as an over-the-counter market. An exchange is a physical location where buyers and sellers come together to buy and sell securities. In an over-the-counter (OTC) market buyers and sellers can transact without meeting at a physical place.
The first trading in shares started in 1602 with the formation of the Dutch East Indies Company in Amsterdam. According to Geoffrey Poitras’s Security Analysis and Investment Strategy (2005), the trading of stocks in the United States goes back to 1792 when twenty-one individual brokers and three firms signed the so-called Buttonwood Agreement. In the end this arrangement evolved into the New York Stock Exchange (NYSE), a title that was introduced in 1863. Over time equity markets have expanded enormously. In 1974 the market capitalization of the combined world equity markets was less than $1 trillion. According to Focus, the monthly overview of the World Federation of Exchanges, this total grew to $43.9 trillion at the end of June 2006. At that time, the largest stock exchange in the world, the earlier mentioned NYSE, had a market capitalization of $13.9 trillion and counted 2,205 listed companies. The second-largest exchange, the Tokyo Stock Exchange, had a market capitalization of $4.5 trillion that was accounted for by 2,377 companies. The third-largest exchange in terms of market capitalization is the National Association of Securities Dealers Automated Quotation system (NASDAQ) with a market capitalization of $3.5 trillion. This is an automated quotation system that operates in the United States. Even though its market capitalization is much smaller than that of the NYSE, it has a larger number of listed companies (3,161) than the NYSE. This also illustrates the move from traditional exchanges to automated quotation systems.
Another source of equity is private equity. This is equity that is not traded in public markets. Categories of private equity include venture capital and equity for companies that are in a restructuring process. Private equity funds offer opportunities to invest large sums of money into this type of equity.
In the context of the internationalization of equity markets, firms are often cross-listed on different stock exchanges. Since the United States is the world largest capital market, a large number of firms want to list their equities there. However, this also means that the firms have to submit themselves to the very strict U.S. financial disclosure requirements. In order to avoid these requirements many firms use American Depositary Receipts (ADRs). With an ADR the firm deposits a number of its own shares with a bank in the United States. The bank then issues an ADR; this is a security with a claim on the dividends and other cash flows of the shares that are deposited with the bank. Another internationalization trend that deserves mentioning is the fact that stock markets in emerging economies have become more important. There is a large growth in equity markets in Asia (e.g., Korea and Hong Kong) as well as in Eastern Europe (e.g., Poland and Slovenia). In a number of emerging markets stocks are divided into A and B shares. In such cases the B shares have no or less voting rights than the A shares. Foreigners are then restricted to holding the B shares in order to prevent them from taking control over the firm.
SEE ALSO Capital; Expectations; Financial Instability Hypothesis; Financial Markets; Hedging; Initial Public Offering (IPO); Liquidity Premium; Stock Exchanges; Stock Exchanges in Developing Countries; Wealth
Poitras, Geoffrey. 2005. Security Analysis and Investment Strategy. Malden, MA: Blackwell.
Ritter, Jay R. 2003. Investment Banking and Security Issuance. In Handbook of the Economics of Finance, eds. George M. Constantinides, Milton Harris, and Rene M. Stulz, 253–304. Amsterdam: Elsevier North-Holland.