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Introduction to Capital Markets

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Contact Information

Stacey Dogan
[email protected] • 617-353-3142

Capital Markets
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The capital market is literally a marketplace where two groups of people meet: those seeking capital and those
who have capital to invest. The capital market consists of much more than just stock exchanges where stocks
are publicly traded; it is extremely complicated, varied, and geographically diverse and has many different
products, participants and regulatory frameworks. As we shall see, lawyers play an important part in much of the
functioning of capital markets and business law in general.

In this section we will discuss the capital markets in the United States and the investments they trade.

NYSE
The main exchange is the New York Stock Exchange, or NYSE for short. Also known as the “Big Board,” the
NYSE was founded in 1792. It’s not the oldest exchange in the country—the Philadelphia exchange was
founded two years earlier—but by the early 1800s New York was the undisputed financial center in the United
States, and the NYSE was the largest exchange.

Only stocks listed on the NYSE are traded on the Big Board, which has specific size and share ownership
requirements. Among other things, these listing requirements dictate that a company must have:

1. aggregate pre-tax earnings over the previous three years of $10 million;
2. an aggregate market value of publicly traded stock of at least $100 million;
3. at least 1,100,000 publicly held shares; and
4. ordinarily at least 2,200 stockholders.

Companies listed on the NYSE include multinationals from around the world and some of the largest and best-
known American companies. They are identified by name and their abbreviation, otherwise known as a “ticker
symbol,” In some cases, you can easily see the relationship between the company and its ticker symbol—for
example, General Electric (GE), Disney (DIS), or Ford Motor Company (F)—while others are more obscure, like
Exxon Mobil (XOM) or Coca Cola (KO).

While the NYSE does still have a trading “floor” where buyer and seller meet, it is a highly-computerized
operation, and virtually all trading takes place electronically. It’s also a very high-volume operation: between 2
and 6 billion shares are traded on an average day.

NASDAQ
If you follow stocks and other investments, you will no doubt also have heard of “NASDAQ,” short for the
National Association of Security Dealers Automated Quote System. The world’s first and largest electronic stock
market, NASDAQ began operating in 1971. It is not a physical trading floor like the NYSE, but is an OTC (or
“over-the-counter”) market for stocks that are not listed in exchanges. This over-the-counter market is a network
that links thousands of brokers and sellers together using an electronic trading platform. The 3,000 companies

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traded there include many tech companies and corporations whose names undoubtedly be well-known to you.
Some examples are Amazon.com (AMZN), Apple (AAPL), eBay (EBAY), Facebook (FB), and Microsoft (MSFT).

Bonds
Stocks are one way that corporations raise capital for their operations; bonds are another. The “bond market” is
therefore a very important capital market in the United States; when we refer to the bond market, we’re referring
to the market through which traders buy and sell different types of bonds. The U.S. government issues bonds to
finance its operating costs, a practice it began during World War I. Corporations also issue bonds, known as
corporate bonds, to raise capital to enter new markets, expand facilities and product lines, modernize plants,
and develop new products. There are other forms of bonds, as well, such as savings bonds (issued by the U.S.
Treasury) and municipal bonds (issued by state and local governments), but for current purposes, we’ll focus on
corporate bonds.

The core difference between stocks and bonds is that stocks give you a share of
ownership in the corporation, while bonds are effectively a loan from you to the
corporation, which pays you back with interest. Because stocks involve an ownership
interest, they come with voting rights, and pay dividends based on corporate
performance.

Corporate bonds can be traded by investors through brokerage accounts in the same way that one trades
stocks. Bonds generally trade in opposition to stocks, meaning that when stocks go up, bonds generally go
down, and vice versa. Why? Because stocks generally do well when the economy is booming. Businesses are
making money and bringing higher returns to investors, so investors favor stocks over bonds during those
periods. The reduced demand for bonds results in a decline in bond prices. When the economy is weak, on the
other hand, consumers buy less, corporate earnings are reduced, and stock prices tend to go lower, so
investors move to bonds—which drives prices up. There are also times when both stocks and bonds rise—when
there is too much liquidity, or money, looking for investments in the markets—and times when they both fall (as
was the case at the beginning of the Great Recession in 2008, when widespread negative sentiment depressed
both stock and bond prices).

Mutual Funds
One of the most popular investment vehicles, particularly in retirement accounts, is mutual funds. Mutual funds
are designed to pool the resources of a large group of investors and invest them in a diverse set of holdings,
with the goal of spreading risk among investors. Index funds are a particular type of mutual fund that tracks an
entire index of stocks, such as the Dow Jones. Another fairly recent innovation is no-load (meaning “no fee”)
mutual funds. The industry continues to grow and today there are more than 10,000 mutual funds, of every

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description, traded in the United States. Mutual funds are particular favorites in retirement accounts as they are
generally cost-effective ways to diversify a portfolio. In addition to index funds, mutual funds fall into many
different categories, including emerging markets funds, large cap stock funds, and municipal bond funds.

Private Markets: Private Equity and Venture Capital

In addition to bonds and publicly traded stocks, many firms raise funds through private markets or investments
made between parties that do not take place through public exchanges. You have probably heard of private
equity and venture capital firms, both of which play important roles in private markets.

Venture capital firms—or “VCs,” for short—fund and mentor start-ups, often in the tech space. VC firms fund
companies in the very early, high-risk phase at which there’s often tremendous opportunity but also tremendous
risk. VCs typically offer funding in exchange for a minority equity stake in the company. They have played an
instrumental role in developing many industries, including technology companies in Silicon Valley and Boston.

Private equity firms, on the other hand, tend to invest in more mature companies and usually take a controlling
stake—50% or more of a company’s equity. Private equity firms often take over businesses that are struggling
because of some inefficiency or other problem and invest in the tools to fix the problem, with the hope of later
selling the company for a profit.

How do private markets work? Typically, a new or “start-up” company will need seed money for investment.
Given its small size, lack of a track record, and high-risk nature, it cannot tap public markets for investment.
Private investors invest in these companies in exchange for partial ownership, or equity, in the company. While
very few of these companies survive, a few go on to become industry leaders. Companies such as Amazon,
eBay, and Google began this way. VC firms understand that most of the companies they invest in will fail. But
the huge upside gains from these star performers outweigh the losses from the companies that never really get
off the ground.

Bull Markets and Bear Markets

When discussing markets, you will often hear investors and commentators use the expression “bear market” or
“bull market”.

Did You Know?

What does “bull market” mean?

A market in which stock prices are generally going up

This is true. A bull market is a period of market optimism in which prices are rising or
are expected to rise—hence the famous “charging bull” statue located near the
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NYSE.

A market in which stock prices are generally going down

This is false.

How credible the average stock market prediction is

This is false.

The market in beef commodities.

This is false.

A bull market, one in which investors are said to feel “bullish” about the market’s prospects, is one in which
prices are going up. Conversely, a “bear market” is one in which the prices of securities are falling, and
widespread pessimism causes the negative sentiment to be self-sustaining. Formally, you need a 20% decline
in stock prices to qualify as a bear market and a 20% rise for a bull market.

Notable bear markets have occurred during a number of economic downturns, such as in 1929–1932 (during
the Great Depression), 1937–1942 (straddling World War II), 1973–1982 (during the 1970s energy crisis), 2000–
2002 (coinciding with the bursting of the dot-com bubble), and, most recently, 2007–2009 (which straddled the
last global financial crisis).

Charging Bull Statue, Wall Street, NYC

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The last several years in general have shown us examples of both the bull and the bear, the rise and fall of the
markets:

October 9, 2007—S&P 500 peaks at 1565

December 2007—The “Great Recession” begins; S&P 500 at 1500
January 24, 2008—National Association of Realtors indicates that home prices dropped for the first time
in decades; S&P 500 falls below 1400
September 15, 2008—Lehman Brothers files for bankruptcy; S&P 500 at 1200
September 29, 2008—S&P 500 drops nearly 10% after House of Representatives rejects bailout
March 9, 2009—S&P 500 bottoms out at 676; bear market ends
June 2009—“Great Recession” ends; S&P 500 at 900.
May 6, 2010—DJIA plunges nearly 1,000 points in “flash crash” but recovers more than half of the losses
by end of day
August 5, 2011—S&P downgrades United States' debt rating from AAA to AA+; S&P 500 at 1200
January 22, 2013—NAR reports home sales in 2012 were highest in 5 years; S&P 500 at 1500
December 31, 2013—S&P 500 finishes at over 1800, with a total yearly return of 32%, the biggest annual
gain since 1997
June 2015 to January 2016—Chinese markets crash, starting a global market rout
August 18–21, 2015—Dow Jones falls more than 1,300 points over three days alone
September 2018—cryptocurrency crashes; Dow Jones falls nearly 19% during the same period
February 24, 2020—the COVID-19 pandemic causes global supply disruptions, sudden economic
recessions, and rapid shuttering of businesses and layoffs, triggering the fastest correction from record
highs in United States markets; global market routs continue amid highest unemployment rates since the
Great Depression; longest-running United States bull market ends
March 23, 2020—markets begin to recover and return to bull market territory; S&P 500 rises over 75%
between March 23 and mid-February 2021

So, when does the bull market end? And when will the next one begin? That's the proverbial $64,000 question—
and one that many investors are always trying to answer! The only thing certain about a bull market is that at
some point it stops, but investors who do not hold stocks during those bull markets can lose out on some
oversized gains. This shows one of the perils of trying to “time” the market: one might sell too early and lose out
on significant gains, or one might sell too late and sustain loses or leave money on the table, which we will
discuss below.

Let’s use the events from early 2020 through early 2021 as a “snapshot” to explore some of these concepts. The
market entered 2020 after an 11-year bull market, the longest bull market in history. In February 2020, however,
stocks in the United States and around the world entered a sudden bear market in the wake of the global
pandemic. The Dow Jones Industrial Average shot down 38% from its high on February 12 (29,568) to a low on
March 23 (18,213), easily meeting the bear-market definition of a 20% drop in value. The first graphic below
shows the long-term trends in the Dow Jones Industrial Average, including the sustained bull market from 2009
through early 2020. The second graphic shows in more detail the precipitous drop in February and March of
2020, followed by a market recovery through early 2021.

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As the first graphic shows, investors who did not dump equities during the 2008–2009 recession did very well:
from the start of the bull market to its end in February 2020 the Dow Jones Industrial Average grew by over
350%. Equally clear is the significant drop by March 11, which marked the official “correction” that ended the
spectacular bull market of 2009–2020. But in subsequent months, the market fully recovered, and indeed had
reached a new all-time high by February 2021.

So, why did the markets collapse, and why have they since recovered?

The markets were certainly due for a correction—markets cannot continue

growing indefinitely—and COVID-19 slammed the brakes on global economic
activity, which shook investors and led to widespread sell-offs.
But it didn’t last long. It is important to note that markets are forward-looking,
attempting to capture what they feel companies’ earnings will look like, what
global markets will be doing, and how strong or weak economies will be. After
the 2020 crash, a combination of factors led investors to return to buying
stocks. Government stimulus spending, general optimism about a long-term
recovery, and the unprecedented speed of successful vaccine development all
played a role, as did factors like skyrocketing prices of a handful of high-

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performing tech stocks. General optimism about the future economy tends to
lead people to invest; so, signs of an impending economic recovery usually
support an increase in market prices.
As you can see, though, neither the bear market nor the ensuing bull market
was a smooth ride. And that’s typical. Volatility is common in both crises and
recoveries. In other words, even during market “crashes,” the market
experiences some up days, and long-term bull markets include many days in
which the market loses significant value.

So why do experts suggest we just wait out market corrections rather than selling in a panic, or trying to time the
markets? This “buy-and-hold” strategy is premised on the idea that if you buy solid equities in companies with
strong balance sheets, they will generally weather economic downturns and you’ll do well in the long term. To
illustrate this, look at a snapshot showing what the main U.S. stock index did between January 2017 and March
2020:

Two things will probably stand out: the extent of the drop in 2020 and the fact that even after that drop the
market average was pretty much back to where it was in 2017. In other words, even at the depth of the crash,
prices did not go to zero. The market had reset and, in general, portfolios were back to where they had been
three years earlier. And, of course, in the subsequent months the market not only recovered but reached a new
high. All of this suggests that selling in the midst of a downturn probably doesn’t make sense unless you have
to, because things will eventually improve, even if it takes time. The patient investor is usually rewarded.

Let’s explore this idea a little more. We know there will be downturns, but the upturns usually more than make
up for them in the long run. But you may also wonder how long the average recovery takes. The truth is that it
can take a long time. The average bear market over the past half-century has lasted for 14 months and taken 25

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months to recover. The most severe bear market lasted for 23 months and took
58 months for the markets to rebound. That’s a long time! It can be challenging
for investors not to panic and to hold on to the investments they own (or even
invest more) during these down markets. As you can see from the charts
above, however, it often pays to do so. In fact, it often pays to be a “contrarian”
and invest precisely when others are fearful of doing so, rather than paying
elevated prices when everyone else is confident. A saying attributed to
legendary investor Warren Buffett sums this up: “Be fearful when others are
greedy, and greedy when others are fearful.” This is precisely what some of the
most successful investors do—but it tends to fly in the face of human nature—
Warren Buffett, as featured
on cover of Forbes one of the reasons there aren’t a lot of Warren Buffetts!
(February 2014)

Purpose and Structure of Markets

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A primary market is the market for newly issued securities released to the public through initial public offerings,
or IPOs. As such, a primary market is said to involve “issuer transactions,” which are closely regulated by
federal securities law. These stocks are registered with the Securities and Exchange Commission (or “SEC”),
and companies who have issued stock must report their earnings and file financial statements.

Investors, in addition to hoping that they will profit from their investments, also want access to a ready market to
trade their investments. A secondary market gives them this opportunity. As the name suggests, secondary
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markets deal with securities that are already issued and traded and involve “trading transactions.” Shares in
public corporations are freely transferable, so buyers and sellers can trade them without corporate approval.
The trading that takes place here gives companies information about the relative demand for their securities, as
shown through trading volume and stock price. Both the primary and secondary markets reflect the law of
supply and demand: if there are more buyers than sellers, prices tend to rise. If there are more sellers than
buyers, prices tend to drop. Share price can be a factor of many different variables, but it is largely driven by the
expected future profits a corporation will earn.

A second category of market, equity markets, consists of both public and private markets. For our purposes,
we are most concerned with public equity markets, which include national exchanges such as the NYSE,
regional public markets such the Chicago and Boston stock exchange, and over-the-counter markets, of which
NASDAQ is the most prominent example.

Debt markets, as the name suggests, trade debt (as opposed to equity). Securities issued by the U.S.
government, which make up our national debt, are traded on the treasury market. Our government is the
world's largest issuer of debt, which our government uses to finance our ongoing capital needs. This debt
consists of Treasury bills, notes, and bonds, which are issued in the primary market by an auction process in
which dealers (usually banks) buy them. They are then traded on the secondary markets where investors such
as you and I can purchase them. Historically, U.S. treasuries have been considered essentially “risk-free,”
among the safest in the world, because it has been unthinkable that the world's largest economy could default
on its debt. Given the current state of deficits and political brinkmanship over the debt ceiling, there could be
growing doubt about this. Some economists warn that if our debt continues to grow, it may become harder and
harder for the government to issue debt and find buyers for it. If you are curious to know the difference between
Treasury bills, notes, and bonds, here is a simple explanation: the difference between them is the length of time
you will have to wait until you can receive your principal back—the amount you lent the government. Bills have
maturities of a year or less; notes have maturities of 2 to 10 years; and treasury bonds have maturities of 10 to
30 years.

Securitization markets are for the trading of asset-based and mortgage-backed securities (ABS). ABS are
financial products that can be packaged out of virtually anything that creates a steady stream of cash flow. This
can range from billboards, to airplane leases, to credit card receivables, to Peanuts cartoons, to their best-
known and most infamous variety—mortgage-based securities—whose failure brought on a recession in 2008. If
you think about it, things like mortgages are inherently illiquid—but bundling them and making them available as
investments converts them into liquid assets that can be traded. Asset-based securities are once again popular,
although mainly for non-mortgage linked securities. Individual investors cannot purchase asset-based securities
except through specialized mutual funds.

Corporate debt markets are where corporations seek credit financing; this is also the area where most lawyers
involved in capital markets work. Sometimes corporations do not want to issue debt securities but want a
traditional bank loan. If the loan is too big, or considered too risky, it may be spread out among a group of
banks. These kinds of loans would be illiquid—meaning there’s no market for them individually—but similarly to
mortgage-backed and other securities, they can be packaged into a portfolio called "collateralized loan

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obligations," which once again turns illiquid loans into a liquid security instrument. Corporations also float bonds,
which is a major segment of the corporate debt market. Companies that issue bonds typically include public
utilities, transportation companies, banks and financing companies, and industrial companies. These are
generally mature, stable businesses that generate significant cash flow. Many insurance companies and
pension funds invest in these types of corporate bonds. These bonds are rated for their risk of default by
agencies like Moody's and Standard and Poor's (S&P). The higher the risk of default, the lower rated the bonds
are; the lower they are rated, the higher the "yield rates"—or interest rates—are, as investors want to be
rewarded for taking on greater risk.

Derivatives, currency, and commodities markets also make up a segment of capital markets. Like stocks
and bonds, these are also traded on exchanges. In derivative markets, investors do not own the underlying
asset, but they make a bet on the direction of the price movement of the underlying asset through an agreement
with another party. Currency markets, or foreign exchange markets, are global decentralized markets for the
trading of currencies with floating currency rates. Commodity markets are physical or virtual marketplaces for
buying, selling, and trading a wide range of raw goods, agricultural products, precious metals, and even financial
products.

Participants in the Capital Markets

Who are the participants in capital markets? The two main categories are issuers—those who are seeking
capital for investment—and investors—those who have capital to “rent” in exchange for returns. Issuers include
private firms that need short-term, long-term, or permanent capital financing to operate their businesses. This is
where many business lawyers operate. Issuers can also be public entities, such as the U.S. government, state
or municipal governments, and foreign governments. Investors may be individuals or institutions (such as banks,
pension funds, mutual funds, asset managers, insurance companies, university endowments, and venture
capital funds).

We measure the performance of markets through market indexes. Stock market indexes, or averages, attempt
to measure the general level of stock prices over time. Some of the best-known examples are the Dow Jones
Industrial Average (DJIA), or Dow for short, which has been calculating a basket of stocks since 1896. The New
York Stock Exchange Composite Index (or NYSE Composite) tracks the overall NYSE, while the Standard &
Poor's 500 Index (or S&P 500) tracks the 500 largest domestic stocks. Here you will see a chart detailing the
historic pattern of growth in trading volume in shares that make up the DJIA:

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How the markets are doing is the source for much commentary on the news each day. Of course, markets do
not only go up. Some of you have probably heard of “Black Tuesday”—so here's a question:

Did You Know?

“Black Tuesday” refers to:

the start of the financial crisis of 2008–2009

This is false.

the stock market crash of October 29, 1929

This is true. The stock market crash of 1929 triggered the start of the Great
Depression. That day, investors traded some 16 million shares on the NYSE in a
single day and billions of dollars were lost, wiping out thousands of investors. The
effects of the financial collapse spread beyond Wall Street. Four years later about
25% of the U.S. labor force was unemployed. In all, the crisis and its aftermath
provided emphatic evidence of how fragile and precious our capital markets are.

October 19, 1987, when the Dow Jones lost over 22%, the largest one-day
percentage drop in its history

This is false.

the beginning of the tech bust in 2000

This is false.

Out of the ensuing misery and panic during the Great Depression came a public outcry for greater regulation
and reform of the securities markets. The Securities Act of 1933 and the Securities Exchange Act of 1934 were

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created in order to fill the gaps in state law and to remedy Wall Street's weak self-regulation. The Securities Act
of 1933 set requirements for the issuance of new securities, such as requiring the issuance of a formal
prospectus and registration statement. The Securities Exchange Act of 1934 set up the Securities Exchange
Commission (SEC) to regulate exchanges, brokers, and dealers, and required quarterly reports and proxy
statements. This latter piece of legislation led to Rule 10b-5, one of the most well-known securities regulations,
which is an anti-fraud provision that governs insider training and provides penalties for misrepresentation. This
pattern of remedial legislation following in the wake of crises continues; the latest examples are the Sarbanes-
Oxley Act of 2002 and Dodd-Frank Act of 2010.

Today, capital markets are heavily regulated and generally becoming ever more so. Lawyers play an important
role in business law in general, assisting in setting up business entities, providing legal services and
governance, and working in many areas of law, including corporate law, anti-trust law, labor and employment
law, and contract law. They also play a central role in securities law, by managing the regulatory process, and
ensure compliance with federal and state law. The main regulator, as mentioned earlier, is the SEC (which
enforces its own rules as well as laws passed by Congress), but there are also a number of regulators that have
different but sometimes overlapping jurisdictions, including state regulators and self-regulatory organizations. In
general, securities laws seek to ensure transparency and smooth functioning of the securities markets and to
prevent corporations and their officers from failing to disclose material news, misstating corporate balance
sheets, or engaging in insider trading.

Categories of Securities

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Many of you have no doubt heard the term “junk bonds.” These bonds are not junk in the sense of being
worthless, but they are called this to signify that they have been rated as below investment grade based on the
likelihood of default. Junk bonds, otherwise known as “high-yield” bonds, are riskier than regular investment-
grade bonds and subordinated to other regular bonds. In short, they provide greater potential returns but at
increased risk. During the height of the leveraged buyouts in the 1980s, for example, junk bonds were used to
raise billions of dollars to finance corporate takeover bids.

Now when some corporations issue bonds, they are aware that interest rates may fall in the future. If that were
to happen, they might get stuck paying out higher rates of interest to bond holders than the current rate. To
offset this risk, they issue callable bonds that give the issuer the option to buy back the bond if interest rates
should fall in the future. If the company calls the bonds, they pay the holders an agreed-upon price, usually
called the call price, and this allows them to refinance by issuing new bonds at a lower rate of interest.

Some more facts to add to our discussion of different types of securities: As mentioned, stock is an equity, rather
than a debt, investment, which gives you ownership in a slice of the corporation. In addition to common and
preferred stock, companies may also issue different classes of common stock, listing them separately on a stock
market. The stocks may differ in that they have ownership in a specific division or subsidiary, have different
dividend policies, have different voting rights, etc.

As you can imagine, stocks trade at widely different values. Five dollars a share is the threshold value at which
many mutual funds will consider investing in a stock; and all stock markets have minimum stock prices at which
stocks must trade or risk being de-listed. In addition to free market forces, stock price can be adjusted by a
company itself. A company may engineer a stock split if it thinks its stock price has become too expensive for
the average investor in order to reduce the price and make it more attractive. Stocks can be split in any
combination. Splitting a stock gives you a larger number of shares but at the same total market value. For
example, if you have 10 shares trading at $100/share (worth $1,000) and the stocks undergoes a 2-for-1 split,
you will now have two shares for each one that you own, but the price is halved. Thus, after the split you have
20 shares trading at $50/share (for a market value of $1,000).

A company may also want to increase stock price, and therefore do what is called a reverse split, which works
the opposite way from a stock split. As an example, if you have 1000 shares trading at $1/share (again, worth
$1,000), a 1-for-4 stock split would leave you with 250 shares worth $4/share (again, worth $1,000). This is
often done if a stock is trading at a price too low for institutional investors, or if the stock has fallen below the
minimum trading price required by the stock exchange on which it is traded.

In contrast to stocks, bonds are debt rather than equity investments. This makes sense if you think about the
differences between the two: bonds are essentially loans taken out by a corporation or government. The investor
loans the corporation or government the money (the sales price of the bond) in exchange for the interest
payments on the bond. The investor also may benefit from potential capital gains if the price of the bond rises
over time, but the primary focus to the investor is the interest that bond pays out plus the ability to have the IOU
paid back at maturity.

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One more quick point before we move onto the next section: perhaps you are wondering why I did not mention
savings bonds, when they are one of the most well-known types of bonds? Well, savings bonds are actually
quite different from other forms of bonds in many ways, including that there is no secondary market for savings
bonds, and an individual owner of a savings bond cannot sell it to another potential investor. Savings bonds are
also offered only by the federal government. Historically, the purchaser bought it at less than face value
(typically 50% of face value), but it took a number of years to reach maturity at which time the savings bond was
worth face value—the growth in value over time equals the interest you accumulate on the bond. Generally, they
stopped accruing interest at the time of maturity. In recent years, the U.S. government has offered them for sale
only electronically from the Treasury and there are now different types of savings bonds that pay fixed and
variable interest (and include inflation-protected savings bonds, called Series I). They are purchased at face
value, in increments of $25, up to $5,000, so they can be (and usually are) purchased in much smaller dollar
amounts than other types of bonds.

Investment Strategies

So, what are some strategies that investors use to choose their investments? Here are a few of the most
popular:

Did You Know?

You may have heard the expression “shorting a stock.” What does shorting a stock
mean?

An investor is betting the stock's share price will go up.

This is false.

An investor is betting the trading window for the stock will get shorter.

This is false.

An investor feels his or her life is getting shorter by worrying about the stock market.

This is false.

An investor is betting the stock's share price will go down.

This is true.

“Shorting,” or “going short” on a stock, is the opposite of “going long.” Going long refers to what most investors
do, namely buying a stock and holding on to it with the hope that it will gain in value. Shorting a stock is to bet
the other way: namely, you bet a stock is going to go down. You may be asking yourself: why would someone

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buy a stock and bet that it goes down in value? Well, that’s a good question, so let me explain how shorting a
stock is different from going long, by giving you an example of each.

If I wish to go long on a stock, I purchase it through my broker and hold it until I’m ready to sell. Let’s say I have
100 shares of X Corporation that I bought at $10/share (market value of $1,000) and I sell it later at $15/share
(market value of $1,500). My profit for “going long” on the stock is $500, the difference between the purchase
price and the sale price. If I sell it for less than I paid, then my loss clearly would also be the difference between
the purchase and sale price.

However, if I am betting the stock price will or should go down, I “short” it. I contact my broker and say I want to
short X Corporation (I would have to have a margin account to do this). The broker essentially lends me the 100
shares of X Corporation I want to short and lets me sell them. I have now netted the sales price for this stock; for
example, 100 shares at $15/share equals $1500. If the stock prices go back down to $10 (or whatever price is
my target, but lower than what I sold it at), I buy it back and return the shares to the broker. Buying it back to
replace the shares for a short sale is known as “covering.” Of course, I will also owe interest on the amount I
have borrowed on margin during that time. So, shorting a stock is to borrow it, sell it, and hope it goes down in
price so I can buy it for less. In this example, my profit would also have been $500 (shorted and sold at $1,500,
covered at $1,000, netted $500). If the stock price rose instead, and I covered it for more than I sold it, then my
loss would be the difference between my sale price and my cover (purchase) price. The number of shares of a
company that are being shorted is known as the “short interest,” and is tracked as a percentage of the shares
outstanding. The larger the percentage, the larger the number of shares held by investors who are betting the
stock price will go down. Shorting is usually not done by the average investor and is generally riskier—why?
Because the lowest a stock can go to is zero, but, in theory, a stock can go up to almost any price. Investors
who short stocks tend to be sophisticated investors who spend a great deal of time researching individual stocks
or market patterns. The average investor is not likely to ever short a stock or even to necessarily know how it
works, but no explanation of investment strategies would be complete without at least a brief discussion of this
concept.

While speculative investing drives up risk in the hopes of outsized rewards, hedging is an approach originally
designed to reduce investment risk, or to “hedge” against it. The earliest hedge funds typically shorted the
market, with the intention that if the markets went down, the returns of the hedge fund went up. Today hedge
funds perform a lot of different roles and do not necessarily seek to “hedge” against risk; point of fact, they may
be very high-risk indeed. Hedge funds may invest in fixed income securities, precious metals like gold,
commodities, or any number of other investments. Some hedge funds may only be available to very wealthy
private investors.

Stock investors also invest in different categories of stocks depending on the size of the companies. Small cap
investors, for example, invest in small companies; while the definition of small cap can vary among brokerages,
it generally is a company with a market capitalization of between $300 million and $2 billion. Other investors
may invest in large cap stocks, or the stocks of companies with market valuations of $10 billion or more. The
so-called “blue chip” stocks, those of market leaders that are considered the stodgiest but safest investments,
fall into this category. In general, you can say that investing in small caps is more aligned with speculative

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investing, while investing in large caps is more like hedging. And while we’re on the topic, how do you calculate
market capitalization, or market cap for short? You multiply the number of shares outstanding by the price per
share. A company with 1,000,000 shares trading at $8/share therefore has a market capitalization of $8,000,000
(1 million shares times 8).

Another common investment strategy is to focus on yield or income by seeking out companies that provide a
steady stream of income through dividends, capital gain distributions, and the like. Examples are government
securities, high-quality corporate bonds, and high-income stocks such as blue chips, dividend stocks (stocks
that pay high dividends, such as utility companies), and preferred stock. A popular, and potentially very lucrative,
long-term strategy is using a Dividend Reinvestment Plan (DRiP). This means setting up your brokerage
account so that dividends from individual stocks are automatically reinvested in shares of that stock rather than
being paid to you as cash. While you pay taxes on dividends either way, these additional shares are added to
your holdings in that stock while you own it. You therefore can benefit from the power of compounding: similarly
to how money grows if you keep it in an interest-bearing account, using a DRiP will allow you to grow your
holdings in a stock. Assuming the company continues to pay dividends, over time you would be receiving those
dividends on a steadily increasing number of shares. Simply put, the dividends are turned into more shares, and
more shares earn you more dividends. For example, you buy 100 shares of ABC stock. The dividend is
reinvested and buys you one more share. At the next dividend period, you receive a dividend on 101 shares,
and so forth over time.

Some other advantages to this, other than the magic of compounding: you do not pay
commissions on the purchase of those shares; it may feel like a painless way to invest
since you don’t really see the money (similarly, again, to the reason why some people
use automatic withdrawals from their paychecks to go into savings or investments);
and unlike on the open markets where this is not possible, the dividends can be
reinvested into fractional shares.

This last fact is important because otherwise you would never get additional shares
unless your dividend was sufficient to buy a non-fractional position in the stock. Since
the entire dividend is reinvested, it will buy its equivalent value in the stock of that
company even if that is not a whole number. For example, if a stock trades at
$10/share, you own 100 shares, and the dividend is $1, reinvesting the dividend will
buy you 1/10th of a share (or .10 additional shares). The next dividend reinvestment
would therefore be on your holding of 100.10 shares, and so on). Not all stocks pay
dividends, and there is a prestigious group of stocks that have a history of consistently
raising dividends over many years. The “dividend yield” is calculated as a percentage
based on the relationship between the dividend rate and the current stock price. To
reuse the previous example, if a stock trades at $10/share, and pays a dividend of $1,
the dividend yield would be 10%, since the dividend is equivalent to 10% of the current
share price ($1 divided by $10 = .10 or 10%). Dividends are usually paid on a quarterly
basis, so a dividend of $1.00 would generally be paid four times a year, after every
quarter.

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Some investors employ a strategy known as averaging down, or reducing one’s cost basis. The premise
here is simple: the investor buys more shares when the stock price goes down. This has the benefit, at least in
theory, of purchasing more shares at a lower price and reducing the overall price per share that the investor has
paid. If the stock eventually gains in value, then the investor has increased the value of her investment.
However, averaging down can also demonstrate the well-known maxim of “throwing good money after bad.”
Buying more shares of a company as its stock price goes down can also compound one’s losses should the
stock continue to fall. This strategy tends to work best for investors when general market downturns have
lowered the stock price—for example, in 2014–2015, as oil prices plummeted, stock prices of oil and energy
companies also went down considerably, creating some potential buying opportunities. In 2020, investors with
strong stomachs may have bought shares in airlines, cruise lines, energy companies, or generally in stocks that
they had been watching that had reached attractive valuations.

Buying on margin means buying investments from your broker with money that you have borrowed from them
based on the value of your underlying holdings. While this is used often by experienced investors and those who
do a lot of rapid buying and selling, buying on margin can be extremely risky because both your potential gains
and potential losses are amplified. Plus, you have to pay interest on the money you borrow. And if your holdings
go down in value too much, the broker may make a “margin call” where some of your holdings will be sold
unless you can deposit cash or securities equal to the amount of the call. It is usually recommended that only
experienced investors trade on margin.

Some investors engage in growth investing—seeking out securities of companies whose earnings are
expected to grow at above-average rates compared to their industry or the overall market. This is often seen as
the opposite of value investing—value investors actively seek out companies that they believe are undervalued
by the market relative to their actual or potential worth. Growth stocks may be highly priced relative to their
current earnings because investors are betting on the long-term prospects of that company, rather than on its
current performance.

Of course, some investors are bigger risk takers than others. Some invest in speculative investments, ones
where there is a significant risk of losing most or all of the initial investment but possibly the chance for
substantial gains. Investors who make speculative investments often limit this to just a small part of their overall
portfolios and engage in a lot of market research and due diligence, hoping to take a calculated risk on the
outcome. These may be investments in companies that are on the verge of bankruptcy or are restructuring;
early-stage start-ups with unproven technologies or products; companies in sectors with high failure rates, like
biotechnology/pharmaceuticals; or companies that are seeking to make a niche for themselves in a crowded
market. It is probably true that most speculative investments fail (just look at the dot.com bust, where the vast
majority of internet companies did not survive), but it is also true that many market leaders (think Apple, Google,
Facebook, Microsoft, Amazon, etc.) were speculative when they began.

Different Categories of Pooled Funds

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Sometimes groups of investors will get together and pool their money to invest; these are known as pooled
funds. Some of the primary advantages of pooled investments are the economies of scale that go with them,
allowing for lower trading costs, diversification of investments, and professional investment managers.
Examples of pooled funds include mutual funds, closed end funds, hedge funds, ETFs, and REITs. We will say a
few words about each.

The pooled fund that most of you are familiar with is a mutual fund. Mutual funds are investment vehicles that
collect, or pool, money from many investors and invest that money in securities such as stocks, bonds, money
market instruments and similar assets. Because mutual funds do not have a fixed number of shares
outstanding, they are called open-end funds. In theory, they can remain “open,” or continue to take new
investors as long as they want. Mutual funds are not publicly traded on exchanges but rather are sold directly by
the fund (such as Vanguard or Fidelity) or through brokers. The price that investors pay for mutual fund shares is
the fund's per share net asset value (NAV) plus any shareholder fees that the fund imposes at the time of
purchase (such as sales loads). Funds can impose loads at the time of purchase (otherwise known as front-
loaded) or at the time of sale (otherwise known as back-loaded), or they may waive these fees after you have
held the fund for a certain length of time. Mutual funds stand ready to redeem shares at NAV when investors
want to sell shares back to the fund, and they are operated by investment advisers that are registered with, and
regulated by, the SEC. The Investment Company Act of 1940 is the cornerstone of mutual fund regulation.
Mutual funds are priced at the closing of the trading day only, in contrast with stocks’ continuous pricing and
trading throughout the trading day.

In contrast to mutual funds (or open-end funds) that have an unlimited number of shares, there are also closed-
end funds. These are publicly traded funds that sell a fixed number of shares at one time (in an IPO) that later
trade on a secondary market such as the NYSE or NASDAQ. In short, you can think of them as essentially like
mutual funds that trade like stocks. One interesting feature of closed-end funds is that they often trade at
discounts, and sometimes deep discounts, from their NAV. Professional traders play the discount, buying when
the discounts widen and selling or short-selling when the discounts narrow or when prices creep up. Besides the
difference in the number of shares, closed-end funds are not redeemable at NAV like mutual funds—they are
bought and sold like stocks, although they too are strictly regulated by the SEC. Unlike regular stocks, however,
closed-end funds represent an interest in a specialized portfolio of securities that is actively managed by an
investment advisor and that typically concentrates on a specific industry, geographic market, or sector.

We mentioned hedging risk and hedge funds earlier, but now let's explain them in a little more detail.
Traditionally, these were only open to wealthy private investors—hedge funds are private, unregistered
investment pools that are mainly unregulated. They are most often set up as private investment partnerships
that limit themselves to fewer than 100 investors with a net worth of more than $1,000,000, and usually require a
very large initial minimum investment. And while hedging is the practice of attempting to reduce risk, most hedge
funds in reality seek to maximize investment return rather than to minimize risk, so the name “hedge fund” is
mainly a historical legacy rather than an accurate description of their purpose. Hedge funds use advanced
investment strategies such as leverage (borrowing to increase investment exposure as well as risk), long, short,
and derivative positions to generate high returns.

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So don't let the name fool you—these funds often carry more risk than the overall market. So, how do they
compare to mutual funds? Well, you can think of them as high-risk, high-reward mutual funds for the wealthy.
They are similar to mutual funds in that investments are pooled and professionally managed, but they typically
have more flexible investment strategies than mutual funds and use speculative investment practices that are
not often used by mutual funds. They also are not subject to the numerous regulations that apply to mutual
funds for the protection of investors—including regulations requiring a certain degree of liquidity, regulations
requiring that mutual fund shares be redeemable at any time, regulations protecting against conflicts of interest,
regulations to assure fairness in the pricing of fund shares, disclosure regulations, regulations limiting the use of
leverage, and more.

Other Investment Vehicles

An investment vehicle that has become more and more popular in recent years is the ETF, or Exchange Traded
Fund. An ETF tracks a basket of stocks that reflects the performance of an industry sector, style, or region, but
trades as a single stock on an exchange. Individual investors buy ETFs through the secondary markets. The
most common types of ETFs are index-based ETFs that seek to achieve the same return as a particular index,
such as the Dow Jones Index Fund (DIA, otherwise known as “DIAMONDS,” for short), various S&P 500
indexes (known as SPIDERS), and the NASDAQ 100 (whose symbol is QQQ). There are also actively managed
ETFs that do not follow indexes.

Perhaps the easiest way to understand ETFs is to think of them as mutual funds that trade like stocks, similar to
closed-end funds. ETFs offer public investors a way of investing in a pool of securities and other assets and
thus are similar in many ways to traditional mutual funds, except they trade throughout the day like stocks and
offer lower transaction costs. As you know, mutual funds have once-a-day pricing that occurs at the end of the
trading day; in contrast, ETFs offer continuous pricing like stocks, which is part of the reason they have become
so popular.

REITs are another fairly recent phenomenon, standing for Real Estate Investment Trust. REITs are investments
provided by real estate companies that allow investors to put their money into income-producing real estate in a
manner similar to how investors invest in stocks and bonds through mutual funds. REITs invest in many types of
commercial real estate, such as shopping malls, office buildings, apartments, warehouses, and hotels. They can
be publicly or privately held but nearly 300 REITs are listed on public stock exchanges. Individuals can invest in
REITs either by purchasing their shares directly on an open exchange or by investing in a mutual fund or ETF
that specializes in real estate holdings. Investing in REITs is a liquid, dividend-paying means of participating in
the real estate market. Here are some of the most common forms of REITs:

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Equity REITs: These invest in and own properties, and revenues come principally from rents generated
by their holdings.
Mortgage REITs: Mortgage REITs deal in investment and ownership of property mortgages. These REITs
loan money for mortgages to owners of real estate, or purchase existing mortgages or mortgage-backed
securities. Their revenues are generated primarily by the interest that they earn on the mortgage loans.
Hybrid REITs: These combine the investment strategies of equity REITs and mortgage REITs by investing
in both properties and mortgages.

The IRS oversees what qualifies as a REIT. Because REITs are entitled to a corporate tax deduction for
dividends paid to their shareholders, they are required to distribute at least 90% of their taxable income directly
to investors. Consequently, these are popular investments for producing income since they throw off at least
90% of their earnings to their shareholders. Publicly registered REITs are also regulated by the SEC.

Commodities, Futures, Options, and Derivatives

The last category of investments we will cover in this module is another group you have no doubt heard of but
which most investors never trade in: commodities, futures, options, and derivatives. As the mechanics of these
can be quite tricky, we will only cover the basic features of these investments.

Let's start with commodities, which we mentioned earlier. Commodities are goods—and this can include a wide
range of things, such as corn, grain, pork bellies, petroleum, steel, coal and even the stocks of a particular
company or companies. Commodities trading, primarily based in the United States in Chicago and, to a lesser
extent, New York, has existed for well over a century. In recent years, these markets have been broadened to
include trading in a variety of financial products as well. There are two main types of trading that take place: the
cash, or spot, market—this is the market for commodities that are available today, which the suppliers,
producers, and users of the various commodities buy and sell—and the futures market, which, as the name
suggests, is speculative trading on whether the prices of these commodities will go up or down at some specific
time in the future. Most of the trading in futures today actually relates to financial and index futures, but some
producers and users of commodities use futures to hedge against future price changes.

Options are similar to futures, in which someone has the right, but not the obligation, to fulfill the contract. For
example, an issuer of a contract may sell the option to buy a specific commodity at a specific price on or before

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the maturity date. If it provides the holder of the option the right to buy, it is referred to as a call option. A put
option is the opposite; namely, it gives the holder the right to sell a specific commodity at a specific price
(otherwise known as a fixed strike price) on or before the maturity date. Options are a great tool for hedging,
and conservative investors may use options as a way of insuring against the possibility that a particular stock, or
a portfolio of stocks, or commodities, will rise or fall in price. For example, if you are selling an option to buy a
commodity for $10 by June 20, 2020, you are giving the option holder the right to buy that commodity for $10
any time prior to that date. In exchange for that right, the option buyer pays you an agreed-upon premium or
amount upfront. If the commodity rises above that price, the option holder will probably happily use, or
“exercise,” that option. If, however, the price falls below $10 and never rises above it, the option will expire
without value.

So, how do futures and options differ?

While they seem similar, there is one fundamental difference: in a futures contract, the
buyer and seller are committed to conclude the transaction (or “close out the position”).
If a price goes down when a buyer had hoped it would go up, for example, the buyer
will have to close out the position and take the loss.

In contrast, an option is essentially a “right” rather than a “duty”—if the price goes down
when a buyer had hoped it would go up, the buyer can simply let the option expire and
only lose the premium he or she paid to obtain the option.

Lastly, let’s say a few words about derivatives. As you no doubt remember, derivatives were at the center of
some of our recent financial crises as well. Simply put, this is a security instrument that derives its value from
some other thing, hence the name “derivative.” It is essentially a financial bet on the future value of something.
Part of what made some derivatives so risky in the past is that they could be incredibly complex and based on
many different variables and contingencies. Some were so incredibly complex that it was difficult, if not
impossible, to ascertain what the actual underlying value of the derivative really was. However, most derivative
trading is undertaken as a form of hedging activity and is designed to minimize risk, although to many investors
they continue to have a bad reputation due to their contribution to the collapse of financial markets during recent
financial crises. Derivatives can be bought and sold privately between parties, or on exchanges, as shown in the
following:

All derivatives are not the same. Here are some of the differences between over-the-
counter and exchange-traded derivatives.

Two Types of Derivatives

Over-The-Counter Derivatives Exchange-Traded Derivative

Private contract between Standardized contract between

counterparties counterparties.

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Booked by each party without the need Booked through a clearinghouse that
to go through a clearinghouse or serves as a counterparty to each party
organized exchange such as NYMEX. (e.g., seller to buyer and buyer to seller).

Collateral and margin requirements are Collateral and margin requirements are
not mandated. mandated.

Terms are flexible and established by Terms are standardized and established
counterparties. by an exchange.

Summary

So, that's it for Introduction to Capital Markets. Let's take a moment to recap some of the main points:

The role of lawyers in capital markets is varied but most commonly includes managing the regulatory
process, drafting contracts, and advising clients and employers on risk.
The main participants in capital markets are issuers (who issue securities) and investors (who invest by
buying and selling them).
The main regulator of U.S. capital markets is the SEC, although each state also has a regulatory body.
Four important categories of capital markets are primary and secondary markets; equity markets; debt
markets; and derivatives, currency, and commodities markets. A primary market is the market for newly
issued securities released to the public, while a secondary market is the market for securities that have
been previously issued.
Stocks are the most obvious category of securities. Common stock is the most prevalent form of stock
and provides the investor with an ownership interest in the corporation as well as the right to vote on
boards of directors and on fundamental corporate business that requires shareholder approval. Preferred
stock is different from common stock in that it has a higher claim on assets and earnings than common
stock, generally trades at $25/share, and is a type of hybrid between a stock and a bond.
The most common bonds include: treasury bonds (TIPS and T-bills), municipal bonds (issued by local
governments), corporate bonds (issued by corporations), zero coupon bonds (sold at a discount in lieu of
interest), junk bonds (those that are below-investment grade), and callable bonds (that can be redeemed
by the issuer prior to maturity).
Investors use different investment strategies and some of the most popular ones include buying on
margin, growth investing, value investing, speculation, hedging, and yield/income investing.
Most investors buy stock hoping it will go up in price, known as “going long,” “Shorting” a stock, in
contrast, means borrowing it, selling it, and covering it at a lower price to return it to your broker. When
you go long, your profit or loss is the difference between your purchase price and your sale price. When
you short, your profit or loss is the difference between your sale price and the price you buy it back at.
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Investors can pool their money into funds to invest. Mutual funds are “open-end” funds because they do
not have a fixed number of shares outstanding, as opposed to closed-end funds that do. Pooled funds
also include hedge funds, ETFs, and REITs.
Buyers of futures speculate on the rise or fall of prices of specific products at some specific time in the
future and are committed to close the transaction. A call option gives the holder the right (but not an
obligation) to buy a specified asset at a fixed strike price on or before the maturity date.

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Important
You must complete the quiz for this module before you can go to the next.

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