The role of the stock exchange
GOOD DAY to you all. So how did you fare with the putting together of your personal budgets? I hope you made them as realistic as possible, and even though times are tough, you still budgeted something for savings.
The topic under consideration this week is from the section of the Business Finance syllabus which we started a few weeks ago. Many persons have heard about stock exchanges, but they do not know very much if anything about them. If you are in that situation, I hope that after reading this lesson you will be more enlightened on the topic.
A stock exchange (formerly a securities exchange) is a corporation or mutual organisation which provides ‘trading’ facilities for stockbrokers and traders to trade stocks and other securities. Stock exchanges also provide facilities for the issue and redemption of securities as well as other financial instruments and capital events, including the payment of income and dividends.
The securities traded on a stock exchange include shares issued by companies, unit trusts, derivatives, pooled investment products, and bonds. To be able to trade a security on a certain stock exchange, it has to be listed there. Usually, there is a central location at least for record keeping, but trade is less and less linked to such a physical place, as modern markets are electronic networks, which gives them advantages of speed and cost of transactions. Trade on an exchange is by members only.
The initial offering of stocks and bonds to investors is, by definition, done in the primary market and subsequent trading is done in the secondary market. A stock exchange is often the most important component of a stock market. Supply and demand in stock markets are driven by various factors which, as in all free markets, affect the price of stocks. Stock exchanges have multiple roles in the economy and may include the following:
RAISING CAPITAL FOR BUSINESSES
The stock exchange provides companies with the facility to raise capital for expansion through selling shares to the investing public.
MOBILISING SAVINGS FOR INVESTMENT
When people draw their savings and invest in shares, it leads to a more rational allocation of resources because funds, which could have been consumed, or kept in idle deposits with banks, are mobilised and redirected to promote business activity with benefits for several economic sectors such as agriculture, commerce and industry, resulting in stronger economic growth and higher productivity levels and more productive firms.
FACILITATING COMPANY GROWTH
Companies view acquisitions as an opportunity to expand product lines, increase distribution channels, hedge against volatility, increase market share, or acquire other necessary business assets. A takeover bid or a merger agreement through the stock market is one of the simplest and most common ways for a company to grow by acquisition or fusion.
REDISTRIBUTION OF WEALTH
Stock exchanges do not exist to redistribute wealth. However, both casual and professional stock investors, through dividends and stock price increases that may result in capital gains, will share in the wealth of profitable businesses.
CORPORATE GOVERNANCE
By having a wide and varied scope of owners, companies generally tend to improve on their management standards and efficiency in order to satisfy the demands of these shareholders and the more stringent rules for public corporations imposed by public stock exchanges and the government. Consequently, it is alleged that public companies (companies that are owned by shareholders who are members of the general public and trade shares on public exchanges) tend to have better management records than privately held companies (those companies where shares are not publicly traded, often owned by the company founders and/or their families and heirs, or otherwise by a small group of investors).
CREATING INVESTMENT OPPORTUNITIES FOR SMALL INVESTORS
As opposed to other businesses that require huge capital outlay, investing in shares is open to both the large and small stock investors, because a person buys the number of shares he or she can afford. Therefore, the stock exchange provides the opportunity for small investors to own shares of the same companies as large investors.
GOVERNMENT CAPITAL RAISING FOR DEVELOPMENT PROJECTS
Governments at various levels may decide to borrow money in order to finance infrastructure projects, such as sewage and water treatment, works or housing estates, by selling another category of securities known as bonds. These bonds can be raised through the stock exchange whereby members of the public buy them, thus loaning money to the government. The issuance of such bonds can obviate the need to directly tax the citizens in order to finance development. Although securing such bonds with the full faith and credit of the government instead of with collateral, the result is that the government must tax the citizens or otherwise raise additional funds to make any regular coupon payments and refund the principal when the bonds mature.
BAROMETER OF THE ECONOMY
At the stock exchange, share prices rise and fall depending, largely, on market forces. Share prices tend to rise or remain stable when companies and the economy in general show signs of stability and growth. An economic recession, depression or financial crisis could eventually lead to a stock market crash. Therefore, the movement of share prices and, in general, of the stock indexes can be an indicator of the general trend in the economy. Do you feel a little more enlightened? Good! Next week, we will cover another topic from this same section of the syllabus. When the entire section is complete, I will present a simple test so you can see how well you have grasped the topics in this section. Bye for now.