Of all the financial markets, none receives as much media coverage as the stock market. Unlike bond markets, where investors are making loans to governments and firms, the stock market is where investors are able to purchase partial ownership in firms represented by shares of stock.
Companies that are privately held don’t issue stock for public purchase. Instead, they keep the shares among a small group of owners, often the founders. But for companies that want or need outside investment, trading on one of the stock exchanges is a good way to do this.
Stock options are a type of derivative that allow for the purchase of shares of stock at a predetermined price. Companies often issue stock options to key employees as a reward for performance. The recipients can either sell their option contract on the options exchange or wait and exercise their option when the share price of the stock increases.
The majority of stock purchases and sales occur in the secondary market. When you place an order to buy stock, you are most likely buying shares that were previously owned by another individual. If Tina buys Coca-Cola stock in the market, she is buying it from someone else, not Coca-Cola. If she pays $150 for two shares of Coca-Cola stock, some other investor who sold the stock will receive $150, but Coca-Cola will receive nothing. The only time the firm receives money in a stock purchase is through an IPO or when the firm sells stock that it had repurchased earlier.
Companies issue two types of stock, common or preferred. Common stock provides investors with partial ownership of a firm and also grants them the right to vote for the firm’s leadership. Preferred stock also provides an ownership claim on a firm, but does not allow for voting privileges. Preferred stock is so named because preferred stockholders get paid before common stockholders when it comes time to pay dividends. The decision to issue common stock or preferred stock is influenced by the possible downsides of each. Because common stock allows shareholders a voice in corporate governance, the original founders of a firm might find themselves displaced if new common stockholders gain either a majority or plurality of the shares and elect new leadership. Because preferred stock guarantees dividends to shareholders, firms seeking to grow by reinvesting profits in the company might be hindered by this liability.
Ultimately the function of these various markets is to allow savers to connect with borrowers. Businesses seeking to expand their capital investment look to the bond market and stock market as a source of needed funds. Firms are very conscious of their operating cost, so finding the appropriate combination of stock and bond financing, or capital structure, with which to finance investment is important both to the business and the economy as a whole.
There is an inverse relationship between the interest rate and investment. The lower the interest rate, the lower the cost of capital, and the more firms are able to invest in physical capital. Likewise, as the interest rate increases, the cost of capital increases, and firms become less willing to invest in physical capital.
Are low interest rates enough to encourage investment? Unfortunately, the answer to that question is no. A firm’s decision to invest in capital is also conditioned on the expected rates of return. If firms expect higher rates of return, they are more willing to invest at each and every interest rate. If firms think there is little chance to earn a profit, then they are much less willing to invest in capital.
Here’s a way of looking at the effects of interest rates and expected rates of return on a business. Imagine that the expected rate of return is the pressure applied to a car’s gas pedal and the interest rate is the pressure applied to the brake pedal. Increased profit opportunities are represented by pressing down on the gas pedal and decreased profit opportunities are represented by letting your foot off of the gas pedal. Similarly, increased interest rates are represented by pressing down on the brake pedal, lower interest rates are represented by putting less pressure on the brake pedal, and zero interest rate is analogous to not putting any pressure on the brake pedal. If interest rates are low and expected profits are high, the business moves forward with investment and grows. If, however, the interest rate is higher than the expected rate of return, firms are stationary. In the end, increases in the expected rate of return will accelerate investment while increases in interest rate will slow investment or even bring it to a complete stop.