Understanding Stock Exchanges: A Beginner's Guide to Stocks & Bonds

A stock exchange is a marketplace where securities, such as stocksStockWhat is a stock? An individual who owns stock in a company is called a shareholder and is eligible to claim part of the company’s residual assets and earnings (should the company ever be dissolved). The terms "stock", "shares", and "equity" are used interchangeably. and bondsBondsBonds are fixed-income securities that are issued by corporations and governments to raise capital. The bond issuer borrows capital from the bondholder and makes fixed payments to them at a fixed (or variable) interest rate for a specified period., are bought and sold. Bonds are typically traded Over-the-Counter (OTC)Over-the-Counter (OTC)Over-the-counter (OTC) is the trading of securities between two counter-parties executed outside of formal exchanges and without the supervision of an exchange regulator. OTC trading is done in over-the-counter markets (a decentralized place with no physical location), through dealer networks., but some corporate bonds can be traded on stock exchanges. Stock exchanges allow companies to raise capitalCapitalCapital is anything that increases one’s ability to generate value. It can be used to increase value across a wide range of categories, such as financial, social, physical, intellectual, etc. In business and economics, the two most common types of capital are financial and human. and investors to make informed decisions using real-time price information. Exchanges can be a physical location or an electronic trading platform. Though people are typically familiar with the image of the trading floor, many exchanges now use electronic trading.

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Purpose of Stock Exchanges

Stock exchanges act as an agent for the economy by facilitating trade and disseminating information. Below are some of the ways exchanges contribute:

1. Raising Capital

Through initial public offerings (IPO)Initial Public Offering (IPO)An Initial Public Offering (IPO) is the first sale of stocks issued by a company to the public. Prior to an IPO, a company is considered a private company, usually with a small number of investors (founders, friends, family, and business investors such as venture capitalists or angel investors). Learn what an IPO is or issuing of new shares, companies are able to raise capital to fund operations and expansion projects. This provides companies with avenues to increase growth.

2. Corporate Governance

Companies that are publicly listed on a stock exchange must conform to reporting standardsGAAPGAAP, Generally Accepted Accounting Principles, is a recognized set of rules and procedures that govern corporate accounting and financial that are set by regulating bodies. This includes having to regularly and publicly report their financial statements and earnings to their shareholders.

The actions of a company’s management are constantly under public scrutiny and directly affect the value of the company. Public reporting helps ensure that management will make decisions that benefit the goals of the company and its shareholders, thereby acting efficiently.

3. Economic Efficiency

In addition to encouraging management efficiency, exchanges also facilitate economic efficiency through the allocation of capital. Stock exchanges provide an avenue for individuals to invest their cash, as opposed to merely saving these funds. This means that the capital that would otherwise be untouched is utilized towards economic benefits, resulting in a more efficient economy.

In addition, exchanges also provide liquidity, as it is relatively easy to sell one’s holdings. By providing liquidity and real-time price information on company shares, the stock exchange also encourages an efficient market by allowing investors to actively decide the value of companies through supply and demandSupply and DemandThe laws of supply and demand are microeconomic concepts that state that in efficient markets, the quantity supplied of a good and quantity.

Notable Stock Exchanges

1. New York Stock Exchange (NYSE)

Founded in 1792, the New York Stock Exchange is by far the largest exchange in the world. As of March 2018, the NYSE’s market capitalizationMarket CapitalizationMarket Capitalization (Market Cap) is the most recent market value of a company’s outstanding shares. Market Cap is equal to the current share price multiplied by the number of shares outstanding. The investing community often uses the market capitalization value to rank companies was US$23.12 trillion.

2. NASDAQ

Founded in 1971, NASDAQ is a US-based stock exchange. With a market capitalization of US$10.93 trillion as of March 2018, it is the second-largest in the world by market capitalization. Many tech and growth firms choose to be listed on the NASDAQ.

3. Shanghai Stock Exchange (SSE)

Founded in November 1990, the Shanghai Stock Exchange is the fourth-largest exchange in the world. It reported a market capitalization of US$5.01 trillion in March 2018. There are two types of stocks listed on the SSE, ‘A shares’ and ‘B shares’. Shares are quoted in RMB, with trading in A shares historically restricted to domestic investors.

In July 2018, China announced additional plans to allow foreign investors to access A shares through domestic brokerages. B shares are quoted in USD and are open to domestic and foreign investors alike.

Listing Requirements

All companies that wish to go public must satisfy certain reporting requirements as outlined by the securities commissions of their respective jurisdictions.

In the United States, the Securities and Exchange CommissionSecurities and Exchange Commission (SEC)The US Securities and Exchange Commission, or SEC, is an independent agency of the US federal government that is responsible for implementing federal securities laws and proposing securities rules. It is also in charge of maintaining the securities industry and stock and options exchanges dictates that companies must discuss and publish their financial statements, as well as make other disclosures. These are published in the form of quarterly and annual reports.

On top of these requirements, in order to be listed on an exchange, a company must also satisfy the requirements of the stock exchange they wish to be listed on. Below are some examples of listing requirements by the three aforementioned exchanges. Listing requirements may also differ for initial public offerings (IPO).

New York Stock Exchange (NYSE):

• Pre-tax income for the past 3 years must be at least US$10,000,000
• The market capitalization of publicly held shares must be at least US$100,000,000
• Publicly held shares must be greater than 1,100,000

NASDAQ:

• Pre-tax income for the past 3 years must be at least US$11,000,000
• The market capitalization of publicly held shares must be at least US$45,000,000
• Publicly held shares must be greater than 1,250,000

Shanghai Stock Exchange (SSE):

• Capital stock must exceed RMB¥50,000,000
• Publicly issued shares must account for at least 25% of all shares; if the company’s capital stock exceeds RMB¥400,000,000, publicly issued shares must account for at least 10% of all shares
• No major legal violations in the past three years or fraudulent records in the company’s financial reports

Please note this is not an exhaustive list of the requirements to be listed in each respective stock exchange.

Primary Market

When a company issues new securities that did not previously exist on any exchange, it is issuing securities to the primary marketPrimary MarketThe primary market is the financial market where new securities are issued and become available for trading by individuals and institutions. The trading activities of the capital markets are separated into the primary market and secondary market.. Undergoing an IPO is an example of this. The company offers securities to the investors to raise capital and becomes listed on the stock exchange.

Image from CFI’s Free Introduction to Corporate Finance course.

Secondary Market

After a company undergoes an IPO, its shares continue to be traded between investors on the market. This is referred to as the secondary marketSecondary MarketThe secondary market is where investors buy and sell securities from other investors. Examples: New York Stock Exchange (NYSE), London Stock Exchange (LSE).. The company is no longer involved in any of these transactions. The stock exchange facilitates trade between buyers and sellers in the secondary market.

Image from CFI’s Free Introduction to Corporate Finance course.

Additional Resources

Looking to learn more about finance and stock markets? Corporate Finance Institute offers a range of courses and resources that can help you expand your knowledge and further your career! Check them out below:

• Introduction to Corporate Finance
• Reading Financial Statements
• Stock MarketStock MarketThe stock market refers to public markets that exist for issuing, buying and selling stocks that trade on a stock exchange or over-the-counter. Stocks, also known as equities, represent fractional ownership in a company
• Stock Investment StrategiesStock Investment StrategiesStock investment strategies pertain to the different types of stock investing. These strategies are namely value, growth and index investing. The strategy an investor chooses is affected by a number of factors, such as the investor’s financial situation, investing goals, and risk tolerance.