Debt and equity Markets A firm or an individual can obtain funds in a financial market in two ways. The most common method is through the issuance of a debt instrument, such as a bond or a mortgage, which is a contractual agreement by the borrower to pay the holder of the instrument fixed dollar amounts at regular intervals (interest and principal payments) until a specified date (the maturity date), when a final payment is made. The maturity of a debt instrument is the number of years (term) until that instrument’s expiration date. A debt instrument is short-term if its maturity term is less than a year and longterm if its maturity term is ten years or longer. Debt instruments with a maturity term between one and ten years are said to be intermediate-term.
The second method of raising funds is through the issuance of equities, such as common stock, which are claims to share in the net income (income after expenses and taxes) and the assets of a business. If you own one share of common stock in a company that has issued one million shares, you are entitled to 1 one-millionth of the firm’s net income and 1 one-millionth of the firm’s assets. Equities often make periodic payments (dividends) to their holders and are considered long-term securities because they have no maturity date. In addition, owning stock means that you own a portion of the firm and thus have the right to vote on issues important to the firm and to elect its directors.
The main disadvantage of owning a corporation’s equities rather than its debt is that an equity holder is a residual claimant; that is, the corporation must pay all its debt holders before it pays its equity holders. The advantage of holding equities is that equity holders benefit directly from any increases in the corporation’s profitability or asset value because equities confer ownership rights on the equity holders. Debt holders do not share in this benefit, because their dollar payments are fixed. We examine the pros and cons of debt versus equity instruments in more detail in Chapter 8, which provides an economic analysis of financial structure.
The total value of equities in the United States has fluctuated between $4 and $25 trillion since the early 1990s, depending on the prices of shares. Although the average person is more aware of the stock market than of any other financial market, the size of the debt market is often substantially larger than the size of the equities market: At the end of 2013, the value of debt instruments was $42 trillion, while the value of equities was $21.3 trillion.