Power Point Slides for:
Financial Institutions, Markets, and
Money, 9th Edition
Authors: Kidwell, Blackwell, Whidbee &
Peterson
Prepared by: Babu G. Baradwaj, Towson University
and
Lanny R. Martindale, Texas A&M University
Copyright© 2006 John Wiley & Sons, Inc.
1
CHAPTER 10
EQUITY MARKETS
Common Stock
Ownership in a Corporation
One vote per share.
Have a residual (last) claim on income and
assets in liquidation, thus a riskier position
than bonds and preferred stockholders.
Shareholders’ liability for the debts of the
corporation is limited to their investment in
the common stock.
Copyright© 2006 John Wiley & Sons, Inc.
3
Common Stock (concluded)
Shareholders’ return is derived from
dividends declared by the board of directors
and from market appreciation in the value
of the stock.
Common shareholders may vote their shares
to elect the members of the board of
directors.
Members of the board of directors can be
elected by cumulative voting or straight
voting.
Copyright© 2006 John Wiley & Sons, Inc.
4
Preferred Stock
A Preferred or prior claim on earnings and
assets compared to common stock
Dividends paid ahead of common if
declared.
Cumulative - arrearage plus current dividends paid
before any payment made to common shareholders.
Non-participating preferred receive a fixed level
of dividends, thus not participating in possible high
earnings level of the corporation.
Adjustable rate preferred, indexed to market rates,
vary as the index varies.
Copyright© 2006 John Wiley & Sons, Inc.
5
Preferred Stock
(continued)
Preferred stockholders are usually excluded
from voting for board of directors and
shareholder issues.
Many corporations buy preferred stock.
A high percentage (70%), depending on the
extent of ownership, of dividends received from
one corporation by another corporation are
federally tax exempt.
Investors are concerned about after-tax return.
Copyright© 2006 John Wiley & Sons, Inc.
6
Convertible Securities
Convertible preferred stock - convertible to
common stock at specific common price or
number of shares (conversion ratio).
Dividends received until conversion
Investor may participate in growth of firm.
Convertible bonds - convertible to common stock
at specific common price or number of shares
(conversion ratio).
Pays fixed bond rate until conversion.
Provides potential for higher returns for investors.
Convertibles are mostly subordinated debt and hence
have a higher risk.
Issuing firm is essentially “selling” the company’s stock
at a higher future price.
Copyright© 2006 John Wiley & Sons, Inc.
7
Equity Owners
Copyright© 2006 John Wiley & Sons, Inc.
8
Primary Market for Equities
The first time shares are sold in the market is an
unseasoned offering or an initial public offering (IPO);
additional shares may be sold later as a seasoned
offering.
Equities may be:
Sold directly to investors by the firm.
Purchased and sold at a higher price (underwriter’s
spread) by investment bankers in an underwritten
offering.
Sold to existing shareholders in a rights offering.
The size of the underwriter’s spread depends on the
underwriter’s level of uncertainty concerning the
shares’ market price.
Copyright© 2006 John Wiley & Sons, Inc.
9
The Secondary Market for Equity Securities
Subsequent Trading in Securities after
primary issue
Stock may trade on:
Exchanges.
Over the counter
Provides investor liquidity
Copyright© 2006 John Wiley & Sons, Inc.
10
The Secondary Market (concluded)
Stable prices are related to the extent of:
Breadth of the market or the number of varied
traders of the stock.
Depth of the market or the extent to which
there are conditional orders to buy and sell
below and above the current price, respectively.
Resiliency of the market or the ability of the
market to attract buyer/sellers when the stock
prices decreases/increases, respectively.
Copyright© 2006 John Wiley & Sons, Inc.
11
Secondary Markets
Bring Buyers/ Sellers Together Four Ways:
A buyer may incur search costs and find a seller
on their own, called a direct search.
A broker may bring buyer and seller together,
charging a commission.
A dealer may sell/buy (bid/ask) securities from
an inventory of securities, reducing search
costs. The dealer’s return is the bid/ask spread.
An auction market allocates the selling shares
to the highest bidder, providing a buyer/seller.
Copyright© 2006 John Wiley & Sons, Inc.
12
Equity Trading
Over-the-counter market (OTC)
Securities not listed are traded over-the-counter
(OTC). The reasons for not listing a stock
include:
little investor interest.
small issue size.
insufficient order flow.
The OTC market is a dealer market, which
includes a large number of relatively small OTC
dealers.
Brokers seek favorable prices from a variety of
dealers.
Copyright© 2006 John Wiley & Sons, Inc.
13
NASDAQ
National Association of Securities Dealers Automated Quotation
(NASDAQ)
Before 1971 daily "pink sheet" information of the National Quotation
Bureau listed stocks and associated dealers.
After 1971 the National Association of Securities Dealers (NASD)
initiated the NASDAQ, the NASD automated quotation system,
providing continuous bid/ask information.
NASDAQ is an electronic pink sheet.
NASDAQ is available to:
Level 3 terminals are available only to dealers who enter bid/ask
quotes into the system.
Level 2 terminals display price information and are available to
brokers and institutions.
Level 1 terminals provide the best bid/ask quote for a given stock.
NASDAQ accelerated the disclosure of dealer quotes to brokers,
reducing search time and enhancing the ability to find the best price.
Copyright© 2006 John Wiley & Sons, Inc.
14
Stock Exchanges
Exchanges are physical places or
electronically connected markets where
listed stocks are traded by members of the
exchange.
The New York Stock Exchange is the
largest of the U.S. stock exchanges.
Stocks are traded on an auction basis at specific
locations on the trading floor, called posts.
All bid/ask information is at a single place.
Copyright© 2006 John Wiley & Sons, Inc.
15
Stock Exchanges (continued)
Three major sources of active bids and offerings
are located at each trading post.
floor brokers handling customer orders.
limit price orders.
the specialist in the stock buying and selling for his/her
own account, making a continuous market for the stock.
Buy/ sell orders include
market orders to buy or sell at the available price and
limit orders to sell at a designated price are sent by
brokers to members trading on the floor of the NYSE.
limit orders (order to buy or sell at a designated price)
are held by the specialists.
Copyright© 2006 John Wiley & Sons, Inc.
16
Globalization of the Equity Markets
Electronically linking equity dealer and exchange markets
is slowly leading toward a national market system.
Electronically linking international markets has created 24
hour trading opportunities for some stocks.
U. S. stock exchanges have extended (after hours) their
normal trading hours in which shares are traded
electronically, linking U. S. with the hours of international
markets.
Investors’ ability to invest in foreign stocks is enhanced by
American Depository Receipts (ADRs)
An American Depository Receipt (ADR) is a negotiable
instrument issued by the U.S. financial intermediaries (FIs) against
shares in foreign companies, with the shares held in custody by the
FIs for investors.
ADRs are issued in the U.S. and are denominated in U.S. dollars.
All cash flows to the investor are in dollars.
Copyright© 2006 John Wiley & Sons, Inc.
17
Globalization of the Equity Markets (continued)
Global Depository Receipts (GDRs) are
negotiable receipts issued by financial
intermediaries in developed countries other than
the U.S. against shares in foreign companies that
are held in custody for investors.
ADRs and GDRs allow investors to diversify their
portfolio globally by reducing both transaction
costs and risk for investors.
Enhances a company’s visibility, status and profile
in the U.S. and internationally among investors,
consumers and customers.
Establishes/increases the foreign firm’s U.S.
liquidity (and potentially total global issuer
liquidity) by attracting new investors.
Copyright© 2006 John Wiley & Sons, Inc.
18
Regulation of Equity Markets
Securities Act of 1933
requires full disclosure of relevant information related
to a primary issue of securities.
requires registration of publicly traded securities across
state lines.
requires issuance of prospectus, a summary of
registration statement, to interested investors.
Securities Exchange Act of 1934
Established the SEC.
SEC administers the Securities Act of 1933
SEC registers and regulates securities exchanges, OTC
trading, brokers, and dealers.
SEC has broad powers over securities industry.
Copyright© 2006 John Wiley & Sons, Inc.
19
Equity Valuation Basics
The value of a security is the present value
of expected cash flows, discounted at the
required rate of return.
Identify the size of the relevant, future cash
flows and when the cash flows occur.
Select the appropriate discount rate.
Calculate the present value by discounting
the cash flows at the discount rate,
recognizing when the cash flows occur.
Copyright© 2006 John Wiley & Sons, Inc.
20
The Total Risk of a Security
Comprised of the Systematic (Market or
Undiversifiable) Risk and the Unsystematic Risk
(Diversifiable).
Proper diversification can reduce unsystematic,
unique, or security-specific risk.
A portfolio of securities can result in
diversification, the reduction of total risk or the
variability of returns (portfolio) below that of
holding the individual securities.
Copyright© 2006 John Wiley & Sons, Inc.
21
The Total Risk of a Security
Diversification occurs when securities,
whose historic returns have correlation
coefficients less than +1, are assembled in a
portfolio. Unsystematic or diversifiable
risks offset one another.
The systematic risk of the portfolio cannot
be diversified away by adding additional
securities.
Copyright© 2006 John Wiley & Sons, Inc.
22
Effect of Diversification on Portfolio Risk
Copyright© 2006 John Wiley & Sons, Inc.
23
Measuring Systematic Risk: Beta
Investors are assumed to hold securities in a
diversified portfolio with only systematic or
market risk to analyze.
The relevant risk of a security is how it correlates
with the portfolio.
The extent to which the variability of returns (risk)
of a stock related to the risk of a broad-based
market portfolio is called the beta of the stock. It
is a measure of relative risk of a security.
Copyright© 2006 John Wiley & Sons, Inc.
24
Measuring Systematic Risk: Beta (concluded)
If a stock varies as the market portfolio does, the
beta is 1.0 and the stock has a risk level matching
the market portfolio such as the S&P 500.
A beta greater than one is riskier (aggressive
stock) than the “market” while a beta less than one
is not as risky as the market and are called
defensive stocks.
Betas calculated for securities identify their
relative historic riskiness.
Copyright© 2006 John Wiley & Sons, Inc.
25
Stock Market Indexes
Stock market indexes are useful to assess
the performance of various portfolios of
securities.
An index is constructed by selecting a starting
point and a portfolio of securities, establishing a
date and value at a point in time.
With time the relative value of the index from
the base, starting point is the useful
information.
Copyright© 2006 John Wiley & Sons, Inc.
26
Stock Market Indexes (continued)
Each stock is assigned a relative weight in the portfolio, by
price (price-weighted) of the stock or by weighting the
relative market value of the company associated with the
stock.
A price-weighted index is computed by summing the prices of the
individual stocks in the index then dividing by a divisor to
determine the base index value.
The divisor, such as 100, relates the starting value and is adjusted
as stocks split or composition of the index is changed.
A market value-weighted index is calculated by summing the
total market value of the firms whose stock in the index. The
percentage change in the total market value of the firms is the
index.
Both composition and weighting affect the value of an
index over time.
Copyright© 2006 John Wiley & Sons, Inc.
27
The Stock Market As a Predictor of Economic Activity
The stock market's value changes may predict real
economic activity because:
Stock prices are thought to represent the present value
of expected cash flows. If a recession is coming with
lower earnings and dividends, the market should reflect
those expectations with lower prices.
Stock price declines reduce wealth and may reduce
consumption and negative business expectations should
curtail investment spending.
Evidence indicates that the stock market is not very
successful in predicting economic activity.
Copyright© 2006 John Wiley & Sons, Inc.
28