CHAPTER 10
EQUITY MARKETS
CHAPTER OVERVIEW AND LEARNING OBJECTIVES

In this second capital markets chapter we shift from the debt market to the equity market.
Capital markets and their instruments, bonds, mortgages, and equities develop only where
there is prospect for political stability and economic development.

The world comes to U.S. financial centers (and increasingly, European and Asian) to finance
long-term capital projects. As you study this chapter, note the need for a viable secondary
market in order to bring new issues to market (underwriting). With secondary markets,
investors can alter their portfolio as their "real" conditions change (retirement, college tuition,
etc.).

As the number of market participants increases, and as technology improves, efficiency
increases.

When finished, review the Flow of Funds tables noting the credit flows (transactions) in the
equity capital markets over the last several years.
CAREER PLANNING NOTE: TAKE A TRIP TO A FINANCIAL CENTER
Most campuses and homes of most students in this course are miles away from "financial centers" such as
New York, Boston, Chicago, San Francisco, and regional centers such as Houston, Denver, and
Cleveland. For those of you with a "finance" career on your mind, take the time to check out the Big
Apple or other centers where there is a concentration of financial activity. Don't be concerned if you do
not know anyone there! They (financial center employers) are expecting you! Book a tour (campus,
organization, or private) or go with a friend. Take advantage of discount fares, coupon book room
discounts, and the tours available from exchanges and others. Talk to your professors or alumni about
people to meet and places to hit! Read the want ads in the city's newspaper before you go. Check out the
universities and MBA degrees offered in the "money-center" area. Some students "get" to the right job
and the city by relocating for prior MBA work. Look over the options and your strategy. Don't worry
about leaving home. If you want, you can come home later – with "financial center" experience! Don't sit
on your assets! Get that career plan going!
READING THE WALL STREET JOURNAL: PREDICTING THE MARKET
The “Ahead of the Tape” column on page C1 tries to make sense of what will happen in the market on a
given day. If there is a meeting of the Federal Open Market Committee on a given day, you can be sure
that the “Ahead of the Tape” column will discuss the likely outcome of the meeting and how it will affect
markets. Likewise, if important economic data is to be released, the “Ahead of the Tape” column will
give you a heads up about it.
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TOPIC OUTLINE AND KEY TERMS
I.
What Are Equity Securities?
A.
Common Stock - Basic Ownership in a Corporation
1.
2.
3.
4.
5.
6.
7.
8.
9.
B.
Preferred Stock - Preferred claim on earnings and assets compared to common stock.
1.
2.
3.
C.
One vote per share.
Board of directors declares dividends.
Residual (last) claim on income and assets in liquidation, thus a riskier position
than bondholders and preferred stockholders.
Shareholders' liability for the debts of the corporation is limited to their
investment in the common stock.
Shareholders' return is derived from dividends declared by the board of directors
and from appreciation of the stock’s market value.
Common shareholders may vote their shares to elect the members of the board of
directors.
A shareholder may proxy their votes so that others, usually management, may
vote the shares at shareholders' meetings.
Dual-class stock provides voting for one class of stock and limits or excludes
voting for another class of common stock.
With cumulative voting, voting for the board is made in one ballot, permitting
shareholders the opportunity to aggregate their votes and cast them together. The
largest block of votes may appoint the first director, etc. Minority shareholder
interests may be represented on the board. Majority or straight voting permits a
majority or plurality to win all contested board seats, for each board seat is a
separate election and the majority will win all.
Preferred dividends are paid ahead of common if declared.
a.
Cumulative – arrearage plus current dividends must be paid before any
payment can be made to common shareholders.
b.
Non-participating – preferred stockholders receive fixed dividends, thus
not participating in possible high earnings of the corporation.
c.
Adjustable-rate preferred, indexed to market rates, has dividend levels
varying with the index interest rate.
Preferred stockholders are usually excluded from voting for board of directors
and shareholder issues.
Many corporations (e.g., casualty insurance companies) buy preferred stock.
a.
A high percent (70%), depending on the extent of ownership, of
dividends received from one corporation by another are federally taxexempt.
b.
Investors are concerned about after-tax return.
c.
As firm’s common stock price increases, so does the value of the
preferred stock.
Convertible Securities
1.
Convertible preferred stock - convertible to common stock at specific common
price or number of shares (conversion ratio).
a.
Dividends received until conversion.
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2.
II.
b.
Investor may participate in growth of firm.
Convertible bonds - convertible to a specific number of shares of common stock
at a specific price.
a.
Pays fixed bond coupon rate until conversion.
b.
Provides potential for higher returns for investors.
c.
Convertibles are mostly subordinated debt and hence have a higher risk.
d.
Issuing firm is essentially “selling” the company’s stock at a higher
future price.
The Market for Equity Securities
A.
Shareholder Ownership
1.
2.
B.
Primary Market for Equities
1.
2.
3.
4.
C.
Households dominate direct holdings of equity securities.
a.
May own directly or,
b.
Households hold many indirect claims on stock through mutual funds.
Mutual funds rank number one in institutional ownership, followed by foreign
investors and pension funds.
Primary market transactions refer to the first sale of shares in the market an
initial public offering (IPO) as well as additional shares sold later in a seasoned
offering.
They may be:
a.
sold directly to investors by the firm.
b.
purchased and sold at a higher price ( the difference is the underwriter's
spread) by investment bankers in an underwritten offering.
c.
sold to existing shareholders in a rights offering.
Regulation and adequate disclosure are required by the Securities and Exchange
Commission (federal) and securities offices of fifty states where they are sold.
a.
Securities and Exchange Commission enforces the Securities Act of
1933 and the SEC Act of 1934.
b.
Firms traditionally registered each new publicly distributed issue with
the SEC just prior to distribution.
c.
Qualified firms may now "shelf" register or register and then delay
issuance (keep issue on the shelf) until the appropriate time to issue
(within a two year period).
The size of the underwriter's spread is:
a.
inversely related to the size of the primary offering.
b.
directly related to risk of the offering, or potential variability of the stock
price.
c.
smaller with shelf registrations (usually larger, well known companies).
The Secondary Market for Equity Securities - Subsequent Trading in Securities
1.
2.
3.
Largest dollar volume traded of any security.
Stock does not mature - must be traded.
Stock may trade on:
a.
Exchanges.
(1)
Listed
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(2)
Traded by exchange members
Over-the-counter (OTC).
(1)
Dealers hold inventory
(2)
Sell on bid/ask basis
Stable prices are related to the extent of:
a.
Breadth of the market or the number of varied traders of the stock.
b.
Depth of the market or the extent to which there are conditional orders to
buy and sell below and above the current price, respectively.
c.
Resiliency of the market or the ability of the market to attract
buyers/sellers when the stock prices decrease/increase, respectively.
Secondary markets bring buyers/sellers together in four ways:
a.
A buyer may incur search costs and find a seller on their own, called a
direct search.
b.
A broker may bring buyers and sellers together, charging a commission.
c.
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.
d.
An auction market allocates the selling shares to the highest bidder,
providing a buyer/seller.
The size of a dealer’s bid/ask spread
a.
is proportionally higher for low-priced stocks due to fixed costs of
operations.
b.
is higher for trades of a few shares.
c.
is higher for large block trades, for a liquidity service is performed.
d.
is narrower for more frequently traded stocks, where the costs of
providing liquidity are less.
e.
is wider with traders with insider information, where the dealer may have
to incur the cost of price discovery, or buying high and selling low!
b.
4.
5.
6.
III.
Equity Trading
A.
Over-the-counter market (OTC)
1.
2.
3.
B.
Securities not listed on exchanges are traded over-the-counter (OTC). The
reasons for not listing a stock include:
a.
little investor interest.
b.
small issue size.
c.
insufficient order flow.
The OTC market is a dealer market, which includes a large number of relatively
small dealers.
Brokers seek favorable prices from a variety of dealers.
National Association of Securities Dealers Automated Quotation (NASDAQ)
1.
2.
3.
4.
5.
Before 1971 daily "pink sheet" information of the National Quotation Bureau
listed stocks and associated dealers.
"Pink sheets" had late price information.
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:
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a.
6.
C.
Stock Exchanges
1.
2.
3.
4.
D.
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.
a.
Stocks are traded on an auction basis at specific locations on the trading
floor, called posts.
b.
All bid/ask information is at a single place.
Three major sources of active bids and offerings are located at each trading post.
a.
floor brokers handling customer orders.
b.
limit price orders.
c.
the specialist in the stock buying and selling for his/her own account,
making a continuous market for the stock.
Buy/ sell orders include
a.
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.
b.
limit orders (order to buy or sell at a designated price) are held by the
specialists.
Merger of American Stock Exchange and NASDAQ
1.
2.
3.
4.
E.
Level 3 terminals are available only to dealers who enter bid/ask quotes
into the system.
b.
Level 2 terminals display price information and are available to brokers
and institutions.
c.
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.
National Association of Securities Dealers (NASD) and American Stock
Exchange announced it on 10/30/98.
First combination of central auction specialists (AMEX) and multiple marketmakers (NASD).
Operated separately but attempt to provide combination of services to customers.
Use of electronic limit order book, allowing investors/traders to execute orders
on or off the physical trading floor of the AMEX. Limit order book is visible to
investors.
Globalization of the Equity Markets
1.
2.
3.
4.
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)
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a.
b.
c.
d.
e.
f.
g.
h.
IV.
Regulation of Equity Markets
A.
Trading in securities markets in the U.S. are regulated by several federal laws and many
state laws.
1.
Securities Act of 1933
a.
requires full disclosure of relevant information related to a primary issue
of securities.
b.
requires registration of publicly traded securities across state lines.
c.
requires issuance of prospectus, a summary of registration statement, to
interested investors.
2.
Securities Exchange Act of 1934
a.
b.
c.
d.
V.
An American Depository Receipt (ADR) is a negotiable 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.
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.
As of December 2006 there were 450 listed ADRs representing over $1.9
trillion of equity in companies from 76 countries.
In 2006, ADR dollar trading volume in the U.S. totaled $1.58 trillion, up
from $953 billion in 2005.
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.
Equity Valuation Basics
A.
The value of a security is the present value of expected cash flows, discounted at the
required rate of return.
1.
Identify the relevant future cash flows and their timing.
2.
Select the appropriate discount rate.
3.
Calculate the present value found by discounting the cash flows at the discount
rate, recognizing the timing of cash flows.
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B.
Preferred stock valuation
1.
2.
Discount the expected dividend stream at the required rate of return to determine
its value.
A fixed-rate preferred stock approximates a perpetuity, and the value can be
found by dividing the annual dividends by the discount rate. [See Equation 10.2]
P0  D r
3.
C.
The preferred stock price varies to give the going rate of return to the new
investor.
Common Stock Valuation
1.
2.
3.
4.
The analyst must approximate the future cash flow stream and select an
appropriate discounting equation that approximates the cash flows of the stock.
The value of a stock held for a long time is the present value of the dividend
stream discounted at the required rate of return, a perpetuity similar to the
preferred stock above.
The value of a stock to be held for a determined period of time is the present
value of the dividend stream plus the PV of the expected selling price of the
stock.
The present value, now in period zero, of a steadily increasing stream of cash
flows is the value of the cash flow in the first year divided by the difference
between the discount rate and the (constant) rate of growth. This expression is a
math expression of a steadily growing perpetuity. [See Equation 10.9]
P0  D1 ( r  g )
5.
The valuation of a stock growing at varied assumed growth rates in the future is
calculated in several steps:
a.
first, calculate the dividends expected in the first few years of the
supernormal growth.
b.
Calculate the price or present value of the stock at the end of the
supernormal growth period.
c.
Combine the assumed new perpetual growth rate with the cash flows
computed above in the following equation: [See Equation 10.11]
Pt 
VI.
Dt (1  g )
(r  g )
Equity Risk
A.
Systematic & Unsystematic Risk
1.
2.
3.
The total risk of a security is comprised of the systematic (market or nondiversifiable) risk and the unsystematic risk (diversifiable) risk.
Proper diversification can reduce unsystematic, or security-specific risk.
A portfolio of selected securities can result in diversification, the reduction of
total risk or the variability of returns (portfolio) below that of holding individual
securities.
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4.
5.
B.
Measuring Systematic Risk: Beta
1.
2.
3.
4.
5.
6.
C.
Diversification occurs when securities whose historic returns are less than
perfectly positively correlated are assembled in a portfolio. Unsystematic or
diversifiable risks of different firms offset one another to some extent.
Adding properly selected securities to a portfolio has a limit as the systematic
risk of the portfolio cannot be diversified away.
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 market portfolio.
The extent to which the variability of returns (risk) of a stock relates to the risk of
a broad-based market portfolio is called the beta of the stock. It is a measure of
market (systematic) risk of a security.
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.
The Security Market Line (SML)
1.
2.
3.
4.
The security market line depicts the returns demanded for increased increments
of risk, the classic risk/return tradeoff.
The security market line is part of the capital asset pricing model (CAPM), which
explains the risk/return tradeoff.
The security market line enables one to conceptualize the risk of a stock as the
sum of the risk-free rate plus the market risk premium adjusted for the relative
risk of the stock (beta).
The equation for the SML is expressed as the risk premium of a stock is the sum
of the risk-free rate plus the market risk premium over the risk free rate times the
beta. (Equation 10.12a)
E ( R j )  R f   j [ E ( RM )  R f ]
VII.
Stock Market Indexes
A.
Stock market indexes are useful benchmarks that help assess performance of stock
portfolios.
1.
2.
B.
An index is constructed by selecting a starting point and a portfolio of securities,
establishing a date and value at a point in time.
The index value changes as time passes by. This value by itself is not
meaningful; it is the changes in the value over time that measure the return on the
index.
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.
1.
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.
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2.
3.
4.
C.
The Dow Jones Averages
1.
2.
D.
2.
2.
3.
The S&P 500 Index is a market value-weighted index of 500 of large U.S.
company stocks from various industries.
The S&P Index was initiated in 1943 and has two sub-indices, the industrial and
utility.
The S&P MidCap Index is a market value-weighted index of 400 companies
smaller than those on the S&P 500 index.
NASDAQ
1.
2.
G.
The NYSE composite index, started in 1966, includes all the common and
preferred stocks listed on the NYSE.
The NYSE composite and its sub-indices are market value-weighted indices.
Standard & Poor's Indexes
1.
F.
The DJIA is a price-weighted index of thirty large U.S. industrial company
stocks.
Dow Jones also publishes a 20 transportation index, a 15 utility index and a
composite 65 index of the stocks of the industrial, transportation, and utility
indices. All are price-weighted indices.
New York Stock Exchange Index
1.
E.
The divisor is originally needed to establish a nice round starting index value,
such as 100; it 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. The divisor plays the same role here.
Both composition and weighting affect the value of an index over time.
The NASDAQ Composite, started in 1970, is an index of all stocks traded on the
NASDAQ.
The NASDAQ National Market System indices, introduced in 1984, include a
Composite and an Industrial index, both weighted by market value capitalization
with a starting base value of 100.
Other Stock Indexes
1.
2.
3.
4.
The American Stock Exchange Composite Index is market value-weighted.
The Russell 3000 Index includes the stocks of the largest companies, ranked by
market value. The Russell 1000 includes the largest 1000 of the 3000; the Russell
2000 includes the smallest of the top 3000 companies.
The Value Line Composite Index measures the value of approximately 1,700
common stocks of large firms. It is an index of equally weighted geometric
average of stock price.
The Wilshire 5000 Index started in 1971 and includes 5,000 stocks, including all
stocks from the NYSE and the ASE. It is a market value-weighted index.
128
VIII.
The Stock Market as a Predictor of Economic Activity
A.
The stock market's value changes may predict real economic activity because:
1.
2.
3.
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; negative
business expectations should curtail investment spending.
Evidence indicates that the stock market is not very successful in predicting
economic activity.
COMPLETION QUESTIONS
1.
A majority shareholder group will win all the board seats in a board of directors’ election using
________ voting.
2.
Securities are first issued in the ________ market; subsequent trading is in the ________ market.
3.
While the money market is a ________ market, the capital market finances ________.
4.
The largest amount outstanding of any one capital market security is ________ followed by
________.
5.
The capital market securities, which are issued by corporations, are different from one another.
List the types of capital market securities issued by corporations and the major differences in the
securities.
1.
Securities Issued
_______________________________________
2.
_______________________________________
3.
_______________________________________
4.
_______________________________________
Major Differences in Securities
6.
1.
_______________________________________________________
2.
_______________________________________________________
3.
_______________________________________________________
4.
_______________________________________________________
5.
_______________________________________________________
An order to buy or sell at the best price available is a ___________ order.
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7.
A major federal regulator of stock exchanges is the ____________.
8.
While brokers earn _________ for their services; dealers earn their return for services from the
_____________.
9.
________ risk may be reduced by diversifying a security portfolio.
10.
Stock indices are usually constructed using either ______or ________ weights.
TRUE-FALSE QUESTIONS
1.
T
F
Common stock has a residual claim on earnings and assets ahead of bondholders.
2.
T
F
Limited liability sets a limit on the amount of their investment that a common
stockholder might lose in case of bankruptcy and liquidation.
3.
T
F
All common stockholder have one vote per share owned.
4.
T
F
An initial public offering is made in the primary market.
5.
T
F
The household sector is the largest single direct investor in common stock.
6.
T
F
The underwriter's spread is inversely related to the size of the primary offering.
7.
T
F
A market price for common stock with a high degree of depth, breadth, and
resiliency will be quite stable.
8.
T
F
Prices for stocks on the New York Stock Exchange are determined by brokers
and dealers.
9.
T
F
The NASDAQ is an exchange-based, electronic method for trading common
stock.
10.
T
F
A limit order to buy or sell stock may be delayed on the NYSE.
MULTIPLE-CHOICE QUESTIONS
1.
A(n) ___________ is sold in the ___________ market.
a.
unseasoned; primary
b.
initial public offering; secondary
c.
seasoned offering; secondary
d.
initial public offering; primary
130
2.
Select the answer that best depicts increasing required rates of return by investors.
a.
common stock, corporate bonds, treasury bonds, agency debt
b.
treasury bonds, agency bonds, common stock, preferred stock
c.
treasury bonds, agency bonds, corporate bonds, common stock
d.
agency bonds, corporate bonds, treasury bonds, preferred stock
3.
Which of the following securities would be in default if periodic payments were not made?
a.
debentures
b.
preferred stock
c.
common stock
d.
convertible preferred stock
4.
All but one of the following is associated with the primary market?
a.
rights offering
b.
shelf registration
c.
over-the-counter
d.
underwriter's spread
5.
What is the price of a share of common stock that paid a $4.00 dividend this last year, expects to
grow steadily at 6 per cent per year, and investors are requiring an 18 per cent rate of return?
a.
$16.67
b.
$17.67
c.
$33.33
d.
$35.33
6.
Malley Corporation's preferred stock is currently priced at $85, was issued at $100, and pays an
$8.00 annual dividend. What is the market required rate of return?
a.
8 per cent
b.
9.4 per cent
c.
10 per cent
d.
cannot be calculated
7.
What is the current value of a share of common stock that is expected to pay a $3 dividend each
year for five years, and at the end of the fifth year, be sold for $40, if the discount rate is 18 per
cent?
a.
$26.87
b.
$16.62
c.
$21.68
d.
$28.43
8.
The relevant risk of a common stock is
a.
its diversifiable risk.
b.
its risk relative to the market portfolio
c.
its beta.
d.
both "b" and "c" above.
9.
The Security Market Line shows the relationship between
a.
systematic and unsystematic risk.
b.
risk and return.
c.
aggressive versus defensive stocks.
d.
a dividend yield versus a capital gains yield.
131
10.
The stocks associated with a price-weighted index with a current value of 150 with a base of 100
over five years has had an annual compound rate of return of
a.
50 per cent
b.
10 per cent
c.
9.2 per cent
d.
8.5 per cent
11.
All but one of the following is associated with characteristics of common stock:
a.
residual claim on income and assets
b.
proxy
c.
cumulative dividends
d.
dual-class stock
12.
Security exchanges provide a valuable function in that they
a.
create interest in stocks.
b.
increase the marketability of securities.
c.
provide a legal way to gamble.
d.
supply money to deficit spending units.
13.
The New York Stock Exchange is a(n) ________ market.
a.
auction
b.
exchange
c.
secondary
d.
all of the above
14.
Which of the following is not true about American Depository Receipts (ADR)?
a.
An American Depository Receipt (ADR) is a claim issued by the U.S. financial
intermediaries (FIs) against shares in foreign companies, with the shares held in custody
by the FIs for investors.
b.
ADRs are issued in the U.S. and are denominated in U.S. dollars. All cash flows to the
investor are in dollars.
c.
Enhances a company’s visibility, status and profile in the U.S. and internationally among
investors, consumers and customers.
d
Decreases the foreign firm’s U.S. liquidity (and potentially total global issuer liquidity).
15.
Which of the following is true about secondary markets?
a.
A buyer may incur search costs and find a seller on their own, called a direct search.
b.
A broker may bring buyer and seller together, charging a commission.
c.
A dealer may buy and sell securities from his inventory, reducing search costs. The
dealer's return is the bid/ask spread.
d.
An auction market allocates the selling shares to the highest bidder, providing a
buyer/seller.
e.
all of the above are true.
132
SUPPLEMENTARY ASSIGNMENTS
Flow of Funds Accounts. Study the transaction accounts of the capital market securities for the last five
years. Note the years of the greatest change in the levels outstanding (flows). What economic events of
that period are related to, and possibly explain the major changes (flows)?
Title of Transaction Accounts to Study
Municipal Securities and Loans
Corporate and Foreign Bonds
Corporate Equities
SOLUTION TO COMPLETION QUESTIONS
1.
straight or majority voting
2.
primary; secondary
3.
liquidity; real capital, growth, or long-term capital investments
4.
stock; mortgages
5.
Securities issued: bonds; preferred and common stock; convertibles
Major differences in the securities:
(1)
(2)
(3)
(4)
(5)
maturity
claim on income
claim on assets in liquidation
voice in management (control)
cost of capital (required rate of return)
6.
market
7.
Securities and Exchange Commission (SEC)
8.
commissions; bid/ask spread
9.
specific, unsystematic, diversifiable risk
10.
price; market value
SOLUTIONS TO TRUE-FALSE QUESTIONS
1.
F
Bondholders have a prior claim on income and assets
2.
F
Stockholders may lose all of their investment in common, but no more than that.
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3.
F
Some companies have dual-class common, which may restrict voting.
4.
T
Subsequent trading is in the secondary market.
5.
T
See Federal Reserve Bulletin "Flow of Funds Accounts" or the Annual Statistical Digest
published by the Federal Reserve System.
6.
T
The larger the issue, the smaller the underwriter spread.
7.
T
Many investors are interested in prices above (sell) and below (buy) the current price,
thus stabilizing the price.
8.
F
Prices are determined by auction at the trading post on the floor of the exchange.
9.
F
The NASDAQ is the contact point for the over-the-counter dealer market.
10.
T
The limit order will be held by the specialist until the order expires or price hits the level
specified in the limit order.
SOLUTIONS TO MULTIPLE CHOICE QUESTIONS
1.
d
The investment banker buys and sells the issue for the first time.
2.
c
Increased risk, increased returns required.
3.
a
Debentures are contractual debt requiring specific payment of interest and principal.
4.
c
The over-the-counter market is associated with secondary market trading.
5.
d
$4.00 (1.06) / (0.18 - 0.06) = $35.33
6.
b
The security price varies to give the new investor the required rate of return or
$8.00/$85.00 = 9.4 per cent.
7.
a
The value of the stock is the sum of the present value stream of dividends plus the PV of
the future selling price discounted at the required rate of return. The calculator solution
is:
5N
18 i
40 FV
3 PMT
PV = $26.87
8.
d
The relevant risk is the risk the stock brings to the portfolio. A measure of the relative
riskiness of the stock relative to the market portfolio is the beta coefficient.
9.
b
The SML represents the risk/return tradeoff.
10.
d
The price level has grown from 100 to 150 over five years, an 8.45 per cent annual rate of
return. 100 PV, 150 FV, 5n; I = 8.45%
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11.
c
Cumulative dividends is associated with preferred stock, not common stock.
12.
b
Security exchanges provide a valuable function in that they increase the marketability of
securities.
13.
d
The New York Stock Exchange is a secondary market in the form of a physical exchange
where securities are traded in an auction process.
14.
d
It actually increases the foreign firm’s U.S. liquidity (and potentially total global issuer
liquidity).
15.
e
All of the four are true about secondary markets. The statements a through d describe the
four types of secondary markets.
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