Chapter Eight
Stock Markets
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Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved.
Chapter Outline
1.
2.
3.
4.
5.
Overview
Transaction Process of Stock Markets
Efficiency of Stock Markets
Regulation
International Stock Markets
1. Stock Market Participants
Holders of Corporate Stock (in billions of dollars)
Household sector
State and local gov.
Rest of world
Depository inst.
Life ins. co.
Other ins. co.
Private pension funds
Public pension funds
Mutual funds
Closed-end funds
Brokers and dealers
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1994
$3,070.9
10.6
397.7
180.6
246.1
112.1
996.3
557.4
709.6
31.9
20.1
1997
$5,689.6
79.0
919.5
331.4
558.6
186.0
1,863.9
1,431.7
2,018.7
50.2
51.9
2004
$6,132.7
87.6
1,670.3
260.1
962.4
187.5
1,536.3
1,180.3
3,431.7
70.8
107.5
% of
Total
39.2
0.6
10.7
1.7
6.2
1.2
9.8
7.5
22.0
0.4
0.7
Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved.
Stock Markets Overview
• Stockholders are the legal owners of a
corporation
– they have a residual claim to all earnings and assets
after debt and tax claims are satisfied
– voting rights (e.g., to elect board of directors)
– shareholders do not exercise control regularly (they
elect a board, who chooses a CEO, etc.)
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Market Value of Common Stock
Outstanding, by Type of Issuer ($Bn)
14000
12000
10000
8000
6000
4000
2000
0
1994
1997
Nonfinancial corp. bus
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2000
Financial corp
2004
Rest of world
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Stock Market Securities
• Two types of corporate stock exist
– Common stock
• the fundamental ownership claim in a public
corporation
– Preferred stock
• a hybrid security that has characteristics of both
bonds and common stock
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Characteristics of Common Stock
• Dividends
– payment and size of dividends is determined by the
board of directors of the issuing firm
• Residual Claim
– in the event of liquidation, common stockholders have
the lowest priority in terms of any cash distribution
• Limited Liability
– common stockholders losses are limited to the amount of
their original investment in the firm
• Voting Rights
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Characteristics of Preferred Stock
• Similar to common stock in that it represents an
ownership interest but, like bonds, pays a fixed
periodic dividend
• Senior to common stock but junior to bonds
• Generally do not have voting rights
• Nonparticipating preferred stock
– dividend is fixed regardless of any increase or decrease in the
firm’s value
• Cumulative preferred stock
– missed dividend payments go into arrears and must be made
up before common stock dividends can be paid
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Calculating Stock Returns
Rt = Pt - Pt-1 + Dt
Pt-1
Pt-1
Where:
Rt = Return over period from t-1 to t
Pt = Stock price at time t
Pt-1 = Stock price at time t-1
Dt = Dividends paid over time t - 1 to t
P1 - Pt-1 = Capital gain over time t - 1 to t
Rt = $45 - $40 + $4
$40
$40
= 12.5% + 10.0% = 22.5%
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Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved.
2. Primary and Secondary Markets
• Primary Market
– firm can raise equity capital in its initial public
offering (IPO)
– firm can raise equity capital in a subsequent
seasoned equity offering (SEO)
• Secondary Markets
– trading of shares among investors
2.1 Issuance of Stock in the Primary Market
Stocks
Issuing
Corporation
Stocks
Investment
Bank
Funds
Investors
Funds
Investment bank conducts primary market sale of stock
using firm commitment underwriting (guarantees
corporation a fixed price for newly issued securities) or
best efforts underwriting (no guarantee to issuer and
acts more as a placing or distribution agent)
• Net proceeds - the guaranteed price at which the
investment bank purchases the stock from the issuer
• Gross proceeds - the price at which the investment bank
resells the stock to investors
• Underwriters’ spread - the difference between the
gross proceeds and the net proceeds
• Syndicate - the process of distributing securities
through a group of investment banks
• Originating house – the lead bank in the syndicate
negotiates with the issuer on the syndicate’s behalf
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Public Offerings
• Concept of “Due Diligence” – All parties have a
duty to insure that information is complete and
accurate
• Red herring prospectus - a preliminary version
of the prospectus describing a new security –
pre-selling of security is based on this document
• Final prospectus
New Securities Issued ($Bn)
180
160
140
120
100
80
60
40
20
0
1992
1998
2000
Preferred
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2001
2003
2004
Common
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2.2 Major U.S. Stock Exchanges
• New York Stock Exchange (NYSE)
– buyers and sellers meet at the trading post to negotiate
– specialist acts as a dealer (market maker), as necessary
• American Stock Exchange (AMEX)
– trading system same as NYSE
• National Association of Securities Dealers
Automated Quotation System (NASDAQ)
– multiple dealers (market makers) compete for transactions in
a given stock
– each dealer/market maker posts a bid and offer price on the
system’s network
Trading on NYSE and AMEX
Order
Investor
Shares
Cash
Order
Broker
Shares
Cash
Order
Floor
Broker
Shares
Cash
Market
Maker or
Other Floor
Broker
Functions of Brokers
•
•
•
•
Receive and track orders
Find other parties
Negotiate prices
Execute orders
Functions of Dealers (Market Makers)
• Smooth out temporary supply/demand
imbalances
– Supplies “immediacy”
• Provide better price information
– Privileged access to order flow and limit order
information
• Act as auctioneer
Two Common Types of Orders
• Market order
– an order for the broker and market specialist to
transact at the best price available when the order
reaches the post
• Limit order
– an order to transact at a specified price (the limit
price)
Short Selling
• A way to “bet” that a security will fall in value
– Borrow the security and sell it
• Economic value of short selling
– Limit upward bias
• Limits on short selling
– “Tick” rules
– Risk
2.3 Stock Market Indexes
• The Dow Jones Industrial Average (the DJIA)
– a price-weighted index of the values of 30 large (in terms of
sales and total assets) corporations
• The NYSE composite index
– a value-weighted index of all common stocks listed on NYSE
• the Standard & Poor’s 500 index
– a value-weighted index of the stocks of 500 of the largest U.S.
corporations listed on the NYSE and NASDAQ
• The NASDAQ composite index
– a value-weighted index of three categories of NASDAQ
companies: industrials, banks, and insurance companies
3. Efficient Market Hypothesis
• Market Efficiency: the speed with which financial
security prices adjust to unexpected news
• Three forms of market efficiency
• Weak form (random walk)
• Current prices reflect past prices
• Technical analysis is useless
• Semi-strong form
• Prices reflect all public information
• Financial analysis is useless
• Strong form
• Prices reflect all that is knowable
• Nobody consistently makes superior profits
Relationship among Three Different
Information Sets
All information
relevant to a stock
Information set
of publicly available
information
Information
set of
past prices
Efficient Market Hypothesis: Summary
• Does Not Say:
• Prices are uncaused
• Investors are foolish and too stupid to be in the market
• All shares of stock have the same expected returns
• Investors should throw darts to select stocks
• There is no upward trend in stock prices
• Does Say
• Prices reflect underlying value
• Financial managers cannot time stock and bond sales
Arguments on Market Efficiency
• Argument supporting Efficiency
– Performance of mutual funds – actively managed
mutual funds don’t beat the market
• Argument against Efficiency
– Asset bubbles – Prices depart from fundamental
value on the high side for an extended period
Implications of Market Efficiency
• If believe market IS NOT mostly semi-strong
form efficient
– Active strategies
• If believe market IS mostly semi-strong form
efficient
– Passive strategies
4. Stock Market Regulation
• Stock markets and participants are subject to
regulations imposed by the Securities and
Exchange Commission (SEC)
• Main emphasis of SEC regulation is on full and
fair disclosure of information on securities
• Securities Act of 1933/Securities Exchange Act
of 1934
5. International Aspects of Stock Markets
• European markets becoming an increasing force
with introduction of a common currency, the
Euro
• International stock markets allow investors to
diversify by holding stocks issued by
corporations in foreign countries
• Increased risk due to less complete information
about foreign stocks, foreign exchange risk, and
political risk
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Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved.
Worldwide Stock Market Capitalization,
2004
2.65
3.88 1.77
United State
15.03
Europe
Japan
54.97
21.71
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Canada/Australia/New
Zealand
Pacific Basin
Emerging Markets
Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved.