Chapter Nine
Stock Markets
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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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Financial corp
9-3
2004
Rest of world
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Primary and Secondary Markets Overview
• 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
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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
$40
= 12.5% + 10.0% = 22.5%
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Stock Market Securities
• Two types of corporate stock exist
– Common stock
• the fundamental ownership claim in a public
corporation
– Preferred stock
• a hybrid security that has characteristics of both
bonds and common stock
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New Securities Issued ($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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Characteristics of Common Stock
•
•
•
•
Dividends
Residual Claim
Limited Liability
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
• Cumulative preferred stock
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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)
(continued)
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•
•
•
•
•
•
Net proceeds
Gross proceeds
Underwriters’ spread
Syndicate
Originating house
Red herring proxy
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Secondary Markets:
Major U.S. Stock Exchanges
• New York Stock Exchange (NYSE)
• American Stock Exchange (AMEX)
• 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
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Trading on NYSE and AMEX
Order
Investor
Shares
Cash
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Order
Broker
Shares
Cash
9-13
Order
Comm
or
Floor
Broker
Shares
Cash
Market
Maker or
Other Floor
Broker
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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)
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Stock Market Indexes
•
•
•
•
The Dow Jones Industrial Average (the DJIA)
The NYSE Composite index
the Standard & Poor’s 500 index
The NASDAQ Composite index
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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
9-16
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
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Other Issues Pertaining to Stock Markets
• Does the stock market forecast the economy?
• Market efficiency
– the speed with which financial security prices adjust
to unexpected news pertaining to interest rates or a
stock-specific characteristics, etc.
– Forms of market efficiency
• Weak Form Market Efficiency
• Semistrong Form Market Efficiency
• Strong Form Market Efficiency
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Stock Market Regulation
• 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
• Delegates certain regulatory responsibilities to the
markets for the day-to-day surveillance of activity
• Recently imposed regulations on financial markets
intended to reduce excessive price fluctuations
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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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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
9-20
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