MGT 470 Ch 8 Stock Mkt & Mkt Efficiency (cs3ed) v1.0 Nov 15
Ch 8: Stocks and Stock Markets
Stocks are:
A way to spread/diversify ownership of a firm
A key instrument for holding & creating personal wealth
A way to diversify risk
A way to transfer risk
A way for a firm to obtain financing
Common Stock Basics:
Shares of stock are initially sold by a firm through an investment
bank; proceeds usually used to buy capital assets (plant, machinery,
equipment, etc.)
Large quantities of stock are usually only issued once by a firm
Small quantities may be issued later (stock options, convertible
bonds, warrants, etc.)
A share of stock is a share of ownership in a company
In theory, stock owners are entitled to all revenue from the firm and
all proceeds from the sale of a firm
In reality, stock owners are residual claimants; if a firm goes
bankrupt and all assets are sold, creditors are paid first and stock
holders get the residual
Stock holders have limited liability for the firm’s losses
 their losses are limited to the amount they have invested in
stock
 they cannot be sued for anything the firm may do or may have
done
The publicly traded stock from a particular company has a unique
symbol (the “ticker” symbol) Ex: Apple Inc.: AAPL
Usually a company can have stock listed for trade on only one
particular stock exchange, i.e. the NYSE, the NASDAQ, the AMEX,
etc.
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MGT 470 Ch 8 Stock Mkt & Mkt Efficiency (cs3ed) v1.0 Nov 15
How stocks are sold
Someone wishing to sell a share of stock submits an asking price
(the “ask”) to a broker
Someone wishing to buy a share of stock submits a bidding price
(the “bid”) to a broker
Brokers have access to stock markets and can thus submt these trade
requests for execution in a stock market
Organized Securities Exchanges:
“Brick & mortar” location where buyers and sellers meet on a
regular basis to trade stock
Uses an open-outcry auction on a trading floor for buying and
selling as well as computer assisted trading; this combination is
referred to as “hybrid trading”
Floor traders specialize in trading certain types of stocks (thus they
are called “specialists”)
 specialists represent various brokerage firms and trade stocks
for their firms
 their main purpose is to match buyers and sellers in order to
keep the market running; they “make” the market
 when the bid and ask prices for a share of stock get really
close, a trade is made;
the bid/ask do not have to match exactly
the gap between the bid and ask prices is called the “bid-ask
spread”
specialists are compensated for the bid-ask spread and receive
commissions
 specialists are authorized to buy or sell from their own
accounts or from their firm’s inventory in order to keep up the
pace of trading and maintain an orderly market
On the NYSE about 25% of trades are conducted on the floor by
specialists and the rest are conducted by an electronic order routing
system called SuperDOT (Super Designated
Order Turnaround)
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MGT 470 Ch 8 Stock Mkt & Mkt Efficiency (cs3ed) v1.0 Nov 15
How stocks are sold (continued)
Organized Securities Exchanges: (continued)
The New York Stock Exchange (NYSE) is the preeminent stock
market in the U.S.; established in 1792
In 2007 the NYSE Euronext was created by merging the NYSE and
Euronext N.V. creating a pan europe-american global exchange
 over 8,000 companies from around the world are listed for
trade on this exchange
 the average firm has a market cap of $19.6b
Other major organized stock exchanges include the London Stock
Exchange, the Nikkei (Tokyo), the DAX (Germany)
To have stock listed for trading on one of the organized stock
exchanges, a firm must file an application and meet certain criteria set
by the exchange designed to enhance trading
 usual minimal requirements are $10m/year earnings and
$100m market cap
 firms that violate the rules of the exchange can be “de-listed”
(kicked out of the exchange)
Over-the-Counter (OTC) Exchanges:
The NASDAQ (National Association of Securities Dealers
Automated Quotations) is the most prominent
Operate in the same general manner as organized exchanges
There is no trading floor; all stocks are traded via an electronic
communication network and thus have global reach
As with organized exchanges, investors must go through authorized
brokers for access
Microsoft is the most prominent company that trades on an OTC
exchange (the NASDAQ)
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MGT 470 Ch 8 Stock Mkt & Mkt Efficiency (cs3ed) v1.0 Nov 15
How stocks are sold (continued)
Over-the-Counter (OTC) Markets: (continued)
OTC markets have “market makers” instead of trading floor
specialists
 market makers set bid/ask prices
 there are usually many marker makers for any particular stock
 they each enter their own bid or ask prices
 like organized exchanges, when the bid and ask prices get real
close, the trade is made
 once a price is submitted, the market maker is obligated to buy
or sell at least 1,000 shares
 this obligation ensures the market stays very liquid
Other considerations:
Both types of exchanges (organized and OTC) are public for-profit
businesses
This means that it costs participants (trading firms) money to
participate
These fees are passed on to investors (transaction costs)
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MGT 470 Ch 8 Stock Mkt & Mkt Efficiency (cs3ed) v1.0 Nov 15
How stocks are sold (continued)
Electronic Communications Networks (ECNs):
ECNs bring together major brokerages and traders directly and
bypass the middlemen (organized and OTC exchanges)
ECNs have numerous advantages over organized and OTC
exchanges that have lead to their rapid growth
 transparency: all unfilled orders are available for review; this
provides valuable supply/demand info that traders can use to plan
their strategy
 cost reduction: no middlemen, less transaction costs
 faster execution: no traders or market makers involved
 after-hours trading:
prior to ECNs, only institutional traders were able to trade after
exchanges had closed for the day
lots of business, market and economic info becomes available
after hours and small investors were unable to trade on this info
Disadvantages:
 ECNs only work well for stocks that usually are traded in large
volume; thinly traded stocks have trouble finding buyers/sellers
and may undergo long intervals without trading
 ECN markets are not as well regulated as organized and OTC
markets
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MGT 470 Ch 8 Stock Mkt & Mkt Efficiency (cs3ed) v1.0 Nov 15
The Importance of Stocks Markets
They are a central link between the financial world and the real
economy
They allocate resources via stock trading
They determine stock prices
Stock prices reflect the values of their respective firms
Are fundamental to the functioning of a market-based economy
 firms deemed most valuable in stock markets are the ones that
will be able to obtain financing for growth
 when resources flow to their most valued uses, the economy
operates more efficiently
Measuring the Level of a Stock Market
The performance of a stock market is expressed through stock
market indexes
A stock market index is designed to provide a sense of whether a
market is increasing or decreasing in value
The numerical value of an index is relatively meaningless, it does
not represent the true value of the stocks that comprise the index
A stock index is a representative sample of an entire stock market;
index performance reflects the performance of the whole market
Dow Jones Industrial Average (DJIA):
Created in 1884 based on the prices of 11 stocks
The DJIA is currently based on the stock prices of 30 of the largest
U.S. companies whose stock trade on the NYSE
The DJIA measures the return to holding a portfolio of a single
share of each stock included in the average
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MGT 470 Ch 8 Stock Mkt & Mkt Efficiency (cs3ed) v1.0 Nov 15
Measuring the Level of a Stock Market (continued)
Dow Jones Industrial Average (DJIA): (continued)
The DJIA is a price-weighted average; a price-weighted average
gives greater weight to shares with higher prices
Example (weight by price): Consider a portfolio composed of just 2
companies’ stock; Stock A initial price is $50 and Stock B initial price
is $100
Vportfolio = $50 + $100 = $150
wA = $50/$150 = 0.3333; wB = $100/$150 = 0.6666
Consider a 15% increase in Stock A:
Vportfolio = $50(1.15) + $100 = $57.50 + $100 =$157.50
Consider a 15% increase in Stock B:
Vportfolio = $50 + $100(1.15) = $50 + $115 =$165
The behavior of the higher priced stock dominates the portfolio
The Standard & Poors 500 Index:
Comprised of stocks traded on the NYSE from the largest firms in
the U.S.
The S&P 500 is a value-weighted index
 unlike the DJIA, it tracks the total value of owning the entirety
of those firms
 each firm’s stock price receives a weight equal to its total
market value (market cap)
 unlike the DJIA in which higher priced stocks have more
influence, in the S&P Index the larger firms (by value) are more
influential
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MGT 470 Ch 8 Stock Mkt & Mkt Efficiency (cs3ed) v1.0 Nov 15
Measuring the Level of a Stock Market (continued)
The Standard & Poors 500 Index: (continued)
Example (weight by value): consider a portfolio composed of just 2
companies’ stock; Stock A and Stock B
PA = $50; 100 million shares outstanding
PB = $100; 10 million shares outstanding
Mkt CapA = $50 x 100m = $5 billion
Mkt CapB = $100 x 10m = $1 billion
Vportfolio = $5b + $1b = $6b
wA = $5b/$6b = 0.8333; wB = $1b/$6b = 0.1667
Consider a 15% increase in Stock A:
Vportfolio = $5b(1.15) + $1b = $5.75 + $1b =$6.75b
Consider a 15% increase in Stock B:
Vportfolio = $5b + $1b(1.15) = $5b + $1.15b =$6.15b
The behavior of the higher valued stock dominates the portfolio
World Stock Indexes: Roughly one-third of the countries in the world
have stock markets and each of these has stock indexes, most of which
are value-weighted like the S&P 500
Regulating Stock Markets
Properly functioning capital market are the hallmark of an
economically advanced country
For an economy to flourish, firms must be able to raise funds to take
advantage of growth opportunities as they become available
Firms raise funds in capital markets
For these markets to function properly, investors must be able to
trust the information that is released about firms participating in the
market
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MGT 470 Ch 8 Stock Mkt & Mkt Efficiency (cs3ed) v1.0 Nov 15
Regulating Stock Markets (continued)
Markets can collapse in the absence of trust i.e. the stock market
crash of 1929
Congress passed the Securities Act of 1933 and the Securities Act of
1934; the purpose of these laws was to…
 require firms to tell the public the truth about their businesses
 require brokers, dealers and exchanges to treat investors fairly
Congress created the Securities and Exchange Commission (SEC) to
enforce these laws
The primary mission of the SEC is to protect investors and maintain
the integrity of securities markets
The SEC is organized into four divisions and 18 offices:
 Division of Corporate Finance
collects documents that companies are required to file to include
annual reports, registration statements and quarterly reports
review these documents to check for compliance with regulations
provide assistance to companies in interpreting regulations and
recommends new rules for adoption
 Division of Market Regulation
establishes and maintains standards for an orderly and efficient
markets by regulating the major securities markets
reviews and approves new rules and changes to existing rules
 Division of Investment Management
oversees and regulates the investment management industry
including mutual funds
establishes rules governing investment companies
 Division of Enforcement
investigates the violation of any rules and regulations established
by the other divisions
conducts its own investigations into various types of securities
fraud and acts on tips provided by other SEC divisions
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