Chapter 10Chapter 10

Stock MarketsStock Markets

Chapter objectivesChapter objectives::

We’ll learn to:• Describe how stock exchange facilitate the

trading of stocks. • Describe how stock markets are used by

financial institutions. • Describe valuation models used by value

stock.• Identify the economic factors that affect

stock prices.

Stock MarketsStock Markets

Stock:Stock: Share of ownership in Share of ownership in a corporation, and it is a corporation, and it is frequently traded among frequently traded among individuals and financial individuals and financial institutions.institutions.Stockholder:Stockholder: owner of shares owner of shares of stock in a corporation.of stock in a corporation.Corporate stock may be Corporate stock may be either preferred or common .either preferred or common .

COMMON STOCKSCOMMON STOCKS• Certificate representing partial

ownership in a corporation.• -Issued by firms to obtain funds.• -Shareholders can sell stocks to other

investors within the secondary markets.• Pays dividends only if the corporation

makes profit.• Have the last claims to receive the rights.

VOTING RIGHTSVOTING RIGHTS • Entitles its holder to vote for the members of a

firm’s board of directors.• Board of directors: governing body of a

corporation that reports to its shareholders and delegates power to run day-to-day operations while remaining responsible for sustaining its debts.

• Many investors assign their vote to management through the use of proxy.

• Many other shareholders simply fail to vote at all.

PURCHASING PURCHASING STOCK ON STOCK ON MARGINMARGIN

• Investors can purchase Investors can purchase stock on margin by signing stock on margin by signing up from a margin account up from a margin account with broker.with broker.• Limited by 50 percent.Limited by 50 percent.

• Over short time period the return on stocks (R ) purchased on margin can be estimated as follows:

• R= SP- INV-LOAN+D /INV• Sp=selling price.• INV=initial investment by investors.• LOAN= loan payment paid on

borrowed funds.• D=dividend payments.

PREFERRED STOCKSPREFERRED STOCKS• Represents an equity in a firm.

• Usually doesn’t allow for significant voting rights.

• If the firm doesn’t have sufficient earnings to pay PS dividends, it may omit the dividends without fear of being forced into bankruptcy.

Because payment of Because payment of dividends on PS can be dividends on PS can be omitted, firms assume less omitted, firms assume less risk when they issue it than risk when they issue it than when the issue bonds.when the issue bonds.

Public Placement Public Placement of Stocksof Stocks

Stock offering are classified Stock offering are classified as:as:

**Initial Public Offerings**Initial Public Offerings

**Secondary offerings**Secondary offerings

IPOIPO• Represents a first-time offering of

shares by a specific firm to the public.

• IPO's tend to occur more frequently during bullish stock market periods, when potential investors are more interested in purchasing new stocks.

Secondary Stock OfferingSecondary Stock Offering• Representing a new stock offering by a

specific firm that already has stock outstanding.

• The firm will likely hire an investment banking firm to sell its shares.

• Firms tend to monitor stock market movements when deciding when to engage in a secondary market stock offering.

Shelf-registrationShelf-registration

•It fulfills SEC requirements up to two years before issuing new securities.

•The registration statement contains financing plans over the upcoming two years.

Shelf-Registration Shelf-Registration AdvantagesAdvantages

•It allows firms quick access to funds without repeatedly being slowed by registration process.

It enables corporations to anticipate higher market interest rates.

Stock ExchangeStock Exchange

Brokerage firms serve as Brokerage firms serve as financial intermediaries financial intermediaries between buyers and sellers between buyers and sellers of stock in the secondary of stock in the secondary market.market.

a) Organized exchangesa) Organized exchanges• Used to execute secondary ,market

transactions.

• Most popular organized stock are: 1-New York exchange.” the largest” 2-American stock exchange 3-The Midwest stock exchange 4-Pacific stock exchange.

• Individuals or firms that purchase a seat on the stock exchange are provided the right to trade securities.

• Each brokerage firm must down a seat on the exchange so that it can purchase or sell the securities requested by its clients.

b) Over the counter Marketb) Over the counter Market• Stocks that are not listed on the

organized exchanges are traded in the OTC.

• OTC facilitate secondary market transactions.

• Unlike the organized exchanges, the OTC markets doesn’t have a trading floor

Role of specialists, floor Role of specialists, floor traders& market makerstraders& market makers..

• Specialists: take position in specific stocks, and stand ready to buy or sell those stocks.

• Floor brokers: execute stock transactions for their clients.

• Market makers: who stand ready to buy or sell specific stocks in response to customer orders made through a telecommunication networks.

continuedcontinued

• Market microstructure: represents the process by which securities such as stocks are traded.

Regulations of stock Regulations of stock exchange tradingexchange trading::

• Securities exchange ere created to prevent unfair or unethical trading practices.

• These acts gave the SEC authority to monitor the exchanges& required listed companies to file a registration statement & financial reports with SEC & exchanges.

Program tradingProgram trading• Program trading is casually defined as

the use of computers in stock markets to engage in arbitrage and portfolio insurance strategies. However, the New York Stock Exchange (NYSE) defines the term as "a wide range of portfolio trading strategies involving the purchase or sale of 15 or more stocks having a total market value of $1 million or more" without any direct reference to the use of computers

• The word "program" can be interpreted in its earlier, more general meaning of a defined and pre-arranged sequence of steps, rather than specifically a computer program. Some program trading strategies are subject to regulatory restrictions. For instance, NYSE Rule 80A requires index arbitrage trades to be marked when submitted.

Impact of program trading Impact of program trading on stock volatilityon stock volatility

• Program trading has developed because of three interrelated conditions.

• First, individual investors are learning that trading a diversified portfolio of securities eliminates some of the risks of investing in individual stocks.

• Second, institutions hold and trade a higher fraction of equity than ever before. These professional investors execute their diversified trades directly in the stock market as program trades or in the futures and options markets, where investors or speculators can trade contracts that are tied to changes in market indexes.

• Third, technological advances have reduced trading costs.

Stock Valuation MethodsStock Valuation Methods

– The price of a stock reflects the present value of the stock's future dividends• t = period

•Dt = dividend in period t

•k = discount rate

Dividend Discount Method

1tt

t

k)(1

DPrice

Rj = Rf + j(Rm – Rf)

Capital Asset Pricing Model Capital Asset Pricing Model (CAPM)(CAPM)

– Used to estimate the required return on publicly traded stock

– Assumes that the only relevant risk is systematic (market) risk

• Uses beta to measure risk rather than standard deviation of returns

Determining the Required Rate of Determining the Required Rate of Return to Value StocksReturn to Value Stocks

Rj = Rf + j(Rm – Rf)

• Capital Asset Pricing Model (CAPM)– Estimating the risk-free rate and the

market risk premium• Proxy for risk-free rate is the yield on newly

issued Treasury bonds• The market risk premium, or (Rm-Rf), can be

estimated using a long-term average of historical data.

Determining the Required Rate of Determining the Required Rate of Return to Value StocksReturn to Value Stocks

Rj = Rf + j(Rm – Rf)

– Estimating the firm’s beta• Beta measures systematic risk• Reflects how sensitive individual stock’s returns

are relative to the overall market• Example: beta of 1.2 indicates that the stock’s

return is 20% more volatile than the overall market

Arbitrage Pricing ModelArbitrage Pricing Model

– Differs from CAPM in that it suggests a stock’s price is influenced by a set of factors rather than just the return on the market

– Factors may include things like:• Economic growth• Inflation• Industry effects

– Problem with APT: factors are unspecified and must be defined

n

iju

iFiBBRE

10

Where E(R)= expected return of assets

0B = a constant

nFF ...1 =values of factors 1 to n

iB = sensitivity of the asset return to particular factor

ju = residual term

• This model suggest that in equilibrium , expected returns on assets are linearly related to the covariance between assets returns and the factors (differ to the CAPM).

• Similar to the CAPM, the unique effects are independent and will be diversified away in a large portfolio.