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Chapter NineStock 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.)

• 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)

0

2000

4000

6000

8000

10000

12000

14000

1994 1997 2000 2004

Nonfinancial corp. bus Financial corp Rest of world

0

2000

4000

6000

8000

10000

12000

14000

1994 1997 2000 2004

Nonfinancial corp. bus Financial corp 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

• 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%

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

• 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)

020406080

100120140160180

1992 1998 2000 2001 2003 2004

Preferred Common

020406080

100120140160180

1992 1998 2000 2001 2003 2004

Preferred Common

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Characteristics of Common Stock

• Dividends: if profitable

• Residual Claim: last paid in priority

• Limited Liability: no more loss than the invested amount

• Voting Rights: differential voting rights on stocks

• Dividends: if profitable

• Residual Claim: last paid in priority

• Limited Liability: no more loss than the invested amount

• Voting Rights: differential voting rights on stocks

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Cumulative voting

• The number of votes assigned to each shareholders equals the number of shares held multiplied by the number of seats to be elected.

• In cumulative voting, one can vote all shares to a single candidate to increase the chance of winning, which is otherwise less possible is there is a dominating shareholder. The minimum votes needed to guarantee a seat is

• Total number of votes/(1+k) +1

Where total number of votes= shares outstanding * number of seats • k is number of seats to be elected

• The number of votes assigned to each shareholders equals the number of shares held multiplied by the number of seats to be elected.

• In cumulative voting, one can vote all shares to a single candidate to increase the chance of winning, which is otherwise less possible is there is a dominating shareholder. The minimum votes needed to guarantee a seat is

• Total number of votes/(1+k) +1

Where total number of votes= shares outstanding * number of seats • k is number of seats to be elected

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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: fixed payment • Cumulative preferred stock: if dividend not paid for

any given period, it will be accumulated to be paid later, before any common dividends paid.

• 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: fixed payment • Cumulative preferred stock: if dividend not paid for

any given period, it will be accumulated to be paid later, before any common dividends paid.

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Issuance of Stock in the Primary Market

Stocks Stocks

Issuing Investment InvestorsCorporation Bank Funds Funds

Investment bank conducts primary market sale of stock using firm commitment underwriting (guarantees corporation a fixed price for newly issued securities) orbest efforts underwriting (no guarantee to issuer and acts more as a placing or distribution agent)

Stocks Stocks

Issuing Investment InvestorsCorporation Bank Funds Funds

Investment bank conducts primary market sale of stock using firm commitment underwriting (guarantees corporation a fixed price for newly issued securities) orbest efforts underwriting (no guarantee to issuer and acts more as a placing or distribution agent)

(continued)

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Net proceeds: the guaranteed price at which the investment bank purchase the stock from the issuer.

Gross proceeds: the price at which the investment bank resells the stock to investors

Underwriters’ spread: difference between the gross proceeds and the net proceeds

Syndicate: the process of distributing securities through a group of investment banks

Originating house Red herring: referring to the prospectus of a petition

to be listed at stock exchange pending the SEC endorsement

proxy

Net proceeds: the guaranteed price at which the investment bank purchase the stock from the issuer.

Gross proceeds: the price at which the investment bank resells the stock to investors

Underwriters’ spread: difference between the gross proceeds and the net proceeds

Syndicate: the process of distributing securities through a group of investment banks

Originating house Red herring: referring to the prospectus of a petition

to be listed at stock exchange pending the SEC endorsement

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

• 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 Order Order

Investor Shares Broker Shares Comm Shares Market or Maker or Cash Cash Floor Cash Other Floor Broker Broker

Order Order Order

Investor Shares Broker Shares Comm Shares Market or Maker or Cash Cash Floor Cash Other Floor Broker 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)

• 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): price weighted index

• The NYSE Composite index: value weighted index

• the Standard & Poor’s 500 index

• The NASDAQ Composite index

• The Dow Jones Industrial Average (the DJIA): price weighted index

• The NYSE Composite index: value weighted 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) % of 1994 1997 2004 Total Household sector $3,070.9 $5,689.6 $6,132.7 39.2State and local gov. 10.6 79.0 87.6 0.6Rest of world 397.7 919.5 1,670.3 10.7Depository inst. 180.6 331.4 260.1 1.7Life ins. co. 246.1 558.6 962.4 6.2Other ins. co. 112.1 186.0 187.5 1.2Private pension funds 996.3 1,863.9 1,536.3 9.8Public pension funds 557.4 1,431.7 1,180.3 7.5Mutual funds 709.6 2,018.7 3,431.7 22.0Closed-end funds 31.9 50.2 70.8 0.4Brokers and dealers 20.1 51.9 107.5 0.7

Holders of Corporate Stock (in billions of dollars) % of 1994 1997 2004 Total Household sector $3,070.9 $5,689.6 $6,132.7 39.2State and local gov. 10.6 79.0 87.6 0.6Rest of world 397.7 919.5 1,670.3 10.7Depository inst. 180.6 331.4 260.1 1.7Life ins. co. 246.1 558.6 962.4 6.2Other ins. co. 112.1 186.0 187.5 1.2Private pension funds 996.3 1,863.9 1,536.3 9.8Public pension funds 557.4 1,431.7 1,180.3 7.5Mutual funds 709.6 2,018.7 3,431.7 22.0Closed-end funds 31.9 50.2 70.8 0.4Brokers and dealers 20.1 51.9 107.5 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

• 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

• 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

• 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

54.97

21.71

15.03

2.653.88 1.77

United State

Europe

Japan

Canada/Australia/NewZealand

Pacific Basin

Emerging Markets