Stock Markets

Chapter EightStock Markets1McGraw-Hill/IrwinOverview of Stock MarketsPrimary stock markets allow suppliers of funds to raise equity capitalSecondary stock markets are the most closely watched and reported of all financial marketsStockholders are the legal owners of a corporationhave a right to share in the firm’s profits (e.g., through dividends)are residual claimantshave limited liabilityhave voting rights (e.g., to elect board of directors)2McGraw-Hill/IrwinStock ReturnsThe returns on a stock over one period (Rt) can be divided into capital gains and dividend returns:Pt = stock price at time tDt = dividends paid over time t – 1 to t(Pt – Pt – 1) / Pt – 1 = capital gain over time t – 1 to tDt / Pt – 1 = return from dividends paid over time t – 1 to t3McGraw-Hill/IrwinCommon StockCommon stock is the fundamental ownership claim in a public or private corporationDividends are discretionary and are thus not guaranteedCommon stockholders have the lowest priority claim in the event of bankruptcy (i.e., a residual claim)Limited liability implies that common stockholders can lose no more than their original investmentCommon stockholders control the firm’s activities indirectly by exercising their voting rights in the election of the board of directors4McGraw-Hill/IrwinCommon StockDual-class firms have two classes of common shares outstanding, with different voting rights assigned to each classWith cumulative voting, the number of votes assigned to each stockholder equals the number of shares held multiplied by the number of directors to be electedthe number of shares needed to elect p directors, Np, is: Np = [(p x # of shares outstanding)/(# of directors to be elected + 1)] +1A proxy vote allows stockholders to vote by absentee ballot (e.g., by mail)5McGraw-Hill/IrwinPreferred StockPreferred stock is a hybrid security that has characteristics of both bonds and common stockGenerally has fixed dividends that are paid quarterlyGenerally does not have voting rights unless dividend payments are missedNonparticipating versus participating Cumulative versus noncumulative6McGraw-Hill/IrwinPrimary Stock MarketsPrimary markets are markets in which corporations raise funds through new issues of stock, most of the time through investment banksInvestment banks act as distribution agents in best efforts underwritingInvestment banks act as principals in firm commitment underwriting gross proceeds – net proceeds = underwriter’s spreadA syndicate is a group of investment banks working in concert to issue stock; the lead underwriter is the originating house7McGraw-Hill/IrwinPrimary Stock MarketsAn initial public offering (IPO) is the first public issue of financial instruments by a firmA seasoned offering is the sale of additional securities by a firm whose securities are already publicly tradedpreemptive rights give existing stockholders the ability to maintain their proportional ownershipA red herring prospectus is a preliminary version of the prospectus that describes a new security issueShelf registration allows firms to offer multiple issues of stock over a two-year period with only one registration statement8McGraw-Hill/IrwinSecondary Stock MarketsSecondary stock markets are the markets in which stocks, once issued, are traded among investorsThe U.S. has three major stock marketsthe New York Stock Exchange Euronext (NYSE Euronext)the National Association of Securities Dealers Automated Quotation (NASDAQ)the American Stock Exchange (AMEX)9McGraw-Hill/IrwinNYSE EuronextCreated by the merger of NYSE Group, Inc. and Euronext N.V. on April 4, 2007 to become the first truly global stock marketOver 3,200 different stocks trade on NYSE EuronextTrading occurs at a specific place on the floor of the exchange called a trading postEach stock has a special market maker called a specialist that maintains liquidity for the stock at all times10McGraw-Hill/IrwinNYSE EuronextThree types of transactions occur at trading postsa market order is an order to transact at the best price available when the order reaches the trading posta limit order is an order to transact at a specified pricespecialists transact for their own accountProgram trading is the simultaneous buying and selling of a portfolio of at least 15 different stocks valued at more than $1 million using computer programs to initiate the tradesCircuit breakers give investors time to make informed choices during periods of high market volatility11McGraw-Hill/IrwinTrading on NYSE Euronext and AMEX Order Order Order Investor Shares Broker Shares Comm. Shares Market or Maker or Cash Cash Floor Cash Other Floor Broker Broker12McGraw-Hill/IrwinStock Market QuotesNameSymbolOpenHighLowCloseNet Chg% ChgVolume52 Wk High52 Wk LowDivYieldP/EYTD % Chg13McGraw-Hill/IrwinAMEXGenerally lists smaller firms than NYSE EuronextOperates as a broker-specialist market-maker system similar to NYSE EuronextPioneered exchange traded funds (ETFs)ETFs are index funds that are listed on an exchange and can be traded intraday14McGraw-Hill/IrwinNASDAQ and OTC MarketsNASDAQ is the world’s first electronic market and has no physical trading floorProvides continuous trading for the most active stocks traded over the counter (OTC)Primarily a dealer market in which often more than 20 dealers act as market makersA small order execution system (SOES) provides automatic order execution for orders of less than or equal to 1,000 sharesThe NASD maintains an electronic “OTC bulletin board” and “pink sheets” for small firms that are not part of the NASDAQ15McGraw-Hill/IrwinSecondary Stock MarketsChoice of market listingsNYSE has extensive listing requirements (e.g., firm market value and trading volume)AMEX listing requirements are less stringent than NYSE and NASDAQ requirements are even less soElectronic communication networks (ECNs)normal trading occurs between 9:30 a.m. and 4:00 p.m. eastern standard timeextended-hours trading occurs through computerized alternative trading systems (ATSs) a.k.a. ECNsOnline trading via the internet is becoming increasingly popular to both individual and professional investors16McGraw-Hill/IrwinStock Market IndexesA stock market index is the composite value of a group of secondary market-traded stocksPrice-weighted indexthe Dow Jones Industrial Average (DJIA), composed of 30 companies, is the most widely know stock market indexValue-weighted indexesNYSE CompositeStandard & Poor’s 500NASDAQ CompositeWilshire 500017McGraw-Hill/IrwinStock MarketsHouseholds, mutual funds, and private pension funds are the largest holders of corporate stockDoes the stock market forecast the economy?Market efficiency is the speed with which financial security prices adjust to unexpected news weak form market efficiencysemistrong form market efficiencystrong form market efficiency18McGraw-Hill/IrwinStock Market RegulationsThe Securities and Exchange Commission (SEC) is the primary regulator of stock marketsThe main emphasis of SEC regulation is on full and fair disclosure of information on securities Securities Act of 1933/Securities Exchange Act of 1934The SEC delegates certain regulatory responsibilities to the exchanges for the day-to-day surveillance of activityRecently imposed regulations aim to reduce excessive price fluctuations and increase auditing oversight19McGraw-Hill/IrwinInternational Aspects of Stock MarketsU.S. stock markets are the world’s largestEuropean markets have increased their share of the global market with the advent of a common currency, the EuroGrowth has recently strengthened in the U.K., Canada, Japan, and Pacific Basin countriesInternational stock markets allow investors to diversify by holding stocks issued by corporations in foreign countriesInternational diversification can increase risk due to incomplete information about foreign stocks as well as foreign exchange and political risk20McGraw-Hill/Irwin