Stock Markets Overview

1
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 (elected
  board chooses CEO, etc.)

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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

3
Characteristics of Common Stock

• Dividends
• payment and size of dividends is determined by
  the board of directors of the issuing firm
• Residual Claim
• in the event of liquidation, common stockholders
  have the lowest priority in terms of any cash
  distribution
• Limited Liability
• common stockholders losses are limited to the
  amount of their original investment in the firm
• Voting Rights

4
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
• dividend is fixed regardless of any increase or
  decrease in the firms value
• Cumulative preferred stock
• missed dividend payments go into arrears and must
  be made up before common stock dividends can be
  paid

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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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Issuance of Stock in the Primary Market
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Public Offerings

• Concept of Due Diligence All parties have a
  duty to insure that information is complete and
  accurate
• Red herring prospectus - a preliminary version of
  the prospectus describing a new security
  pre-selling of security is based on this document
• Final prospectus

8
Underwriting Terms

• Syndicate - process of distributing securities
  through a group of investment banks
• Originating house - the lead bank in the
  syndicate negotiates with the issuing company on
  behalf of the syndicate
• Net proceeds - the guaranteed price at which the
  investment bank purchases the stock from the
  issuer
• Gross proceeds - the price at which the
  investment bank resells the stock to investors
• Underwriters spread - the difference between the
  gross proceeds and the net proceeds

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Secondary Markets Characteristics

• Trading Locations
• Central Exchange
• Over-the-counter
• Market Structure
• Continuous
• Call market

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Secondary Markets Major U.S. Stock Exchanges

• New York Stock Exchange (NYSE)
• buyers and sellers meet at the trading post to
  negotiate
• specialist acts as a dealer (market maker), as
  necessary
• American Stock Exchange (AMEX)
• trading system same as NYSE
• 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 systems network

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Stock Exchanges in U.S.

• New York Stock Exchange (NYSE)
• American Stock Exchange (AMEX)
• NASDAQ (not technically an exchange)
• Regional Exchanges
• Midwest
• Pacific
• Philadelphia
• Boston
• Cincinnati

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International Stock Exchanges

• Japan Tokyo plus 7 others
• United Kingdom London
• Germany Frankfurt
• France Paris
• Hong Kong
• Canada Toronto

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Trading on NYSE and AMEX
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Functions of Brokers

• Receive and track orders
• Find other parties
• Negotiate prices
• Server as focal point trading
• Execute orders

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Functions of Dealers (Market Makers)

• Smooth out temporary supply/demand imbalances
• Supplies immediacy
• Provide better price information
• Privileged access to order flow and limit order
  information
• Act as auctioneer

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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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Short Selling

• A way to bet that a security will fall in value
• Borrow the security and sell it
• Economic value of short selling
• Limit upward bias
• Limits on short selling
• Tick rules
• Risk

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Margin Transactions

• Borrow funds using securities as collateral
• Margin Requirements
• Initial margin
• Maintenance margin
• Margin call

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Stock Market Indexes

• The Dow Jones Industrial Average (the DJIA)
• a price-weighted index of the values of 30 large
  (in terms of sales and total assets) corporations
• The NYSE composite index
• a value-weighted index of all common stocks
  listed on NYSE
• the Standard Poors 500 index
• a value-weighted index of the stocks of 500 of
  the largest U.S. corporations listed on the NYSE
  and NASDAQ
• The NASDAQ composite index
• a value-weighted index of three categories of
  NASDAQ companies industrials, banks, and
  insurance companies

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Major US Market Indices

• Dow Jones Industrial Average (DOW)
• SP 500
• NYSE
• AMEX
• NASDAQ
• Wilshire 5000 (also 4500)
• Russell 2000 (also 3000 and 1000)
• Value Line

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Major International Indices

• World
• Morgan Stanley (EAFE)
• Country
• Japan Nikkei 225, Nikkei 300, Topix
• UK FTSE 100, FTSE 250
• Germany DAX
• France CAC
• Hong Kong Hang Seng
• Canada Toronto 300 Composite

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Efficient Market Hypothesis Summary

• Three forms of market efficiency
• Weak form (random walk)
• Current prices reflect past prices
• Technical analysis is useless
• Semi-strong form
• Prices reflect all public information
• Most financial analysis is useless
• Strong form
• Prices reflect all that is knowable
• Nobody consistently makes superior profits

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Relationship among Three Different Information
Sets
All informationrelevant to a stock
Information setof publicly availableinformation
Informationset ofpast prices
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Reaction of Stock Price to New Information in
Efficient and Inefficient Markets
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Market Efficiency Nuclear Weapons

• Argument for Efficiency
• Performance of mutual funds actively managed
  mutual funds dont beat the market
• Argument against Efficiency
• Asset bubbles Prices depart from fundamental
  value on the high side for an extended period

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Market Anomalies

• Small firm
• Price to book (earnings)
• Neglected firm
• Calendar effects
• January
• Turn of the month
• Weekend
• Weather

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Efficient Market Hypothesis Summary

• Does Not Say
• Prices are uncaused
• Investors are foolish and too stupid to be in the
  market
• All shares of stock have the same expected
  returns
• Investors should throw darts to select stocks
• There is no upward trend in stock prices
• Does Say
• Prices reflect underlying value
• Financial managers cannot time stock and bond
  sales
• Sales of stock and bonds will not depress prices
• You cannot cook the books

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Efficient Market Hypothesis Summary

• Why Doesnt Everyone Believe It?
• There are optical illusions, mirages and apparent
  patterns in charts of stock and market returns
• The truth is less interesting
• There is some evidence against efficiency
• Seasonality
• Small vs large stocks
• Value vs growth stocks
• Tests of market efficiency are weak

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Implications of Market Efficiency for Investors

• If believe market IS NOT mostly semi-strong form
  efficient
• Active strategies
• If believe market IS mostly semi-strong form
  efficient
• Passive strategies

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Stock Market Regulation

• Stock markets and participants are subject to
  regulations imposed by 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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World Capital Markets

• Why Raise Funds Outside Domestic Markets?
• Domestic market not sufficiently developed to
  supply the funds needed
• Reduced costs (assumes markets not completely
  integrated)
• Diversify funding sources
• Foreign currency exposure management