What Is A Market?

• Basic Concepts
– It brings buyers and sellers together to aid in the
transfer of goods and services
– It does not need to have a physical location
– The market does not necessarily have to own the
goods and services
– It can deal in any variety of goods and services
– Both buyers and sellers benefit from the market

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 • Covariance is when two variables vary with each
other, whereas Correlation is when the change in
one variable results in the change in another
variable.
• Variance
• Variance is the expectation of the squared
deviation of a random variable from its mean.
Informally, it measures how far a set of numbers
are spread out from their average value.

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 Standard Deviation
Standard deviation is a measure of the amount of variation or dispersion of a set
of values. A low standard deviation indicates that the values tend to be close to
the mean of the set, while a high standard deviation indicates that the values are
spread out over a wider range. It essentially measures the absolute variability of a
random variable.

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 Covariance
Covariance signifies the direction of the linear relationship between the two
variables. By direction we mean if the variables are directly proportional or
inversely proportional to each other. (Increasing the value of one variable might
have a positive or a negative impact on the value of the other variabl

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 Correlation
Correlation analysis is a method of statistical evaluation used to study the
strength of a relationship between two, numerically measured, continuous
variables.
we can say the correlation values have standardized notions, whereas the
covariance values are not standardized and cannot be used to compare
how strong or weak the relationship is because the magnitude has no
direct significance. It can assume values from -1 to +1. 

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 What Is A Market?
• Characteristics of a Good Market
– Availability of past transaction information
 must be timely and accurate
– Liquidity
 Marketability
 Price continuity
 Depth
– Low transaction costs: Internal efficiency
– Rapid adjustment of prices to new information:
External efficiency
Transaction costs are expenses incurred when buying or selling a good or service. ... In a financial
sense, transaction costs include brokers' commissions and spreads, which are the differences
between the price the dealer paid for a security and the price the buyer pays.
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 What Is A Market?
• Primary markets
– Market where new securities are sold and funds
go to issuing unit
• Secondary markets
– Market where outstanding securities are bought
and sold by investors. The issuing unit does not
receive any funds in a secondary market
transaction

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 Primary Capital Markets
• Government Bond Issues
– Treasury Bills: Negotiable, non-interest bearing
securities with original maturities of one year or less
– Treasury Notes: Original maturities of 2 to 10 years
– Treasury Bonds: Original maturities of more than 10
years
– The sales of these bills, notes, and bonds are
conducted through the Federal Reserve System
auctions

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 Primary Capital Markets
• Municipal Bond Issues
– Sold by three methods
 Competitive bid
 Negotiation
 Private placement
– Underwriters sell the bonds to investors
 Origination
 Risk-bearing
 Distribution

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 Primary Capital Markets
• Corporate Bond and Stock Issues
– Corporate bond issues are almost always sold
through a negotiated arrangement with an
investment banking firm that maintains a
relationship with the issuing firm.
– New Stock Issues
 Seasoned new issues: New shares offered by firms
that already have stock outstanding
 Initial public offerings (IPOs): A firm selling its common
stock to the public for the first time
 These new issues are typically underwritten by
investment bankers

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 Exhibit 4.1

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 Relationships with Investment Bankers
• Negotiated
– Most common
– Full services of underwriter
• Competitive bids
– Corporation specifies securities offered
– Lower costs
– Reduced services of underwriter
• Best-efforts
– Investment banker acts as broker

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 Secondary Financial Markets
• Why Secondary Financial Markets Are
Important?
– Provides liquidity to investors who acquire
securities in the primary market
– Results in lower required returns than if issuers
had to compensate for lower liquidity
– Helps determine market pricing for new issues

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 Secondary Financial Markets
• Why Secondary Financial Markets Are
Important?
– Provides liquidity to investors who acquire
securities in the primary market
– Results in lower required returns than if issuers
had to compensate for lower liquidity
– Helps determine market pricing for new issues

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 Secondary Equity Markets
• Basic Trading Systems
– Pure Auction Market: Buyers and sellers submit bid-
and-ask prices (buy and sell orders) for a given stock
to a central location where the orders are matched by a
broker who does not own the stock but acts as a
facilitating agent (It is also known as order-driven
market)
– Dealer Market: Individual dealers provide liquidity for
investors by buying and selling the shares of stock for
themselves (as known as quote-driven market)

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 Uses of Security-Market Indexes
• As benchmarks to evaluate the performance of
professional money managers
• To create and monitor an index fund
• To measure market rates of return in economic
studies
• For predicting future market movements by
technicians
• As a substitute for the market portfolio of risky
assets when calculating the systematic risk of
an asset
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 Factors Affecting Market Indexes
• The Sample
– Size
– Breadth
– Source
• Weighting of Sample Members
– Price-weighted index
– Value-weighted index
– Unweighted (equally weighted) index
– Fundamental weighted index

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 Factors Affecting Market Indexes
• Computational Procedure
– Arithmetic average
– Compute an index and have all changes, whether
in price or value, reported in terms of the basic
index
– Geometric average

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 Stock-Market Indexes
• Price Weighted Index
– Dow Jones Industrial Average (DJIA)
– Nikkei-Dow Jones Average
• Value-Weighted Index
– NYSE Composite
– S&P 500 Index
• Unweighted Index
– Value Line Averages
– Financial Times Ordinary Share Index
• Fundamental Weighted Index

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 Dow Jones Industrial Average (DJIA)
• Best-known, oldest, most popular index
• Price-weighted average of thirty large well-
known industrial stocks, leaders in their
industry, and listed on NYSE
• Total the current price of the 30 stocks and
divide it by a divisor (adjusted for stock splits
and changes in the sample)

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 DJIA-Effect of Stock Split
Assume the index price-weighted index consists of
three stocks, A, B, and C. This example illustrates
how the index and the new divisor are computed
before and after a 3-for-1 stock split for Stock A.

Exhibit 5.1
Stock Price Before Split Price After Split
A 30 10
B 20 20
C 10 10
Index 60 / 3 = 20 40 / X = 20
Divisor 3 X=2

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 DJIA-Effect of Stock Split
The example demonstrates the impact of differently
priced shares on a price-weighted index. It shows that
higher priced stock will affect the index more (Case A)
than lower priced stock (Case B).

Exhibit 5.2
Period T Case A (T+1) Case B (T+1)
A 100 110 100
B 50 50 50
C 30 30 33
Sum 180 190 183
Divisor 3 3 3
Average 60 63.3 61
Percentage Change 5.5% 1.7%
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 Criticism of the DJIA
• Limited to 30 non-randomly selected blue-chip
stocks
• Does not represent a vast majority of stocks
• The divisor needs to be adjusted every time
one of the companies in the index has a stock
split
• Introduces a downward bias by reducing
weighting of fastest growing companies
whose stock splits

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 Nikkei-Dow Jones Average
• Arithmetic average of prices for 225 stocks on
the First Section of the Tokyo Stock Exchange
(TSE)
• Best-known series in Japan
• Price-weighted series formulated by Dow
Jones and Company
• The 225 stocks represent 15 percent of all
stocks on the First Section

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 Value-Weighted Index
• Derive the initial total market value of all
stocks used in the series
– Market Value = Number of Shares Outstanding
X Current Market Price
• Assign an beginning index value (100) and
new market values are compared to the base
index
• Automatic adjustment for splits
• Weighting depends on market value
• See Exhibit 5.4
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 Value-Weighted Index

Index t 
 PQ t
 Beginning t
Index Value
PQ h h

where:
Index t = index value on day t
Pt = ending prices for stocks on day t
Qt = number of outstanding shares on day t
Ph = ending price for stocks on base day
Qh = number of outstanding shares on base day

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 Exhibit 5.4

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 Unweighted Index
• All stocks carry equal weight regardless of
price or market value
• May be used by individuals who randomly
select stocks and invest the same dollar
amount in each stock
• Some use arithmetic average of the percent
price changes for the stocks in the index
• Value Line and the Financial Times Ordinary
Share Index compute a geometric mean of
the holding period returns
• See Exhibit 5.5

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 Exhibit 5.5

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 Fundamental Weighted Index
• Rationale
– Market-value weighting scheme results in
overweighting overvalued stocks and
underweighting undervalued stocks over time
– The tech boom in 1998-2000 was a good example
• Fundamental measures of firm size
– Sales
– Profits (cash flow)
– Net asset (book value)
– Distributions to shareholders (dividends)

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 Style Indexes
• Small-cap growth
• Mid-cap growth
• Large-cap growth
• Small-cap value
• Mid-cap value
• Large-cap value
• Socially responsible investment (SRI) indexes
– By country
– Global ethical stock index

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