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.)

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

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

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

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

Issuance of Stock in the Primary Market

Stocks Stocks

Issuing Corporation
Funds

Investment Bank
Funds

Investors

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

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

Secondary Markets Characteristics

Trading Locations
Central Exchange Over-the-counter

Market Structure
Continuous Call market

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

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

International Stock Exchanges

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

Trading on NYSE and AMEX

Order

Order

Order

Investor

Shares Cash

Broker

Shares Cash

Floor Broker

Shares Cash

Market Maker or Other Floor Broker

Functions of Brokers
Receive and track orders Find other parties Negotiate prices Server as focal point trading Execute orders

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

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)

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

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

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

Major US Market Indices

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

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

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

Relationship among Three Different Information Sets

All information relevant to a stock Information set of publicly available information Information set of past prices

Reaction of Stock Price to New Information in Efficient and Inefficient Markets

Stock Price Overreaction and reversion

Delayed response Efficient-market response to new information

30 20 10

+10 +20 +30

Days before (+) and after (-) announcement

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

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

Weather

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

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

Implications of Market Efficiency for Investors

If believe market IS NOT mostly semistrong form efficient
Active strategies

If believe market IS mostly semi-strong form efficient

Passive strategies

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

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

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