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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 (elected board chooses CEO, etc.)
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Page 1: Stock Markets (.PPT)

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.)

• 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.)

Page 2: Stock Markets (.PPT)

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

Page 3: Stock Markets (.PPT)

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

• 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

Page 4: Stock Markets (.PPT)

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 firm’s value

• Cumulative preferred stock– missed dividend payments go into arrears and must be made

up before common stock dividends can be 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

– dividend is fixed regardless of any increase or decrease in the firm’s value

• Cumulative preferred stock– missed dividend payments go into arrears and must be made

up before common stock dividends can be paid

Page 5: Stock Markets (.PPT)

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

Page 6: Stock Markets (.PPT)

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)

Page 7: Stock Markets (.PPT)

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

• 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

Page 8: Stock Markets (.PPT)

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

• 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

Page 9: Stock Markets (.PPT)

Secondary Markets Characteristics

• Trading Locations– Central Exchange– Over-the-counter

• Market Structure– Continuous– Call market

• Trading Locations– Central Exchange– Over-the-counter

• Market Structure– Continuous– Call market

Page 10: Stock Markets (.PPT)

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 system’s network

• 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 system’s network

Page 11: Stock Markets (.PPT)

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

• New York Stock Exchange (NYSE)

• American Stock Exchange (AMEX)

• NASDAQ (not technically an exchange)

• Regional Exchanges– Midwest– Pacific– Philadelphia– Boston – Cincinnati

Page 12: Stock Markets (.PPT)

International Stock Exchanges

• Japan – Tokyo plus 7 others

• United Kingdom – London

• Germany – Frankfurt

• France – Paris

• Hong Kong

• Canada – Toronto

• Japan – Tokyo plus 7 others

• United Kingdom – London

• Germany – Frankfurt

• France – Paris

• Hong Kong

• Canada – Toronto

Page 13: Stock Markets (.PPT)

Trading on NYSE and AMEX

Order Order Order

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

Order Order Order

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

Page 14: Stock Markets (.PPT)

Functions of Brokers

• Receive and track orders

• Find other parties

• Negotiate prices

• Server as focal point trading

• Execute orders

• Receive and track orders

• Find other parties

• Negotiate prices

• Server as focal point trading

• Execute orders

Page 15: Stock Markets (.PPT)

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

• Smooth out temporary supply/demand imbalances– Supplies “immediacy”

• Provide better price information– Privileged access to order flow and limit

order information

• Act as auctioneer

Page 16: Stock Markets (.PPT)

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)

Page 17: Stock Markets (.PPT)

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

• 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

Page 18: Stock Markets (.PPT)

Margin Transactions

• Borrow funds using securities as collateral

• Margin Requirements– Initial margin– Maintenance margin– Margin call

• Borrow funds using securities as collateral

• Margin Requirements– Initial margin– Maintenance margin– Margin call

Page 19: Stock Markets (.PPT)

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 & Poor’s 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

• 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 & Poor’s 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

Page 20: Stock Markets (.PPT)

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

• Dow Jones Industrial Average (DOW)

• S&P 500

• NYSE

• AMEX

• NASDAQ

• Wilshire 5000 (also 4500)

• Russell 2000 (also 3000 and 1000)

• Value Line

Page 21: Stock Markets (.PPT)

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

• 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

Page 22: Stock Markets (.PPT)

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

• 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

Page 23: Stock Markets (.PPT)

Relationship among Three Different Information Sets

Informationset of

past prices

Information setof publicly available

information

All informationrelevant to a stock

Page 24: Stock Markets (.PPT)

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

StockPrice

Days before (+) andafter (-) announcement–30 –20 –10 0 +10 +20 +30

Overreaction andreversion

Delayed response

Efficient-marketresponse to new information

Page 25: Stock Markets (.PPT)

Market Efficiency “Nuclear Weapons”

• Argument for Efficiency:– Performance of mutual funds – actively

managed mutual funds don’t beat the market

• Argument against Efficiency– Asset bubbles – Prices depart from

fundamental value on the high side for an extended period

• Argument for Efficiency:– Performance of mutual funds – actively

managed mutual funds don’t beat the market

• Argument against Efficiency– Asset bubbles – Prices depart from

fundamental value on the high side for an extended period

Page 26: Stock Markets (.PPT)

Market Anomalies

• Small firm

• Price to book (earnings)

• Neglected firm

• Calendar effects– January– Turn of the month– Weekend

• Weather

• Small firm

• Price to book (earnings)

• Neglected firm

• Calendar effects– January– Turn of the month– Weekend

• Weather

Page 27: Stock Markets (.PPT)

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

• 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

Page 28: Stock Markets (.PPT)

Efficient Market Hypothesis: Summary

• Why Doesn’t 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

• Why Doesn’t 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

Page 29: Stock Markets (.PPT)

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

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

• If believe market IS mostly semi-strong form efficient – Passive strategies

Page 30: Stock Markets (.PPT)

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

• 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

Page 31: Stock Markets (.PPT)

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

Page 32: Stock Markets (.PPT)

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

• 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