Chapter 10 Stock Markets Stock Markets

Chapter objectives: We ’ ll learn to: Describe how stock exchange facilitate the trading of stocks. Describe how stock markets are used by financial institutions. Describe valuation models used by value stock. Identify the economic factors that affect stock prices.

Stock Markets Stock: Share of ownership in a corporation, and it is frequently traded among individuals and financial institutions. Stockholder: owner of shares of stock in a corporation. Corporate stock may be either preferred or common.

COMMON STOCKS Certificate representing partial ownership in a corporation. -Issued by firms to obtain funds. -Shareholders can sell stocks to other investors within the secondary markets. Pays dividends only if the corporation makes profit. Have the last claims to receive the rights.

VOTING RIGHTS Entitles its holder to vote for the members of a firm ’ s board of directors. Board of directors: governing body of a corporation that reports to its shareholders and delegates power to run day-to-day operations while remaining responsible for sustaining its debts. Many investors assign their vote to management through the use of proxy. Many other shareholders simply fail to vote at all.

PURCHASING STOCK ON MARGIN Investors can purchase stock on margin by signing up from a margin account with broker. Investors can purchase stock on margin by signing up from a margin account with broker. Limited by 50 percent. Limited by 50 percent.

Over short time period the return on stocks (R ) purchased on margin can be estimated as follows: R= SP- INV-LOAN+D /INV Sp=selling price. INV=initial investment by investors. LOAN= loan payment paid on borrowed funds. D=dividend payments.

PREFERRED STOCKS Represents an equity in a firm. Usually doesn ’ t allow for significant voting rights. If the firm doesn ’ t have sufficient earnings to pay PS dividends, it may omit the dividends without fear of being forced into bankruptcy.

Because payment of dividends on PS can be omitted, firms assume less risk when they issue it than when the issue bonds.

Public Placement of Stocks Stock offering are classified as: **Initial Public Offerings **Secondary offerings

IPO Represents a first-time offering of shares by a specific firm to the public. IPO's tend to occur more frequently during bullish stock market periods, when potential investors are more interested in purchasing new stocks.

Secondary Stock Offering Representing a new stock offering by a specific firm that already has stock outstanding. The firm will likely hire an investment banking firm to sell its shares. Firms tend to monitor stock market movements when deciding when to engage in a secondary market stock offering.

Shelf-registration It fulfills SEC requirements up to two years before issuing new securities. The registration statement contains financing plans over the upcoming two years.

Shelf-Registration Advantages It allows firms quick access to funds without repeatedly being slowed by registration process. It enables corporations to anticipate higher market interest rates.

Stock Exchange Brokerage firms serve as financial intermediaries between buyers and sellers of stock in the secondary market.

a) Organized exchanges Used to execute secondary,market transactions. Most popular organized stock are: 1-New York exchange. ” the largest ” 2-American stock exchange 3-The Midwest stock exchange 4-Pacific stock exchange.

Individuals or firms that purchase a seat on the stock exchange are provided the right to trade securities. Each brokerage firm must down a seat on the exchange so that it can purchase or sell the securities requested by its clients.

b) Over the counter Market Stocks that are not listed on the organized exchanges are traded in the OTC. OTC facilitate secondary market transactions. Unlike the organized exchanges, the OTC markets doesn ’ t have a trading floor

Role of specialists, floor traders& market makers. Specialists: take position in specific stocks, and stand ready to buy or sell those stocks. Floor brokers: execute stock transactions for their clients. Market makers: who stand ready to buy or sell specific stocks in response to customer orders made through a telecommunication networks.

continued Market microstructure: represents the process by which securities such as stocks are traded.

Regulations of stock exchange trading: Securities exchange ere created to prevent unfair or unethical trading practices. These acts gave the SEC authority to monitor the exchanges& required listed companies to file a registration statement & financial reports with SEC & exchanges.

Program trading Program trading is casually defined as the use of computers in stock markets to engage in arbitrage and portfolio insurance strategies. However, the New York Stock Exchange (NYSE) defines the term as "a wide range of portfolio trading strategies involving the purchase or sale of 15 or more stocks having a total market value of $1 million or more" without any direct reference to the use of computers

The word "program" can be interpreted in its earlier, more general meaning of a defined and pre-arranged sequence of steps, rather than specifically a computer program. Some program trading strategies are subject to regulatory restrictions. For instance, NYSE Rule 80A requires index arbitrage trades to be marked when submitted.

Impact of program trading on stock volatility Program trading has developed because of three interrelated conditions. First, individual investors are learning that trading a diversified portfolio of securities eliminates some of the risks of investing in individual stocks. Second, institutions hold and trade a higher fraction of equity than ever before. These professional investors execute their diversified trades directly in the stock market as program trades or in the futures and options markets, where investors or speculators can trade contracts that are tied to changes in market indexes. Third, technological advances have reduced trading costs.

Stock Valuation Methods –The price of a stock reflects the present value of the stock's future dividends t = period D t = dividend in period t k = discount rate Dividend Discount Method

Rj = Rf + j(Rm – Rf) Capital Asset Pricing Model (CAPM) –Used to estimate the required return on publicly traded stock –Assumes that the only relevant risk is systematic (market) risk Uses beta to measure risk rather than standard deviation of returns

Determining the Required Rate of Return to Value Stocks R j = R f +  j (R m – R f ) Capital Asset Pricing Model (CAPM) –Estimating the risk-free rate and the market risk premium Proxy for risk-free rate is the yield on newly issued Treasury bonds The market risk premium, or (R m -R f ), can be estimated using a long-term average of historical data.

Determining the Required Rate of Return to Value Stocks R j = R f +  j (R m – R f ) –Estimating the firm ’ s beta Beta measures systematic risk Reflects how sensitive individual stock ’ s returns are relative to the overall market Example: beta of 1.2 indicates that the stock ’ s return is 20% more volatile than the overall market

Arbitrage Pricing Model –Differs from CAPM in that it suggests a stock ’ s price is influenced by a set of factors rather than just the return on the market –Factors may include things like: Economic growth Inflation Industry effects –Problem with APT: factors are unspecified and must be defined

Where E(R)= expected return of assets = a constant =values of factors 1 to n = sensitivity of the asset return to particular factor = residual term

This model suggest that in equilibrium, expected returns on assets are linearly related to the covariance between assets returns and the factors (differ to the CAPM). Similar to the CAPM, the unique effects are independent and will be diversified away in a large portfolio.