1. McGraw-Hill /Irwin Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter Eight Stock Markets

2. Chapter Outline 1.Overview 2.Transaction Process of Stock Markets 3.Efficiency of Stock Markets 4.Regulation 5.International Stock Markets 1.Overview 2.Transaction Process of Stock Markets 3.Efficiency of Stock Markets 4.Regulation 5.International Stock Markets

3. McGraw-Hill /Irwin Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved. 1. Stock Market Participants Holders of Corporate Stock (in billions of dollars) % of 1994 1997 2004 Total Household sector $3,070.9 $5,689.6 $6,132.7 39.2 State and local gov. 10.6 79.0 87.6 0.6 Rest of world 397.7 919.5 1,670.3 10.7 Depository inst. 180.6 331.4 260.1 1.7 Life ins. co. 246.1 558.6 962.4 6.2 Other ins. co. 112.1 186.0 187.5 1.2 Private pension funds 996.3 1,863.9 1,536.3 9.8 Public pension funds 557.4 1,431.7 1,180.3 7.5 Mutual funds 709.6 2,018.7 3,431.7 22.0 Closed-end funds 31.9 50.2 70.8 0.4 Brokers and dealers 20.1 51.9 107.5 0.7 Holders of Corporate Stock (in billions of dollars) % of 1994 1997 2004 Total Household sector $3,070.9 $5,689.6 $6,132.7 39.2 State and local gov. 10.6 79.0 87.6 0.6 Rest of world 397.7 919.5 1,670.3 10.7 Depository inst. 180.6 331.4 260.1 1.7 Life ins. co. 246.1 558.6 962.4 6.2 Other ins. co. 112.1 186.0 187.5 1.2 Private pension funds 996.3 1,863.9 1,536.3 9.8 Public pension funds 557.4 1,431.7 1,180.3 7.5 Mutual funds 709.6 2,018.7 3,431.7 22.0 Closed-end funds 31.9 50.2 70.8 0.4 Brokers and dealers 20.1 51.9 107.5 0.7

4. McGraw-Hill /Irwin Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved. 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 regularly (they elect a board, who chooses a 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 regularly (they elect a board, who chooses a CEO, etc.)

5. McGraw-Hill /Irwin Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved. Market Value of Common Stock Outstanding, by Type of Issuer ($Bn)

6. McGraw-Hill /Irwin Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved. 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

7. McGraw-Hill /Irwin Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved. 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

8. McGraw-Hill /Irwin Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved. 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

9. McGraw-Hill /Irwin Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved. Calculating Stock Returns R t = P t - P t-1 + D t P t-1 P t-1 Where: R t = Return over period from t-1 to t P t = Stock price at time t P t-1 = Stock price at time t-1 D t = Dividends paid over time t - 1 to t P 1 - P t-1 = Capital gain over time t - 1 to t R t = $45 - $40 + $4 $40 $40 = 12.5% + 10.0% = 22.5% R t = P t - P t-1 + D t P t-1 P t-1 Where: R t = Return over period from t-1 to t P t = Stock price at time t P t-1 = Stock price at time t-1 D t = Dividends paid over time t - 1 to t P 1 - P t-1 = Capital gain over time t - 1 to t R t = $45 - $40 + $4 $40 $40 = 12.5% + 10.0% = 22.5%

10. 2. Primary and Secondary Markets 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

11. 2.1 Issuance of Stock in the Primary Market Stocks Stocks Issuing Investment Investors Corporation Bank Funds Funds 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) Stocks Stocks Issuing Investment Investors Corporation Bank Funds Funds 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)

12. McGraw-Hill /Irwin Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved. 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 - the process of distributing securities through a group of investment banks Originating house – the lead bank in the syndicate negotiates with the issuer on the syndicate’s behalf 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 - the process of distributing securities through a group of investment banks Originating house – the lead bank in the syndicate negotiates with the issuer on the syndicate’s behalf

13. 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

14. McGraw-Hill /Irwin Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved. New Securities Issued ($Bn)

15. 2.2 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

16. 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

17. Functions of Brokers Receive and track orders Find other parties Negotiate prices Execute orders Receive and track orders Find other parties Negotiate prices Execute orders

18. 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

19. 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)

20. 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

21. 2.3 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

22. 3. Efficient Market Hypothesis Market Efficiency: the speed with which financial security prices adjust to unexpected news 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 Financial analysis is useless Strong form Prices reflect all that is knowable Nobody consistently makes superior profits Market Efficiency: the speed with which financial security prices adjust to unexpected news 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 Financial analysis is useless Strong form Prices reflect all that is knowable Nobody consistently makes superior profits

23. Relationship among Three Different Information Sets Information set of past prices Information set of publicly available information All information relevant to a stock

24. 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 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

25. Arguments on Market Efficiency Argument supporting 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 supporting 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

26. Implications of Market Efficiency 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

27. 4. 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 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

28. McGraw-Hill /Irwin Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved. 5. 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

29. McGraw-Hill /Irwin Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved. Worldwide Stock Market Capitalization, 2004