Chapter Nine
Stock Markets
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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 regularly (they elect a board, who chooses a CEO, etc.)
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Market Value of Common Stock Outstanding, by Type of Issuer ($Bn)
14000 12000 10000 8000 6000 4000 2000 0 1994 1997 2000 2004
Nonfinancial corp. bus
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Financial corp
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Rest of world
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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
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Calculating Stock Returns
Rt = Pt - Pt-1 + Dt Pt-1 Pt-1
Where:
Rt = Return over period from t-1 to t Pt = Stock price at time t Pt-1 = Stock price at time t-1 Dt = Dividends paid over time t - 1 to t P1 - Pt-1 = Capital gain over time t - 1 to t
Rt = $45 - $40 + $4 $40 $40 = 12.5% + 10.0% = 22.5%
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Stock Market Securities
Two types of corporate stock exist
Common stock
the fundamental ownership claim in a public
corporation
Preferred stock
a hybrid security that has characteristics of both bonds and common stock
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New Securities Issued ($Bn)
180 160 140 120 100 80 60 40 20 0 1992 1998 2000 2001 2003 2004 Preferred
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Common
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Characteristics of Common Stock Dividends: if profitable Residual Claim: last paid in priority Limited Liability: no more loss than the invested amount Voting Rights: differential voting rights on stocks
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Cumulative voting
The number of votes assigned to each shareholders equals the number of shares held multiplied by the number of seats to be elected. In cumulative voting, one can vote all shares to a single candidate to increase the chance of winning, which is otherwise less possible is there is a dominating shareholder. The minimum votes needed to guarantee a seat is
Total number of votes/(1+k) +1
Where total number of votes= shares outstanding * number of seats k is number of seats to be elected
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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: fixed payment Cumulative preferred stock: if dividend not paid for any given period, it will be accumulated to be paid later, before any common dividends paid.
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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)
(continued)
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Net proceeds: the guaranteed price at which the investment bank purchase the stock from the issuer. Gross proceeds: the price at which the investment bank resells the stock to investors Underwriters spread: difference between the gross proceeds and the net proceeds Syndicate: the process of distributing securities through a group of investment banks Originating house Red herring: referring to the prospectus of a petition to be listed at stock exchange pending the SEC endorsement proxy
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Secondary Markets: Major U.S. Stock Exchanges
New York Stock Exchange (NYSE) American Stock Exchange (AMEX) 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
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Trading on NYSE and AMEX
Order
Order
Order
Investor
Shares Cash
Broker
Shares Cash
Comm or Floor Broker
Shares Cash
Market Maker or Other Floor Broker
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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)
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Stock Market Indexes
The Dow Jones Industrial Average (the DJIA): price weighted index The NYSE Composite index: value weighted index the Standard & Poors 500 index The NASDAQ Composite index
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Stock Market Participants
Holders of Corporate Stock (in billions of dollars)
Household sector State and local gov. Rest of world Depository inst. Life ins. co. Other ins. co. Private pension funds Public pension funds Mutual funds Closed-end funds Brokers and dealers
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1994 $3,070.9 10.6 397.7 180.6 246.1 112.1 996.3 557.4 709.6 31.9 20.1
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1997 $5,689.6 79.0 919.5 331.4 558.6 186.0 1,863.9 1,431.7 2,018.7 50.2 51.9
2004 $6,132.7 87.6 1,670.3 260.1 962.4 187.5 1,536.3 1,180.3 3,431.7 70.8 107.5
% of Total 39.2 0.6 10.7 1.7 6.2 1.2 9.8 7.5 22.0 0.4 0.7
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Other Issues Pertaining to Stock Markets
Does the stock market forecast the economy? Market efficiency
the speed with which financial security prices adjust to unexpected news pertaining to interest rates or a stock-specific characteristics, etc. Forms of market efficiency
Weak Form Market Efficiency Semistrong Form Market Efficiency Strong Form Market Efficiency
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Stock Market Regulation
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
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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
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Worldwide Stock Market Capitalization, 2004
2.65 15.03 3.88 1.77
United State Europe Japan Canada/Australia/New Zealand Pacific Basin Emerging Markets
54.97 21.71
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