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 Residual Claim Limited Liability Voting Rights

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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 Cumulative preferred stock

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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 Gross proceeds Underwriters spread Syndicate Originating house Red herring 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) The NYSE Composite 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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