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9-1McGraw-Hill/Irwin ©2007, The McGraw-Hill Companies, All Rights Reserved
Chapter NineStock Markets
9-2McGraw-Hill/Irwin ©2007, The McGraw-Hill Companies, 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.)
9-3McGraw-Hill/Irwin ©2007, The McGraw-Hill Companies, All Rights Reserved
Market Value of Common Stock Outstanding, by Type of Issuer ($Bn)
0
2000
4000
6000
8000
10000
12000
14000
1994 1997 2000 2004
Nonfinancial corp. bus Financial corp Rest of world
0
2000
4000
6000
8000
10000
12000
14000
1994 1997 2000 2004
Nonfinancial corp. bus Financial corp Rest of world
9-4McGraw-Hill/Irwin ©2007, The McGraw-Hill Companies, All Rights Reserved
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
9-5McGraw-Hill/Irwin ©2007, The McGraw-Hill Companies, All Rights Reserved
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%
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 $40 = 12.5% + 10.0% = 22.5%
9-6McGraw-Hill/Irwin ©2007, The McGraw-Hill Companies, All Rights Reserved
Stock Market Securities
• Two types of corporate stock exist– Common stock
• the fundamental ownership claim in a public corporation
– Preferred stock• a hybrid security that has characteristics of both
bonds and common stock
• Two types of corporate stock exist– Common stock
• the fundamental ownership claim in a public corporation
– Preferred stock• a hybrid security that has characteristics of both
bonds and common stock
9-7McGraw-Hill/Irwin ©2007, The McGraw-Hill Companies, All Rights Reserved
New Securities Issued ($Bn)
020406080
100120140160180
1992 1998 2000 2001 2003 2004
Preferred Common
020406080
100120140160180
1992 1998 2000 2001 2003 2004
Preferred Common
9-8McGraw-Hill/Irwin ©2007, The McGraw-Hill Companies, All Rights Reserved
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
• 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
9-9McGraw-Hill/Irwin ©2007, The McGraw-Hill Companies, All Rights Reserved
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
• 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
9-10McGraw-Hill/Irwin ©2007, The McGraw-Hill Companies, 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: 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.
• 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.
9-11McGraw-Hill/Irwin ©2007, The McGraw-Hill Companies, All Rights Reserved
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)
9-12McGraw-Hill/Irwin ©2007, The McGraw-Hill Companies, All Rights Reserved
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
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
9-13McGraw-Hill/Irwin ©2007, The McGraw-Hill Companies, All Rights Reserved
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 system’s network
• 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 system’s network
9-14McGraw-Hill/Irwin ©2007, The McGraw-Hill Companies, All Rights Reserved
Trading on NYSE and AMEX
Order Order Order
Investor Shares Broker Shares Comm Shares Market or Maker or Cash Cash Floor Cash Other Floor Broker Broker
Order Order Order
Investor Shares Broker Shares Comm Shares Market or Maker or Cash Cash Floor Cash Other Floor Broker Broker
9-15McGraw-Hill/Irwin ©2007, The McGraw-Hill Companies, All Rights Reserved
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)
9-16McGraw-Hill/Irwin ©2007, The McGraw-Hill Companies, All Rights Reserved
Stock Market Indexes
• The Dow Jones Industrial Average (the DJIA): price weighted index
• The NYSE Composite index: value weighted index
• the Standard & Poor’s 500 index
• The NASDAQ Composite index
• The Dow Jones Industrial Average (the DJIA): price weighted index
• The NYSE Composite index: value weighted index
• the Standard & Poor’s 500 index
• The NASDAQ Composite index
9-17McGraw-Hill/Irwin ©2007, The McGraw-Hill Companies, All Rights Reserved
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 39.2State and local gov. 10.6 79.0 87.6 0.6Rest of world 397.7 919.5 1,670.3 10.7Depository inst. 180.6 331.4 260.1 1.7Life ins. co. 246.1 558.6 962.4 6.2Other ins. co. 112.1 186.0 187.5 1.2Private pension funds 996.3 1,863.9 1,536.3 9.8Public pension funds 557.4 1,431.7 1,180.3 7.5Mutual funds 709.6 2,018.7 3,431.7 22.0Closed-end funds 31.9 50.2 70.8 0.4Brokers 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 39.2State and local gov. 10.6 79.0 87.6 0.6Rest of world 397.7 919.5 1,670.3 10.7Depository inst. 180.6 331.4 260.1 1.7Life ins. co. 246.1 558.6 962.4 6.2Other ins. co. 112.1 186.0 187.5 1.2Private pension funds 996.3 1,863.9 1,536.3 9.8Public pension funds 557.4 1,431.7 1,180.3 7.5Mutual funds 709.6 2,018.7 3,431.7 22.0Closed-end funds 31.9 50.2 70.8 0.4Brokers and dealers 20.1 51.9 107.5 0.7
9-18McGraw-Hill/Irwin ©2007, The McGraw-Hill Companies, All Rights Reserved
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
• 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
9-19McGraw-Hill/Irwin ©2007, The McGraw-Hill Companies, All Rights Reserved
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
• 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
9-20McGraw-Hill/Irwin ©2007, The McGraw-Hill Companies, All Rights Reserved
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
9-21McGraw-Hill/Irwin ©2007, The McGraw-Hill Companies, All Rights Reserved
Worldwide Stock Market Capitalization, 2004
54.97
21.71
15.03
2.653.88 1.77
United State
Europe
Japan
Canada/Australia/NewZealand
Pacific Basin
Emerging Markets