Chapter Five

Stock Markets
Overview of Stock Markets

 Primary stock markets allow suppliers of funds to raise equity

capital
 Secondary stock markets are the most closely watched and
reported of all financial markets
 Stockholders are the legal owners of a corporation
 Have a right to share in the firm’s profits (e.g., through
dividends)
 Are residual claimants
 Have limited liability
 Have voting rights (e.g., to elect board of directors)

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Common Stock

 Common stock is the fundamental ownership claim in a

public or private corporation
 Dividends are discretionary, and are thus not guaranteed
 Common stockholders have the lowest priority claim in the
event of bankruptcy (i.e., a residual claim)
 Limited liability implies that common stockholders can lose
no more than their original investment
 Common stockholders control the firm’s activities indirectly by
exercising their voting rights in the election of the board of
directors

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Common Stock Voting Rights

 Dual-class firms have two classes of common shares

outstanding, with different voting rights assigned to each
class
 With cumulative voting, the number of votes assigned to
each stockholder equals the number of shares held multiplied
by the number of directors to be elected
 A proxy vote allows stockholders to vote by absentee ballot
(e.g., by internet or by mail)

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Stock Returns

 The return on a stock over one period (Rt) can be divided into
capital gains and dividend returns:

Pt  Pt 1 Dt
Rt  
Pt 1 Pt 1
Pt = stock price at time t
Dt = dividends paid over time t – 1 to t
(Pt – Pt – 1) / Pt – 1 = capital gain over time t – 1 to t
Dt / Pt – 1 = return from dividends over time t – 1 to t

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Stock Returns Example

 Suppose an investor buys 10 shares of stock priced at $55.10

and sells the stock one year later for $56.30 after collecting a
$0.30 dividend per share. What was the investor’s pre-tax
holding period return?
$56.30  $55.10 $0.30
HPR    2.18%  .54%  2.72%
$55.10 $55.10
 If dividend income is taxed at a 28% rate and capital gains are taxed
at 20%, what was the investor’s after-tax holding period return?

HPR AT  2.18%(1 20%)  0.54%(1 28%)  2.13%

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Preferred Stock

 Preferred stock is a hybrid security that has

characteristics of both bonds and common stock
 Similar to common stock in that it represents an ownership
interest in the issuing firm, but like a bond it pays a fixed
periodic (dividend) payment
 Generally has fixed dividends that are paid
quarterly
 Generally does not have voting rights unless
dividend payments are missed
 Nonparticipating versus participating
 Cumulative versus noncumulative
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Primary Stock Markets

 Primary markets are markets in which corporations raise

funds through new issues of securities, most of the time
through investment banks
 E.g., Morgan Stanley or Bank of America Merrill Lynch
 Investment banks act as distribution agents in best efforts
underwriting
 Investment banks act as principals in firm commitment
underwriting
 A syndicate is a group of investment banks working in
concert to issue stock; the lead underwriter is the originating
house

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Primary Stock Markets Continued

 An initial public offering (IPO) is the first public issue of

financial instruments by a firm
 A seasoned offering is the sale of additional securities by a
firm whose securities are already publicly traded
 Preemptive rights give existing stockholders the ability to
maintain their proportional ownership
 A red herring prospectus is a preliminary version of the
prospectus that describes a new security issue
 Shelf registration allows firms to offer multiple issues of
stock over a two-year period with only one registration
statement

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Secondary Stock Markets

 Secondary stock markets are the markets in

which stocks, once issued, are traded among
investors
 The U.S. has several major stock markets
 New York Stock Exchange Euronext (NYSE/Euronext)
 The NYSE/Euronext Exchange was purchased by ICE in
2013.
 National Association of Securities Dealers Automated
Quotation (NASDAQ)
 Bats/Direct Edge (former ECNs)
NYSE Euronext

 Trading occurs at a specific place on the floor of the

exchange called a trading post

 Each stock has a special market maker called a specialist

or Designated Market Maker (DMM) that maintains liquidity
for the stock at all times

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NYSE Euronext Continued

 Three types of transactions occur at trading posts

 A market order is an order to transact at the best price available
when the order reaches the trading post
 A limit order is an order to transact at a specified price
 Specialists transact for their own account
 Circuit breakers give investors time to make informed
choices during periods of high market volatility

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Circuit-Breaker Levels

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Purchase of a Stock on the NYSE

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Stock Market Quote

 Name  Volume
 Symbol  52 Wk High
 Open  52 Wk Low
 High  Div
 Low  Yield
 Close  P/E
 Net Chg  YTD % Chg
 % Chg

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Stock Market Quote Example

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Exchange Traded Funds (ETFs)

 Pioneered by the former AMEX (now NYSE/AMEX)

 ETFs are index funds that are listed on an exchange and
can be traded intraday and shorted
 Prices may not exactly match an index

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NASDAQ and OTC Markets

 NASDAQ was the world’s first electronic market and has

no physical trading floor
 Provides continuous trading for the most active stocks traded
over-the-counter (OTC)
 Primarily a dealer market where many, often more than 20,
dealers act as market makers

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Secondary Stock Markets

 Choice of market listings

 NYSE has extensive listing requirements (e.g., firm market value
and trading volume)
 NASDAQ requirements are cheaper and can be met by smaller
firms with less active trading
 Electronic communication networks (ECNs)
 Normal trading occurs between 9:30 a.m. and 4:00 p.m. eastern
standard time
 Extended-hours trading occurs through computerized

 Online trading via the internet is becoming increasingly

popular with both individual and professional investors

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Stock Market Indexes

 A stock market index is the composite value of a group of

secondary market-traded stocks
 Price-weighted index
 The Dow Jones Industrial Average (DJIA), composed of 30 large
companies, is the most widely reported stock market index
 Value-weighted indexes
 NYSE Composite
 Standard & Poor’s 500
 NASDAQ Composite
 Wilshire 5000

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Holders of Corporate Stock

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Other Stock Market Issues

 Economic indicators
 Stock market indexes might be used to forecast future
economic activity
 An increase (decrease) in stock market indexes today potentially
signals the market’s expectation of higher (lower) corporate
dividends and profits and, in turn, higher (lower) economic
growth
 Stock prices are one of the 10 variables included in the
index of leading economic indicators used by the Federal
Reserve as it formulates economic policy

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Other Stock Market Issues
Continued
 Market efficiency refers to the speed with which
financial security prices reflect unexpected news
events
 Weak form market efficiency
 Concludes that investors cannot make more than the fair
(required) return using information based on historical price
movements
 Empirical research suggests that markets are weak form efficient
 Semistrong form market efficiency
 According to semistrong form market efficiency, investors
cannot make more than the fair (required) return by trading on
public news releases
 Note that if semistrong form market efficiency holds, weak form
market efficiency must hold as well
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Other Stock Market Issues
Concluded
 Market efficiency refers to the speed with which
financial security prices reflect unexpected news
events
 Strong form market efficiency
 States that stock prices fully reflect all information about
the firm, both public and private
 According to strong form efficiency, even learning private
information about the firm is of not help in earning more
than the required rate of return
 Limited empirical testing, but studies do suggest that corporate
insiders earn abnormal returns from trading and the more
informed the insider, the more often abnormal returns are earned
 For this reason, laws prohibit investors from trading on the basis
of private information
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Stock Market Regulations

 The Securities and Exchange Commission (SEC) is the

primary regulator of stock markets
 Promote full and fair disclosure of information on securities and
ensure fair treatment of investors
 Enforce Securities Act of 1933/Securities Exchange Act of 1934
 Prosecute inside trading
 Galleon Fund, Raj Rajaranam
 SAC Capital Advisors LP

 SEC failed to uncover Madoff fraud

 Significant turnover of personnel since

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Stock Market Regulations
Continued
 The Financial Industry Regulatory Authority (FINRA) is
the regulator for all U.S. securities firms
 FINRA oversees registering and educating brokers and
dealers, examining securities firms, promulgating rules,
enforcing federal securities laws, and conducting dispute
arbitration

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International Aspects of Stock
Markets
 U.S. stock markets are the world’s largest
 European markets have increased their share of the global
market with the advent of a common currency, the Euro, but
hurt by the Euro area crisis
 Growth has strengthened China and Pacific Basin countries
 International stock markets allow investors to diversify by
holding stocks issued by corporations in foreign countries
 International diversification can increase risk due to
incomplete information about foreign stocks as well as
foreign exchange and political risk

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American Depository Receipts
(ADRs)
 An ADR is a certificate that represents ownership of a
foreign stock
 Created by a U.S. bank, after acquiring stock in foreign
corporations in their domestic currencies
 The bank then issues dollar ADRs backed by the shares of the
foreign stock, investors earn returns in U.S. dollars
 There are currently over 3,600 ADRs of foreign
corporations available to U.S. investors representing
asset values of over $3.1 trillion in 2015

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American Depository Receipts
(ADRs) Continued
There are 3 types of ADRs:
 Level 1 ADRs trade OTC and are not required to meet U.S.
GAAP nor issue annual reports
 Level 2 ADRs trade on the exchanges and must meet
exchange requirements and adhere to U.S. reporting
standards
 Level 3 ADRs meet the same reporting standards as Level 2
and must register with the SEC and file the equivalent of 10K
forms. These firms are allowed to raise public capital in the
U.S.

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Impact of Change in Foreign
Currency Exchange Rates on
Market Returns

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Capital Asset Pricing Model
 CAPM
 A model that predicts the relationship between the
risk and equilibrium required returns on risky
assets
 Built on the theory that the appropriate risk
premium on an asset will be determined by its
contribution to the risk of an investor’s overall
portfolio

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