Chapter Eight

Stock Markets

Copyright © 2014 by The McGraw-Hill Companies, Inc. All rights reserved.

 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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 Peak to Trough Aggregate U.S.
Stock Value & Recent Value

Mkt Value U.S. Stock ($Trill.)

$30.00

$25.00

$20.00

$15.00

$10.00

$5.00

$0.00
2007 peak 2009 March 2010 2013

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 Stock Returns

⚫ The returns 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 paid over time t – 1 to t

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 Stock Returns

⚫ 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

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 Stock Returns

⚫ 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
⚫ 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 stock, most of the time through
investment banks
⚫ Investment banks act as distribution agents in best efforts
underwriting
⚫ Investment banks act as principals in firm commitment
underwriting
gross proceeds – net proceeds = underwriter’s spread
⚫ 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

⚫ 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
⚫ the New York Stock Exchange Euronext
(NYSE/Euronext)
⚫ The NYSE/Euronext Exchange was purchased by ICE in
2013.
⚫ the National Association of Securities Dealers
Automated Quotation (NASDAQ)
⚫ Bats/Direct Edge (former ECNs)

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 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

⚫ 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

⚫ Program trading is the simultaneous buying and selling of a

portfolio of at least 15 different stocks valued at more than $1
million using computer programs to initiate the trades

⚫ Circuit breakers give investors time to make informed

choices during periods of high market volatility

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 Circuit Breakers

Drop in DJIA* Impact

1,450 point drop before 2:00 pm Trading halted for one hour
1,450 point drop 2:00-2:30 pm Trading halted for 30 minutes
1,450 point drop after 2:30 pm No halt
2,900 point drop before 1:00 pm Trading halted for two hours
2,900 point drop 1:00-2:00 pm Trading halted for one hour
2,900 point drop after 2:30 pm Trading halted for the rest of the day
4,350 point drop anytime Trading halted for the rest of the day
Source: Text
* the point drops are approximately 10%, 20% and 30% respectively.

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 Trading on NYSE Euronext
and AMEX

Order Order Order

Investor Shares Broker Shares Comm. Shares Market
or Maker or
Cash Cash Floor Cash Other Floor
Broker Broker

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 Stock Market Quotes

⚫ 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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 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
⚫ A small order execution system (SOES) provides
automatic order execution for orders of less than or equal to
1,000 shares
⚫ The NASD maintains an electronic “OTC bulletin board” and
“pink sheets” for small firms that are not part of the
NASDAQ

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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
alternative trading systems (ATSs) a.k.a. ECNs
⚫ BATS (Better Alternative Trading System) has now become an
exchange;

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 Secondary Stock Markets

⚫ Online trading via the internet is becoming increasingly

popular with both individual and professional investors

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 Flash Trading

⚫ On May 6, 2010, the financial markets experienced the ‘flash

crash.’
⚫ Markets fell about 5% in a very brief time, only to just as quickly
recover most of the loss.

⚫ Even now a definitive cause is not known, but supposedly

trades of $4.1 billion S&P500 futures contracts by a Kansas
City based mutual fund, Asset Strategy Fund, triggered the
crash

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 Flash Trading

⚫ In flash trading, traders are allowed to see incoming buy or

sell orders milliseconds earlier than general market traders
⚫ Flash traders then use computerized statistical analysis to
generate high frequency trading strategies that are executed
by computer as well
⚫ Pro: Flash trading creates more liquidity and the possibility of
price improvement
⚫ Con:
⚫ Creates a disadvantage for regular traders and investors who
are not allowed to view incoming orders
⚫ High volume of trading generated by multiple computers can
lead to events like the so called flash crash

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 Flash Trading

⚫ As a result of the flash crash the SEC imposed circuit breaker

rules for individual stocks
⚫ Trading is halted if the price breaks the price band calculated
as price band = (Reference Price) ± [(Reference price) ×
(Percentage parameter)]

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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
companies, is the most widely know stock market index
⚫ Value-weighted indexes
⚫ NYSE Composite
⚫ Standard & Poor’s 500
⚫ NASDAQ Composite
⚫ Wilshire 5000

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 Stock Markets
⚫ Households & mutual funds are the largest U.S.
holders of corporate stock

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 Stock Market Holdings and the
Aftermath of the Crisis
Modified Text TABLE 8–4 Holders of Corporate Stock (in billions of dollars)
% of % of
Sector 2007 Total 2013 Total Change
Household sector $9,975.00 37.8% $11,242.80 39.53% 1.70%
State & local govt. 111.40 0.4% 68.50 0.24% -0.18%
Rest of world 2822.00 10.7% 3445.80 12.12% 1.41%
Federal Government 0.00 0.0% 38.60 0.14% 0.14%
Monetary Authority 0.00 0.0% 0.00 0.00% 0.00%
Depository Institution 68.60 0.3% 96.80 0.34% 0.08%
Life insurance companies 1505.10 5.7% 1654.90 5.82% 0.11%
Property-casualty insurers 248.50 0.9% 273.40 0.96% 0.02%
Private pensions 2829.00 10.7% 2283.30 8.03% -2.70%
Public pensions 2210.50 8.4% 2360.90 8.30% -0.08%
Mutual funds 5701.30 21.6% 5557.80 19.54% -2.08%
Closed-end funds 153.60 0.6% 107.30 0.38% -0.21%
ETFs 521.90 2.0% 1195.90 4.21% 2.23%
Brokers & Dealers 220.60 0.8% 112.40 0.40% -0.44%
Finance Companies 0.00 0.0% 0.00 0.00% 0.00%
$26,367.50 100.0% $28,438.40 100.0%

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 Stock Markets

⚫ Does the stock market forecast the economy?

Leading Economic Indicators

Average weekly hours of manufacturing production workers
Average weekly initial claims for unemployment insurance
Manufactures’ new orders for consumer goods and materials
Vendor performance, slower deliveries diffusion index
Manufactures’ new orders for nondefense capital goods
Building permits for new private housing units
Stock prices
Money supply (M2)
Interest rate spread of 10 year Treasury over federal funds rate
Index of consumer expectations

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 Stock Markets

⚫ Market efficiency refers to the extent and speed

with which financial security prices reflect
unexpected news events
⚫ weak form market efficiency
⚫ If an investor can use historical news, or historical price
and volume information, to consistently predict future
stock price changes then the markets are not weak form
efficient
⚫ semistrong form market efficiency
⚫ If one can use any publicly available information, including
forecasts based on publicly available information, to
consistently predict future stock price changes then the
markets are not semistrong form efficient

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 Stock Markets

⚫ Market efficiency refers to the extent and speed

with which financial security prices reflect
unexpected news events
⚫ strong form market efficiency
⚫ If one can use any information, including ‘inside’
information to consistently predict future stock price
changes then the markets are not strong form efficient

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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
⚫ SEC has failed to implement many of the changes required by
the Dodd-Frank bill

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 Stock Market Regulations

⚫ 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 recently strengthened in the U.K., Canada,
Japan, 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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