FINA3010 C13 Stock Markets

Chapter 13 Stock Markets
Hung Wan Kot

Department of Finance, CUHK
1 FINA3010 Chapter 13 H.W. Kot

FINA3010
Financial Markets Financial Institutions
Money Market Mutual Fund Ind
Bond Market Insurance Companies
Stock Market Investment Banks
Mortgage Market Venture Capital Firms
Financial Crisis Commercial Banks

Chapter Outline
 Investing in Stocks
 Computing the Price of Common Stock
 How the Market Sets Security Prices
 Errors in Valuation
 Stock Market Index
 ADRs

Investing in Stocks
 Represents ownership in a firm
 Earn a return in two ways
 Price of the stock rises over time
 Dividends are paid to the stockholder
 Stockholders have claim on all assets

 Right to vote for directors and on certain issues
 Two types
 Common stock: Right to vote | Receive dividends
 Preferred stock: Receive a fixed dividend | Do not usually vote

Sample Stock Certificate: Sapir Consolidated Airlines

Investing in Stocks: How Stocks are Sold
 Organized exchanges
─ NYSE is best known, began trading in 1792. 24 brokers began trading a few stocks on
Wall Street.
─ “Organized” used to imply a specific trading location. But computer systems (ECNs)
have replaced this idea.
─ Others include the ASE (US), and Nikkei, LSE, DAX (international)
─ Listing requirements exclude small firms
NYSE merged NYSE combined Euronext to NYSE Euronext Intercontinental Ex

Archipelago NYSE Euronext acquired Amex purchased NYSE Euronext
2006 2007 2009 2013

Circuit-breaker in U.S.
https://news.cgtn.com/news/2020-03-28/What-are-stock-market-circuit-breakers-and-how-do-they-work--Pd2lBRmfza/index.html

March 2020
Warren Buffett said that he

lived for 89 years old also have
not seen this scene when
March 8, the fist “circuit
breaker” happens.

Investing in Stocks: How Stocks are Sold
 Over-the-counter markets
─ Best example is NASDAQ
─ Dealers stand ready to make a market
─ Today, about 3,000 different securities are listed on NASDAQ.
─ Important market for thinly-traded securities—securities that don’t trade very often.
Without a dealer ready to make a market, the equity would be difficult to trade.

Investing in Stocks: Organized vs. OTC
 Organized exchanges (e.g., NYSE)
─ Auction markets with floor specialists
─ 25% of trades are filled directly by specialist
─ Remaining trades are filled through SuperDOT
 Over-the-counter markets (e.g., NASDAQ)
─ National Association of Securities Dealers Automated Quotation System
─ Multiple market makers set bid and ask prices
─ Multiple dealers for any given security

Investing in Stocks: ATSs and MTFs
 Alternative trading systems (ATSs)
 Multilateral trading facilities (MTFs)
 ATSs and MTFs consist of Electronic Communications Networks (ECNs)
 ECNs allow brokers and traders to trade without the need of the middleman.
They provide:
• Transparency: everyone can see unfilled orders
• Cost reduction: smaller spreads
• Faster execution
• After-hours trading

Investing in Stocks: ECNs
However, ECNs are not without their drawbacks:
 Don’t work as well with thinly-traded stocks
 Many ECNs competing for volume, which can be confusing
 Major exchanges are fighting ECNs, with an uncertain outcome

Trading
Exchanges ATSs & MTFs
• NYSE • Dark pools (黑池)

• NASDAQ • ECNs
• LSE • …
• HKEx
• SHSE
• …

Dark Pool
 A dark pool is a private financial forum or exchange for trading securities. dark pools
are not accessible by the investing public.
 Non-exchange trading accounting for about 40% of all U.S. stock trades in 2014 (15%
from Dark pools).
 They are mostly used by institutional investors for block trades involving a large
number of securities.
 As of Feb 2020, there were >50 dark pools in the U.S.
Dark pools explained

https://www.youtube.com/watch?v=hq9waP7goSc
http://www.investopedia.com/articles/markets/050614/introduction-dark-pools.asp

Types of Dark Pools
 Broker-dealer owned: These dark pools are set up by large broker-dealers for their
clients.
 Examples Goldman Sachs’ Sigma X, Citi’s Citi Match and Citi Cross, and Morgan Stanley’s MS Pool.
 Agency broker or exchange-owned: These are dark pools that act as agents, not as
principals. As prices are derived from exchanges
 Examples of agency broker dark pools include Instinet,, while exchange-owned dark pools include
NYSE Euronext.
 Electronic market makers: These are dark pools offered by independent operators
like Getco and Knight.

Dark Pools: Pros and Cons
 Reduced market impact/Avoidance of  Exchange prices may not reflect the
price devaluation real market
 Lower transaction costs  Pool participatns may not get the best
price
 Private trading
 Vulnerability to predatory trading by
HFTs
 Small average trade size reduces need
for dark pools (averaged 187 shares per
HSBC: StockMax
in 2013
trade)

ECNs vs Dark Pool
 ECNs are a type of ATS that trade listed stocks and other exchange-traded products.
 Unlike dark pools, another type of ATS, ECNs display order in the consolidated
quote stream.
 As ATSs, ECNs are required to register with the Commission as broker-dealers and
are also members of FINRA.
 Examples of ECNs: Instinet, SelectNet, and NYSE Arca.
https://www.sec.gov/answers/ecn.htm
orders
orders
Exchanges ECN (BATS)
Dark Pools
order

ECNs vs Dark Pool
 To place orders directly with an ECN, a person must be an ECN subscribers.
 Typically, only broker-dealers and certain institutional traders are permitted to
become ECN subscribers.
 Individual investors must have an account with a broker-dealer subscriber to place an
order on an ECN.
https://www.sec.gov/answers/ecn.htm
ATSs vs Exchanges
 Although both exchanges and ATSs provide marketplaces for buyers and sellers to
transact in securities, ATSs do not necessarily provide public information on the best
prices available to traders within their system.
 They also do not set rules governing the conduct of subscribers and they perform
no self-regulation, while exchanges perform all of these functions.
 Additionally, because ATSs are regulated as broker-dealers, they comply with a
different set of regulations than traditional exchanges.
https://www.sec.gov/marketstructure/research/alternative-trading-systems-march-2014.pdf

New Trading Strategies: Algorithmic Trading and High-
Frequency Trading
https://tradingsim.com/blog/how-has-algorithmic-trading-impacted-the-futures-markets/

https://tradingsim.com/blog/how-has-algorithmic-trading-impacted-the-futures-markets/

Source: The Bogle Effect, Eric Balchunas, 2022.
26 FINA3010 Special Topic on index and ETF I H.W. Kot

Chapter Outline
 ADRs

Computing the Price of Common Stock
 Valuing common stock is, in theory, no different from valuing debt securities:
─ determine the cash flows
─ discount them to the present
 We will review four different methods for valuing stock, each with its
advantages and drawbacks.

Computing the Price of Common Stock: The One-Period
Valuation Model
 Simplest model, just taking using the expected dividend and price over the
next year.
 What is the price for a stock with an expected dividend and price next year
of $0.16 and $60, respectively? Use a 12% discount rate.

Computing the Price of Common Stock: The Generalized
Dividend Valuation Model
 Most general model, but the infinite sum may not converge.
 Rather than worry about computational problems, we use a simpler version,

known as the Gordon growth model.

Estimating Dividends: Special Cases
 Constant dividend
 The firm will pay a constant dividend forever
 This is like preferred stock
 The price is computed using the perpetuity formula
 Constant dividend growth
 The firm will increase the dividend by a constant percent every
period
 Supernormal growth
 Dividend growth is not consistent initially, but settles down to
constant growth eventually

16000
Profit
14000
12000
Revenue
10000
8000
6000
4000
Average
2000
Dividend Dividend growth
3% (2001-2007)
0
1998 1999 2000 2001 2002 2003 2004 2005 2006 2007
http://www.mtr.com.hk/chi/investrelation/financialinfo.php

Billion Growth
700 60%
Revenue
600 50%
40% Profit
500
30%
400
20%
300 Revenue
10%
200 Profit 0%
100 -10%
0 -20%
2001
2002
2003
2004
2005
2006
2007
2008
2009
2010
2011
2012
2013
2014
2002
2003
2004
2005
2006
2007
2008
2009
2010
2011
2011
2013
2014
Revenue growth Profit growth
2001-2008 22% 22%
2009-2014 6% 0%
http://www.chinamobileltd.com/?lang=en
Generalized formula
D1 + P1 D1 D2 P2
Po = = + +
(1 + r ) (1 + r ) (1 + r ) 2 (1 + r ) 2
D1 D2 D3 P3
= + + +
(1 + r ) (1 + r ) 2 (1 + r ) 3 (1 + r )3
D1 D2 D3 D4 DT PT
= + + + + ... + +
(1 + r ) (1 + r ) 2 (1 + r ) 3 (1 + r ) 4 (1 + r )T (1 + r )T
T
Dt PT
= +
t =1 (1 + r )t (1 + r )T
If T →∞ No matter how high the stock price is

in the very distant future, its present

Dt value is essentially zero
Po = 
t =1 (1 + r ) t

Remarks
 P0 is the ex-dividend price of the stock
 The stock price immediately after paying
the current dividend! (This is also true
for any Pt)
 The stock price does not depends on how
long an investor is going to keep the stock.
 We implicitly assume that corporations will
not go bankrupt in the future.
 Why are shares of stock in companies that
currently pay no dividends traded at
positive prices? For example, BioTech firms.

Currently Pays No Dividends

Constant Growth
 Assume that dividends will grow at a constant rate, g, forever
D1 = D 0 (1 + g )
D 2 = D1 (1 + g ) = D 0 (1 + g ) 2
D 3 = D 2 (1 + g ) = D 0 (1 + g ) 3
D t = D t −1 (1 + g ) = D t − 2 (1 + g ) 2 = ... = D0 (1 + g ) t
 
D1 (1 + g ) t −1 Do (1 + g )
 (1 + r) 
Dt D1
P0 = = … t = = .
t =1
t
t =1 (1 + r ) (r - g) (r - g)
D1
P0 =
r−g
Computing the Price of Common Stock: The Gordon
Growth Model
 Same as the previous model, but it assumes that dividend grow at a constant
rate, g. That is,

Computing the Price of Common Stock: The Gordon
Growth Model
The model is useful, with the following assumptions:
 Dividends do, indeed, grow at a constant rate forever
 The growth rate of dividends, g, is less than the required return on the equity,
ke.

Remarks
 How can g ever be assumed to be constant?

Remarks
 How can we assume that r > g ?

Computing the Price of Common Stock: The Generalized
Dividend Valuation Model
 The price earnings ratio (PE) is a widely watched measure of much the market
is willing to pay for $1.00 of earnings from the firms.
 If the industry PE ratio for a firm is 16, what is the current stock price for a
firm with earnings for $1.13 / share?
Answer:
Price = 16  $1.13 = $18.08
More on P/E ratio https://www.youtube.com/watch?v=_NAZxlIaf8U

Overpriced P↓
High
Good prospects E↑ E.g., Tencent in 2010s
P/E
Underpriced P↑ Value investment
Low
Poor prospects E↓ Value trap
44 FINA6602 Ch03 H.W. Kot

P/E trap
Current stock price

Earnings per share
Low P/E ratio is from:

• Low current price => high future price
• High current earnings => Low future
earnings
Tip: stocks paying stable (high) dividends

Chapter Outline
 ADRs

How the Market Sets Security Prices
 Generally speaking, prices are set in competitive markets as the price set by
the buyer willing to pay the most for an item.
 The buyer willing to pay the most for an asset is usually the buyer who can
make the best use of the asset.
 Superior information can play an important role.
 Short-term: Demand & Supply

 Long-term: Fundamental

How the Market Sets Security Prices
 Consider the following three valuations for a stock with certain dividends but
different perceived risk:
 Bud, who perceives the lowest risk, is willing to pay the most and will
determine the “market” price.

Errors in Valuation
Although the pricing models are useful, market participants frequently

encounter problems in using them. Any of these can have a significant impact
on price in the Gordon model P=D/(r-g).
• Problems with Estimating Growth
• Problems with Estimating Risk
• Problems with Forecasting Dividends

Errors in Valuation: Dividend growth rates
Table 13.1 Stock Prices for a Security with D0 = $2.00, ke = 15%, and
Constant Growth Rates as Listed

Errors in Valuation: Required returns

Errors in Valuation
Security valuation is not an exact science!
Considering different growth rates, required rates, etc., is important in
determining if a stock is a good value as an investment.
在市場轉捩點附近，大多數人的感覺 DJIA
永遠是錯誤的。
如果你是瑞士口音，人们将会把你的
智商高估50分；如果是牛津剑桥口音，
可被高看25分；而可怜的老美，在这
里是入不了品的。
——對沖基金風雲錄

Case: The 2007–2009 Financial Crisis and the Stock Market
 The financial crisis, which started in August 2007, was the start of one of
the worst bear markets.
 The crisis lowered “g” in the Gordon Growth model - driving down prices.
 Also impacts ke - higher uncertainty increases this value, again lowering
prices.
 The expectations were still optimistic at the start of the crisis. But, as the
reality of the severity of the crisis was understood, prices plummeted.

Case: 9/11, Enron and the Market
 Both 9/11 and the Enron scandal were events in 2001.

 Both should lower “g” in the Gordon Growth model - driving down prices.
 Also impacts ke - higher uncertainty increases this value, again lowering
prices.
 We did observe in both cases that prices in the market fell. And
subsequently rebounded as confidence in US markets returned.
Hang Seng Index performance in 2024?

Chapter Outline
 ADRs

Stock Market Indexes
 Stock market indexes are
frequently used to monitor the
behavior of a groups of stocks.
 Major indexes include the Dow
Jones Industrial Average, the S&P
500, and the NASDAQ composite.
https://www.youtube.com/watch?v=f0vdMBsC6fM

The Thirty Companies That Make Up the Dow Jones Industrial Average

Stock Market Indexes
 $1.00 invested in the DJIA back in 1980 (DJIA was around 800) would have
grown to about $16.40 in 2012 (Dow closed year at 13,104). This represented
an annual growth rate around 8.8%.
 What’s annual growth rate if Down closed in year 2023 at 37689.54?

 800*[(1+g)^43]=37689.54
 g=9.15%

DJIA 1896-2023
5.00 40000
4.50
35000
4.00
30000
3.50
25000
Log(Index value)
3.00
Log (index)
Index
2.50 20000
2.00
15000
1.50
10000
1.00
5000
0.50
0.00 0
1960
1896
1900
1904
1908
1912
1916
1920
1924
1928
1932
1936
1940
1944
1948
1952
1956
1964
1968
1972
1976
1980
1984
1988
1992
1996
2000
2004
2008
2012
2016
2020
https://en.wikipedia.org/wiki/Dow_Jones_Industrial_Average

Hang Seng Index
 The Hang Seng Index ("HSI") is one of the earliest stock market
indexes in Hong Kong. Publicly launched on 24 November 1969, the
HSI has become the most widely quoted indicator of the performance of
the Hong Kong stock market.
 To better reflect the price movements of major industry sectors of the
market, HSI constituent securities are grouped into 4 sectors including
Finance, Utilities, Properties, and Commerce and Industry Sub-indexes.

Buying Foreign Stocks
 Buying foreign stocks is useful from a diversification perspective. However, the
purchase may be complicated if the shares are not traded in the U.S or your
home country.
 American depository receipts (ADRs) allow foreign firms to trade on U.S.
exchanges, facilitating their purchase. U.S. banks buy foreign shares and issue
receipts against the shares in U.S. markets.

Designing a Strategy to Source Equity Globally (refer to Citibank ADR
guide)
 Depositary receipts (depositary shares) are negotiable certificates issued by a
bank to represent the underlying shares of stock, which are held in trust at a
foreign custodian bank.
 American depository receipts (ADRs) are certificates traded in the United States
and denominated in US dollars.
 ADRs are sold, registered, and transferred in the US in the same manner as
any share of stock with each ADR representing some multiple of the
underlying foreign share. (China Mobile, 1 ADR=5 shares)

Mechanics of American Depositary Receipts (ADRs)

ADR vs ADS
• An American depositary receipt (ADR) allows foreign companies to list their
shares on U.S. stock exchanges.
• An American depositary share (ADS) is the U.S. dollar-denominated equity
share of a foreign-based company available for purchase on an American stock
exchange.
• The entire issuance is called an American Depositary Receipt (ADR), and the
individual shares are referred to as ADS.

Designing a Strategy to Source Equity Globally
 ADRs can be exchanged for the underlying foreign shares, or vice versa, so
arbitrage keeps foreign and US prices of any given share the same after
adjusting for transfer costs.
 While ADRs are quoted only in US dollars and traded only in the US, Global
Registered Shares (GRSs) can be traded on equity exchanges around the globe
in a variety of currencies.
 May not list on home market, like Baidu, Alibaba.

Panel A: Pure domestic listing
1800
1600
1400
1200
1000
800
600
400
200
0
1990
1991
1992
1993
1994
1995
1996
1997
1998
1999
2000
2001
2002
2003
2004
2005
2006
2007
2008
2009
2010
2011
2012
2013
2014
Developed Emerging
Hung Wan Kot, Liang Shao and Lewis Tam, 2021, Cross-listing and reverse cross-listing: Role of national culture.

Panel B: Cross-listings
250
200
150
100
50
0
1990
1991
1992
1993
1994
1995
1996
1997
1998
1999
2000
2001
2002
2003
2004
2005
2006
2007
2008
2009
2010
2011
2012
2013
2014
Developed Emerging

Panel A: Proceeds from local portion and global portion
300000
250000
200000
Million USD
150000
100000
50000
0
1990
1991
1992
1993
1994
1995
1996
1997
1998
1999
2000
2001
2002
2003
2004
2005
2006
2007
2008
2009
2010
2011
2012
2013
2014
Local Proceeds Global Proceeds

Panel B: Cross-listing IPOs
120,000 60%
100,000 50%
Croll-listing/Total proceeds
80,000 40%
Million USD
60,000 30%
40,000 20%
20,000 10%
- 0%
1990
1991
1992
1993
1994
1995
1996
1997
1998
1999
2000
2001
2002
2003
2004
2005
2006
2007
2008
2009
2010
2011
2012
2013
2014
Total Proceeds from Cross-listing IPOs Proceeds of cross-listing/Total porceeds

Year 2021
DR programmes are either "sponsored" by an
issuing company or "unsponsored". If a company
sponsors a DR programme, it enters into a
contractual agreement with the depositary bank.
A DR programme may also be "unsponsored",

meaning that it is set up without the company's
participation or even its consent.
A depositary will typically establish an unsponsored

DR programme only if it believes that there is
sufficient interest in the company's shares to
generate adequate fee income, or if a broker-dealer
has requested such a programme and agreed to
assist with the expense.
Source: Depositary Receipts 2021 in review, Deutsche Bank


Benefits for a DR program for issuers
 Access capital outside the issuer’s home market
 Build company visibility in the U.S. and internationally
 Broaden and diversify shareholder base
 Expand opportunity to increase local share price as a result of global
demand/trading
 Enlarge the market for the company’s shares, potentially increasing liquidity
 Adjust share price levels to those of peers through DR ratio
 Facilitate merger and acquisition activity through use as acquisition currency
 Develop stock option plans and stock purchases plans for U.S. employees


Benefits of a DR program for investors
 Facilitating diversification into Non-U.S. securities
 Trading, clearing and settling in accordance with practices of the investor’s
home market
 Eliminating cross border custody safekeeping charges
 Providing enhanced accessibility of research, and of price and trading
information
 Allowing easy comparison to securities of similar companies trading in the
investor’s home market
 Permitting dividend payments in US$ and corporate action notifications in
English
 Allowing for lower dividend tax rates for exchanged-listed ADRs
Who are investors?

China Mobile
listed on HKEx
and NYSE

China Mobile listed on HKEx and Shanghai A-share market
March 22, 2022

Academic studies on cross-listing
 Karolyi, G. Andrew, 1998, Why Do Companies List Shares
Abroad? A Survey of the Evidence and its managerial
Implications, Financial Markets, Institutions & Instruments 7,
1-60.
 Karolyi, G. Andrew, 2006, The world of cross-listings and
cross-listings of the world: Challenging conventional
wisdom, Review of Finance 10, 73-115.
Prof Andrew Karolyi @Cornell

Cross-listing and reverse cross-listing: The role of national culture
Hung Wan Kot, Liang Shao, and Lewis H.K. Tam (2024)
 Using global Initial Public Offering data from 1990 to 2014, we
study the role of Hofstede’s national culture characteristics on
firms’ cross-listing decisions.
 The results reveal that firms located in countries with high
individualism, low uncertainty avoidance, and low power
distance are more likely to cross-list in overseas markets.
 We further find that cultural factors could play different roles
in the emerging markets and developed markets.
 In emerging markets, firms from countries with low
individualism and low masculinity are more likely to cross-list in
overseas markets.
 Firms from countries with low uncertainty avoidance are more
likely to reverse cross-list in home markets, especially in firms
from developed markets.

My related articles in the HK newspapers
明報
• 5國企退美市不足為奇（2022.8.17）
• 中概股回港上市高股價之謎（2021.6.18）
• 跨境上市貴在「承諾」——中國三大電訊商被
美退市的啟示（2021.1.13）
香港經濟日報
• 中資股來港第二上市續增有何啟示（2020.9.14）
• 阿里回港上市衣錦還鄉抑另有所求？
（2019.11.20）
• 澳交所倘成立吸4類企業跨境上市（2019.11.7）
• 阿里巴巴不來港人焉知非福（2013.12.24）

Regulation of the Stock Market
 The primary mission of the SEC of HK is “…to protect investors and maintain
the integrity of the securities markets.”
 The SEC brings around 500 actions against individuals and firms each year
toward this effort. This is accomplished through the joint efforts of four
divisions.

Regulation of the Stock Market: Divisions of the SEC
Division Duty
Corporate responsible for collecting, reviewing, and making available all of

Finance the documents corporations and individuals are required to file
Market Regulation establishes and maintains rules for orderly and efficient markets
Investment oversees and regulates the investment management industry

Management
Enforcement investigates violations of the rules and regulations established by
the other divisions

https://podcast.rthk.hk/podcast/item.php?pid=911&lang=zh-CN
此劇集根據真實個案改編，主題包括社交媒體投資騙局、“唱高散貨”計劃、內幕交易及市場操縱，借此揭露現時金融市場上違規
者的作案手法，警惕公眾在作出投資決定時務必審慎行事。《證義搜查線》將於2024年1月11日至2月1日逢星期四晚上8時至8時30
分在港台電視31頻道播出。在港台電視31啟播後，全部四集均可在證監會的YouTube頻道上觀看。

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Chapter 13 Stock Markets

Hung Wan Kot

1 FINA3010 Chapter 13 H.W. Kot

Financial Markets Financial Institutions

Money Market Mutual Fund Ind

Bond Market Insurance Companies

Stock Market Investment Banks

Mortgage Market Venture Capital Firms

Financial Crisis Commercial Banks

2 FINA3010 Chapter 13 H.W. Kot

3 FINA3010 Chapter 13 H.W. Kot

 Stockholders have claim on all assets

4 FINA3010 Chapter 13 H.W. Kot

6 FINA3010 Chapter 13 H.W. Kot

NYSE merged NYSE combined Euronext to NYSE Euronext Intercontinental Ex

2006 2007 2009 2013

7 FINA3010 Chapter 13 H.W. Kot

9 FINA3010 Chapter 13 H.W. Kot

Warren Buffett said that he

10 FINA3010 Chapter 13 H.W. Kot

12 FINA3010 Chapter 13 H.W. Kot

13 FINA3010 Chapter 13 H.W. Kot

14 FINA3010 Chapter 13 H.W. Kot

15 FINA3010 Chapter 13 H.W. Kot

Exchanges ATSs & MTFs

• NYSE • Dark pools (黑池)

16 FINA3010 Chapter 13 H.W. Kot

Dark pools explained

17 FINA3010 Chapter 13 H.W. Kot

18 FINA3010 Chapter 13 H.W. Kot

19 FINA3010 Chapter 13 H.W. Kot

Exchanges ECN (BATS)

21 FINA3010 Chapter 13 H.W. Kot

23 FINA3010 Chapter 13 H.W. Kot

24 FINA3010 Chapter 13 H.W. Kot

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26 FINA3010 Special Topic on index and ETF I H.W. Kot

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 Rather than worry about computational problems, we use a simpler version,

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If T →∞ No matter how high the stock price is

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More on P/E ratio https://www.youtube.com/watch?v=_NAZxlIaf8U

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Current stock price

Low P/E ratio is from:

Tip: stocks paying stable (high) dividends

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 Short-term: Demand & Supply

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Although the pricing models are useful, market participants frequently