Chapter Eight

Capital Market
Stock Market
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)
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
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
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. CIBC World Market
 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
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
 SFPD employs a shelf registration system designed to
reduce repetitive filing requirements for large companies
 Multilateral Instrument Crowdfunding Exemption (MI 45-
108) aims to facilitate online capital raising activities by start-
ups and SMEs with a limit of $1.5 million and a maximum of
$2,500 from any one individual investor
Secondary Stock Markets
 Secondary stock markets are the markets in
which stocks, once issued, are traded among
investors
 Canada has several major stock markets
 Toronto Stock Exchange (TSX) (1852) is for trading
shares of large and established Canadian corporations
 TSX Venture Exchange (TSX-V) (1999) lists new, smaller
companies including those active in technology natural
resources exploration
 Both TSX and TSX-V are owned by the TMX group

 Canadian Securities Exchange (CSE) (2004) deals with

very small and emerging ventures
NEO Exchange
 A new stock exchange (NEO), Aequitas Innovations Inc.,
launched in March 2015 and based in Toronto, has the
backing of major financial institutions such as RBC
Capital Markets, Barclays, Mackenzie Investments,
OMERS Capital Markets and ITG Canada.
 Aequitas hopes to provide competition to the TSX as an
alternative for “buys side” retail investors seeing no
difference compared to trading TSX and TSXV listed
securities.
 Today, it represents close to 10% of all volume traded in
Canadian-listed securities with more than 70 ETFs,
closed-end funds and corporate listings
TSX & TSX Venture Exchange
TSX-V TSX
Listed Companies 2,258 1,569
Total Market Capitalization $40.3 B $2,149.2 B
Medium Market $3.7 M $112.3 M
Capitalization
Average Market $17.8 M $1.4 B
Capitalization
Total Financing $6.0 B $50.5 B
Average Financing $3.2 M $69.9 M
Going Public Activities 240 132
Graduates to TSX -- 27
Listing Requirements
Criteria
Net tangible assets
Pre-tax income
Pre-tax cash flow
Market value of publicly held shares
Number of outstanding shares
Number of shareholders of “board” lots 300
Working capital requirements
TSX (Canadian $)
≥ $2 million
≥ $200,000 in most recent year
≥ $500,000 previous year
≥ $5 million
≥ $10 million (technology companies)
1 million
Adequate W/C and capitalization to
carry on the business
Purchase of a Stock on the TSX

Without any physical trading facility, floor brokers no

longer exist because all Canadian stock exchanges have
shifted to electronic auction markets
Stock Market Quote Example
Stock Market Indexes

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

secondary market-traded stocks giving a feel for the market
 Most indexes are designed for particular market segment
(e.g. blue chips) aiding investors in evaluating overall
performance
 Price-weighted index
 The Dow Jones Industrial Average (DJIA) is the most widely
reported stock market index
 Value-weighted indexes
 S&P/TSX Composite Index
 Standard & Poor’s 500
Stock Market Indexes
 Dow Jones Industrial Average (DJIA): a price-
weighted index consisting of 30 large industrial
of over 2,300 stocks trading on the NYSE
 The composition of the DJIA changes from time
to time to reflect changes in the economy and
the relative importance of industries or of
companies within an industry
 Although the DJIA is the most widely reported
market index, it has little use as a performance
benchmark because of its narrow makeup and
price weighting
Stock Market Indexes
 The S&P 500 Index is a market value-weighted
index of NYSE and AMEX-Nasdaq stocks
 It consists of 400 industrial companies, 20
transportation companies, 40 utility firms, and 40
financial companies
 Because it is much broader than the DJIA, many
use the S&P 500 as a performance benchmark
for large cap stocks (i.e. companies with a
market capitalization greater than $5 billion)
S&P/TSX Composite Index
 Launched in 1977, a value-weighted measure of the value
of shares of companies listed on the TSX
 Shares are weighted in the index by their market
capitalization
 There are 11 categories of securities included in the index
 RBC has the largest weight at 5.36%
 Reflect the value of about 250 of the largest firms out of
1,500 companies listed, which together account for about
70% of the total market capitalization
 Stocks must meet certain market capitalization, liquidity
and domicile eligibility requirements to be added to the
index
 The components of the index are reevaluated quarterly by
Standards and Poor’s
Example
 Price-weighted stock market index in which stocks
are held in proportion to their share price
Shares Outstanding Beginning Ending
Firm A 50 million $10/share $14/share
Firm B 1 million $50/share $40/share
 At the beginning: ($10 + $50)/2 = $30. At the
ending: ($14 + $40)/2 = $27
 Index falls from 30 to 27 for a change of -$3, which
is equivalent to -3/30 = -10%. Market is “off” by 10%
 The index is down because B’s stock price is 5
times bigger than A although A gains 40% whereas
B loses 20%
 Example
 Value-weighted stock market index in which stocks
are held in proportion to their total company market
value
Shares Outstanding Beginning Ending
Firm A 50 million @$10/share = $500 m @$14/share= $700 m
Firm B 1 million @$50/share = $50 m @$40/share = $40 m

 At beginning: ($500 + $50)/2 = $275. At ending: ($700

+ $40)/2 = $370.
 The index rises from 275 to 370 (i.e. a 35% increase),
although the average share price goes down
 Since the number of shares is considered, the true
impact on the overall market can be better detected.
Example: Index Divisor
 A stock split has no effect on a value-weighted index
since the total value of the company does not change.
 Split has a dramatic effect on a price-weighted index
 A new index divisor is adjusted as needed to remove
the effect of stock splits
 With a 2-for-1 split, B’s share prices fall to $25 =
$50/2
 The price-weighted index falls to (10 + 25)/2 = 17.5
from 30 although nothing really happens
 As stock prices are $10 and $25, we want the index to
equal to 30. Index level = (Sum of stock
prices)/Divisor
 Solving 30 = (10 + 25)/D gives Divisor = 35/30 = 1.17
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
Other Stock Market Issues

 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
Other Stock Market Issues

 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
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
International Aspects of Stock
Markets
 Top 10 largest stock exchanges
 New York Stock Exchange (1792)
 Nasdaq (1971)
 Toyko Stock Exchange (1878)
 Shanghai Stock Exchange (1891)
 Euronext (2000)
 London Stock Exchange (1698)
 Shenzhen Stock Exchange (1990)
 Toronto Stock Exchange (1852)
 Bombay Stock Exchange (1875)