PFS2173/CHAPTER 3 : EQUITY MARKET

What Is an Equity Market?

 An equity market is a market in which shares of companies are issued and traded, either through exchanges or over-the-counter markets.
Also known as the stock market, it is one of the most vital areas of a market economy. It gives companies access to capital to grow their
business, and investors a piece of ownership in a company with the potential to realize gains in their investment based on the company's
future performance. 
 Understanding an Equity Market
 Equity markets are the meeting point for buyers and sellers of stocks. The securities traded in the equity market can either be public
stocks, which are those listed on the stock exchange, or privately traded stocks. Often, private stocks are traded through dealers, which
is the definition of an over-the-counter market.
 When companies are born they are private companies, and after a certain time, they go through an initial public offering (IPO), which is
a process that turns them into public companies traded on a stock exchange. Private stocks operate slightly differently as they are only
offered to employees and certain investors.
 Some of the largest equity markets, or stock markets, in the world are the New York Stock Exchange, Nasdaq,  Tokyo Stock Exchange, 
Shanghai Stock Exchange, and Euronext Europe.
 Companies list their stocks on an exchange as a way to obtain capital to grow their business. An equity market is a form of  
equity financing, in which a company gives up a certain percentage of ownership in exchange for capital. That capital is then used for a
variety of business needs. Equity financing is the opposite of debt financing, which utilizes loans and other forms of borrowing to obtain
capital.
Trading in an Equity Market

 In the equity market, investors bid for stocks by offering a certain price, and sellers ask for a
specific price. When these two prices match, a sale occurs. Often, there are many investors
bidding on the same stock. When this occurs, the first investor to place the bid is the first to
get the stock. When a buyer will pay any price for the stock, they are buying at market value;
similarly, when a seller will take any price for the stock, they are selling at market value.
 When a company offers its stock on the market, it means the company is publicly traded, and
each stock represents a piece of ownership. This appeals to investors, and when a company
does well, its investors are rewarded as the value of their stocks rise.
 The risk comes when a company is not doing well, and its stock value may fall. Stocks can be
bought and sold easily and quickly, and the activity surrounding a certain stock impacts its
value. For example, when there is a high demand to invest in the company, the price of the
stock tends to rise, and when many investors want to sell their stocks, the value goes down.
Stock Exchanges

 Stock exchanges can be either physical places or virtual gathering spots. Nasdaq is an example of a

virtual trading post, in which stocks are traded electronically through a network of computers. Electronic
trading posts are becoming more common and a preferred method of trading over physical exchanges.
 The New York Stock Exchange (NYSE) on Wall Street is a famous example of a physical stock
exchange; however, there is also the option to trade in online exchanges from that location, so it is
technically a hybrid market.
 Most large companies have stocks that are listed on multiple stock exchanges throughout the world.
However, companies with stocks in the equity market range from large-scale to small, and traders range
from big companies to individual investors.
 Most buyers and sellers tend to prefer trading at larger exchanges, where there are more options and
opportunities than at smaller exchanges. However, in recent years, there has been an uptick in the number
of exchanges through third-party markets, which bypass the commission of a stock exchange, but pose a
greater risk of adverse selection and don't guarantee the payment or delivery of the stock.
Physical Exchanges

 In a physical exchange, orders are made in open outcry format, which is reminiscent of depictions of
Wall Street in the movies: traders shout and display hand signals across the floor in order to place
trades. Physical exchanges are made on the trading floor and filter through a floor broker, who finds the
trading post specialist for that stock to put through the order.

 Physical exchanges are still very much human environments, although there are a lot of functions
performed by computers. Brokers are paid commissions on the stocks they work. This form of trading

has become rare and replaced by electronic communication .

 
What Is a Primary Market?
 A primary market is a source of new securities. Often on an exchange, it's where companies, governments, and other groups go to obtain
financing through debt-based or equity-based securities. Primary markets are facilitated by underwriting groups consisting of investment
banks that set a beginning price range for a given security and oversee its sale to investors.
 Once the initial sale is complete, further trading is conducted on the secondary market, where the bulk of exchange trading occurs each
day.
Understanding Primary Markets
 The primary market is where securities are created. It's in this market that firms sell or float (in finance lingo) new stocks and bonds to
the public for the first time. 
 Companies and government entities sell new issues of common and preferred stock, corporate bonds and government bonds, notes, and
bills on the primary market to fund business improvements or expand operations. Although an investment bank may set the securities'
initial price and receive a fee for facilitating sales, most of the money raised from the sales goes to the issuer.
 The primary market isn't a physical place; it reflects more the nature of the goods. The key defining characteristic of a primary market is
that securities on it are purchased directly from an issuer—as opposed to being bought from a previous purchaser or investor, "second-
hand" so to speak.
 All issues on the primary market are subject to strict regulation. Companies must file statements with the 
Securities and Exchange Commission (SEC) and other securities agencies and must wait until their filings are approved before they can
offer them for sale to investors.
 After the initial offering is completed—that is, all the stock shares or bonds are sold—that primary market closes. Those securities then
start trading on the secondary market.
Types of Primary Market Issues

 An initialpublic offering, or IPO, is an example of a security issued on a primary market. An IPO

occurs when a private company sells shares of stock to the public for the first time, a process known
as "going public." The process, including the original price of the new shares, is set by a designated
investment bank, hired by the company to do the initial underwriting for a particular stock. 
 For example, company ABCWXYZ Inc. hires five underwriting firms to determine the financial
details of its IPO. The underwriters’ detail that the issue price of the stock will be $15. Investors can
then buy the IPO at this price directly from the issuing company. This is the first opportunity that
investors have to contribute capital to a company through the purchase of its stock. A company's
equity capital is comprised of the funds generated by the sale of stock on the primary market.
 A rights offering (issue) permits companies to raise additional equity through the primary market
after already having securities enter the secondary market. Current investors are offered prorated
rights based on the shares they currently own, and others can invest anew in newly minted shares.
Private Placement and Primary Market

 Other types of primary market offerings for stocks include private placement and preferential allotment.
Private placement allows companies to sell directly to more significant investors such as hedge funds
and banks without making shares publicly available. Preferential allotment offers shares to select
investors (usually hedge funds, banks, and mutual funds) at a special price not available to the general
public.

 Similarly, businesses and governments that want to generate debt capital can choose to issue new short-
and long-term bonds on the primary market. New bonds are issued with coupon rates that correspond to
the current interest rates at the time of issuance, which may be higher or lower than those offered by pre-
existing bonds.
Primary Market vs. Secondary Market
The primary market refers to the market where securities are created and first issued, while the secondary market is one

in which they are traded afterward among investors.
Primary Market
 Take, for example, U.S. Treasuries—the bonds, bills, and notes issued by the U.S. government. The Dept. of the Treasury
announces new issues of these debt securities at periodic intervals and sells them at auctions, which are held multiple
times throughout the year. This is an example of the primary market in action.
Secondary Market
 Now, let's say some of the investors who bought some of the government's bonds or bills at these auctions—they're
usually institutional investors, like brokerages, banks, pension funds, or investment funds—want to sell them. They offer
them on stock exchanges or markets like the NYSE, Nasdaq, or over-the-counter (OTC), where other investors can buy
them. These U.S. Treasuries are now on the secondary market.
 With equities, the distinction between primary and secondary markets can seem a little cloudier. Essentially, the
secondary market is what's commonly referred to as "the stock market," the stock exchanges where investors buy and sell
shares from one another. But in fact, a stock exchange can be the site of both a primary and secondary market.
 For example, when a company makes its public debut on the New York Stock Exchange (NYSE), the first offering of its
new shares constitutes a primary market. The shares that trade afterward, with their prices daily listed on the NYSE, are
part of the secondary market.
Types of Secondary Markets

Secondary markets are further divided into two types:

 An auction market, an open outcry system where buyers and sellers congregate in one location and
announce the prices at which they are willing to buy and sell their securities

 A dealer market, in which participants in the market are joined through electronic networks. The
dealers hold an inventory of security, then stand ready to buy or sell with market participants.

 The key distinction between primary and secondary markets: the seller or source of the securities. In a
primary market, it's the issuer of the shares or bonds or whatever the asset is. In a secondary market,
it's another investor or owner. When you buy a security on the primary market, you're buying a new
issue directly from the issuer, and it's a one-time transaction. When you buy a security on the
secondary market, the original issuer of that security—be it a company or a government—doesn't take
any part and doesn't share in the proceeds.

 In short, securities are bought on the primary market. They trade on the secondary market.
What Are the Types of Primary Markets?

 There's a primary market for just about every sort of financial asset out there. The biggest ones are
the primary stock market, the primary bond market, and the primary mortgage market.

 The most common type of primary market issues include:

 Initial public offering (IPO): when a company issue shares of stock to the public for the first time

 Rights issue/offering: an offer to the company’s current stockholders to buy additional new shares
at a discount.

 Private placement: an issue of company stock shares to an individual person, corporate entity, or a
small group of investors—usually institutional or accredited ones—as opposed to being issued in
the public marketplace.

 Preferential allotment: shares offered to a particular group at a special or discounted price, different
from the publicly traded share price
Common Stocks (Ordinary Stock/Equity Stock)

 Common stock, also known as ordinary shares or common shares, is a security that reflects the
investor’s ownership of a company. Holding this stock offers investors the power to elect the
company’s board of directors and have voting rights. These voting rights allow you to be a part
of the company’s internal decision-making and vote to plan for various corporate policies.
 Common stocks have the potential to realise better returns in the long term at a high rate. Also,
common shareholders are compensated with dividend income, which is paid after distributing
the accrued profits to preference shareholders. Furthermore, in the event of liquidation, the
common shareholders have the rights to company assets only after the company repays the
preference shareholders, bondholders, creditors and other debtors in full. 
 These shares are issued in the market through Initial Public Offering (IPO). In the company’s
balance sheet, the common socks are reported under the equity section. It can be expressed as – 
Number of outstanding shares = Total number of issued shares – Total treasury stocks.
What are the Features of Common Stocks?

 The following are the features of common stocks – 

 Ownership – Common stocks reflect the investor’s ownership of a company to the proportion of shares
held. For instance, if you hold 2000 common shares in a company, you are the company’s owner in the same
proportion of its percentage value. 
 Rights – These stocks offer certain rights/power to their shareholders. They are entitled to voting rights such
as electing the board of directors and voting for internal policy matters. Also, shareholders are entitled to
receive dividends, receive assets in the event of liquidation and pre-emptive rights. 
 Transaction – These stocks can be bought and sold like any other stocks listed on the stock exchange. You
will require a defat and trading account to buy and sell equity shares. 
 Stock Exchange – Like any other shares, these stocks are listed on the National Stock Exchange (NSE) and
Bombay Stock Exchange (BSE). 
 Repayment – Common stockholders are paid at the time of company liquidation but after paying the
preference shareholders, bondholders and other debt holders. 
Why do Companies Issue Common Stocks?
 

 Theprimary reason why companies issue common stocks is to raise capital. The following are the ways the
company uses the raised capital – 
 Business Expansion – Companies want to increase their goodwill and profits by expanding their business
further. Therefore, companies issue common stocks to raise funds, allowing them to capture the market share
and use this money to achieve their expansion plans. 
 Acquisition – This is one of the best ways for a company to expand by acquiring a competitor or a promising
company within the same sector. However, acquisitions can be expensive, and companies require additional
funds to purchase. Thus, they issue common shares. 
 Paying Outstanding Debts – Most companies borrow money to fund their initial stages of business
operations. After stabilising their business activities, companies use revenues to clear off the outstanding debt.
Sometimes, companies may issue common stocks to raise money and clear their debts in one go. 
 Creating Cash Reserve – As individuals save for an emergency, companies also make a cash reserve for
emergency requirements. Usually, companies create this reserve from their profits. But sometimes, they can
issue these stocks and use the funds to make a cash reserve for future requirements. 
Advantages of Investing in Common Stocks

 The following are the advantages of investing in common stocks –

 Returns – In comparison to bonds, deposit certificates, etc., common stocks have the potential to perform better.
Also, there is no upper limit where investors can benefit from their investment in these stocks. Moreover, these stocks
are less expensive and more feasible alternatives to debt instruments. This is because companies do not have to pay
interest to investors and choose to reward them in case of excess profits. 
 Voting Rights – Being a common stockholder gives you the right to vote and be a part of the company’s decision-
making process. For instance, investors can vote to elect the company’s director or may decide on the company’s
strategic policies. Moreover, investors with substantial common stocks can make the most of such power.  
 Limited Legal Liability – Beyond the events that occur within the company, the obligations of common shareholders
still exist, and they need to be concerned with all legal liabilities. If the company grows and generates good profits,
shareholders are entitled to receive dividends. However, if the company is making losses or decides to liquidate, it
cannot be held liable. 
 Liquidity – These stocks are very liquid, and investors can efficiently buy and sell anytime. Investors can buy more
shares and increase the shareholding in a company. Similarly, they can immediately sell all the shares if the
investment is not profitable enough. Therefore, it offers flexibility to do with their investments without any hassle.  
Disadvantages of Investing in Common Stocks

The following are the disadvantages of investing in common stocks – 

 Market Risk – The major disadvantage of these stocks is a market risk where companies can underperform
over a period. Due to market volatility, stock prices tend to fluctuate. This leads to a change in company
valuation, which makes the performance evaluation process quite challenging. Moreover, in case of
bankruptcy, the shareholders are more exposed to losing their investments. 

 Lack of Control – The common shareholder’s profitability largely depends on the business strategies and
associated policies. This makes the investors have no control over it. Also, investors do not have the right to
participate in all decision-making sessions or scrutinise the company’s account books or business plans.
This limits their power in the company. 

 Uncertainty of Profits – The market conditions affect the business revenue generation, and income is not
fixed. There is no guarantee when it comes to generating profits for the company. Therefore, investors
looking for common stocks with growth potential can be a drawback when the company is not able to
generate consistent profits. 
Common Stocks vs Preferred Stocks
Basis of Difference Common Stocks Preference Stocks
Potential High potential for capital appreciation. Potential is limited for capital appreciation. 

Risk Value may fall to zero. Less likely for the value to fall to zero. 

Volatility High Low 

Suitable For investors seeking long term growth For investors seeking high dividends.
through capital appreciation.

Voting Rights Yes No 

Payments During Liquidation Paid last (after debt and preference Paid before common stock holders.
stockholders)

Redemption Not subject to redemption. Redeemable at fixed prices.

 Common stocks can be an effective way of investing in equity markets and realise good returns on
investment. However, there are other investment avenues where you can invest based on your
investment horizon and risk levels. For instance, mutual funds can provide good diversification.
Mutual funds invest in multiple stocks, and professionals manage them. Therefore, this can
eliminate the risk of exposure to one stock. However, this also does not guarantee returns.