Chapter Eight

Stock Markets

Financial Markets and Institutions

Javed Anwar

International Institute of Islamic Economics

International Islamic University, Islamabad

8-1
 Chapter Navigator
•• What
What are are the
the major
major characteristics
characteristics of of common
common
stock?
stock?
•• What
What areare the
the major
major characteristics
characteristics of of preferred
preferred
stock?
stock?
•• What
What isis the
the process
process byby which
which common
common stock
stock isis
issued
issued in
in primary
primary markets?
markets?
•• What
What areare the
the major
majorsecondary
secondarystock
stock markets?
markets?
•• What
What isis the
the process
process byby which
which aa trade
trade takes
takes place
place in
in
the
the stock
stock markets?
markets?
•• What
What areare the
the major
majorstock
stock market
market indexes?
indexes?
•• Who
Who areare the
the major
major stock
stock market
market participants?
participants?
•• What
What areare the
the three
three forms
forms of
of market
market efficiency?
efficiency?
8-2
 Stock Markets Overview
•• Stock
Stock markets
markets allow allow suppliers
suppliers of of funds
funds toto
efficiently
efficiently and and cheaply
cheaply get get equity
equity funds
funds toto
public
public corporations
corporations (users(users of
of funds).
funds).
•• In
In exchange,
exchange, the the fund
fund users
users (firms)
(firms) give
give the
the fund
fund
suppliers
suppliers ownership
ownership rightsrights in
in the
the firm
firm as
as well
well as
as
cash
cash flows
flows in in the
the form
form of
of dividends.
dividends.
•• Thus,
Thus, corporate
corporate stock stock oror equity
equity serves
serves asas aa
source
source ofof financing
financing for for firms,
firms, in
in addition
addition to
to debt
debt
financing
financing or or retained
retained earnings
earnings financing.
financing.

8-3
 Stock Markets Overview

•• Stockholders
Stockholders are
are the
the legal
legal owners
owners of
of aa corporation
corporation
–– they
theyhave
haveaaresidual
residualclaim
claimto toall
allearnings
earningsand
andassets
assetsafter
afterdebt
debt
and
andtax
taxclaims
claimsare
aresatisfied
satisfied
–– voting
votingrights
rights(e.g.,
(e.g.,to
toelect
electboard
boardofofdirectors)
directors)
–– while
while stockholders
stockholders havehave nono direct
direct control
control over
over aa firm's
firm's day-
day-
to-day
to-day operations,
operations, they
they dodo decide
decide on
on who
who will
will oversee
oversee these
these
operations
operations andand they
they can
can replace
replace the
the board
board when
when they
they feel
feel the
the
firm
firm isis not
not being
being run
run efficiently
efficiently from
from aa value-maximizing
value-maximizing
perspective.
perspective.
–– The
The secondary
secondary market
market forfor corporate
corporate stock
stock isis the
the most
most closely
closely
watched
watchedand andreported
reportedof ofall
allfinancial
financialsecurity
securitymarkets.
markets.

8-4
 Market Value of Common Stock
Outstanding, by Type of Issuer ($Bn)
14000
14000
12000
12000
10000
10000
8000
8000
6000
6000
4000
4000
2000
2000
00
1994
1994 1997
1997 2000
2000 2001
2001
Nonfinancial
Nonfinancialcorp.
corp.bus
bus Financial
Financialcorp
corp Rest
Restof
ofworld
world

8-5
 Primary and Secondary Markets
Overview
•• Primary
Primary Market
Market
–– firm
firm can
can raise
raise equity
equity capital
capital in
in its
its initial
initial public
public
offering
offering (IPO)
(IPO)
–– firm
firm can
can raise
raise equity
equity capital
capital in
in aa subsequent
subsequent
seasoned
seasoned equity
equity offering
offering (SEO)
(SEO)
•• Secondary
Secondary Markets
Markets
–– trading
trading of
of shares
shares among
among investors
investors

8-6
 Stock Market Securities

•• Two
Two types
types of
of corporate
corporate stock
stock exist
exist
––Common
Common stock
stock
•• the
the fundamental
fundamental ownership
ownership claim
claim in
in aa public
public
corporation
corporation
––Preferred
Preferred stock
stock
•• aa hybrid
hybrid security
security that
that has
has characteristics
characteristics of
of both
both
bonds
bonds and
and common
common stock
stock

8-7
Calculating Stock Returns

8-8
Calculating Stock Returns

8-9
 New Securities Issued ($Bn)

180
180
160
160
140
140
120
120
100
100
80
80
60
60
40
40
20
20
00
1992
1992 1995
1995 1998
1998 2000
2000 2001
2001
Preferred
Preferred Common
Common
8-10
 Characteristics of Common Stock
•• Common
Common stockstock isis the
the fundamental
fundamental ownership
ownership claim
claim in
in
aa public
public corporation.
corporation. There
There are
are many
many characteristics
characteristics of
of
common
common stock
stock that
that differentiate
differentiate itit from
from other
other types
types of
of
financial
financial securities
securities (e.g.,
(e.g., bonds,
bonds, mortgages,
mortgages, preferred
preferred
stock).
stock).
•• These
These include
include
(1)
(1)discretionary
discretionarydividend
dividendpayments,
payments,
(2)
(2)residual
residualclaim
claimstatus,
status,
(3)
(3)limited
limitedliability,
liability,
(4)
(4)voting
votingrights.
rights.

8-11
 Characteristics of Common Stock
•• Dividends
Dividends
–– payment
paymentand andsize
sizeofofdividends
dividendsisisdetermined
determinedby bythe
theboard
boardof ofdirectors
directorsofof
the
theissuing
issuingfirm
firm
–– Further,
Further,unlike
unlikeinterest
interestpayments
paymentson ondebt,
debt,aacorporation
corporationdoes
doesnotnotdefault
defaultifif
ititmisses
missesaadividend
dividendpay­ mment
pay­ enttotocommon
commonstockholders.
stockholders.
–– common
common stockstock dividends,
dividends, from
from anan investor's
investor's viewpoint,
viewpoint, isis that
that they
they are
are
taxed
taxedtwice—once
twice—onceatatthe thefirm
firmlevel
level(at
(atthe
thecorporate
corporatetaxtaxrate,
rate,bybyvirtue
virtueof
of
the
the fact
fact that
that dividend
dividend payments
payments are are not
not tax
tax deductible
deductible from
from the
the firm's
firm's
profits
profits or
or net
net earnings)
earnings) andand once
once atat the
the personal
personal level
level (at
(at the
the personal
personal
income
incometaxtaxrate).
rate).
•• Residual
ResidualClaimClaim
–– ininthe
theevent
eventof ofliquidation,
liquidation,common
commonstockholders
stockholdershave havethe
thelowest
lowestpriority
priority
ininterms
termsof ofany
anycash
cashdistribution
distribution
•• Limited
LimitedLiability
Liability
–– common
common stockholders
stockholders losses
losses are
are limited
limited toto the
the amount
amount of of their
their original
original
investment
investmentininthethefirm
firm
•• Voting
VotingRights
Rights
8-12
Characteristics of Common Stock

8-13
 Characteristics of Preferred Stock
•• Preferred
Preferredstock
stockisisaahybrid
hybridsecurity
securitythat
thathashascharacteristics
characteristicsofofboth
both
aabond
bondand
andaacommon
commonstock.stock.
•• Similar
Similar toto common
common stock stock inin that
that itit represents
represents an an ownership
ownership
interest
interestbut,
but,like
likebonds,
bonds,pays
paysaafixed
fixedperiodic
periodicdividend
dividend
•• Senior
Seniortotocommon
commonstock stockbutbutjunior
juniorto tobonds
bonds
•• Generally
Generallydo donot
nothave
havevoting
votingrights
rights
•• Nonparticipating
Nonparticipatingpreferred
preferredstock
stock
–– dividend
dividend isis fixed
fixed regardless
regardless ofof any
any increase
increase oror decrease
decrease in
in the
the
firm’s
firm’svalue
value
•• Cumulative
Cumulativepreferred
preferredstockstock
–– missed
missed dividend
dividend payments
payments go go into
into arrears
arrears and
and must
must be
be made
made
up
upbefore
beforecommon
commonstock stockdividends
dividendscan canbebepaid
paid

8-14
Issuance of Stock in the Primary Market

Stocks
Stocks Stocks
Stocks
Issuing
Issuing Investment
Investment Investors
Investors
Corporation
Corporation Bank
Bank
Funds
Funds Funds
Funds

Investment
Investment bank
bank conducts
conducts primary
primary market
market sale
sale of
of stock
stock
using
using firm
firmcommitment
commitment underwriting
underwriting (guarantees
(guarantees
corporation
corporation aa fixed
fixed price
pricefor
for newly
newly issued
issued securities)
securities) or
or
best
best efforts
efforts underwriting
underwriting (no(no guarantee
guarantee to
to issuer
issuer and
and
acts
acts more
more as
as aa placing
placing or
or distribution
distribution agent)
agent)
(continued)
8-15
•• Net
Net proceeds
proceeds -- the the guaranteed
guaranteed priceprice atat which
which thethe
investment
investment bank
bank purchases
purchasesthe thestock
stock from
fromthe
theissuer
issuer
•• Gross
Gross proceeds
proceeds -- the the price
price atat which
which thethe investment
investment
bank
bank resells
resells the
the stock
stock to
to investors
investors
•• Underwriters’
Underwriters’ spread spread -- the the difference
difference between
between thethe
gross
gross proceeds
proceeds and
and the
thenet
net proceeds
proceeds
•• Syndicate
Syndicate -- the the process
process of of distributing
distributing securities
securities
through
through aa group
group of of investment
investment banks
banks
•• Originating
Originating househouse –– thethe lead
lead bank
bank inin the
the syndicate
syndicate
negotiates
negotiates with
with the
the issuer
issueron on the
the syndicate’s
syndicate’s behalf
behalf
•• Red
Red herring
herring proxy
proxy -- aa preliminary
preliminary version
version ofof the
the
prospectus
prospectus describing
describing aa newnew security
security

8-16
8-17
 Secondary Markets:
Major U.S. Stock Exchanges
•• New
New York
York Stock
Stock Exchange
Exchange (NYSE)
(NYSE)
–– buyers
buyersand
andsellers
sellersmeet
meetatatthe
thetrading
tradingpost
postto
tonegotiate
negotiate
–– specialist
specialistacts
actsas
asaadealer
dealer(market
(marketmaker),
maker),as
asnecessary
necessary
•• American
American Stock
Stock Exchange
Exchange (AMEX)
(AMEX)
–– trading
tradingsystem
systemsame
sameas
asNYSE
NYSE
•• National
National Association
Association of
of Securities
Securities Dealers
Dealers
Automated
Automated Quotation
Quotation System
System (NASDAQ)
(NASDAQ)
–– multiple
multipledealers
dealers(market
(marketmakers)
makers)compete
competeforfortransactions
transactionsin
in
aagiven
givenstock
stock
–– each
eachdealer/market
dealer/marketmaker
makerposts
postsaabid
bidand
andoffer
offerprice
priceon
onthe
the
system’s
system’snetwork
network
8-18
Trading on NYSE and AMEX

8-19
 Trading on NYSE and AMEX

Order
Order Order
Order Order
Order
Investor
Investor Shares
Shares
Broker
Broker Shares
Shares
Comm
Comm Shares
Shares
Market
Market
or
or Maker
Makeroror
Cash
Cash Cash
Cash Floor
Floor
Cash
Cash Other
OtherFloor
Floor
Broker
Broker Broker
Broker

8-20
 Two Common Types of Orders

•• Market
Market order
order
–– an
an order
order for
for the
the broker
broker and
and market
market specialist
specialist to
to
transact
transact at
at the
the best
best price
price available
available when
when the
the order
order
reaches
reaches the
the post
post
•• Limit
Limit order
order
–– an
an order
order to
to transact
transact at
at aa specified
specified price
price (the
(the limit
limit
price)
price)

8-21
 Stock Market Indexes

•• The
The Dow
Dow Jones
Jones Industrial
Industrial Average
Average (the
(the DJIA)
DJIA)
–– aaprice-weighted
price-weightedindex
indexofofthe
thevalues
valuesof
of30
30large
large(in
(interms
termsof
of
sales
salesand
andtotal
totalassets)
assets)corporations
corporations
•• The
The NYSE
NYSEComposite
Composite index
index
–– aavalue-weighted
value-weightedindex
indexof
ofall
allcommon
commonstocks
stockslisted
listedon
onNYSE
NYSE
•• the
the Standard
Standard &
& Poor’s
Poor’s 500
500 index
index
–– aavalue-weighted
value-weightedindex
indexofofthe
thestocks
stocksof
of500
500of
ofthe
thelargest
largest
U.S.
U.S.corporations
corporationslisted
listedon
onthe
theNYSE
NYSEandandNASDAQ
NASDAQ
•• The
The NASDAQ
NASDAQComposite
Composite index
index
–– aavalue-weighted
value-weightedindex
indexofofthree
threecategories
categoriesof
ofNASDAQ
NASDAQ
companies:
companies:industrials,
industrials,banks,
banks,and
andinsurance
insurancecompanies
companies
8-22
 Stock Market Participants
Holders
Holdersof
ofCorporate
CorporateStock
Stock(in
(inbillions
billionsof
ofdollars)
dollars)
%
%of
of
1994
1994 1997
1997 2001
2001 Total
Total

Household
Householdsector
sector $3,070.9
$3,070.9 $5,689.6
$5,689.6 $5,832.2
$5,832.2 38.4
38.4
State
Stateand
andlocal
localgov.
gov. 10.6
10.6 79.0
79.0 126.3
126.3 0.8
0.8
Rest
Restofofworld
world 397.7
397.7 919.5
919.5 1,692.8
1,692.8 11.2
11.2
Depository
Depositoryinst.
inst. 180.6
180.6 331.4
331.4 261.0
261.0 1.7
1.7
Life
Lifeins.
ins.co.
co. 246.1
246.1 558.6
558.6 935.2
935.2 6.2
6.2
Other
Otherins.
ins.co.
co. 112.1
112.1 186.0
186.0 185.2
185.2 1.2
1.2
Private
Privatepension
pensionfunds
funds 996.3
996.3 1,863.9
1,863.9 1,902.3
1,902.3 12.5
12.5
Public
Publicpension
pensionfunds
funds 557.4
557.4 1,431.7
1,431.7 1,215.7
1,215.7 8.0
8.0
Mutual
Mutualfunds
funds 709.6
709.6 2,018.7
2,018.7 2,919.8
2,919.8 19.2
19.2
Closed-end
Closed-endfundsfunds 31.9
31.9 50.2
50.2 31.9
31.9 0.12
0.12
Brokers
Brokersand anddealers
dealers 20.1
20.1 51.9
51.9 82.8
82.8 0.16
0.16
8-23
Other Issues Pertaining to Stock Markets

•• Does
Does the
the stock
stock market
market forecast
forecast the
the economy?
economy?
–– Some
Some evidence
evidence suggests
suggests that
that the
the stock
stock market
market forecasts
forecasts the
the
economy
economybut
butevidence
evidenceisisnot
notreliable
reliable
•• Market
Market efficiency
efficiency
–– the
the speed
speed with
with which
which financial
financial security
security prices
prices adjust
adjust to
to
unexpected
unexpected news
news pertaining
pertaining to to interest
interest rates
rates or
or aa stock-
stock-
specific
specificcharacteristics,
characteristics,etc.
etc.
–– Forms
Formsofofmarket
marketefficiency
efficiency
•• Weak
WeakForm
FormMarket
MarketEfficiency
Efficiency
•• Semistrong
Semistrong Form
Form Market
Market Efficiency
Efficiency Semistrong
Semistrong Form
Form Market
Market
Efficiency
Efficiency
•• Strong
StrongForm
FormMarket
MarketEfficiency
Efficiency

8-24
Other Issues Pertaining to Stock Markets
•• Weak
WeakForm
FormMarket
MarketEfficiency
Efficiency
–– According
According toto the the weak
weak form
form ofof market
market efficiency,
efficiency, current
current stock
stock prices
prices
reflect
reflect all
all historic
historic public
public information
information about
about aa company.
company. OldOld news
news and
and
trends
trends are already impounded in historic prices and are of no use inin
are already impounded in historic prices and are of no use
predicting
predicting to­ dday's
to­ ay's or
or future
future stock
stock prices.
prices. Thus,
Thus, weak
weak form
form market
market
efficiency
efficiency concludes that in­vestors cannot make more than the fair
concludes that in­
v estors cannot make more than the fair
(required)
(required)return
returnusing
usinginformation
informationbased
basedon
onhistoric
historicprice
pricemovements.
movements.
•• Semi-Strong
Semi-StrongForm
FormMarket
MarketEfficiency
Efficiency
–– The
The semi-strong
semi-strong form
form market
market efficiency
efficiency hy­ppothesis
hy­ othesis focuses
focuses on
on the
the speed
speed
with which public information is impounded into stock prices. According
with which public information is impounded into stock prices. According
toto the
the concept
concept ofof semi-strong
semi-strong form
form market
market efficiency,
efficiency, as
as public
public in­
in­
formation arrives about a company, it is immediately impounded
formation arrives about a company, it is immediately impounded into its into its
stock
stockprice.
price.
•• Strong
StrongForm
FormMarket
MarketEfficiency
Efficiency
–– The
Thestrong
strongform
form of
ofmarket
marketefficiency
efficiencystates
statesthat
thatstock
stockprices
pricesfully
fullyreflect
reflect
all
all information about the firm, both public and private. Thus, accordingtoto
information about the firm, both public and private. Thus, according
strong
strongform
formmarket
marketefficiency,
efficiency,even
evenlearning
learninginside
insideinformation
informationabout
aboutthe
the
firm is of no help in earning more than the required rate of return.
firm is of no help in earning more than the required rate of return.

8-25
 Stock Market Regulation

•• Stock
Stock markets
markets and and participants
participants are are subject
subject to to
regulations
regulations imposed
imposed by by the
the Securities
Securities and
and Exchange
Exchange
Commission
Commission (SEC)(SEC)
•• Main
Main emphasis
emphasis of of SEC
SEC regulation
regulation isis onon full
full and
and fair
fair
disclosure
disclosure of
of information
information on on securities
securities
•• Securities
Securities Act
Act ofof 1933/Securities
1933/Securities Exchange
Exchange Act Act of
of 1934
1934
•• Delegates
Delegates certain
certain regulatory
regulatory responsibilities
responsibilities to to the
the
markets
markets for
for the
the day-to-day
day-to-day surveillance
surveillance of of activity
activity
•• Recently
Recently imposed
imposed regulations
regulations onon financial
financial markets
markets
intended
intended to
to reduce
reduce excessive
excessive price
price fluctuations
fluctuations
8-26
 International Aspects of Stock Markets

•• European
European markets
markets becoming
becoming an an increasing
increasing force
force
with
with introduction
introduction of of aa common
common currency,
currency, thethe
Euro
Euro
•• International
International stock
stock markets
markets allow
allow investors
investors toto
diversify
diversify by by holding
holding stocks
stocks issued
issued by by
corporations
corporations in in foreign
foreign countries
countries
•• Increased
Increased risk
risk due
due toto less
less complete
complete information
information
about
about foreign
foreign stocks,
stocks, foreign
foreign exchange
exchange risk,
risk, and
and
political
political risk
risk
8-27