Chapter Eight

Stock Markets

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The Stock Markets: Chapter
Overview
 Corporate stock serves as a source of financing for
firms, in addition to debt financing or retained
earnings financing
 Secondary stock markets are the most closely
watched and reported of all financial security markets
 Stockholders are the legal owners of a corporation
 Have a right to share in the firm’s profits (through
dividends) after the payment of interest to bond holders
and taxes
 Have a residual claim on the firm’s assets
 Have limited liability
 Have voting rights (e.g., to elect board of directors)
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Market Value of Common Stock
Outstanding, by Type of Issuer

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 Stock Market Securities:
Common Stock
 Two types of corporate stock exist:
1. Common stock
2. Preferred stock
 All public corporations issue common stock, but few issue
preferred stock
 Common stock is the fundamental ownership claim in a
public or private corporation, and many characteristics
differentiate it from other types of securities:
 Discretionary dividend payments
 Residual claim status
 Limited liability
 Voting rights
© 2022 McGraw-Hill Education. 8-4
Common Stock: Dividends

 Dividends are discretionary, and are thus not

guaranteed
 Payment and size of dividends are determined by the
board of directors of the issuing firm
 Dividends are taxed twice – once at the firm level and
once at the personal level
 May partially avoid this double taxation effect by holding
stocks in growth firms that reinvest most of their earnings
to finance growth rather than paying larger dividends

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Common Stock: Dividends
(Continued)
 The return to a stockholder over a period t-1:

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Common Stock: Residual Claim

 Common stockholders have the lowest priority claim

in the event of bankruptcy (i.e., they have a residual
claim)
 Only after all senior claims are paid are common
stockholders entitled to what assets of the firm are left
 Senior claims may be payments owed to creditors such as
the firm’s employees, bond holders, the government (taxes),
and preferred stockholders
 Residual claim feature associated with common stock
makes it riskier than bonds as an investible asset

© 2022 McGraw-Hill Education. 8-7

Common Stock: Limited Liability

 Limited liability implies that common stockholder

losses are limited to the amount of their original
investment in the firm if the company’s asset value
falls to less than the value of the debt it owes
 In contrast, sole proprietorship or partnership stock interests
mean the stockholders may be liable for the firm’s debts out
of their total private wealth holdings if the company
experiences financial difficulties

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Common Stock: Voting Rights

 Common stockholders control the firm’s activities

indirectly by exercising their voting rights in the
election of the board of directors
 Typical voting rights arrangement is to assign one
vote per share of common stock
 Some firms are organized as dual-class firms, where
two classes of common stock are outstanding, with
different voting and/or dividend rights for each class
 Two methods of electing a board are generally used:
1. Cumulative voting
2. Straight voting

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Common Stock: Proxy Votes

 Most shareholders do not attend annual meetings

 A proxy is a voting ballot sent by a corporation to its
stockholders
 When returned to the issuing firm, a proxy allows
stockholders to vote by absentee ballot or authorizes
representatives of the stockholders to vote on their behalf
 By the 2010s, virtually all U.S. firms were putting
proxy statements online and allowing votes to be cast
via the Internet

© 2022 McGraw-Hill Education. 8-10

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
 Dividends are generally fixed (paid quarterly)
 Preferred stockholders generally do not have voting
rights in the firm, but most stock may be converted to
common stock at any time the investor chooses

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Preferred Stock (Continued)

 Typically, preferred stock is nonparticipating and

cumulative
 Nonparticipating preferred stock means the dividend is
fixed regardless of any increase of decrease in the issuing
firm’s profits, while participating preferred stock means
actual dividends paid in any year may be greater than
promised dividends
 Cumulative preferred stock means that any missed
dividend payments go into arrears and must be made up
before any common stock dividends can be paid, while
dividends of noncumulative preferred stocks do not go
into arrears and are never paid

© 2022 McGraw-Hill Education. 8-12

 Primary Stock Markets

 Primary stock markets are markets in which corporations

raise funds through new issues of stocks
 Most primary market transactions go through investment banks
 Investment bank can conduct a primary sale using either a
firm commitment or best efforts underwriting basis
 In firm commitment underwriting, the investment bank
guarantees the corporation a price for the newly issued
securities
 Best efforts underwriting occurs when the underwriter does not
guarantee a price to the issuer
 A syndicate is a group of investment banks working in
concert to sell and distribute a new issue; the lead banks
in the syndicate is the originating house
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Primary Market Stock Transaction

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Primary Stock Markets
(Continued)
 An initial public offering (IPO) is the first public
issue of a financial instrument by a firm
 A seasoned offering is the sale of additional
securities by a firm whose securities are currently
publicly traded
 Preemptive rights give existing stockholders the ability to
maintain their proportional ownership
 Registration of a stock can be a lengthy process
 A red herring prospectus is a preliminary version of the
prospectus that describes a new security issue
 Shelf registration allows firms that plan to offer multiple
issues of stock over a two-year period to submit one
registration statement (i.e., master registration statement)

© 2022 McGraw-Hill Education. 8-15

Getting Shares of Stock to the
Investing Public

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Getting Shelf Registrations to the
Investing Public

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Secondary Stock Markets:
Stock Exchanges
 Secondary stock markets are the markets in which
stocks, once issued, are traded by investors
 In secondary market transactions, funds are exchanged,
usually with the help of a securities broker or firm acting as
an intermediary between the buyer and seller of the stock
 Original issuer of the stock is not involved in this transfer
of stocks or funds
 Two major U.S. stock markets are the following:
1. New York Stock Exchange Euronext (NYSE Euronext)
2. National Association of Securities Dealers Automated
Quotation (NASDAQ) system

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Secondary Stock Markets:
The New York Stock Exchange
 Worldwide, the NYSE Euronext is the most well
known of all the organized exchanges
 Exchange was created by the merger of the NYSE Group,
Inc. and Euronext N.V. on April 4, 2007
 World leader for listings, trading in cash equities, equity
and interest rate derivatives, bonds, and the distribution of
market data
 First to create a truly global stock market

© 2022 McGraw-Hill Education. 8-19

 Trading Process

 All transactions occurring on the NYSE occur at a specific

place on the floor of the exchange (trading post), and
each stock is assigned a special market maker (a
specialist)
 Specialists often organize themselves as firms due to large
amount of capital needed to serve the market-making function
 Three types of transactions can occur at a given post:
1. Brokers trade on behalf of customers at the “market” price
(market order)
2. Limit orders are left with a specialist to be executed
3. Specialists transaction for their own account

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 Trading Process (Continued)

 Majority of orders sent to brokers are of two types:

 A market order is an order to transact at the best price available
when the order reaches the post
 A limit order is an order to transact at a specified price

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 Program Trading

 Program trading is the simultaneous buying and selling of

a portfolio of at least 15 different stocks valued at more
than $1m, using computer programs to initiate the trades
 Criticized for impact on stock market prices and increased
volatility
 NYSE introduced circuit breakers, which served as trading
curbs, to account for increased volatility
 Circuit breakers are an imposed halt in trading that gives buyers
and sellers time to assimilate incoming information
 Limit up-limit down (LULD) rules halts trading on individual stocks
if the stock price moves outside the following price band:

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Circuit-Breaker Levels

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 Controversial Trading Practices

 Flash trading is a practice in which, for a fee, traders are

allowed to see incoming buy or sell orders milliseconds
earlier than general market traders
 Naked access allows some traders to rapidly buy and sell
stocks directly on exchanges using a broker’s computer
code without exchanges or regulators always knowing
who is making the trades
 SEC banned naked access trading in late 2010
 Dark pools of liquidity are trading networks that provide
liquidity but that do not display trades on order books
 In 2013, the SEC approved a plan for new rules requiring dark
pools to disclose and detail trading activity on their platforms
© 2022 McGraw-Hill Education. 8-24
U.S. Stock Gainers,
February 21, 2020

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 The NASDAQ and OTC Market

 Securities not sold on one of the organized exchanges

are traded over the counter (OTC)
 OTC markets do not have a physical trading floor; rather,
transactions are completed via an electronic market
 NASDAQ was the world’s first electronic stock market
 Primarily a dealer market, where dealers are the market
makers who stand ready to buy or sell particular securities
 In contrast to the NYSE, NASDAQ is a negotiated market (e.g.,
quotes from several dealers are usually obtained before a
transaction is made)
 Small Order Execution System (SOES) provides automatic
order execution for individual traders with orders of less than or
equal to 1,000 shares
© 2022 McGraw-Hill Education. 8-26
 The NASDAQ and OTC Market

 Securities not sold on one of the organized exchanges

are traded over the counter (OTC)
 OTC markets do not have a physical trading floor; rather,
transactions are completed via an electronic market
 NASDAQ was the world’s first electronic stock market
 Primarily a dealer market, where dealers are the market
makers who stand ready to buy or sell particular securities
 In contrast to the NYSE, NASDAQ is a negotiated market (e.g.,
quotes from several dealers are usually obtained before a
transaction is made)
 Small Order Execution System (SOES) provides automatic
order execution for individual traders with orders of less than or
equal to 1,000 shares
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 Choice of Market Listing

 Firms listed with the NYSE Euronext must meet the listing
requirements of the exchange
 Requirements are extensive
 Reasons a NYSE listing is attractive to a firm:
 Improved marketability of the firm’s stock
 Publicity for the firm
 Improved access to the financial markets
 Firms that do not meet the requirements of the NYSE
Euronext exchange listings trade on the NASDAQ
 Most NASDAQ firms are smaller, of regional interest, or unable to
meet the listing requirements of the organized exchanges
 Over time, many NASDAQ firms apply for NYSE listing
© 2022 McGraw-Hill Education. 8-28
 Electronic Communications
Networks and Online Trading
 Major stock markets currently open at 9:30 am eastern
time and close at 4:00 pm eastern time
 Extended-hours trading involves any securities transaction that
occurs outside these regular trading hours
 Most extended-hours trading is processed through computerized
alternative trading systems (ATSs), also known as electronic
communication networks (ECNs) such as NYSE Arca or Instinet
 ECNs are computerized systems that automatically match
orders between buyers and sellers and serve as an
alternative to traditional market making and floor trading

© 2022 McGraw-Hill Education. 8-29

 Stock Market Indexes

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

secondary market-traded stocks
 Dow Jones Industrial Average (DJIA) is the most widely reported
stock market index and includes the values of 30 large
corporations selected by the editors of The Wall Street Journal
 Dow indexes are price-weighted averages
 NYSE Composite Index includes all NYSE-listed common stocks
 NYSE is a value-weighted index
 S&P 500 Index consists of the stocks of the top 500 of the
largest U.S. corporations listed on the NYSE and the NASDAQ
 NASDAQ Composite Index consist of stocks traded through
NASDAQ that are industrials, banks, and insurance companies

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 Stock Market Indexes (Continued)

 Wilshire 5000 Index is the broadest stock market index and

possibly the most accurate reflection of the overall stock
markets
 Contains virtually every stock that meets three criteria:
1. Firm is headquartered in the U.S.
2. Stock is actively traded in a U.S.-based stock market
3. Stock has widely available price information (which rules out the
smaller OTC stocks from inclusion)
 Though the index started with 5,000 firms, because of firm
delistings, privatizations, and acquisitions it currently includes
just 3,618 stocks
 Value-weighted index

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 Market Participants

 Holders of corporate stock from 1994 through 2019:

 Households are the single largest holders (38% in 2019)
 Mutual funds and foreign investors are also prominent holders
(23.5% and 15.9%, respectively)
 Households indirectly invest in corporate stock through
investments in mutual funds and pension funds
 Together, these holdings totaled approximately 74% in 2019
 U.S. stock ownership rates are highly related to income,
but also vary by age
 On average, 62% of U.S. adults aged 30 to 64 own stocks,
compared with 31% of those aged 18 to 29 and 54% of those
aged 65 and older
© 2022 McGraw-Hill Education. 8-32
Other Issues Pertaining to Stock
Markets: 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

© 2022 McGraw-Hill Education. 8-33

 Other Issues Pertaining to Stock
Markets: Market Efficiency
 Market efficiency refers to the speed with which financial
security prices reflect unexpected news
 Weak form market efficiency concludes that investors cannot make
more than the fair (required) return using information based on
historic price movements
 Empirical research suggests markets are weak form efficient
 According to semistrong form market efficiency, investors cannot
make more than the fair (required) return by trading on public news
releases
 Financial markets have generally been found to immediately reflect
information from news announcements
 Strong form market efficiency states that stock prices fully reflect
all information about the firm, both public and private
 Implies that there is no set of information that allows investors to
make more than the fair (required) rate of return on a stock
© 2022 McGraw-Hill Education. 8-34
Other Issues Pertaining to Stock
Markets: Stock Market Regulations
 Main emphasis of SEC regulation is on full and fair
disclosure of information on securities issues
 Securities Act of 1933 required listed companies to file a
registration statement and to issue a prospectus
 Securities Exchange Act of 1934 established the SEC as
the main administrative agency responsible for the
oversight of secondary stock markets
 Sarbanes-Oxley Act, passed in July 2002, created an
independent auditing oversight board under the SEC,
increased penalties for corporate wrongdoers, forced
faster and more extensive financial disclosure, and
created avenues of recourse for aggrieved shareholders

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Other Issues Pertaining to Stock
Markets: Stock Market Regulations
(Continued)
 SEC has delegated certain regulatory responsibilities to
the markets (e.g., NYSE or NASDAQ)
 In these matters, the NYSE and NASDAQ are self-regulatory
organizations
 Financial Industry Regulatory Authority (FINRA) is the
largest independent regulatory for all securities firms
doing business in the U.S.
 Formed in July 2007
 Oversees all aspects of the securities business
 Wall Street Reform and Consumer Protection Act of 2010
gave the SEC and other regulators new powers to
oversee the operations of stock markets

© 2022 McGraw-Hill Education. 8-36

 International Aspects of Stock
Markets
 U.S. stock markets are the world’s largest
 European markets grew in importance during the 2000s, as a
result of implementing the euro, a common currency, in 2002
 International stock markets are attractive to investors
because some risk can be eliminated by holding stocks
issued by corporations in foreign countries
 International diversification can also introduce risk in the
following manners:
 Information about foreign stocks is less complete and timely than
that for U.S. stocks
 Foreign exchange risk
 Political (sovereign risk)
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Worldwide Stock Market Capitalization

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 American Depository Receipts
(ADRs)
 An ADR is a certificate that represents ownership of a
foreign stock
 Typically created by a U.S. bank, which buys stock in foreign
corporations in their domestic currencies and places them with a
custodian. The bank then issues dollar ADRs backed by the
shares of the foreign stock
 Three main types of ADR issuances
 Level 1 ADRs are the most common and most basic of the ADRs
 Have the least amount of regulatory requirements

 Level 2 ADRs can be listed on the major stock exchanges, but

they have more regulatory requirements than Level 1 ADRs
 Level 3 ADRs represent the most respected ADR level a foreign
company can achieve in the U.S. markets
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Impact of Change in Foreign
Currency Exchange Rates on
Index Returns

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