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Chapter 8 Summary - book "Financial Markets and

Institutions"

Fin Inst & Mkts (Clemson University)

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Chapter 8: Stock Markets

The Stock Markets: Chapter Overview and Intro

 Stock markets allow suppliers of funds to efficiently and cheaply get equity funds
to public corporations (users) and in exchange the fund users (firms) give the
fund suppliers ownership rights in the firm as well as cash flows in the form of
dividends
 Holders Privileges
o Holders of a corporations common stock or equity have ownership stake
in all issuing firm that reflects the percentage of the corporations stock
they hold
o Voting, election of board members
o No control over day to day
 Bond holders are creditors of the firm and have no direct ownership but have
claim to earnings
 Secondary market for corporate stock is the most closely watched and reposted
of all financial security markets
o Seen as predicator of economic activity
o Most people own corporate stock

Stock Market Securities

 Common Stock: the fundamental ownership claim in a public or private
corporation
o Discretionary dividends
 Dividends are determined by the board of directors
 No promise dividend payments, no legal recourse if dividends are
not paid
 Potential for no dividend if the firm performs poorly and large
divides if the firm does well
 Taxed twice- firm level (corporate tax) and personal level (income
tax)
o Residual Claim
 In the event of liquidation, common stockholders have the lowest
priority in terms of cash distribution
 The residual claim feature associated with common stock makes it
riskier than bonds as an investable asset
o Limited Liability
 No matter what financial difficulties the issuing corporation
encountered, neither it nor its creditors can seek repayment from
the firms common stockholders
 This implies that common stockholders’ losses are limited to the
original amount of their investment
o Voting Rights
 Common stockholders elect board of directors
 Board of directors hire and oversees senior managers (CEO)
 Senior managers perform day to day

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 Common stockholders also vote on major firm issues such as

mergers and acquisitions, audits, compensation plans
 Dual-class firms: two classes of common stock are outstanding,
with differential voting rights assigned to each class
 Ex: Facebook
 Cumulative Voting: all directors up for election are voted on at the
same time. The number of votes assigned toe ach stockholder
equals the number of shares held multiplied by the number of
directors to be elected
 Proxy votes: a voting ballot sent by a corporation to its
stockholders. When retuned to the issuing firm, a proxy allows
stockholders to vote by absentee
Trading
 Primary Markets: IPO
 Secondary Markets: the markets in which stocks one issues are traded- rebought
and resold
o Organized Exchanges
 NYSE
 NASDAQ
 Traded with help from security brokers
o Decentralized Exchanges
 Some stocks trade OTC
 Penny stocks (less than $5)
 Very small stocks, but larger number than in organized exchanges,
possibly 30,000 stocks
 Illiquid stocks, infrequent trading, subject to price manipulation
Stock Market Indexes
 Is the composite value of a group of secondary market-traded stocks
 Provide investors with information on movements of a broader range of
secondary market securities
 NYSE, Dow Jones, S&P 500

Efficient Markets Hypothesis

 The hypothesis that the process of securities fully reflect the availability
information about securities
 Eugene Fana
o History and logic behind the EMH- he found that random stock price
changes market is efficient
o Random stock price changes leader to the conclusion that the market is
efficient
 Market efficiency: the speed with which financial security prices adjust to
unexpected news pertaining to interest rates or a stock-specific characteristic
 How do we calculate stock prices? Discount cash flow

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 What changes stock prices?

o When an event occurs that unexpected changes interest or a characteristic
of a company, the current market price of a stock can change
o When market traders determine that a stock is undervalued, they will
purchase the stock and vice versa
o Return should reflect the risk your bear (CAPM)
 Weak form
o Current stock prices reflect all historic price and volume information
about a company
o Concludes that investors cannot make more than the fair (required) return
using information based on historic price movements
o Evidence suggests that successive price changes are generally random
o Correlation between stock prices day to day are virtually zero
 Semi-Strong form
o Focuses on the speed with which public information is impounded into
stock prices (past prices, financials, patents, earnings, brand image)
o As public information arrives, it is immediately impounded into stock
o Investors cannot make more than the fair return by trading on public news
releases
o Implies that investors can earn abnormal returns by trading on current
public news releases
o Evidence for stock price reaction to major firm events- death of CEO,
mergers
 Strong form
o Stock prices fully reflect all information about the firm, both private and
public
o Acting on private stock information- ex: MARTHA STEWART WENT TO
JAIL
o According to this theory, even acting on private information is no help in
earning more than the required rate of return
o Implies that private information can be used to produce abnormal returns,
but as soon as the private or inside information is publicly released,
abnormal returns are unobtainable
 Passive management strategies are better than active strategies
 Implications of EMH
o Returns: investors earn a fair return based on risk they bear (CAPM)
investing is not gambling
o Rewards: there are rewards for those who keep prices in line. Hard work,
time, effort, creativity
o Market prices: market prices are not “right” and “wrong”
 They are the best unbiased expectation of future cash flows
o Crashes: stock market crashed do not invalidate EMH
 Remember: we need lots of trading, few frictions for this hypothesis to work!!!

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Stock Market Indexes

Stock Price Shares

Outstanding
Tech A $498 1 billion
Tech B $44 10 billion
Tech C $37 1 billion

 Price Weighted Average

o Dow index’s are price-weighted averages, meaning that the stock prices of the
companies in the indexes are added together and divided by an adjusted value
(or divisor)

 Value Weighted Index

o NYSE, S&P 500, NASDQ
o The current market values of all stocks in the index re added together and
divided by their value on a base date
o Any changes in the stocks included in the index are incorporated b adjusting
the base value of the index
o Wilshire 5000 index
 Tracks the value of the entire stock
 Highly representative of overall market

 Equal Weighted Average

o Equal dollar amounts in each stock
o Problem: rebalance constantly

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Event Study
Estimate abnormal stock returns around events.
Step 1. Estimate β and α.
Step 2. Use actual stock market return to predict the expected return.
Step 3. Calculate abnormal return.

AirTran Merger: Cumulative Abnormal Return

S&P
Ticke Return 500 Bet Alpha Expecte Abnorma
Date Name
r % Retur a % d Return l Return
n%
AIRTRAN
2010092
AAI HOLDING 3.64% 2.12% 1.17 -0.1%
4
S
AIRTRAN
2010092 -
AAI HOLDING 61.32% 1.17 -0.1%
7 0.57%
S
AIRTRAN
2010092
AAI HOLDING -0.14% 0.49% 1.17 -0.1%
8
S
Three day cumulative return

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Long vs. Short Positions on Stocks

You can invest in two stocks: GM and Apple. Each stock trades for $100 today and you
trade 1,000 shares. In one year, Apple trades for $125 while GM trades for $75.
Calculate the returns to the following strategies.
1. Long position in Apple
2. Long position in GM
3. Short position in Apple
4. Short position in GM

Long Apple Long GM Short Apple Short GM

Stock Price Today $100 $100 $100 $100

Shares Traded Today 1,000 1,000 1,000 1,000

Cash Flow Today

Liabilities Today
(shares)

Stock Price One Year $125 $75 $125 $75

Shares Traded One Year 1,000 1,000 1,000 1,000

Cash Flow One Year

Liabilities Paid Off

Profit (dollars)

Fill in the matrix with the profit (in dollars) of each strategy

Apple GM
Stock Price Rises Stock Price Falls
Long Position

Short Position

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Practice Problem, Long vs. Short Positions on Stocks

You engage in a long-short strategy with Interpublic and Omnicom (rival advertising
groups). You go long 700 shares of Interpublic, currently trading at $45 per share. You
short 900 shares of Omnicom, currently trading at $35 per share. The price of
Interpublic rises to $48 per share. The price of Omnicom rises. What is the maximum
price of Omnicom stock that will allow your strategy to be profitable?

International Perspective
 Us is not the largest in banking, or debt (right behind the Euro)
 We are the largest in equity
 International Stock Markets
o Pros
 Risk can be eliminated by diversifying your portfolio
 Exposure to growth in wealth
o Cons
 Lack of information
 International regulation differences
 Exchange rate risk or political risks

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