The Stock Market Chapter 11 © 2003 South-Western/Thomson Learning

Learning Objectives Major characteristics of stock market How organized exchanges and over-the-counter markets function Various stock indexes and what each measures How value of a share of stock is determined

Speculative Bubble An irrational increase in stock prices accompanied by euphoric expectations Market participants liquidate their positions Prices fall to lower than before bubble Causes financial instability as gains and losses are magnified Resulting losses cause unemployment and recession

Anatomy of Stocks Preferred Stock Common Stock Equity claims representing ownership of net income and assets of corporation that receive a fixed dividend before common stockholders are entitled to anything Common Stock Equity claims representing ownership of net income and assets of corporation that receive a variable or no dividend after preferred stockholders have been paid and retained earnings have been put aside

Anatomy of Stocks Stock Offerings Initial Public Offering (IPO) When a corporation issues stocks publicly for the first time Secondary Stock Offering Offering on newly issued shares by firm that already has outstanding publicly held shares

Anatomy of Stocks Shelf Registration Procedure that permits a company to: Register a quantity of securities with the SEC Sell the quantity of securities over a 2-year period rather than at the time of registration

Stock Markets Program Trading Margin Requirement Pre-programming of computers to buy or sell a large number (basket) of stocks usually by institutional investors Margin Requirement Percentage of invested funds that can be borrowed as opposed to being paid in readily available funds Currently are set by the Fed at 50% Maintenance Margin Requirement Minimum amount of equity the investor needs in his account relative to the market value of his stock

Net Non-U.S. Purchase of U.S. Stock Exhibit 11–3 Net Non-U.S. Purchase of U.S. Stock *Analyzed through second quarter 2001 Source: Flow of Funds of the United States, Z1, Board of Governors of the Federal Reserve System, September 18, 2001, page 22.

Stock Market and Mutual Funds Many individuals can tap into the higher returns of the stock market while minimizing the risk of doing so by purchasing shares of a mutual fund.

Stock Market and Mutual Funds Companies that pool the funds of many investors and then invest in bonds or some combination of both stocks and bonds Offer less risk and greater safety than individual stocks because of diversification Highly specialized to reflect amount of risk an investor wishes to accept

Major Domestic Exchanges New York Stock Exchange (NYSE) World’s largest market for trading stocks Trades stocks of over 3,000 companies Designated Order Turnaround (DOT) Computer system used for trades of fewer than 3,000 shares on the NYSE Circuit Breakers Reforms introduced in 1987 on the NYSE to temporarily halt market trading if prices change by a specified amount.

Major Domestic Exchanges American Stock Exchange Located in New York City Trades the stock of over 660 companies

Over-the-Counter Market Network of securities dealers who trade stocks of over 30,000 companies via telephone or computer

Over-the-Counter Market National Association of Securities Dealers (NASD) Privately owned organization Regulates market participants in over-the-counter market under supervision of SEC National Association of Securities Dealers Automated Quotation System (NASDAQ) Association whose members trade stocks over an advanced computer system that provides immediate information about prices and the number of shares traded

Stock Market Indexes Dow Jones Industrial Average (the Dow) Index that measures movements in the stock prices of 30 of the largest companies traded on the NYSE

Valuation of Stocks Market Risk Premium Firm-specific Risk Premium Risk based on historical data that shows how much on average the ownership of stocks pays over a risk-free return Firm-specific Risk Premium Risk measured by beta that shows the overall sensitivity of the stock’s return relative to changes in entire market

Valuation of Stocks Beta Capital Asset Pricing Model (CAPM) Measure of the overall variability of a stock relative to changes in the entire stock market Capital Asset Pricing Model (CAPM) Model that asserts that the value of a share of stock includes: Risk-free return Market risk premium Firm-specific risk premium that is based on beta