©2007, The McGraw-Hill Companies, All Rights Reserved 9-1 McGraw-Hill/Irwin Chapter Nine Stock Markets

©2007, The McGraw-Hill Companies, All Rights Reserved 9-2 McGraw-Hill/Irwin Stock Markets Overview Stockholders are the legal owners of a corporation –they have a residual claim to all earnings and assets after debt and tax claims are satisfied –voting rights (e.g., to elect board of directors) –shareholders do not exercise control regularly (they elect a board, who chooses a CEO, etc.) Stockholders are the legal owners of a corporation –they have a residual claim to all earnings and assets after debt and tax claims are satisfied –voting rights (e.g., to elect board of directors) –shareholders do not exercise control regularly (they elect a board, who chooses a CEO, etc.)

©2007, The McGraw-Hill Companies, All Rights Reserved 9-3 McGraw-Hill/Irwin Market Value of Common Stock Outstanding, by Type of Issuer ($Bn)

©2007, The McGraw-Hill Companies, All Rights Reserved 9-4 McGraw-Hill/Irwin Primary and Secondary Markets Overview Primary Market –firm can raise equity capital in its initial public offering (IPO) –firm can raise equity capital in a subsequent seasoned equity offering (SEO) Secondary Markets –trading of shares among investors Primary Market –firm can raise equity capital in its initial public offering (IPO) –firm can raise equity capital in a subsequent seasoned equity offering (SEO) Secondary Markets –trading of shares among investors

©2007, The McGraw-Hill Companies, All Rights Reserved 9-5 McGraw-Hill/Irwin Calculating Stock Returns R t = P t - P t-1 + D t P t-1 P t-1 Where: R t = Return over period from t-1 to t P t = Stock price at time t P t-1 = Stock price at time t-1 D t = Dividends paid over time t - 1 to t P 1 - P t-1 = Capital gain over time t - 1 to t R t = $45 - $40 + $4 $40 $40 = 12.5% % = 22.5% R t = P t - P t-1 + D t P t-1 P t-1 Where: R t = Return over period from t-1 to t P t = Stock price at time t P t-1 = Stock price at time t-1 D t = Dividends paid over time t - 1 to t P 1 - P t-1 = Capital gain over time t - 1 to t R t = $45 - $40 + $4 $40 $40 = 12.5% % = 22.5%

©2007, The McGraw-Hill Companies, All Rights Reserved 9-6 McGraw-Hill/Irwin Stock Market Securities Two types of corporate stock exist –Common stock the fundamental ownership claim in a public corporation –Preferred stock a hybrid security that has characteristics of both bonds and common stock Two types of corporate stock exist –Common stock the fundamental ownership claim in a public corporation –Preferred stock a hybrid security that has characteristics of both bonds and common stock

©2007, The McGraw-Hill Companies, All Rights Reserved 9-7 McGraw-Hill/Irwin New Securities Issued ($Bn)

©2007, The McGraw-Hill Companies, All Rights Reserved 9-8 McGraw-Hill/Irwin Characteristics of Common Stock Dividends Residual Claim Limited Liability Voting Rights Dividends Residual Claim Limited Liability Voting Rights

©2007, The McGraw-Hill Companies, All Rights Reserved 9-9 McGraw-Hill/Irwin Characteristics of Preferred Stock Similar to common stock in that it represents an ownership interest but, like bonds, pays a fixed periodic dividend Senior to common stock but junior to bonds Generally do not have voting rights Nonparticipating preferred stock Cumulative preferred stock Similar to common stock in that it represents an ownership interest but, like bonds, pays a fixed periodic dividend Senior to common stock but junior to bonds Generally do not have voting rights Nonparticipating preferred stock Cumulative preferred stock

©2007, The McGraw-Hill Companies, All Rights Reserved 9-10 McGraw-Hill/Irwin Issuance of Stock in the Primary Market Stocks Stocks Issuing Investment Investors Corporation Bank Funds Funds Investment bank conducts primary market sale of stock using firm commitment underwriting (guarantees corporation a fixed price for newly issued securities) or best efforts underwriting (no guarantee to issuer and acts more as a placing or distribution agent) Stocks Stocks Issuing Investment Investors Corporation Bank Funds Funds Investment bank conducts primary market sale of stock using firm commitment underwriting (guarantees corporation a fixed price for newly issued securities) or best efforts underwriting (no guarantee to issuer and acts more as a placing or distribution agent) (continued)

©2007, The McGraw-Hill Companies, All Rights Reserved 9-11 McGraw-Hill/Irwin Net proceeds Gross proceeds Underwriters’ spread Syndicate Originating house Red herring proxy Net proceeds Gross proceeds Underwriters’ spread Syndicate Originating house Red herring proxy

©2007, The McGraw-Hill Companies, All Rights Reserved 9-12 McGraw-Hill/Irwin Secondary Markets: Major U.S. Stock Exchanges New York Stock Exchange (NYSE) American Stock Exchange (AMEX) National Association of Securities Dealers Automated Quotation System (NASDAQ) –multiple dealers (market makers) compete for transactions in a given stock –each dealer/market maker posts a bid and offer price on the system’s network New York Stock Exchange (NYSE) American Stock Exchange (AMEX) National Association of Securities Dealers Automated Quotation System (NASDAQ) –multiple dealers (market makers) compete for transactions in a given stock –each dealer/market maker posts a bid and offer price on the system’s network

©2007, The McGraw-Hill Companies, All Rights Reserved 9-13 McGraw-Hill/Irwin Trading on NYSE and AMEX Order Order Order Investor Shares Broker Shares Comm Shares Market or Maker or Cash Cash Floor Cash Other Floor Broker Broker Order Order Order Investor Shares Broker Shares Comm Shares Market or Maker or Cash Cash Floor Cash Other Floor Broker Broker

©2007, The McGraw-Hill Companies, All Rights Reserved 9-14 McGraw-Hill/Irwin Two Common Types of Orders Market order – an order for the broker and market specialist to transact at the best price available when the order reaches the post Limit order – an order to transact at a specified price (the limit price) Market order – an order for the broker and market specialist to transact at the best price available when the order reaches the post Limit order – an order to transact at a specified price (the limit price)

©2007, The McGraw-Hill Companies, All Rights Reserved 9-15 McGraw-Hill/Irwin Stock Market Indexes The Dow Jones Industrial Average (the DJIA) The NYSE Composite index the Standard & Poor’s 500 index The NASDAQ Composite index The Dow Jones Industrial Average (the DJIA) The NYSE Composite index the Standard & Poor’s 500 index The NASDAQ Composite index

©2007, The McGraw-Hill Companies, All Rights Reserved 9-16 McGraw-Hill/Irwin Stock Market Participants Holders of Corporate Stock (in billions of dollars) % of Total Household sector $3,070.9 $5,689.6 $6, State and local gov Rest of world , Depository inst Life ins. co Other ins. co Private pension funds , , Public pension funds , , Mutual funds , , Closed-end funds Brokers and dealers Holders of Corporate Stock (in billions of dollars) % of Total Household sector $3,070.9 $5,689.6 $6, State and local gov Rest of world , Depository inst Life ins. co Other ins. co Private pension funds , , Public pension funds , , Mutual funds , , Closed-end funds Brokers and dealers

©2007, The McGraw-Hill Companies, All Rights Reserved 9-17 McGraw-Hill/Irwin Other Issues Pertaining to Stock Markets Does the stock market forecast the economy? Market efficiency –the speed with which financial security prices adjust to unexpected news pertaining to interest rates or a stock-specific characteristics, etc. –Forms of market efficiency Weak Form Market Efficiency Semistrong Form Market Efficiency Strong Form Market Efficiency Does the stock market forecast the economy? Market efficiency –the speed with which financial security prices adjust to unexpected news pertaining to interest rates or a stock-specific characteristics, etc. –Forms of market efficiency Weak Form Market Efficiency Semistrong Form Market Efficiency Strong Form Market Efficiency

©2007, The McGraw-Hill Companies, All Rights Reserved 9-18 McGraw-Hill/Irwin Stock Market Regulation The Securities and Exchange Commission (SEC) Main emphasis of SEC regulation is on full and fair disclosure of information on securities Securities Act of 1933/Securities Exchange Act of 1934 Delegates certain regulatory responsibilities to the markets for the day-to-day surveillance of activity Recently imposed regulations on financial markets intended to reduce excessive price fluctuations The Securities and Exchange Commission (SEC) Main emphasis of SEC regulation is on full and fair disclosure of information on securities Securities Act of 1933/Securities Exchange Act of 1934 Delegates certain regulatory responsibilities to the markets for the day-to-day surveillance of activity Recently imposed regulations on financial markets intended to reduce excessive price fluctuations

©2007, The McGraw-Hill Companies, All Rights Reserved 9-19 McGraw-Hill/Irwin International Aspects of Stock Markets European markets becoming an increasing force with introduction of a common currency, the Euro International stock markets allow investors to diversify by holding stocks issued by corporations in foreign countries Increased risk due to less complete information about foreign stocks, foreign exchange risk, and political risk European markets becoming an increasing force with introduction of a common currency, the Euro International stock markets allow investors to diversify by holding stocks issued by corporations in foreign countries Increased risk due to less complete information about foreign stocks, foreign exchange risk, and political risk

©2007, The McGraw-Hill Companies, All Rights Reserved 9-20 McGraw-Hill/Irwin Worldwide Stock Market Capitalization, 2004