MGT 470 Ch 8 Stock Mkt & Mkt Efficiency (cs3ed) v1.0 Nov 15 1 Stocks are:  A way to spread/diversify ownership of a firm  A key instrument for holding & creating personal wealth  A way to diversify risk  A way to transfer risk  A way for a firm to obtain financing Common Stock Basics:  Shares of stock are initially sold by a firm through an investment bank; proceeds usually used to buy capital assets (plant, machinery, equipment, etc.)  Large quantities of stock are usually only issued once by a firm  Small quantities may be issued later (stock options, convertible bonds, warrants, etc.)  A share of stock is a share of ownership in a company  In theory, stock owners are entitled to all revenue from the firm and all proceeds from the sale of a firm  In reality, stock owners are residual claimants; if a firm goes bankrupt and all assets are sold, creditors are paid first and stock holders get the residual  Stock holders have limited liability for the firm’s losses  their losses are limited to the amount they have invested in stock  they cannot be sued for anything the firm may do or may have done  The publicly traded stock from a particular company has a unique symbol (the “ticker” symbol) Ex: Apple Inc.: AAPL  Usually a company can have stock listed for trade on only one particular stock exchange, i.e. the NYSE, the NASDAQ, the AMEX, etc. Ch 8: Stocks and Stock Markets

MGT 470 Ch 8 Stock Mkt & Mkt Efficiency (cs3ed) v1.0 Nov 15 2 How stocks are sold  Someone wishing to sell a share of stock submits an asking price (the “ask”) to a broker  Someone wishing to buy a share of stock submits a bidding price (the “bid”) to a broker  Brokers have access to stock markets and can thus submt these trade requests for execution in a stock market Organized Securities Exchanges:  “Brick & mortar” location where buyers and sellers meet on a regular basis to trade stock  Uses an open-outcry auction on a trading floor for buying and selling as well as computer assisted trading; this combination is referred to as “hybrid trading”  Floor traders specialize in trading certain types of stocks (thus they are called “specialists”)  specialists represent various brokerage firms and trade stocks for their firms  their main purpose is to match buyers and sellers in order to keep the market running; they “make” the market  when the bid and ask prices for a share of stock get really close, a trade is made;  the bid/ask do not have to match exactly  the gap between the bid and ask prices is called the “bid-ask spread”  specialists are compensated for the bid-ask spread and receive commissions  specialists are authorized to buy or sell from their own accounts or from their firm’s inventory in order to keep up the pace of trading and maintain an orderly market  On the NYSE about 25% of trades are conducted on the floor by specialists and the rest are conducted by an electronic order routing system called SuperDOT (Super Designated Order Turnaround)

MGT 470 Ch 8 Stock Mkt & Mkt Efficiency (cs3ed) v1.0 Nov 15 3 How stocks are sold (continued) Organized Securities Exchanges: (continued)  The New York Stock Exchange (NYSE) is the preeminent stock market in the U.S.; established in 1792  In 2007 the NYSE Euronext was created by merging the NYSE and Euronext N.V. creating a pan europe-american global exchange  over 8,000 companies from around the world are listed for trade on this exchange  the average firm has a market cap of $19.6b  Other major organized stock exchanges include the London Stock Exchange, the Nikkei (Tokyo), the DAX (Germany)  To have stock listed for trading on one of the organized stock exchanges, a firm must file an application and meet certain criteria set by the exchange designed to enhance trading  usual minimal requirements are $10m/year earnings and $100m market cap  firms that violate the rules of the exchange can be “de-listed” (kicked out of the exchange) Over-the-Counter (OTC) Exchanges:  The NASDAQ (National Association of Securities Dealers Automated Quotations) is the most prominent  Operate in the same general manner as organized exchanges  There is no trading floor; all stocks are traded via an electronic communication network and thus have global reach  As with organized exchanges, investors must go through authorized brokers for access  Microsoft is the most prominent company that trades on an OTC exchange (the NASDAQ)

MGT 470 Ch 8 Stock Mkt & Mkt Efficiency (cs3ed) v1.0 Nov 15 4 How stocks are sold (continued) Over-the-Counter (OTC) Markets: (continued)  OTC markets have “market makers” instead of trading floor specialists  market makers set bid/ask prices  there are usually many marker makers for any particular stock  they each enter their own bid or ask prices  like organized exchanges, when the bid and ask prices get real close, the trade is made  once a price is submitted, the market maker is obligated to buy or sell at least 1,000 shares  this obligation ensures the market stays very liquid Other considerations:  Both types of exchanges (organized and OTC) are public for-profit businesses  This means that it costs participants (trading firms) money to participate  These fees are passed on to investors (transaction costs)

MGT 470 Ch 8 Stock Mkt & Mkt Efficiency (cs3ed) v1.0 Nov 15 5 How stocks are sold (continued) Electronic Communications Networks (ECNs):  ECNs bring together major brokerages and traders directly and bypass the middlemen (organized and OTC exchanges)  ECNs have numerous advantages over organized and OTC exchanges that have lead to their rapid growth  transparency: all unfilled orders are available for review; this provides valuable supply/demand info that traders can use to plan their strategy  cost reduction: no middlemen, less transaction costs  faster execution: no traders or market makers involved  after-hours trading:  prior to ECNs, only institutional traders were able to trade after exchanges had closed for the day  lots of business, market and economic info becomes available after hours and small investors were unable to trade on this info  Disadvantages:  ECNs only work well for stocks that usually are traded in large volume; thinly traded stocks have trouble finding buyers/sellers and may undergo long intervals without trading  ECN markets are not as well regulated as organized and OTC markets

MGT 470 Ch 8 Stock Mkt & Mkt Efficiency (cs3ed) v1.0 Nov 15 6 The Importance of Stocks Markets  They are a central link between the financial world and the real economy  They allocate resources via stock trading  They determine stock prices  Stock prices reflect the values of their respective firms  Are fundamental to the functioning of a market-based economy  firms deemed most valuable in stock markets are the ones that will be able to obtain financing for growth  when resources flow to their most valued uses, the economy operates more efficiently Measuring the Level of a Stock Market  The performance of a stock market is expressed through stock market indexes  A stock market index is designed to provide a sense of whether a market is increasing or decreasing in value  The numerical value of an index is relatively meaningless, it does not represent the true value of the stocks that comprise the index  A stock index is a representative sample of an entire stock market; index performance reflects the performance of the whole market Dow Jones Industrial Average (DJIA):  Created in 1884 based on the prices of 11 stocks  The DJIA is currently based on the stock prices of 30 of the largest U.S. companies whose stock trade on the NYSE  The DJIA measures the return to holding a portfolio of a single share of each stock included in the average

MGT 470 Ch 8 Stock Mkt & Mkt Efficiency (cs3ed) v1.0 Nov 15 7 Measuring the Level of a Stock Market (continued) Dow Jones Industrial Average (DJIA): (continued)  The DJIA is a price-weighted average; a price-weighted average gives greater weight to shares with higher prices Example (weight by price): Consider a portfolio composed of just 2 companies’ stock; Stock A initial price is $50 and Stock B initial price is $100 V portfolio = $50 + $100 = $150 w A = $50/$150 = ; w B = $100/$150 = Consider a 15% increase in Stock A: V portfolio = $50(1.15) + $100 = $ $100 =$ Consider a 15% increase in Stock B: V portfolio = $50 + $100(1.15) = $50 + $115 =$165 The behavior of the higher priced stock dominates the portfolio The Standard & Poors 500 Index:  Comprised of stocks traded on the NYSE from the largest firms in the U.S.  The S&P 500 is a value-weighted index  unlike the DJIA, it tracks the total value of owning the entirety of those firms  each firm’s stock price receives a weight equal to its total market value (market cap)  unlike the DJIA in which higher priced stocks have more influence, in the S&P Index the larger firms (by value) are more influential

MGT 470 Ch 8 Stock Mkt & Mkt Efficiency (cs3ed) v1.0 Nov 15 8 Measuring the Level of a Stock Market (continued) The Standard & Poors 500 Index: (continued) Example (weight by value): consider a portfolio composed of just 2 companies’ stock; Stock A and Stock B P A = $50; 100 million shares outstanding P B = $100; 10 million shares outstanding Mkt Cap A = $50 x 100m = $5 billion Mkt Cap B = $100 x 10m = $1 billion V portfolio = $5b + $1b = $6b w A = $5b/$6b = ; w B = $1b/$6b = Consider a 15% increase in Stock A: V portfolio = $5b(1.15) + $1b = $ $1b =$6.75b Consider a 15% increase in Stock B: V portfolio = $5b + $1b(1.15) = $5b + $1.15b =$6.15b The behavior of the higher valued stock dominates the portfolio World Stock Indexes: Roughly one-third of the countries in the world have stock markets and each of these has stock indexes, most of which are value-weighted like the S&P 500 Regulating Stock Markets  Properly functioning capital market are the hallmark of an economically advanced country  For an economy to flourish, firms must be able to raise funds to take advantage of growth opportunities as they become available  Firms raise funds in capital markets  For these markets to function properly, investors must be able to trust the information that is released about firms participating in the market

MGT 470 Ch 8 Stock Mkt & Mkt Efficiency (cs3ed) v1.0 Nov 15 9 Regulating Stock Markets (continued)  Markets can collapse in the absence of trust i.e. the stock market crash of 1929  Congress passed the Securities Act of 1933 and the Securities Act of 1934; the purpose of these laws was to…  require firms to tell the public the truth about their businesses  require brokers, dealers and exchanges to treat investors fairly  Congress created the Securities and Exchange Commission (SEC) to enforce these laws  The primary mission of the SEC is to protect investors and maintain the integrity of securities markets  The SEC is organized into four divisions and 18 offices:  Division of Corporate Finance  collects documents that companies are required to file to include annual reports, registration statements and quarterly reports  review these documents to check for compliance with regulations  provide assistance to companies in interpreting regulations and recommends new rules for adoption  Division of Market Regulation  establishes and maintains standards for an orderly and efficient markets by regulating the major securities markets  reviews and approves new rules and changes to existing rules  Division of Investment Management  oversees and regulates the investment management industry including mutual funds  establishes rules governing investment companies  Division of Enforcement  investigates the violation of any rules and regulations established by the other divisions  conducts its own investigations into various types of securities fraud and acts on tips provided by other SEC divisions