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

2. 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

3. 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

4. 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

5. 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

6. 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

7. 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

8. 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.

9. 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.

10. 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

11. 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.

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

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

14. 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

15. 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

16. 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

17. 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