Chapter 8 Summary - book \"Financial Markets and Institutions\" PDF

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Chapter 8: Stock MarketsThe 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 ...

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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

 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!!!

Stock Market Indexes Stock

Price

Tech A Tech B Tech C

$498 $44 $37

Shares Outstanding 1 billion 10 billion 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

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

Date

Ticke r

2010092 AAI 4 2010092 AAI 7 2010092 AAI 8

Name AIRTRAN HOLDING S AIRTRAN HOLDING S AIRTRAN HOLDING S

Return %

S&P 500 Retur n%

Bet a

Alpha %

3.64%

2.12% 1.17

-0.1%

61.32%

1.17 0.57%

-0.1%

-0.14%

0.49% 1.17

-0.1%

Expecte d Return

Three day cumulative return

Abnorma l Return

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

Stock Price Today

Long Apple $100

Long GM $100

Short Apple $100

Short GM $100

Shares Traded Today

1,000

1,000

1,000

1,000

Stock Price One Year

$125

$75

$125

$75

Shares Traded One Year

1,000

1,000

1,000

1,000

Cash Flow Today Liabilities Today (shares)

Cash Flow One Year Liabilities Paid Off

Profit (dollars)

Fill in the matrix with the profit (in dollars) of each strategy Apple Stock Price Rises Long Position Short Position

GM Stock Price Falls

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...