Financial Markets and Institutions 6: The Stock Market and the Market Microstructure

Question 1

Describe the essential characteristics of a common stock

Answer 1

Stocks, also known as common stock or equity, are shares in a firm’s
ownership.
The ownership of common stock conveys rights:
▶ A stockholder is entitled to participate in the profits of the enterprise.
▶ Stockholders are entitled to vote at the firm’s annual meeting.
Stockholders earn a return in two ways:
▶ Price of the stock rises over time.
▶ Dividends are paid to the stockholders

Question 2

Describe stockholders’ relationship with common stocks

Answer 2

Although stockholders are entitled to participate in the profits of the firm,
they are merely a residual claimant.
▶ Stockholders are paid last, only after all other creditors have been paid.
However, stockholders have limited liability in the firm.
▶ Even if a company fails completely, the maximum amount shareholders
can lose is their initial investment.

Question 3

What does it mean when a firm ‘goes public’?

Answer 3

It issues stock in the primary market in exchange
for cash

Question 4

What are the effects of going public on the firm?

Answer 4

1. It changes the firm’s ownership structure by increasing the number of
   owners.
2. It changes the firm’s capital structure by increasing the equity
   investment in the firm, which allows the firm to pay off some of its
   debt, expand its operations, or both

Question 5

Describe & explain ‘Initial Public Offer’

Answer 5

An Initial Public Offer (IPO) happens when a privately owned company
issues shares of stock to be sold to the general public.
Process of going public, which usually involves a security firm serving as the
lead underwriter:
1 Developing a prospectus.
⋆ The prospectus contains detailed information about the firm and
includes financial statements and a discussion of the risks involved.
2 Pricing.
⋆ Offer price at which the shares will be offered at the time of IPO.
3 Allocation of IPO shares.
⋆ Most of the shares are sold to institutional investors.
4 Transaction costs
Timing of IPOs.
▶ IPOs tend to occur more frequently during bullish stock markets.
Initial returns of IPOs (the first day return).
▶ Flipping shares is the process of purchasing the stock at its offer price
and sell it shortly afterwards.

Question 6

Show the ‘pricing process’ in an IPO

Answer 6