How the Stock Market Works Flashcards
Provide a brief overview of the stock market.
The stock market provides a venue where companies raise capital by selling shares of stock, or equity, to investors. Stocks give shareholders voting rights as well as a residual claim on corporate earnings in the form of capital gains and dividends.
Individual and institutional investors come together on stock exchanges to buy and sell shares in a public market. When you buy a share of stock on the stock market, you are not buying it from the company, you are buying it from an existing shareholder.
What happens when you sell a stock? You do not sell your shares back to the company, but instead, sell them to another investor on the exchange.
What is a stock?
A stock is a financial instrument that represents ownership in a company or corporation and a proportionate claim on its assets and earnings. Stocks are also called shares or equity.
What does it mean to own stock?
Owning stock means that a shareholder owns a slice of the company equal to the number of shares held as a proportion of the company’s total outstanding shares.
What are the types of stock?
There are two main types of stock: common shares and preferred shares. Equities are synonymous with common shares because their market value and trading volumes are many times larger than those of preferred shares.
What is a common stock?
Common stock is a security that represents ownership in a corporation. Holders of common stock elect the board of directors and vote on corporate policies. This form of equity ownership typically yields higher rates of return long term. However, in the event of liquidation, common shareholders have rights to a company’s assets only after bondholders, preferred shareholders, and other debtholders are paid in full.
Common stock is reported in the stockholder’s equity section of a company’s balance sheet.
What is a preferred stock?
A class of stock that is granted superior rights to common stock, like higher dividend payments and a higher claim to assets in the event of a liquidation.
What is a stock exchange?
A stock exchange is a marketplace where securities, such as stocks and bonds, are bought and sold. It can be either physical or electronic, but electronic exchanges are now the norm. A stock exchange provides an organized system for the trading process, and brings stability, transparency, and efficiency to the market.
In most countries, the stock exchange has two important functions. As a ready market for securities, it ensures their liquidity and thus encourages people to channel savings into corporate investment. As a pricing mechanism, it allocates capital among firms by determining prices that reflects the true investment value of a company’s stock.
What is an over-the-counter exchange (OTC)?
A decentralized market where securities are traded through a broker-dealer network, rather than on a centralized exchange like the New York Stock Exchange (NYSE). OTC trading can involve stocks, bonds, and derivatives, which are financial contracts that derive their value from an underlying asset such as a commodity. When companies do not meet the requirements to list on a standard market exchange such as the NYSE, their securities can be traded OTC but may still be subject to some regulation by the Securities and Exchange Commission.
OTC markets are electronic networks that allow two parties to trade with each other using a dealer-broker was an intermediary.
What is a stock market index?
A collection of stocks intended to be reflective of the stock market as a whole or a particular industry or segment of the market. It is an index that measures a stock market or a subset of the stock market, that helps investors compare current price levels with past prices to calculate market performance. It is computed from the prices of selected stocks, typically a weighted arithmetic mean. They measure various slices of the stock market and can be used as performance benchmarks for both investment vehicles (such as mutual funds) and one’s own portfolio returns.
Why do companies issue shares?
Raising Capital
A startup can raise capital either by selling shares through equity financing or borrowing money through debt financing. Debt financing can be a problem for a startup because it may have few assets to pledge for a loan.
Listing Shares
Companies can access larger amounts of capital than they can get from ongoing operations or a traditional bank loan by selling shares to the public through an initial public offering (IPO).
How are price shares set?
The prices of shares on a stock market can be set in several ways. The most common way is through an auction process where buyers and sellers place bids and offer to buy or sell. A bid is a price at which somebody wishes to buy, and an offer, or ask, is the price at which somebody wishes to sell. When the bid and ask coincide, a trade is made.
What role does supply and demand play in the stock market?
For every stock transaction, there must be a buyer and a seller. Because of the immutable laws of supply and demand, if there are more buyers for a specific stock than there are sellers of it, the stock price will trend up. Conversely, if there are more sellers of the stock than buyers, the price will trend down.
What is the law of supply and demand?
The law of supply and demand combines two fundamental economic principles describing how changes in the price of a resource, commodity, or product affect its supply and demand.
As the price increases, supply rises while demand declines. Conversely, as the price drops supply constricts while demand grows.
How are buyers matched to sellers?
Some stock markets rely on professional traders to maintain continuous bids and offers since a motivated buyer or seller may not find each other at any given moment. These are known as specialists or market makers.
A two-sided market consists of the bid and the offer, and the spread is the difference in price between the bid and the offer. The more narrow the price spread and the larger size of the bids and offers, the greater the liquidity of the stock. If there are many buyers and sellers at sequentially higher and lower prices, the market is said to have good depth.
What are the advantages of stock exchange listing for companies?
An exchange listing means ready liquidity for shares held by the company’s shareholders.
It enables the company to raise additional funds by issuing more shares.
Having publicly tradable shares makes it easier to set up stock options plans that can attract talented employees.
Listed companies have greater visibility in the marketplace; analyst coverage and demand from institutional investors can drive up the share price.
Listed shares can be used as currency by the company to make acquisitions in which part or all of the consideration is paid in stock.
