Lecture 5: Financial securities continued Flashcards
Stock market
o The stock market generally refers to the collection of markets and exchanges where regular activities of buying, selling, and issuance of shares of public companies take place.
o The four major stock markets of the world by total market capitalization are, in descending order, the USA, China, UK, and Japan.
Functions of stock markets
o Liquidity provision o Pricing of securities o Contributions to economic growth o Spreading of equity culture o among others
Market capitalisation
A listed firm’s market capitalization refers to the total market value of a firm’s outstanding shares of stock. Commonly referred to as “market cap,” it is calculated by multiplying the total number of a company’s outstanding shares by the current market price of one share.
As an example, a company with 10 million shares selling for $100 each would have a market cap of $1 billion. The investment community uses this figure to determine a company’s size, as opposed to using sales or total asset figures. In an acquisition, the market cap is used to determine whether a takeover candidate represents a good value or not to the acquirer.
Classification of stock markets
Stock markets can be classified by following features
- Public or private
- Cash or forward markets
- Fixed or continuous quotation
- Computerizered or floor trading
Private or public bourses
- Private: Self-regulating (UK, US, Japan, Hong Kong, Australia, and Canada)
Exchanges were set up by private members for trading purposes and these
stock exchanges are largely self-regulating. - Public: Government influenced (France, Spain, Italy)
Stock exchanges (bourses) were originally set up by the government, which
still remains a strong influence from the state, i.e., via the licensing of
brokers. - Trading via commercial banks (Germany, Switzerland and Austria)
Cash or forward markets
- Most of markets are cash (spot) markets. The stocks are delivered as quickly as the settlement procedures permit.
- Paris bourse is a forward market. All major stocks are delivered at the end of month.
Fixed or continuous quotation
- Most major stock markets have a high degree of liquidity and therefore quote most stocks on a continuous basis. (i.e., NYES, London, Tokyo)
- In some low liquid stock markets, quoted prices are for a particular day.
Computerized or floor trading
- Computerizered trading is necessary for trading international stocks. (London, NASDAQ)
- Floor trading is still a popular feature in the NYSE. High degree of interaction and rapid exchange of information.
Stock market participation
Investors (institutional and individual) - Pension funds - Mutual funds - Insurance funds Brokers (on behalf of clients) Market-makers (providing information)
The primary stock market
- Privatization: the sale of state-owned enterprises to the private sector, often through the sale of shares to the public and institutions
- Allotment policy: the policy of distributing shares from an initial public offering (IPO) to underwriters and investors.
- Listing requirements: the set of conditions and standards that a company must meet in order to gain and then maintain a stock exchange listing.
Types of shares
Ordinary shares: shares which represent partial ownership of a company, entitling the owner to vote. The holder may or not receive dividends depending on profits.
Preference shares: shares which entitle the holder to a given dividend, holders have priority over ordinary shareholders. Holders entitled to a share of the assets if the firm goes into liquidation but have lower priority than debt holders. Holders are not entitled to vote.
Preference shares
Cumulative preference shares: holder is entitled to any missed dividends if earnings recover sufficiently before any dividends are made to ordinary shareholders.
Convertible preference shares: holders have the right to convert their shares into ordinary shares at predetermined conditions if a certain number of dividend payments are missed.
Redeemable preference shares: the company can buy back the shares at their original price.
Participating preference shares: allow greater dividend in the event that profits are above certain levels.
A rights issue
If a listed company wishes to raise further capital by method other than the issue of debt, it can choose to issue new equity in the form of a rights issue.
Rights issue: the issuance of new shares by company to raise new finance, the shares are offered to current shareholders first in proportion to the number of shares that they own. Shareholders can transfer their rights to a third party.
The new shares are usually offered at a discount to the existing price to encourage take-up of the issue.
Example
A “one-for-two” issue, the existing stockholders (shareholders) are offered one new share for every two shares that they already hold. If the shares are currently valued at 100 pence each, then the new share maybe priced at 70 pence, the stockholder must decide whether to take up his rights or sell them to a third party.
If the stockholder takes up his rights then he retains the same proportion of ownership of the company as prior to the issue, but the price of his shares will fall after the rights issue:
(100 + 100 + 70)/3 = 90 pence
The stockholder also can sell his right to a third party for up to 20 pence (90 pence – 70 pence).
Returns
Return on an investment comes in two forms:
a) Income
i.e. dividends in the case of shares or
coupons in the case of bonds
b) Capital gain / loss
based on change in price
Risk and returns (without dividends)
where P_(t+1) − P_t is the capital gains (price appreciation) and D is the dividend you will obtain. Collectively, (P_(t+1) − P_t + D) / P_t is a relatively ratio – this is the return of holding this stock for a specific period.
Please bear in mind, in some cases, P_(t+1) can denote the next day’s price, and P_t denotes the share price today.
Alternatively, P_(t+1) can also denote the next year-end share price, and P_t denotes the share price the current year end or the beginning of the next year.
D denotes the dividend you will receive – it is perceived as the future cash inflow
