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Financial Markets & Institutions > Stock Markets & Market Microstructure > Flashcards

Stock Markets & Market Microstructure Flashcards

1
Q

how can stockholders earn returns (2)

A

if price of stock rises
dividends

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2
Q

What is meant by a residual claimant?

A

Stockholders are paid last, only after all other creditors have been paid

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3
Q

Stockholders have limited liability: what does this mean

A

maximium shareholders can lose is their initial investment

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4
Q

Primary market

A

The market where firm issues shares

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5
Q

2 impacts of going public on the firm

A

Change of ownership structure - increasing amount of owners. (Shareholders)

Change of capital structure - raise equity investment from sale of shares

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6
Q

IPO

A

Initial public offer - privately owned company issues stock to general public.

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7
Q

What does the process of going public often require

A

A security firm known as the lead underwriter

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8
Q

Lead underwriters process (4 stages)

A

Develop prospectus
Pricing
Allocation of IPO shares
Transaction costs

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9
Q

When do IPOs tend to occur

A

During bullish stock markets (go public when value is high so sale price is high)

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10
Q

What is meant by flipping shares

A

Purchasing stock at offer price then selling it shortly afterwards to gain a return

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11
Q

Google’s IPO - why was it unique

A

Dutch auction (set high) - allowed investors to participate directly in IPO and obtain shares at the initial offer price.

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12
Q

Secondary market - 2 types

A

Organised exchanges - auction markets where floor traders specialise in particular stocks (futures/options)

Over the counter - dealers who trade electronically

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13
Q

Structure of secondary markets (2)

A

Order Driven Market: all participants are natural buyers and natural sellers with no dealer acting as an intermediary.

Quote Driven Market: price determined by the dealer, based on prevailing market conditions.

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14
Q

What is the difference between best offer and best bid known as

A

Bid-ask spread

(Remember offer is a sell order specifying a price, bid is a buy order specifying a price

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15
Q

Orders

A

Instructions that traders give to brokers and exchanges that arrange their trades

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16
Q

What will orders always specify (3)

A

The security to be traded (WHAT)

Quantity to be traded (HOW MUCH)

Side of the order (buy-bid or sell-offer)

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17
Q

What may they also specify (4)

A

Price specifications

Length of order

When order can be executed

Whether they can be partially filled or not

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18
Q

Proprietary orders , and what type of people use (2)

A

Orders submitted by traders for their own account

Broker-dealers (who execute trades on behalf of others and themselves) and dealers (execute trades for themselves)

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19
Q

Why are most orders agency orders (brokers carry out on behalf of client)

A

Because most traders are unable to directly access the market.

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20
Q

Agency orders

A

Orders from traders who cannot directly access financial markets, so send requests to buy/sell through an intermediary ie brokerage/exchanges

21
Q

Market orders

A

Instructs a broker to immediately buy or sell at best price currently available in the market

22
Q

Limit orders

A

Designate a price threshold for the trade:

Buy limit order specifies a max price to buy a stock
Sell limit order specifies a min price to sell for

23
Q

Short selling

A

Selling borrowed securities not owned at time of sale, to be purchased later and returned.

(They do this if they predict prices to fall; they borrow and sell at current price, anticipating the fall, and then if successful buy back shares at the lower price and return back to lender)

24
Q

Buying on margin

A

Borrow money (from broker) to buy securities using securities as collateral for a loan

(So allows more investment than just own cash, but higher risk)

25
Q

Stock market indexes

A

Monitor behaviour of a group of stocks (tells us how much the value of an average stock has changed)

26
Q

Why is it useful

A

Provides benchmark for performance of money managers - u can tell whether a manager has done well or worse than market as a whole

27
Q

Dow Jones Industrial Average Index

  • what is it based on?
  • what type of index?
A

Based on stock prices of 30 largest companies in US.

It is a price weighted average index - greater weight for shares with higher prices. (The higher price stocks strongly determine movement of index)

28
Q

Standard and Poor’s 500 index

  • what is it based on?
  • what type of index
A

500 largest firms in US.

Value weighted index - larger firms (in market value) carry more weight

29
Q

DJIA S&P500 comparison

A

Price weighted gives more importance to stocks with high prices

Value weighted gives more importance to companies with high market value - accurately mirrors changes in economies overall wealth.

30
Q

World stock indexes

Pro and con

A

Diversify risk away from domestic markets

Eval: increased correlation of global markets

31
Q

Why are stocks risky (3)

(1 for shareholders themselves, 1 for business owners, and 1 for borrowing from bank)

A

Residual claimant - as a shareholder we get profits last!- and depends on performance, might not even get any! (Whereas bondholder receive fixed interest)

Borrowing creates leverage, creating risk (if we borrow to buy shares, loans have to be repaid regardless of performance of the shares)

More equity (shares), more leverage and more owner risk of being taken over? (Also if good future, why would we want to share?)

32
Q

Stock market’s role in the economy

B) if stock prices accurately reflect fundamental values…

A

To show market value of company…

B) the resource allocation mechanism works well

33
Q

However, sometimes stock prices can deviate significantly, why? (2)

What can this create

A

Euphoria and depression.

This can create bubbles, causing gaps between prices and prices warranted by fundamentals. Then leads to crashes

34
Q

Why are bubbles bad? (for consumers and firms)

A

Optimism!

Companies sell share prices too high, then invest too much

People think they are wealthier (with higher share price) than they are, and spend too much

35
Q

Valuing stocks - 3 views

A

Chartists - predict changes in price through patterns/past movements (charts!)

Behaviouralists - estimate based on investor psychology and behaviour (in the name!)

Fundamentalists - estimate based on current assets and future profitability

36
Q

Fundamental value and dividend discount model main concept

B) When are dividends made (2)

A

Stock promises to pay dividends

When?
- when firm makes a profit
- if company is sold, they receive a final distribution representative of their share

37
Q

What is the current share price formula in the dividend discount model? (FOR A 1 YEAR HORIZON)

What happens if current price < this amount

A

KEY:
Current price of a share is the present value of next year’s price plus the dividend

P₀ = D₁ + P₁
/
1+ re

D₁ - expected dividend paid at year 1
re - required rate of return

If current price < this amount, attractive since underpriced so investors buy, driving up the stocks price. Vice versa

38
Q

Expected total return - 2 components, and formula

2) What should expected total return equal?

A

Dividend yield
Capital gain rate

re = D₁/P₀ + P₁-P₀/P₀
D₁/P₀ is divident yield
P₁-P₀/P₀ is capital gain rate (since its change in share price!)

2) Expected total return should equal expected return of other investments with equal risk

39
Q

Multiyear horizon formula e.g hold for n years (page 32)

What if we let holding period extend into indefinite future (i.e never sell)

A

P₀ = ΣDt / (1+re) to the t + Pn/(1+re) to the n

Sum of present value of expected dividends
ΣDt/(1+re) + present value of share price at end (price at nth year)

B) ΣDt / (1+re) to the t
It is just the sum of present value expected dividends, no share price at end since not selling!

40
Q

How can we forecast future dividends

A

Using 2 growth patterns

41
Q

What are the 2 growth patterns of dividends overtime

A

Constant growth

Distance stages of growth

42
Q

Constant dividend growth model idea

Formula

A

Dividend growth grows at CONSTANT rate g

Dn = D₀(1+g) to the n

Dn = Dividend at period n

43
Q

What does the share price equation become in the constant dividend growth model? 2 options

(So far we looked at the divident-discount model)

A

P₀= D₀(1+g) /(re - g)

Or

P₀ = D₁ / (re -g)

44
Q

Using this model and equation, when will stock prices be high? (3)

A

When dividends are high

When interest rate (re) is low

Growth rate of dividend (g) is high

45
Q

What assumptions are needed for this model (3)

A

Dividends do actually grow at constant rate (g)

g is less than required return (in denominator re - g)

Expected growth rate of dividends matches the capital gain rate (SHARE PRICE GROWS AT SAME RATE G AS DIVIDENDS, REARRANGE TO MAKE g SUBJECT TO FIND OUT

46
Q

Why is growth rate not constant in reality,

so constant dividend growth may not be accurate

A

Young firms often have very high initial earnings growth rates and retain profits for investment, and then their growth slows, earnings exceed investment needs so begin to pay dividends

47
Q

Dividend-discount model with constant long term growth

i.e If the firm is expected to grow at a long-term rate g after year N + 1 from the constant dividend growth model we get:

A

Pn = Dn+1/re-g

P₀ = sum of present value of expected dividends (as usual) + 1/1+re to the n x Dn+1/re -g (from above!)

48
Q

Limitations of dividend discount model (2)

A

Uncertainty in forecasting dividends

Small changes in g can lead to large changes in estimated stock price

Financial Markets & Institutions (18 decks)

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