The Equity Markets Flashcards
What is Equity
Ownership of a proportion of the company
Shares are a form of long term finance for companies
Individuals, financial institutions and governments that purchases shares are called shareholders
Dividends may be paid to shareholders in the form of dividends
What are Shares
Shares have no maturity date or value but management sometimes decides to buy back shares from shareholders
Shares come in 2 types, ordinary shares and preferred shares
Ordinary shareholders are legal owners of the firm, have voting rights which allows them to appoint and dismiss directors and they also receive dividends
What are the 2 types of shares
Ordinary shares and preferred shares
Compared to Bonds
They are riskier as shareholders are lower priority than bond holders if the company goes bankrupt
Returns to shares aren’t guaranteed
Shareholders may benefit significantly if the company performs well
Shareholders have a right to vote and shares are more difficult to value
Equity risk and reward
Risk: Greater but limited liability
Reward: dividends and capital gains
Since a share gives its owner a claim upon the nominal profits of a firm:
We expect dividends to vary but grow in the long run and the market value of shares to grow in the long run
A company financed entirely by shares
The total market value of the shares represents the value of the firm
A shift in the demand for shares changes the firms market value and could make it a target for a takeover
The rate of return required by shareholders represents the firms cost of capital
What are preference shares
A preference share is preferred into 2 basic forms:
The preference share dividend must be paid out before any other dividend is paid out
Preference shares carry no voting rights
Why invest in preference shares
Preference shares may be attractive to institutional investors, since dividends would be classed as franked investment income and not subject to corporation tax.
Conversion rights
Redemption dates
Right issues
Rights issues are simply a way of raising new finance from existing investors. Shares are normally offered at a discount to their price prior to the rights issue being announced
Example of rights issue
One for three rights issue at £4 when the market price is £5
Existing holdings is 3 shares at £5 which is £15
Right shares issue 1 share at £4
Now have 4 shares for £19
Therefore each has a value of £4.75
Bonus Issues
Also referred to as scrip issues, capitalisation issues and free issues
Company issues new shares, but does not require a payment for them from the shareholder.
Main use is to dilute the price of the share in the marketplace by spreading it over large number of securities
Bonus Issues Example
One for three bonus/scrip issue when the market price is £5
Existing holding 3 shares at £5 is £15
Bonus share issue 1 share for free
4 shares @ 15
Each share now has a value of 3.75
Stock Split
Like a scrip issue, stock split increase the number of shares in issue there are some differences
As 2 for 1 stock split will offer investors a new share for every old share held
As well as reducing the share price the stock split will reduce the nominal value of the shares in issue
Stock Split example
A company with 100 shares at £50 per share
The company now issues a stock split there are now 200 shares but at £25 so the market capitalisation stays the same
Equity Market Characteristics 1-4
Like other securities, new issues of shares are made in the primary market and shares are subsequently traded in the secondary market
As with other markets, new borrowing takes place (new funds are raised) only when a new issue takes place in the primary market
In the primary market, shares will be issued by an investment bank which underwrites the issue (it will buy any unsold shares) . This provides the issuing firm with a guarantee that it will raise the funds that it wants (the underwriter charges a fee for the risk it takes)
If the new issue is the firms first ever issue of shares the offer for sale is an ‘initial public offering’
Equity Market Characteristics 5-7
If the new issue is an issue of additional shares, it is often known as ‘rights issue’. This is because existing shareholders have a prior claim (right) to buy new shares in order to maintain their proportion of ownership
Secondary markets have various trading agreements
- Quote Driven, markets involve market makers holding inventories of shares and post prices at which they are ready to deal
- Auctioneer, markets involve markets involve the electronic matching of buy and sell orders
There are various ways in which the size of equity markets can be judged
Stock Market Characteristics
A ‘fair game takes’ place (level playing field)
Not possible for some investors and fund raisers to benefit at the expense of other participants
Well regulated to avoid abuse, negligence and fraud
Reasonably cheap to carry out transactions
A large number of buyers and sellers
The Role of Stock Exchanges
Supervision of trading to ensure fairness and efficiency
Authorise market participants e.g. brokers, market makers
Assist price formation on price discrepancies
Clear and settle transactions
Regulate the admission of companies and companies on the exchange
Brokers and Market Makers
Brokers: Agent acting on behalf of the investors buying and selling shares in the market
Market Maker: These middlemen are ready to buy and sell shares on their own account
They quote 2 prices the price at which they are willing to buy (bid) and the price they offer shares for sales (offer)
The small margin between bid and offer delivers the profit to the market makers
Securities Trading
Proprietary Trading - When a bank trades shares, options, commodities or other items with its own money as opposed to clients money
Client Trading - A client might call the investment bank to buy some shares if the bank finds some shares and routes the client to buying the shares, they are merely acting as a a broker and taking commission
Market Participants
Lenders: households and firms with a financial surplus which they want to lend
Borrowers: firms and governments with a financial deficit and need to borrow
In addition to lenders and borrowers their agents are
Arbitrageurs
Speculators
Hedges
Arbitrage
Means to be able to buy something and then selling it immediately tu guarantee a profit
Anomalies occur when the same asset is priced differently in two markets at the same time. Because financial markets are well informed and highly competitive, such as anomalies are very rare and short lived
Speculation
Involves the buying, holding and selling of stocks, bonds, commodities, currencies or anything valuable thing to profit from fluctuations in its price rather than buying it for use or income
Bear - One who sells in hopes of buying it back at a lower price, a bear market is a falling market
Bull - One who buys a security in hopes of selling it at a higher price
Stag - One who applies for shares in the new issue with the intention of selling them after the trading begins
