The Equity Markets

Question 1

What is Equity

Answer 1

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

Question 2

What are Shares

Answer 2

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

Question 3

What are the 2 types of shares

Answer 3

Ordinary shares and preferred shares

Question 4

Compared to Bonds

Answer 4

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

Question 5

Equity risk and reward

Answer 5

Risk: Greater but limited liability

Reward: dividends and capital gains

Question 6

Since a share gives its owner a claim upon the nominal profits of a firm:

Answer 6

We expect dividends to vary but grow in the long run and the market value of shares to grow in the long run

Question 7

A company financed entirely by shares

Answer 7

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

Question 8

What are preference shares

Answer 8

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

Question 9

Why invest in preference shares

Answer 9

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

Question 10

Right issues

Answer 10

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

Question 11

Example of rights issue

Answer 11

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

Question 12

Bonus Issues

Answer 12

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

Question 13

Bonus Issues Example

Answer 13

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

Question 14

Stock Split

Answer 14

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

Question 15

Stock Split example

Answer 15

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

Question 16

Equity Market Characteristics 1-4

Answer 16

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’

Question 17

Equity Market Characteristics 5-7

Answer 17

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

Question 18

Stock Market Characteristics

Answer 18

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

Question 19

The Role of Stock Exchanges

Answer 19

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

Question 20

Brokers and Market Makers

Answer 20

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

Question 21

Securities Trading

Answer 21

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

Question 22

Market Participants

Answer 22

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

Question 23

Arbitrage

Answer 23

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

Question 24

Speculation

Answer 24

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

Question 25

Hedging

Answer 25

Hedging is a strategy usually designed through some form of transaction designed to minimise risk exposure

An importer who knows he will have to pay for goods in US$ in 3 months may contract today to buy $ at a known price in £ for delivery in 3 months time. This avoids risk in the form of the pound falling against the dollar