Week 5 Flashcards
Common Stock Shares
Common stockholders votes, receive variable dividends, usually involve higher risks and do not have a priority claim on assets than preferred stockholders.
Common stockholders have voting rights
Preferred Stock Shares
Preferred Stock is different from common stock in four ways:
1. Preferred stockholders receive a fixed dividend
2. The price of a preferred stock is relatively stable
3. Usually don’t have voting rights
4. Have a higher priority claim on assets than common stockholders
How are stocks sold?
Organized Exchanges: platforms where investors come together to buy and sell stocks, as well as other financial instruments like bonds, options, and ETFs. It is more regulated, centralized and auction based trading with marketmakers involved.
Over-the-counter market: The OTC market refers to a decentralized market where financial instruments, such as stocks, bonds, commodities, and derivatives, are traded directly between two parties without being listed on an official exchange. and it requires dealers to facilitate exchanges
Electronize communication networks (ECNs): decentralized platforms which allow brokers and traders to trade directly with each other online, without the need of the middleman
Exchange Traded Funds (ETFs): are funds that aggregate multiple assets and are traded on organized exchanges (like the NYSE or NASDAQ). They can be purchased or sold through brokers just like stocks. It represents a diversified set of assets, providing exposure to various sectors or indices.
Advantages and Disadvantages of ECNs
They provide:
o Transparency: everyone can see unfilled orders
o Cost reduction: smaller spreads because of lower transaction costs
o Faster execution: computers work faster than humans
o After-hours trading: ECNs never close
However, ECNs are not without their drawbacks:
o Don’t work as well with thinly-traded stocks
o Many ECNs competing for volume, which can be confusing
o Major exchanges are fighting ECNs, with an uncertain outcome
One-Period Valuation Model
The One-Period Valuation Model is a simple method used in finance to determine the value of a financial asset, typically a stock, over a single period. This model assumes that the investor will hold the asset for only one period (such as one year) and will sell it after that period.
THE GENERALIZED DIVIDEND VALUATION MODEL
Extension of the one period valuation model with any number of periods
GORDON GROWTH MODEL
we use a simpler version, known as the Gordon Growth Model. It assumes that dividends grow at a
constant rate, g.
This model is useful for finding the value of stock, given two assumptions:
- Dividends are assumed to continue growing at a constant rate forever
- The growth rate is assumed to be less than the required return on equity
THE PRICE EARNINGS VALUTAION METHOD
The P/E ratio is essentially the price investors are willing to pay today for a dollar of the company’s earnings.
How the market sets security prices
The price of an asset in the market is typically determined by the buyer who is willing to pay the highest price, within the competitive environment of the market. However, this highest price is not necessarily the absolute maximum value the asset could potentially fetch. Rather, it is the incrementally higher price compared to the second-highest price a buyer is willing to pay.
Another important factor when determining the prices is information. The buyer who has the best information
about the cash flows will discount them at a lower interest rate than will a buyer who is very uncertain.
ERRORS IN VALUATION (gordan models)
Problems with estimating growth
Problems with estimating risk
Problems with forecasting dividends
The 2007-2009 Financial Crisis and 9/11 event (impacts shown in gordon models)
Financial crisis led to economic contraction and as a result, growth expectations for dividends were lowered.
Investors and shareholders are more risk-averse and demand higher returns of the same assets. Thus, there will be an increase in Ke (cost of equity) i.e. increase in the risk premium for higher market volatility
Thus, the increase in the denominator increases the price
Margin Trading
refers to the practice of borrowing money from a broker to purchase securities, such as stocks, bonds, or other financial instruments.
By using margin, investors can potentially increase their purchasing power and leverage their positions, allowing them to buy more securities than they could with just their own funds.
Margin = Equity/Value of securities
Initial Margin
The initial margin is the amount of money an investor must contribute from their own funds when purchasing securities on margin. It is usually expressed as a percentage of the total purchase price.
Maintenance margin
The maintenance margin is the minimum amount of equity (in percentage terms) that the investor must maintain in their margin account after the purchase. It is set by the broker and regulated by the Federal Reserve in the U.S.
What is stock market indexes
Stock market indexed are frequently used to monitor the behavior of a group of stocks. By reviewing the average behavior of a group of stocks, investors are able to gain some insight as to how a broad group of stocks may have performed.
