Module 4 Equity Securities

Financial Institutions & Markets
10th Edition
by Jeff Madura
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1
Part 4 Equity Markets
2 © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as
10 Investor Monitoring and Stock Offerings
3
Private Equity
Private equity is a business that is privately held and

the owners cannot sell their shares to the public.
Some business owners hope to go public so that:
■ They can obtain financing to support the firm’s growth
■ They can “cash out” by selling their original equity
investment to others.
A public offering is feasible if:

■ The owners want to sell at least $50 million in stock.
■ The shareholder base will be large enough to support an
active secondary market.
Private Equity
Financing by Venture Capital Funds

■ Venture capital funds (VC funds) receive money from
wealthy investors and from pension funds that are willing to
maintain the investment for a long-term period, such as 5 or
10 years.
■ Investors are not allowed to withdraw their money before a
specified deadline.
Private Equity
Venture Capital Market

■ Brings together the private businesses that need equity
funding and the VC funds that can provide funding.
Terms of a Venture Capital Deal

■ A VC fund will negotiate the terms of the deal when it
decides to invest in a business.
■ The VC fund will set out requirements for the business and
VC fund managers may serve as advisers to the business.
Private Equity
Exit Strategy of VC Funds

■ VC funds typically plan to exit in 4 to 7 years by selling the
equity stake to the public.
Financing by Private Equity Funds

■ Private equity funds pool money provided by institutional
investors (such as pension funds and insurance companies)
and invest in businesses.
■ They also rely heavily on debt to finance their investments.
Public Equity
■ When a firm goes public, it issues stock in the primary

market in exchange for cash.
■ Going public has two effects on the firm.
 It changes the firm’s ownership structure by increasing the
number of owners.
 It changes the firm’s capital structure by increasing the equity
investment in the firm.
■ Stock markets are like other financial markets in that they

link the surplus units (that have excess funds) with deficit
units (that need funds).
■ The secondary market allows investors to sell the stock
they previously purchased to other investors.
Exhibit 10.1 How Stock Markets Facilitate the Flow of
Funds
Ownership and Voting Rights
■ Owners of small companies also tend to be the

managers. In publicly traded firms, most shareholders are
not the managers.
■ Ownership of common stock entitles shareholders to a
number of rights.
 Normally, only the owners of common stock are permitted
to vote on certain key matters concerning the firm.
 Many investors assign their vote to management through
the use of a proxy.
Preferred Stock
■ Preferred stock represents an equity interest in a firm that

usually does not allow for significant voting rights.
■ Preferred shareholders share the ownership of the firm with

common shareholders and are therefore compensated only
when earnings have been generated.
■ A cumulative provision on most preferred stock prevents

dividends from being paid on common stock until all preferred
stock dividends have been paid.
■ Because the dividends on preferred stock can be omitted, a

firm assumes less risk when issuing it than when issuing
bonds.
Participation in Stock Markets
■ How Investor Decisions Affect Stock Prices

 When there is a shift in the demand for shares or the supply of
shares for sale, the equilibrium price changes.
 Overall, the prevailing market price is determined by the
participation of investors in aggregate.
■ Investor Reliance on Information
 In general, favorable news about a firm’s performance will make
investors believe that the firm’s stock is undervalued at its
prevailing price.
 Information is incorporated into stock prices through its impact
on investors’ demand for shares and the supply of shares for sale
by investors.
Initial Public Offerings
A first-time offering of shares by a specific firm to the public.

1. Process of Going Public
a. The issuer must develop a prospectus containing detailed
information about the firm, including financial statements and a
discussion of risks. The prospectus is filed with the Securities
and Exchange Commission (SEC).
b. The lead underwriter must determine the offer price at which the
shares will be offered at the time of the IPO.
c. Allocation of IPO Shares: The lead underwriter may rely on a
group (called a syndicate) of other securities firms to participate
in the underwriting process and share the fees to be received for
the underwriting.
d. Transaction Costs - Usually 7 percent of the funds raised.
2. Underwriter Efforts to Ensure Price Stability

a. Underwriters may attempt to stabilize the stock’s price by
purchasing shares that are for sale in the secondary market
shortly after the IPO.
b. Lockup
i. Prevents the original owners of the firm and the VC firms
from selling their shares for a specified period.
ii. Prevents downward pressure that could occur if the
original owners or VC firms immediately sold their
shares in the secondary market.
3. Timing of IPOs
Initial public offerings tend to occur more frequently during
bullish stock markets.
4. Initial Returns of IPOs

a. The initial (first-day) return of IPOs in the United States has
averaged about 20 percent over the last 30 years.
b. Flipping Shares
i. Investors flip shares by buying the stock at its offer price
and selling the stock shortly afterward.
ii. If many institutional investors flip their shares, the
market price of the stock may decline shortly after the
IPO.
Stock Offerings and Repurchases
1. Secondary Stock Offerings

a. A secondary stock offering is a new stock offering by a specific
firm whose stock is already publicly traded.
b. Corporations sometimes direct their sales of stock toward their
existing shareholders by giving them preemptive rights.
c. Shelf Registration - Corporations can publicly place securities
without the time lag often caused by registering with the SEC.
2. Stock Repurchases
a. Firms tend to repurchase some of their shares when share prices
are at very low levels.
b. Many stock repurchase plans are viewed as a favorable signal,
some investors may ask why the firm does not use its funds to
expand its business instead of buying back its stock.
Stock Exchanges
1. Organized Exchanges
a. Each organized exchange has a trading floor where floor
traders execute transactions in the secondary market for their
clients.
b. New York Stock Exchange (NYSE) is by far the largest with
two broad types of members.
i. Floor brokers are either commission brokers or
independent brokers.
ii. Specialists can match orders of buyers and sellers.
c. Listing Requirements - minimum number of shares
outstanding and a minimum level of earnings, cash flow, and
revenue over a recent period.
Stock Exchanges
2. Over-the-Counter Market
a. Stocks not listed on the organized exchanges are traded in the
over-the-counter (OTC) market.
b. Nasdaq - National Association of Securities Dealers Automatic
Quotations (Nasdaq), which is an electronic quotation system that
provides immediate price quotations.
c. OTC Bulletin Board - lists stocks that have a price below $1 per
share, which are sometimes referred to as penny stocks.
d. Pink Sheets - The OTC market has where even smaller stocks are
traded. Some of the stocks have very little trading volume and
may not be traded at all for several weeks.
Stock Exchanges
3. Extended Trading Sessions

a. The NYSE and Nasdaq market offer extended trading
sessions beyond normal trading hours.
b. Market liquidity during the extended trading sessions is
limited.
Stock Exchanges
4. Stock Quotations Provided by Exchanges

a. 52-Week Price Range - The stock’s highest price and lowest
price over the previous 52 weeks are commonly listed just to the
left of the stock’s name.
b. Symbol - Each stock has a specific symbol that is used to identify
the firm.
c. Dividend - The annual dividend (DIV) is commonly listed to the
right of the firm’s name and symbol.
d. Dividend Yield - Annual dividend per share as a percentage of
the stock’s prevailing price. Shown next to the annual dividend.
e. Price-Earnings Ratio - Represents its prevailing stock price per
share divided by the firm’s earnings per share (earnings divided
by number of existing shares of stock) generated over the last
year.
Stock Exchanges
4. Stock Quotations Provided by Exchanges (Cont.)

f. Volume - Stock quotations also usually include the volume of
shares traded on the previous day. The volume is normally
quoted in hundreds of shares.
g. Closing Price Quotations - Stock quotations show the closing
price (“Last”) on the day (on the previous day if the quotations
are in a newspaper). In addition, the change in the price (“Net
Chg”) is typically provided and indicates the increase or decrease
in the stock price from the closing price on the day before.
Stock Exchanges
5. Stock Index Quotations

a. Dow Jones Industrial Average - value-weighted average of stock
prices of 30 large U.S. firms.
b. Standard & Poor’s 500 - a value-weighted index of stock prices
of 500 large U.S. firms.
c. Wilshire 5000 Total Market Index - index now contains more
than 5,000 stocks. The Wilshire 5000 is the broadest index of the
U.S. stock market.
d. New York Stock Exchange Indexes - The Composite Index is the
average of all stocks traded on the NYSE. NYSE also provides indexes
for four sectors: Industrial, Transportation, Utility, Financial.
e. Nasdaq Stock Indexes - The National Association of Securities
Dealers (NASD) provides quotations on indexes of stocks traded
on the Nasdaq.
Monitoring Publicly Traded Companies
 The easiest way for shareholders to monitor the firm is to

monitor changes in its value (as measured by its share
price) over time.
 If the stock price is lower than expected, shareholders
may attempt to take action to improve the management
of the firm.
 Investors also rely on the board of directors of each firm
to ensure that its managers make decisions that enhance
the firm’s performance and maximize the stock price.
1. Role of Analysts
a.Analysts are often employed by securities firms and assigned
to monitor a small set of publicly traded firms.
b.Stock Exchange Rules - In the 2002–2004 period, U.S. stock
exchanges imposed new rules to prevent some obvious
conflicts of interest faced by analysts.
i. Analysts cannot be supervised by the division that provides
advisory services, and their compensation cannot be based
on the amount of advisory business they generate.
ii. Securities firms must disclose summaries of their analysts’
ratings for all the firms that they rate so that investors can
determine whether the ratings are excessively optimistic.
2. Accounting Irregularities
a.In recent years, many firms used unusual accounting methods
to create their financial statements.
b.Overall, investors’ monitoring of some firms was limited
because the accountants distorted the financial statements, the
auditors did not properly audit, and the audit committees of
those firms did not properly oversee the audit.
3. Sarbanes-Oxley Act
a.Prevents a public accounting firm from auditing a client firm
whose chief executive officer (CEO), chief financial officer
(CFO), or other employees with similar job descriptions were
employed by the accounting firm within one year prior to the
audit.
b.Requires that only outside board members of a firm be on the
firm’s audit committee, which is responsible for making sure
that the audit is conducted in an unbiased manner.
c.Prevents the members of a firm’s audit committee from
receiving consulting or advising fees or other compensation
from the firm beyond that earned from serving on the board.
3. Sarbanes-Oxley Act (Cont.)

d.Requires that the CEO and CFO of firms of a specified size (or
larger) certify that the audited financial statements are accurate.
e. Specifies major fines or imprisonment for employees who mislead
investors or hide evidence.
f. Allows public accounting firms to offer nonaudit consulting
services to an audit client only if the client’s audit committee pre-
approves the nonaudit services to be rendered before the audit
begins.
Cost of Being Public
Establishing a process that satisfies the Sarbanes-Oxley provisions
can be very costly. For many firms, the cost of adhering to the
guidelines of the act exceeds $1 million per year.
4. Shareholder Activism
a. If shareholders are displeased with the way managers are managing
a firm, they have three choices.
i. Do nothing and retain their shares.
ii. Sell the stock.
iii. Engage in shareholder activism
b.Communication with the Firm - Shareholders can communicate
their concerns to other investors in an effort to place more pressure
on the firm’s managers or its board members.
c. Proxy Contest - Shareholders may also engage in proxy contests in
an attempt to change the composition of the board.
d.Shareholder Lawsuits - Investors may sue the board if they
believe that the directors are not fulfilling their responsibilities to
shareholders.
5. Limited Power of Governance

a.There is some evidence that the governance is not very
effective.
b.In spite of the Sarbanes-Oxley Act, shareholder activism,
proxy contests, and shareholder lawsuits, the agency problems
of some firms remain severe.
Market for Corporate Control
1. Use of LBOs to Achieve Corporate Control

The market for corporate control is enhanced by the use of
leveraged buyouts (LBOs), which are acquisitions that require
substantial amounts of borrowed funds.
2. Barriers to the Market for Corporate Control
a.Antitakeover Amendments - an amendment may require that
at least two-thirds of the shareholder votes approve a
takeover.
b.Poison Pills - Special rights awarded to shareholders or
specific managers on the occurrence of specified events.
c.Golden Parachutes - specifies compensation to managers in
the event that they lose their jobs or change in control of the
firm.
Globalization of Stock Markets
1. Privatization - In recent years, the governments of many

countries have allowed privatization, or the sale of
government-owned firms to individuals.
2. Emerging Stock Markets - Emerging markets enable
foreign firms to raise large amounts of capital by issuing
stock.
3. Variation in Characteristics across Stock Markets -
The volume of trading activity in each stock market is
influenced by legal and other characteristics of the
country. Shareholder rights vary among countries, and
shareholders in some countries have more voting power
and can have a stronger influence on corporate
management.
Globalization of Stock Markets
4. Methods Used to Invest in Foreign Stocks.

a.Direct Purchases - Investors can easily invest in stocks of foreign
companies that are listed on the local stock exchanges.
b.American Depository Receipts - certificates representing shares of
non-U.S. stock. Many non-U.S. companies establish ADRs in order
to develop name recognition in the United States.
c. International Mutual Funds - portfolios of international stocks
created and managed by various financial institutions.
d.International Exchange-Traded Funds - Passive funds that track
a specific index. International ETFs represent international stock
indexes, and they have become popular in the last few years.
11 Valuation and Risk of Stocks
33
Stock Valuation Methods
The Price-Earnings (PE) Method applies the

mean price-earnings (PE) ratio based on
expected earnings of all traded competitors to the
firm’s expected earnings for the next year
Valuation = Expected earnings per share x
Mean industry PE ratio
■ Assumes future earnings are an important

determinant of a firm’s value
■ Assumes that the growth in earnings in future
years will be similar to that of the industry
Price-Earnings Method:
■ Reasons for Different Valuations
■ Investors may use different forecasts for the firm’s earnings
or the mean industry earnings over the next year
■ Investors disagree on the proper measure of earnings.
■ Limitations of the PE Method –
■ May result in an inaccurate valuation of a firm if errors are
made in forecasting the firm’s future earnings or in choosing
the industry composite used to derive the PE ratio.
Dividend Discount Model

Dt
P
t 1 1  k 
t
where t = period
Dt = dividend in period t
k = discount rate
Dividend Discount Model

■ Relationship with PE Ratio for Valuing
■ The PE multiple is influenced by the required rate of return
and the expected growth rate of competitors
■ The inverse relationship between rate of return and value
exists in both models
■ The positive relationship between required rate of return and
value exists in both models
■ Limitations of the Dividend Discount Model
■ Errors can be made in determining the dividend to be paid,
the growth rate, and the required rate of return
■ Errors are more pronounced for firms that retain most of their
earnings.
Adjusted Dividend Discount Model

1. The dividend discount model can be adapted to assess
the value of any firm, even those that retain most or all of
their earnings.
■ The value of the stock is equal to the present value of the
future dividends plus the present value of the forecasted
2. Limitations of the Adjusted Dividend Discount Model:
May be inaccurate if errors are made in:
■ deriving the present value of dividends over the investment
horizon or
■ the present value of the forecasted price at which the stock
can be sold at the end of the investment horizon.
Free Cash Flow Model

■ For firms that do not pay dividends:
■ estimate the free cash flows that will result from operations.
■ subtract existing liabilities to determine the value of the firm.
■ divide the value of the firm by the number of shares to derive
a value per share.
■ Limitations - difficulty of obtaining an accurate
estimate of free cash flow per period.
Required Rate of Return on Stocks
Capital Asset Pricing Model

■ Sometimes used to estimate the required rate of return for
any firm with publicly traded stock.
■ The only important risk of a firm is systematic risk.
■ Suggests that the return of a stock (Rj) is influenced by the
prevailing risk-free rate (Rf), the market return (Rm), and the
beta (Bj):
Rj = Rf + Bj(Rm – Rf)
where Bj is measured as the covariance between Rj and Rm,

which reflects the asset’s sensitivity to general stock market
movements.
Capital Asset Pricing Model (Cont.)

■ Estimating the Market Risk Premium
■ The yield on newly issued Treasury bonds is commonly used as a
proxy for the risk-free rate.
■ The term, (Rm – Rf), is the market risk premium: the return of the
market in excess of the risk-free rate.
■ Historical data for 30 or more years can be used to determine the
average market risk premium over time.
■ Estimating the Firm’s Beta - typically measured by
applying regression analysis to determine the sensitivity of
the asset’s return to the market return based on monthly or
quarterly data.
Capital Asset Pricing Model (Cont.)

■ Application of the CAPM
■ Given the risk-free rate as well as estimates of the firm’s beta
and the market risk premium, it is possible to estimate the
required rate of return from investing in the firm’s stock.
■ At any given time, the required rates of return estimated by
the CAPM will vary across stocks because of differences in
their risk premiums, which are due to differences in their
systematic risk (as measured by beta). Historical data for 30
or more years can be used to determine the average market
risk premium over time.
Factors that Affect Stock Prices
Economic Factors
■ Impact of Economic Growth
■ An increase in economic growth is expected to increase the
demand for products and services produced by firms and
thereby increase a firm’s cash flows and valuation.
■ Impact of Interest Rates
■ Given a choice of risk-free Treasury securities or stocks,
investors should purchase stocks only if they are
appropriately priced to reflect a sufficiently high expected
return above the risk-free rate.
■ Interest rates commonly rise in response to an increase in
economic growth.
Economic Factors (Cont.)

■ Impact of the Dollar’s Exchange Rate Value
■ Foreign investors prefer to purchase U.S. stocks when the
dollar is weak and to sell them when the dollar is near its peak.
■ Stock prices are also affected by the impact of the dollar’s
changing value on cash flows.
■ Stock prices of U.S. companies may also be affected by
exchange rates if stock market participants measure
performance by reported earnings.
■ The changing value of the dollar can also affect stock prices by
affecting expectations of economic factors that influence the
firm’s performance.
Market-Related Factors
■ Investor Sentiment
■ Represents the general mood of investors in the stock market.
■ January Effect
■ Portfolio managers prefer investing in riskier, small stocks at
the beginning of the year and then shifting to larger, more
stable companies near the end of the year in order to lock in
their gains.
■ This tendency places upward pressure on small stocks in
January each year.
Firm-Specific Factors
■ Change in Dividend Policy
■ An increase in dividends may reflect the firm’s
expectation that it can more easily afford to pay dividends.
■ Earnings Surprises
■ When a firm’s announced earnings are higher than
expected, some investors raise their estimates of the firm’s
future cash flows and hence revalue its stock upward.
Firm-Specific Factors (Cont.)

■ Acquisitions and Divestitures
■ The expected acquisition of a firm typically results in an increased
demand for the target’s stock, which raises its price.
■ Expectations
■ Attempting to anticipate new policies so that they can make their move
in the market before other investors.
Integration of Factors Affecting Stock Prices

■ Whenever indicators signal the expectation of higher interest
rates, there is upward pressure on the required return by
investors and downward pressure on a firm’s value.
Stock Risk
The return from investing in stock over a

particular period is measured as
( SP  INV )  D
R
INV
where INV  initial investment
D  dividend
SP  selling price of the stock
The risk of a stock can be measured by using its price

volatility, its beta, and the value-at-risk method.
Stock Risk
Volatility of a Stock or total risk serves as a

measure of risk because it may indicate the degree
of uncertainty surrounding the stock’s future
returns.
■ Forecasting Stock Price Volatility
■ Using the historical method: a historical period is used to
derive a stock’s standard deviation of returns, and that
estimate is then used as the forecast over the future.
Stock Risk
Volatility of a Stock (Cont.)

Volatility of a Stock Portfolio - The portfolio’s volatility can
be measured by the standard deviation:
n n
 p  w   w    wi w j i j CORR ij
2
i i
2 2
j
2
j
i 1 j 1
where
 i  standard deviation of returns of the ith stock
 j  standard deviation of returns of the jth stock
CORR ij  correlation coefficient between th e ith and jth stocks
wi  proportion of funds invested in the ith stock
w j  proportion of funds invested in the jth stock
Stock Risk
Beta of a Stock - measures the sensitivity of its

returns to market
Returns
■ Beta of a Stock Portfolio can be measured as the weighted
average of the betas of stocks that make up the portfolio
 p   wi  i
■ High-beta stocks are expected to be relatively volatile because
they are more sensitive to market returns over time. Likewise,
low-beta stocks are expected to be less volatile because they are
less responsive to market returns.
Stock Risk
Value at Risk
1. estimates the largest expected loss to a particular
investment position for a specified confidence level.
2. Is intended to warn investors about the potential
maximum loss that could occur
3. Is commonly used to estimate the risk of a portfolio
Stock Risk
Value at Risk -
■ Application Using Historical Returns
■ E.g. an investor may determine that out of the last trading
100 trading days, a stock experienced a decline of greater
than 7 percent on 5 different days.
■ The investor could infer a maximum daily loss of no more
than 7 percent for that stock based on a 95 percent
confidence level.
Stock Risk
Value at Risk
■ Application Using the Standard Deviation
■ measure the standard deviation of daily returns over the
previous period
■ then apply it to derive boundaries for a specific confidence
level.
Stock Risk
Value at Risk
■ Application Using Beta - A third method of estimating the
maximum expected loss for a given confidence level is to apply
the stock’s beta.
■ Deriving the Maximum Dollar Loss - Once the maximum
percentage loss for a given confidence level is determined, it
can be applied to derive the maximum dollar loss of a particular
investment.
Stock Risk
Value at Risk (Cont.)

■ Application to a Stock Portfolio - The three methods can be
used derive the maximum expected loss of a stock portfolio for
a given confidence level.
■ Adjusting the Investment Horizon Desired – The same
methods can be applied over a week or a month
■ Adjusting the Length of the Historical Period - If conditions
have changed such that only the most recent days reflect the
general state of market conditions, then those days should be
used..
■ Limitations of the Value-at-Risk Method - Portfolio
managers may be using a relatively calm historical period when
assessing possible future risk.
Risk-Adjusted Stock Performance
Sharpe Index
The reward-to-variability ratio, or Sharpe Index, measures risk-
adjusted returns when total variability is the most appropriate
measure of risk.
R  Rf
Sharpe Index 

where R  average return on the stock
R f  average risk - free rate
  standard deviation of the stock's return
This index measures the excess return above the risk-free rate per
unit of risk.
Risk-Adjusted Stock Performance
Treynor Index
The Treynor Index measures risk-adjusted returns when beta is the
most appropriate measure of risk.
R  Rf
Treynor Index 

where R  average return on the stock
R f  average risk - free rate
  stock's beta
Stock Market Efficiency
Forms of Efficiency
■ Weak-Form Efficiency - suggests that security prices reflect
all market-related information, such as historical security price
movements and volume of securities trades.
■ Semistrong-Form Efficiency - suggests that security prices
fully reflect all public information, such as firm announcements,
economic news, or political news.
■ Strong-Form Efficiency - suggests that security prices fully
reflect all information, including private or insider information.
Stock Market Efficiency
Tests of the Efficient Market Hypothesis

■ Test of Weak-Form Efficiency - Weak-form efficiency has
been tested by searching for a nonrandom pattern in security
prices.
■ Test of Semistrong-Form Efficiency - Semistrong-form
efficiency has been tested by assessing how security returns
adjust to particular announcements.
■ Test of Strong-Form Efficiency - Tests of strong-form
efficiency are difficult because the inside information used is
not publicly available and cannot be properly tested.
Foreign Stock Valuation and Performance
Valuation of Foreign Stocks

■ Price–Earnings Method
■ The expected earnings per share are multiplied by the PE
ratio (based on the firm’s risk and local industry) to
determine the price of the stock.
■ The PE ratio for an industry may change, especially when
the industry consists of few firms.
■ The value derived by this method is denominated in the
local foreign currency .
■ Dividend Discount Model - can be applied by discounting
the stream of expected dividends while adjusting to account
for expected exchange rate movements.
International Market Efficiency

Some foreign markets are likely to be inefficient because a
small number of analysts and portfolio managers may monitor
the stocks.
Measuring Performance from Investing in Foreign

Stocks
The returns from investing in foreign stocks is most properly
measured in terms of the investor’s objectives.
Performance from Global Diversification

Research has demonstrated that investors in stocks can benefit
by diversifying internationally.
Diversification among Emerging Stock Markets:

The correlation between stocks of different countries is low,
so investors can reduce risk by including some stocks from
these markets in their portfolios.
12 Market Microstructure and Strategies
Chapter Objectives
64
Stock Market Transactions
Placing an Order - To place an order to buy or sell

a specific stock, an investor contacts a brokerage
firm.
■ The investor communicates the order to the broker by
specifying (1) the name of the stock, (2) whether to buy or sell
that stock, (3) the number of shares to be bought or sold, and
(4) whether the order is a market or a limit order.
■ Broker may provide a bid quote if the investor wants to sell a

stock or an ask quote if the investor wants to buy a stock.
■ A Market Order is executed at the best possible price.
■ A Limit Order places a limit on the price at which a stock can

be purchased or sold.
Placing an Order (Cont.)

■ Stop-Loss Order - to protect gains or to limit losses.
■ Investor specifies a selling price that is below the current
market price of the stock.
■ When the stock price drops to the specified level, the stop-
loss order becomes a market order.
■ Stop-Buy Order
■ Investor specifies a purchase price that is above the current
market price.
■ When the stock price rises to the specified level, the stop-buy
order becomes a market order.
Placing an Order (Cont.)

■ Placing an Order Online
■ Many Internet brokers accept orders online, provide real-time
quotes, and provide access to information about stocks.
■ Some online brokerage services offer zero-commission
trades. However, investors must maintain a certain amount of
funds in their brokerage accounts.
Margin Trading
■ Investors use cash along with funds borrowed from their broker
to make the purchase.
■ The Federal Reserve imposes initial margin requirements,
which represent the minimum proportion of funds that must be
covered with cash (currently 50%).
■ Investors must establish an account (called a margin account)
with their broker.
■ Over time, the market value of the stock will change. Investors
are subject to a maintenance margin, which is the minimum
proportion of equity that an investor must maintain in the
account as a proportion of the market value of the stock
(currently 25%).
Margin Trading
■ Margin Calls
■ A large volume of margin lending exposes the stock markets
to a potential crisis.
■ A high volume of margin calls results in more sales, putting
downward pressure on stock prices, leading to additional
margin calls.
Margin Trading
■ Impact on Returns
■ The return (R) is affected by the proportion of the investment
that is from borrowed funds.
SP  INV  LOAN  D
R
INV
where SP  selling price of stock
INV  initial investment by investor, not including borrowed funds
LOAN  loan payments on borrowed funds, including principal and interest
D  dividend payments
Short Selling
1. Investors place an order to sell a stock that they do not own.
The investor borrows the stock from another investor and will
return it to the investor from whom they borrowed it.
2. If the price of the stock declines by the time the short-sellers
purchase it in the market, the short-sellers earn the difference
between the price at which they initially sold the stock and the
price they paid to obtain the stock.
3. The risk of a short sale is that the stock price may increase
over time, forcing the short-seller to pay a higher price for the
stock than the price at which it was initially sold.
Short Selling (Cont.)

1. Measuring the Short Position of a Stock
■ The ratio of the number of shares that are currently sold short divided by
the total number of shares outstanding.
■ Short interest ratio - the number of shares that are currently sold short
divided by the average daily trading volume over a recent period.
2. Using a Stop-Buy Order to Offset Short Selling - Investors
commonly use a stop-buy order to limit their losses.
3. Concerns about Short Selling - When the credit crisis
intensified in 2008, hedge funds and other investors took large
short positions on many stocks. Some critics argued that the
large short sales placed additional downward pressure on
prices and created paranoia in the stock market..
Short Selling (Cont.)

1. Restrictions on Short Selling
■ In October 2008, the SEC required that short-sellers borrow and deliver
the shares to the buyers within three days. This rule is important because
there were many cases in which brokerage firms were allowing
speculators to engage in naked shorting, in which they sell a stock short
without first borrowing the stock.
■ In 2009, the SEC also reinstated the uptick rule (previously eliminated in
2007), which prohibits speculators from taking a short position except
after the stock price increases. This rule is intended to prevent short
selling in response to a stock’s continuous downward price momentum.
How Stock Transactions are Executed
Floor Brokers
1. Floor brokers are situated on the floor of a stock exchange
and fulfill and execute orders.
Market-Makers (Specialists)
1. Can serve a broker function by matching up buy and sell
orders on the New York Stock Exchange.
2. Making a market implies that they stand ready to buy or sell
certain stocks even if no other investors are willing to
participate.
3. Market-makers take positions to capitalize on the discrepancy
between the prevailing stock price and their own valuation of
the stock.
4. May take the opposite position to uninformed “noise traders.”
The Spread on Stock Transactions

The spread is the difference between the ask price and the bid
price, and is measured as a percentage of the ask price . The
spread is influenced by the following factors:
■ Order Costs - clearing costs and the costs of recording
transactions increase the bid-ask spread.
■ Inventory Costs - the cost of maintaining an inventory of a stock
increases the bid-ask spread.
■ Competition - having multiple market-makers promotes
competition and reduces the bid-ask spread.
■ Volume - Stocks that are more liquid have a large trading volume
and a lower bid-ask spread.
■ Risk - If the firm has risky operations, its stock price is more
volatile, therefore increasing the bid-ask spread.
Electronic Communication Networks

1. ECNs are automated systems for disclosing and executing
stock trades. The SEC requires that any quote provided by a
market-maker be made available to all market participants.
2. Interaction between Direct Access Brokers and ECNs
■ A direct access broker is a trading platform on a computer
website that allows investors to trade stocks without the use of a
broker.
■ The website serves as the broker and interacts with ECNs that can
execute the trade.
■ The advantage of a direct access broker is that investors can
monitor the supply and prices of shares and the demand for shares
on different ECNs.
Program Trading
1. Program trading represents a computerized response by
institutional investors to either buy or sell a large basket of
stocks in response to movements in a particular stock index.
2. Impact of Program Trading on Stock Volatility
■ Program trading is often cited as the cause of a decline or rise in
the stock market.
■ On May 6, 2010, stock prices declined abruptly in what is now
referred to as the “flash crash.” Overall, stocks declined by more
than 9 percent on average before reversing and recovering most
of those losses on that same day, when more than 19 billion
shares were traded. It appears that the flash crash was triggered
by computerized trading.
Regulation of Stock Trading
Circuit Breakers
1. Restrictions on trading when stock prices or a stock index
reaches a specified threshold level.
Trading Halts
1. Stock exchanges may impose trading halts on particular
stocks when they believe market participants need more time
to receive and absorb material information that could affect
the stock’s value.
2. Trading halts are intended to reduce stock price volatility, as
the market price is adjusted by market forces in response to
news.
Securities and Exchange Commission –

The Securities Act of 1933 and the Securities Exchange Act of
1934 gave the SEC authority to monitor exchanges and required
listed companies to file a registration statement and financial
reports with the SEC and the exchanges.
1. Some SEC regulations involve the following requirements:
■ Firms must publicly disclose all information about themselves
that could affect the value of their securities.
■ Employees of firms may take positions in their own firm’s
securities only during periods when they do not know of inside
information.
■ Participants in security markets who facilitate trades must work in
a fair and orderly manner.
Securities and Exchange Commission

1. Structure of the SEC
■ Consists of five commissioners appointed by the President of the
United States and confirmed by the Senate.
■ Each commissioner serves a five-year term. The terms are
staggered so that, each year, one commissioner’s term ends and a
new appointee is added.
■ The president also selects one of the five commissioners to chair
the commission.
Securities and Exchange Commission

1. Key Divisions of the SEC
■ The Division of Corporate Finance reviews the registration
statement filed when a firm goes public, corporate filings for
annual and quarterly reports, and proxy statements.
■ The Division of Market Regulation requires the orderly
disclosure of securities trades
■ The Division of Enforcement assesses possible violations of the
SEC’s regulations and can take action against individuals or
firms.
2. SEC Oversight of Corporate Disclosure
■ In October 2000, the SEC issued Regulation Fair Disclosure
(FD), which requires firms to disclose relevant information
broadly to investors at the same time.
Trading International Stocks
Reduction in Transaction Costs

1. In recent years, countries have consolidated their exchanges,
increasing efficiency and reducing transaction costs.
2. Many international stock exchanges are now fully
computerized.
Reduction in Information Costs
1. Information about foreign stocks is now available on the
Internet, enabling investors to make more informed decisions
without having to purchase information about these stocks.
Reduction in Exchange Rate Risk
1. A firm may be able to obtain all the financing it needs with one
stock offering denominated in euros.

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Financial Institutions & Markets

Private equity is a business that is privately held and

A public offering is feasible if:

Financing by Venture Capital Funds

Venture Capital Market

Terms of a Venture Capital Deal

Exit Strategy of VC Funds

Financing by Private Equity Funds

■ When a firm goes public, it issues stock in the primary

■ Stock markets are like other financial markets in that they

■ Owners of small companies also tend to be the

■ Preferred stock represents an equity interest in a firm that

■ Preferred shareholders share the ownership of the firm with

■ A cumulative provision on most preferred stock prevents

■ Because the dividends on preferred stock can be omitted, a

■ How Investor Decisions Affect Stock Prices

A first-time offering of shares by a specific firm to the public.

2. Underwriter Efforts to Ensure Price Stability

4. Initial Returns of IPOs

1. Secondary Stock Offerings

3. Extended Trading Sessions

4. Stock Quotations Provided by Exchanges

4. Stock Quotations Provided by Exchanges (Cont.)

5. Stock Index Quotations

 The easiest way for shareholders to monitor the firm is to

3. Sarbanes-Oxley Act (Cont.)

5. Limited Power of Governance

1. Use of LBOs to Achieve Corporate Control

1. Privatization - In recent years, the governments of many

4. Methods Used to Invest in Foreign Stocks.

The Price-Earnings (PE) Method applies the

■ Assumes future earnings are an important

Dividend Discount Model

Dividend Discount Model

Adjusted Dividend Discount Model

Free Cash Flow Model

Capital Asset Pricing Model

where Bj is measured as the covariance between Rj and Rm,

Capital Asset Pricing Model (Cont.)

Capital Asset Pricing Model (Cont.)

Economic Factors (Cont.)

Firm-Specific Factors (Cont.)

Integration of Factors Affecting Stock Prices

The return from investing in stock over a

The risk of a stock can be measured by using its price

Volatility of a Stock or total risk serves as a

Volatility of a Stock (Cont.)

Beta of a Stock - measures the sensitivity of its

Value at Risk (Cont.)

Tests of the Efficient Market Hypothesis

Valuation of Foreign Stocks

International Market Efficiency

Measuring Performance from Investing in Foreign

Performance from Global Diversification

Diversification among Emerging Stock Markets:

Placing an Order - To place an order to buy or sell

■ Broker may provide a bid quote if the investor wants to sell a

■ A Market Order is executed at the best possible price.

■ A Limit Order places a limit on the price at which a stock can