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  • 1. The Stock Market Chapter 11 © 2003 South-Western/Thomson Learning
  • 2. Learning Objectives <ul><li>Major characteristics of stock market </li></ul><ul><li>How organized exchanges and over-the-counter markets function </li></ul><ul><li>Various stock indexes and what each measures </li></ul><ul><li>How value of a share of stock is determined </li></ul>
  • 3. Speculative Bubble <ul><li>An irrational increase in stock prices accompanied by euphoric expectations </li></ul><ul><ul><li>Market participants liquidate their positions </li></ul></ul><ul><ul><li>Prices fall to lower than before bubble </li></ul></ul><ul><ul><li>Causes financial instability as gains and losses are magnified </li></ul></ul><ul><ul><li>Resulting losses cause unemployment and recession </li></ul></ul>
  • 4. Anatomy of Stocks <ul><li>Preferred Stock </li></ul><ul><ul><li>Equity claims representing ownership of net income and assets of corporation that receive a fixed dividend before common stockholders are entitled to anything </li></ul></ul><ul><li>Common Stock </li></ul><ul><ul><li>Equity claims representing ownership of net income and assets of corporation that receive a variable or no dividend after preferred stockholders have been paid and retained earnings have been put aside </li></ul></ul>
  • 5. Anatomy of Stocks Stock Offerings <ul><li>Initial Public Offering (IPO) </li></ul><ul><ul><li>When a corporation issues stocks publicly for the first time </li></ul></ul><ul><li>Secondary Stock Offering </li></ul><ul><ul><li>Offering on newly issued shares by firm that already has outstanding publicly held shares </li></ul></ul>
  • 6. Anatomy of Stocks <ul><ul><li>Shelf Registration </li></ul></ul><ul><ul><ul><li>Procedure that permits a company to: </li></ul></ul></ul><ul><ul><ul><ul><li>Register a quantity of securities with the SEC </li></ul></ul></ul></ul><ul><ul><ul><ul><li>Sell the quantity of securities over a 2-year period rather than at the time of registration </li></ul></ul></ul></ul>
  • 7. Stock Markets <ul><li>Program Trading </li></ul><ul><ul><li>Pre-programming of computers to buy or sell a large number (basket) of stocks usually by institutional investors </li></ul></ul><ul><li>Margin Requirement </li></ul><ul><ul><li>Percentage of invested funds that can be borrowed as opposed to being paid in readily available funds </li></ul></ul><ul><ul><li>Currently are set by the Fed at 50% </li></ul></ul><ul><li>Maintenance Margin Requirement </li></ul><ul><ul><li>Minimum amount of equity the investor needs in his account relative to the market value of his stock </li></ul></ul>
  • 8. Exhibit 11–3 Net Non-U.S. Purchase of U.S. Stock *Analyzed through second quarter 2001 Source: Flow of Funds of the United States, Z1, Board of Governors of the Federal Reserve System, September 18, 2001, page 22.
  • 9. Stock Market and Mutual Funds Many individuals can tap into the higher returns of the stock market while minimizing the risk of doing so by purchasing shares of a mutual fund.
  • 10. Stock Market and Mutual Funds <ul><li>Mutual Funds </li></ul><ul><ul><li>Companies that pool the funds of many investors and then invest in bonds or some combination of both stocks and bonds </li></ul></ul><ul><ul><li>Offer less risk and greater safety than individual stocks because of diversification </li></ul></ul><ul><ul><li>Highly specialized to reflect amount of risk an investor wishes to accept </li></ul></ul>
  • 11. Major Domestic Exchanges <ul><li>New York Stock Exchange (NYSE) </li></ul><ul><ul><li>World’s largest market for trading stocks </li></ul></ul><ul><ul><li>Trades stocks of over 3,000 companies </li></ul></ul><ul><ul><li>Designated Order Turnaround (DOT) </li></ul></ul><ul><ul><ul><li>Computer system used for trades of fewer than 3,000 shares on the NYSE </li></ul></ul></ul><ul><ul><li>Circuit Breakers </li></ul></ul><ul><ul><ul><li>Reforms introduced in 1987 on the NYSE to temporarily halt market trading if prices change by a specified amount. </li></ul></ul></ul>
  • 12. Major Domestic Exchanges <ul><li>American Stock Exchange </li></ul><ul><ul><li>Located in New York City </li></ul></ul><ul><ul><li>Trades the stock of over 660 companies </li></ul></ul>
  • 13. Over-the-Counter Market <ul><li>Over-the-Counter Market </li></ul><ul><ul><li>Network of securities dealers who trade stocks of over 30,000 companies via telephone or computer </li></ul></ul>
  • 14. Over-the-Counter Market <ul><li>National Association of Securities Dealers (NASD) </li></ul><ul><ul><li>Privately owned organization </li></ul></ul><ul><ul><li>Regulates market participants in over-the-counter market under supervision of SEC </li></ul></ul><ul><li>National Association of Securities Dealers Automated Quotation System (NASDAQ) </li></ul><ul><ul><li>Association whose members trade stocks over an advanced computer system that provides immediate information about prices and the number of shares traded </li></ul></ul>
  • 15. Stock Market Indexes <ul><li>Dow Jones Industrial Average (the Dow) </li></ul><ul><ul><li>Index that measures movements in the stock prices of 30 of the largest companies traded on the NYSE </li></ul></ul>
  • 16. Valuation of Stocks <ul><li>Market Risk Premium </li></ul><ul><ul><li>Risk based on historical data that shows how much on average the ownership of stocks pays over a risk-free return </li></ul></ul><ul><li>Firm-specific Risk Premium </li></ul><ul><ul><li>Risk measured by beta that shows the overall sensitivity of the stock’s return relative to changes in entire market </li></ul></ul>
  • 17. Valuation of Stocks <ul><li>Beta </li></ul><ul><ul><li>Measure of the overall variability of a stock relative to changes in the entire stock market </li></ul></ul><ul><li>Capital Asset Pricing Model (CAPM) </li></ul><ul><ul><li>Model that asserts that the value of a share of stock includes: </li></ul></ul><ul><ul><ul><li>Risk-free return </li></ul></ul></ul><ul><ul><ul><li>Market risk premium </li></ul></ul></ul><ul><ul><ul><li>Firm-specific risk premium that is based on beta </li></ul></ul></ul>

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