Introduction to the Stock Market

Session 3: The Stock Market

• The session provides an introduction to the stock market.
• It discusses stocks as primary assets, stock indices, ETFs, and stock attributes.
• The session explores stock market trading, efficiency, and investor behaviors.

Introduction to Financial Markets

• Companies can raise external funds through financial markets
• This can be done by issuing bonds (debt) or shares (stocks/equities).
• Each method of raising capital has its own "cost" to the company.
• Shares of publicly held companies are traded on the stock market, which is a physical or digital exchange.
• Stock market exchanges are regulated.
• Regulations govern the types of market participants and how transactions occur.
• Stock market exchanges serve to allow companies to access capital and allow investors to benefit from stock investments.
• Stock prices are determined by supply and demand, and they fluctuate, stocks are considered risky.
• Stock markets are sensitive to the economic state and geopolitical events such as earthquakes and pandemics.

Market Activity & Recent Facts

• Stock market activity has grown.

Stock Market Crises

• Stock market trading involves risk.
• Stock market declines in cases of crisis.
• Events can alter stock prices, leading to price uncertainty.

War in Ukraine

• Stock markets are sensitive to geopolitical events like war.

Stocks as Primary Assets

• A stock is a security that gives a stockholder/shareholder ownership in a company.
• Equity interest is the percentage of company owned by an investor.
• In return for ownership, the stockholder may recieve dividends when the coompany succeeds.
• There are two main types of stocks, common and preferred.

Common Stock vs. Preferred Stock

• Common stock dividends are subject to the firm's policy, while preferred stock provides constant fixed dividends.
• Common stock holders have right to vote, while preferred stock holders typically have no voting rights.
• Common stocks have classes (A, B, etc.) that describe differences in received dividends and rights to vote.
• Preferred stockholders have a priority claim on the company’s assets before common stockholders.

Stock Issuance and Selling

• Stocks are traded on organized securities exchanges (like the NYSE) or OTC markets.
• Buying stocks provides equity capital to companies with growth opportunities.
• When a company goes public (issuing stocks to raise capital), it needs to go to the primary market.
• This is where stocks are issued and sold for the first time (like with bonds).

Twitter Example

• Twitter went from IPO in 2013 to delisting in 2022.
• The company's IPO priced at $26 per share on November 7, 2013.
• The closing price for the IPO was $44.90 per share (+73%) on the first trading day.
• On October 27, 2022, Elon Musk completed the acquisition of Twitter at $54.20 per share.
• An investment bank helps a company make an Initial Public Offering (IPO).
• This allows the investment bank to arrange the shares to be listed on stock exchanges.
• The investment bank sells the shares to institutional and retail investors for a fee.
• Stocks are then traded (bought/sold by investors) on the secondary market.

Central Order Book

• Central order book displays transaction details on a share

Market Capitalization

• Stocks are categorized by market capitalization (small, mid, or large-cap).
• Market capitalization is the number of outstanding shares times the stock price.
• It represents the total market value of a company's shares.
• Market cap also represents the size of the company stock volatility, growth potential and liquidity.

Stock Indices

• A stock market index tracks the progress of a group of stocks (benchmark role).
• General market indices include S&P 500, CAC 40, and Nikkei 225.
• Capitalization and sector-specific stock market indices include MSCI large, small and mid-cap indices.

Stock Indices and ETFs

• There are several ways to "buy" a stock index:
• Buy shares in a mutual fund that follows the index (Vanguard 500 Index fund).
• Purchase shares in an Exchange-Traded Fund (ETF) that tracks the index, ETFs traded as individual stocks.
• Buying all the individual stocks in an index replicates the rate of return.

Stock Reward and Risk Factors

• A stock has two sources of reward: potential dividend and stock price appreciation.
• Stocks are more risky than bonds
• Dividends on stocks may not be paid
• Stock prices fluctuate and can increase or decrease at any time.
• Stockholders as residual claimants on all assests and income, must wait untill all other claimants (debtors, banks) are satisfied (if anything is left).

Risks of Holding Stock

• Those who buy stock take many risks because its price fluctuates.
• Market risk is primary risk that stock price may drop and its is measureed by volatility.
• Liquidity risk means stock trade may vary based on market conditions.

Market Liquidity

• Liquidity is measured by three attributes:
• Immediacy: The ability to quickly buy or sell a stock.
• Tightness: The difference between the bid and ask prices.
• Depth: Availability of buy and sell stocks at the market price
• In a deep market, one can trade stocks without impacting the stock price

Stock Return

• Stock return is the relative price variation of the stock and can be calculated as (current price - price of previous time period)/price of previous time period

Computing Stock Price

• The price of a stock can be computed using the same principles as a bond.
• It is represented in the future value of amounts paid by dividends.

Common Method for Dividends in Stock Pricing

• Dividends per share, example LVMH- caught from Boursorama

2nd Method for Calculating Stock Price

• Shares are supposed to pay forever.
• Therefore the value calculation must account for the rate of required return by the shareholders.

Growing Perpetuity & Stock Value

• For growing perpetuity rate of return to shareholders equals value of stock
• Stock valuation calculation can include the evaluation of analysts' estimates of price.

Stock Risk Calculation

• Stock risk equals the volatility of standard deviation
• Periodic volatility can be converted to annual volatility.
• There is a correlation between volatility and return on stocks.

“Better” Investing

• New type of investing includes consideration of profit, social and environmental factors

ESG, SRI & Impact Investing

• Environmental, social and governmental factors decide if investment will be good or not
• Socially Responsible Investment considers ethics as a factor
• Investing to better measurable environment

EMH or Efficient Market Hypothesis

• The information available or not impacts stock prices on the market
• All publicly known markets affect all stock price in EMH

Stock Market Types

• Market can be affected by publicly known information by strong, semi strong or weak influences.

Market Efficiency Violations

• Mispricing can come about from Behavioral factors.
• Stock prices are unpredictable in efficient market.

Investor Rationality & EMH

• Cognitive biases occur as investor deviate from rational thinking in stock decisions

EMH & Portfolios

• Prevalence or lack of EMH can allow portfolio managers to make passive or active decisions