The Stock Market

Session 3: The Stock Market

• The session covers stocks as primary assets, stock indices, ETFs, stock attributes, stock markets trading, efficiency, and investor behaviours.

Introduction

• Companies can raise external funds in financial markets.
• Capital is raised through bonds (debt) or shares (stocks as ownership/equities), with each channel having its own company cost.
• All public company shares are in the stock market, either physically or digitally.
• Stock market exchanges are regulated; rules dictate market participants and transaction execution.
• Stock market exchanges enable companies to quickly access capital for development.
• Stock market exchanges allow investors to profit from well-chosen companies' shares through buying/selling.
• Trading activity determines stock prices based on supply and demand.
• Stock prices fluctuate, making stocks risky.
• Stock markets are sensitive to economic, geopolitical, and exogenous events like earthquakes or pandemics.

Recent Facts: Growing Activity

• Stock market activity is increasing over time.

Recent Facts: Crises

• Stock market trade is risky.
• Many events impact stock prices leading to price uncertainty.
• During stock market crises and crashes, stock prices fall and economic development halts.
• War in Ukraine makes stock markets sensitive to geopolitical events

Part 1: Stocks as Primary Assets

• The part covers topics like stock indices, ETFs and stock attributes

What is a Stock?

• A stock is a security giving the stockholder (share buyer) ownership in a company (stock issuer).
• Shareholders own a company percentage and may receive dividends if profitable that is a share of the company's profits.
• There are two stock types that give different rights to the shareholders

Common vs. Preferred Stock

• Common Stocks
• Receiving dividends are based on the firm's success.
• Common stock grants the holder voting rights.
• There are various classes A, B, etc
• Preferred Stock
• Receiving constant payments are fixed dividends.
• No voting rights
• Priority of claims on the company's assets before common stockholders

Stock Issuance and Selling

• Stocks are sold and traded on organized exchanges like the NYSE and OTC markets.
• Investors provide equity capital by buying stocks to companies with growth potential.
• "Going public" means issuing stocks to raise capital, requiring a company to enter the primary market, that is where stocks are issued and sold for the first time (like bonds).
• From IPO in 2013 to delisting in 2022 Twitter was issued on the market
• IPO price was $26 per share
• Closing price was $44.90 per share, that is +73% on the first trading day
• On October 27th, 2022 Elon Musk completed the acquisition of Twitter at $54.20 per share.
• Investment banks facilitate Initial Public Offerings (IPO) and arrange share listing on exchanges.
• Investment banks sell shares to institutional and retail investors for a fee.
• Stocks are traded on the secondary market via exchanges and OTC markets.

Transactions on a Share

• The order book of LVMH, the largest French company, was seen on 30/06/2023 at 16h59.
• The order book of Floridienne, a mid Belgian company, was seen on 30/06/2023 at 16h59.

Market Capitalization

• Stocks are categorized by market capitalization such as small, mid or largely capitalized stocks.
• Market capitalization equals outstanding shares times stock price, giving the total market value.
• Reflecting the size of the company, differing volatility, growth potential, and liquidity.

Stock Indices

• A stock market index monitors the evolution and performance of a general stock exchange or group, serving as a benchmark.
• S&P500, CAC 40, Nikkei 225 are general market indices.
• There exists capitalization- and sector-specific stock market indices (e.g., MSCI large-, small- and mid-cap indices).

Stock Indices and ETFs

• A stock index has several ways to “buy”
• Buying shares in a mutual fund tracks an index, such as the Vanguard 500 Index fund, using the S&P 500 Index as a benchmark.
• Buying shares in an Exchange-Traded Fund (ETF) that tracks the index.
• ETFs are like mutual funds but individual stocks get traded on the stock exchange.
• Buying all individual stocks replicates the index return.
• Subject to the last session, mutual Funds and ETFs are the last subject.

Risk/Return of a Stock

• Potential dividend and stock price appreciation are two sources of a stock's reward.
• Stocks are riskier compared to bonds.
• Dividends are uncertain to be paid.
• Stock price fluctuations can happen all the tme which gives price uncertainty.
• The stock price is volatile and unpredictable.
• With residual claimants, if anything's left, stakeholders get a claim on assets and income once debtors and banks are satisfied .

Risks of Holding a Stock

• When buying a stock, shareholders/stockholders face risks.
• The major risk is the market risk, due to stock price fluctuations, especially price drops.
• Measured by the volatility (standard deviation) of stock returns.
• (Market) Liquidity risk refers to the cost and easiness of trading a stock in the market.

Market Liquidity

• Liquidity has three attributes.
• Immediacy: buy or sell stocks quickly (trade speed).
• Tightness: the difference between bid and ask prices. The lower is the cheaper to buy and sell a stock (cheap full round transaction).
• Depth: quantities available in the market price to buy and sell. In a deep market, significant quantities impact the price (no volume impact.)
• The earlier order books of LVMH & Floridienne were reported.

Stock Return

• Investors keep buying stocks at a price Pt-1 at time t-1 until time t and the new stock price fluctuates due to supply and demand at time t.

Stock Price

• A stock price has same computing principles like a bond.

• it is the present of any amounts to be paid by stock over the future, such as the future dividends.

• Questions to consider regarding the first issue

• Which will be the next share dividends?

• Looking forecasting models and how stock brokers view future earnings (ex LVMH and Boursorama)

• Question to consider regarding the second issue

• Bonds stop paying dividends after the last payment, but stocks have infinite time to pay its dividends

• Sums to consider for the overall value is infinite

• The formula that gives this value is:

• Value of a stock = ∑∞t=1 Dividendt/(1+r)t

• The discount rate "r" in the equation is the shareholders required rate of return, or the estimated CAPM

• When only one dividend is known, it is supposed to grow by a factor "g" based on recent year's evolution.

• Where Value equals Value of a growing perpetuity equals D2024/r-g

• Example: Expected dividend will be 5€ and the dividend will grow at 4%, with a discount rate of 6%, the Value of the share is 250€

• For the second form, The first three dividends are are known, then supposed to grow by a constant factor "g".

Stock Risk

• Over T periods, ôt the stock risk is is the return R t's volatility .
• The formula for this is: ôt2=1/T-1 ΣTt=1 (Rt - Rt) 2

Better Investing

• Considering that profit is not the only reason to invest, but to include the social and environmental implications too is an investment
• The three notions often consider:
• Environmental Social and Governance (ESG)
• Socially Responsible Investing (SRI)
• Impact Investing
• Environmental Social and Governance determine the effects of environmental, social and governmental can affect investment returns..
• There are factors such as human rights, quality of management; pollution and natural preservation.
• The removal of investments, based on ethical standards is the goal of Socially Responsible Investment.
• Such as not investing in tobaccos and investing in the wind industry..
• Investments that generate beneficial social/environmental impact, and receive the most returns is Impact Investing.

Part 2: Trading, Efficiency, and Investor Behaviors

• This part will cover the stock markets, investor behaviours and EMH

EMH and Stock Price Analysis

• For stock selection, there are two types:
• Fundamental analysis: Uses fundamentals to establish a "fair" share price, with trading rules based on market price location vs that fair price.
• Technical analysis: Detects paterns, by detecting prices. Trading rules follow detected patterns with the idea that history reproduces itself.

Trading

• An organised changed is a set location for buyers and sellers to meet regularly to trade securities using an open outcry auction model (Mishkin & Eakins, 2016).
• The New York Stock Exchange (NYSE) began as the Organized Securities Exchange in year 1792.
• Electronic trading took place on the NYSE was made possible be new technology in early 2006.

Electronic Trading

• For example, the NYSE takes advantage of Electronics Communication Networks or ECNs.
• ECN makes trading very transparent as supply and demand can easily be tracked
• ECNS give lower commissions to help reduce costs
• Has faster execution as systems are automated and sent and executed electronically
• ECNs enable after hour trade with its open always for work.
• Electronic trading enables complex or fast trading stocks with the help of computers.

Algorithmic and High Frequency Trading:

• Algorithmic trading (AT) applies sophisticated automated trading decisions.
• A subset where high Frequency Trading relies on speed differences between trade orders to make trades faster so it can profit more.

Speed and Arbitrage

• Arbitrage comes from the opportunity in market places where Shares can be sold at varying prices, such as Exchange A selling for cheaper, to Exchange B for higher. This takes advantage of market fragmentation.
• These types of trades work as follows: A stock is purchased when the price is cheaper, then it can be immediately be resold for a higher profit.
• Then any arbitrage can done high price – cheap price > 0!
• However, law of supply and demand dictates the profitability.

Impact of HFT on the Market

• There is no clear consensus.
• On one hand, HFT leads to better liquidity.
• While one the other hand, HFT influences the stock market volatilit, and may have some destabilisationg effects to the intraday market called, flash crashes.

HFT and Flash Crashes

• Greater HFT relates to less stock price.
• Intraday crashes cause HFT to cancel trades and withdrawal from imit price order book.
• When the market decline HFT trades agress and consumes more liquidity.

Information Flow and Market Efficiency

• Stock prices are determined via available information.
• efficient market hypothesis or EMH theory- stock pirces reflect all public info In efficient Market, any price differences are eliminated quickly do to any opportunity In the market, participant base share prices on the expectations and available info.

Forms Of Market Efficiency

• prices indicate the overall market trading volumes and historical prices
  • it will fail you to gain returns by exploiting
• Prices reflect to find any financial data -you may not receive any data
• you may not easily gain extra profits