Understanding the Stock Market

• Session 3 is about the stock market.

Outline

• Introduction covers general and recent facts.
• Part I covers stocks as primary assets, stock indices, ETFs, and stock attributes.
• Part II covers stock market trading, efficiency, and investor behavior.

Introduction

• Companies can raise external funds by using financial markets.
• Capital can be raised by issuing bonds (debt) or shares (stocks representing ownership or equities), each avenue having its own cost.
• Shares issued by publicly held firms are traded on the stock market, a physical or digital exchange.
• Stock markets are regulated, with rules governing market participants and transaction execution.
• Stock market exchanges allow companies to quickly access capital for development.
• Stock market exchanges permit investors to profit from stock investments.
• Trading drives prices based on supply and demand balance.
• Stocks are risky, prices can fluctuate over time.
• Stock markets react sensitively to economic conditions, geopolitical situations, and external events like earthquakes or pandemics.

Recent Facts: Growing Activity

• Stock market activity has been growing over time.
• Global equity issuance was $1.042 billion in 2021.
• Globalequity issuance includes non-convertible IPOs and follow-on equity deals, excludes preferred shares, rights issues, closed-end funds, business development companies, and SPACs
• US equity issuance was $436 million in 2021.
• US Equity Issuance includes rank eligible deals, excludes BDCS, SPACS, ETFs, CLEFs, and Rights Offers.
• IPO = initial public offering, Secondaries = secondary offerings or follow-ons, CS = common stock, Preferred = preferred stock.

Recent Facts: War in Ukraine

• Stock market trading is risky.
• Stock markets are particularly sensitive to geopolitical events.
• Many events can alter stock prices, creating uncertainty.
• During stock market crises, stock prices drop and economic development halts.

Recent Facts: Crises

• The S&P 500 experienced major events and price fluctuations in 2020.

Part I: Stocks as Primary Assets, Stock Indices, ETFs, and Stock Attributes

What is a Stock?

• A stock is a security giving a stockholder ownership in a company.
• The investor owns a percentage of interest in the company.
• Stockholders may receive dividends from company earnings.
• There are two types of stocks that give different rights to the shareholders.
• Common stocks can receive dividends based on the company's policy.
• Common stock gives the shareholder the right to vote.
• Common stocks have various classes with differences in received dividends and voting rights.
• Preferred stock gives the shareholder consistent fixed dividends.
• Preferred stock gives the shareholder no voting rights.
• Preferred stock gives the shareholder priority of claims on the company's assets.

Stock Issuance and Selling

• Stocks are traded on securities exchanges like the NYSE and OTC markets.
• Investors provide equity capital to companies through stock purchases.
• Companies "go public" via the primary market to raise capital by issuing stocks.
• Twitter started with an IPO in 2013, then delisted in 2022.
• Twitter's IPO price was $26 per share on November 7, 2013.
• Twitter closed at $44.90 per share (+73%) on its first trading day.
• Elon Musk acquired Twitter on October 27, 2022, for $54.20 per share.
• Companies work with investment banks for Initial Public Offerings (IPOs).
• At the cost of a fee, Investment banks arrange the shares to be listed in the exchanges.
• The investment bank also sells shares to institutional and retail investors.
• Stocks are traded on the secondary market like organized exchanges and OTC markets.
• An order book of LVMH (largest French company) was recorded on 30/06/2023 at 16h59.
• An order book of Floridienne (mid Belgian company) was recorded on 30/06/2023 at 16h59.

Market Capitalization

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

Market Capitalization: World Level

• As of the current date, Apple is ranked as #1 and LVMH as #12
• France's top companies by market capitalization include LVMH, L'Oréal, and Hermès.

Stock Indices

• A stock market index tracks a general share exchange or a group of stocks.
• General market indexes are S&P 500, CAC 40, and Nikkei 225.
• There are also stock market indices based on capitalization and sector, like MSCI large-, small-, and mid-cap indices.

Stock Indices and ETFs

• Ways to "buy" a stock index:
• Buy shares in a mutual fund that follows the index
• Purchase Exchange-Traded Fund (ETF) shares that track the index
• Buy all the individual stocks in the index in the correct proportions

Risk/Return of a Stock

• Stocks have two return sources: potential dividends and stock price appreciation.
• Stocks are riskier than bonds.
• Dividends may not be paid.
• Stock prices fluctuate.
• Stockholders are residual claimants, receiving assets/income after all other claimants are paid.

Risks of Holding a Stock

• Buying a stock carries risks.
• The major risk is market risk from stock price fluctuations, especially price drops, measured by volatility or standard deviation of returns.
• Liquidity risk is related to the cost and ease of trading on the market.

Market liquidity

• Liquidity has 3 measurement attributes.
• Immediacy is the ability to quickly buy or sell a stock.

Volatility and Stock Returns

• Considering an investor who buys a stock at a price Pt-1 at a time t. This changes to P₁ at time t
• Such trading activity drives stock prices which result from the balance of

R = (P - P ) / P t t t-1 t-1

• Return is the relative price variation of the stock.
• Over T periods, the average return is R = (Σ₁=1Rt)/Τ.

Stock Price

• Stock price computation uses the same principles as bond prices.
• Stock prices are the present value of future dividends.
• A key issue is forecasting future dividends of a share.
• Analyst forecasts are only given for the short term.
• Bonds stop paying interest after a set period of time, while shares are expected to indefinitely pay dividends.
• Thus, the calculation must be considered infinite. Value = Σ∞ (Dividendt) / ((1+r)^t)t=1
• Discount rate r = the rate of return required by the shareholders.
• Use the CAPM theory to estimate the rate of return.
• Only current dividend is known, growth is based on recent years.

Examples

• Next dividend is expected to be 5 €, forecast a constant rate of g - 4%, consider a discount rate r = 6%.
• Value of the growing perpetuity = D2024 / r-g.

Stock Risk

• An investor holds stocks over several periods.
• The stock risk of a stock is its volatility.
• Volatility (i.e. standard deviation) of its return Rt over the T period.

Better Investing

• New types consider social and environmental implications.
• This has three main concepts.
• Environmental Social and Governance (ESG) aims at determining the effect of environmental, social, and governmental factors.
• Socially Responsible Investment (SRI).
• Impact investing.
• The main Environmental Factors are energy consumption, pollution, climate change & natural resource preservation.
• The main Social Factors are human rights, employee relations, child labor & community engagement.
• The main Governmental Factors are Quality of management, conflict of interest & transparency.
• Socially Responsible Investment limits investments due to ethical concerns.
• Examples include avoiding tobacco and investing in wind energy.
• Impact Investing means investing with the intention to generate a measurable, beneficial social or environmental impact, alongside a financial return.

Part II: Stock Markets Trading, Efficiency, and Investor Behaviors

• Covers stock markets trading, efficiency, and investor behavior.

EMH and Stock Price Analysis

• There are two approaches for selecting stocks: fundamental vs. technical analysis.
• Fundamental analysis establishes a "fair" price for a company's shares.
• Technical analysis predicts future prices by assuming that the past reproduces.
• Detected patterns are followed to predict the future market.

Trading

• An organized exchange is a location for regular securities trading via an open-outcry auction model.
• The NYSE began trading in 1792 and started electronic trading.

Electronic Trading

• This method uses ECN. Electronic Communications Networks are used by NYSE.
• Advantages:
• Transparency
• Cost Reduction
• Faster Execution
• After Hours Trading

Algorithmic and High Frequency Trading

• Algorithmic trading (AT) is the use of computer trading strategies.
• High Frequency Trading (HFT) is a type of algorithmic trading that makes money by looking at the differences between trade orders. It relies on speed differences between trade orders to to make profits.
• AT and HFT are different in the speed of trades.

Speed and Arbitrage

• This looks for differences in the stock market.
• An arbitrage opportunity exists when the same share is sold on 2 different markets but at 2 prices.
• The share is thus sold at the cheapest exchange (long position) and then the share is sold at the exchange with a higher price.(short position)
• Arbitrage can give a high profit.
• If the price is, for example, 46.09 dollars. the other is 36.838 EUR a person will
• Speediest traders profit from changing prices quickly!

Impact of HFT on the Market

• Results are not always available.
• Market liquidity is said to be decreasing.
• This is potentially destabilizing which can lead to flash crashes.

Stock Market Efficiency

• Efficient Market Hypothesis (EMH).
• The available (or not) information impacts prices.
• EMH says market reflects available public information.
• In an efficient market stock prices are unpredictable due to price swings.

Forms of Market Efficiency

• Efficient markets follow 3 main trends.
• Weak Form
• Semi Strong Form
• Strong Form

Weak Form

• This one cannot have excess from past practices.
• Technical analysis thus fails.

Semi-Strong Form

• The market cannot have past earnings as it fails past prices.
• Thus , Technical & Fundamental Analyis cannot yield consistents excess returns.

Strong Force

• Information will be in place before trading.

EMH Violation and Explanations

• Market can be in place through sources
• Misprizing: behavior or cognitive biases.
• Market: There is market friction.
• Ineffciencies can cause volatility.

Common Cognitive Bias

•  Anchoring Bias: First piece of information influences the outcome.
  

• Band Wagon Effect: adopts investor belief only on the basis of beliefe.

• Status quo Effect: Prefererence to change.
  

• Overconfidence Effect: Too confident in abilities.
  

• Endoment Effect: cherised asset in portfolio.

EMH Portfolio Management

• Beating martket = beat market
• EMH. It is impossible to beat the market. Only as good as the market is.
• EMH is violation: you have to build something active.