Chapter 8:

Stock Markets

※Main Source:
Anthony Saunders, Marcia Millon Cornett, and Otgontsetseg
Erhemjamts, “Financial Markets and Institutions”, 2022(8e),
McGraw Hill Education. 1
2
Overview of Stock Markets

⚫ Primary stock markets allow suppliers of funds to raise equity

capital.
⚫ Secondary stock markets are the most closely watched and
reported of all financial markets.
⚫ Stockholders are the legal owners of a corporation:
⚫ Have a right to share in the firm’s profits (e.g., through
dividends)
⚫ Are residual claimants
⚫ Have limited liability
⚫ Have voting rights (e.g., to elect board of directors)

3
 Common Stock

⚫ Common stock: the fundamental ownership claim in a public or

private corporation.
⚫ Dividends: discretionary, and are thus not guaranteed.
⚫ Payment and size are determined by the board of directors.

⚫ A missing dividend payment does not make the firm default.

⚫ Taxed twice (firm level and personal level).

⚫ Residual claims: common stockholders have the lowest priority

claim in the event of bankruptcy. →riskier than bond!
⚫ Limited liability: common stockholders losses are limited to
their original investment if the firm’s asset value<debt value.
⚫ Voting rights: Common stockholders control the firm’s activities
indirectly by exercising their voting rights in the election of the
board of directors. 4
 Stock Returns

⚫ The return on a stock over period t-1 to t (Rt) can be divided

into capital gains and dividend returns:

Pt − Pt −1 Dt
Rt = +
Pt −1 Pt −1
Pt = stock price at time t
Dt = dividends paid over time t – 1 to t
(Pt – Pt – 1) / Pt – 1 = capital gain (loss) over time t – 1 to t
Dt / Pt – 1 = return from dividends over time t – 1 to t

5
Stock Returns Example

⚫ Suppose an investor buys 10 shares of stock priced at $55.10

and sells the stock one year later for $56.30 after collecting a
$0.30 dividend per share. What was the investor’s pre-tax
holding period return?

$56.30 − $55.10 $0.30

𝐻𝑃𝑅 = + = 2.18% + 0.54% = 2.72%
$55.10 $55.10
⚫ If dividend income is taxed at a 28% and capital gains are taxed at
20%, what was the investor’s after-tax holding period return?

HPR A −T = 2.18%(1 − 20%) + 0.54%(1 − 28%) = 2.13%

6
7
> the case of paying dividend: 2.8%!
8
 Common Stock Voting Rights
⚫ Dual-class firms: two classes of common shares outstanding, with
different voting rights and/or dividend rights assigned to each class,
e.g., the inferior voting rights with limiting (1) # of votes per share
(2) the fraction of the board of directors can elect (3) the
combination of the two. The reduced voting rights are compensated
with higher dividend rights.
⚫ Often used in firms controlled by a single family or group to retain
voting control.
⚫ Cumulative voting: # of votes assigned to each stockholder equals
# of shares held multiplied by # of directors to be elected.
⚫ The number of shares needed to elect p directors, Np, is:
Np = [(p x # of votes available) / (# of directors to be elected + 1)] +1
⚫ Straight voting: # of votes for eligible each director is # of shares
outstanding. An owner of over half voting shares can elect the entire
board of directors →advantageous to large stockholders!
⚫ A proxy vote allows stockholders to vote by absentee ballot (e.g.,
by internet or by mail) or authorize representatives to vote. 9
 直接選舉法V.S.累積選舉法
⚫ 公司發行了100萬股，甲派掌握 60 萬股，乙派為掌握30 萬股。此次 公司
欲選出 3 席董事，兩派各派出3位候選人，爭奪本屆的董事席位。甲派可投
票數：180萬；乙派可投票數：90萬。

甲派候選人 乙派候選人

A B C D E F
直接選舉法

60萬 60萬 60萬 30萬 30萬 30萬

甲派候選人 乙派候選人

A B C D E F
累積選舉法

90萬 90萬 0 90萬 0 0

※資料來源：謝劍平，「投資學：理論與實務」，2018 (七版)，智勝文化出版。 10
Preferred Stock
⚫ Preferred stock is a hybrid security that has
characteristics of both bonds and common stock
⚫ Similar to common stock: represents an ownership interest in
the issuing firm; like a bond: pays a fixed periodic (dividend)
payment.
⚫ Cannot force the firm into bankruptcy if the firm has
insufficient profits to pay the dividends.
⚫ Senior to common stock but junior to bonds.
⚫ Dividends are paid out of after-tax earnings.
⚫ Generally has fixed dividends that are paid quarterly.
⚫ Generally does not have voting rights unless
dividend payments are missed.
⚫ May be converted to common stock at any time.
⚫ Typically nonparticipating and cumulative. 11
 Preferred Stock
⚫ Nonparticipating versus participating:
Nonparticipating: fixed dividends regardless of
any change in the firm’s profit.
Participating: promised dividends + (potential)
extra dividends.
⚫ Cumulative versus noncumulative:
Cumulative: missed dividend payments go into
arrears and must be made up before common stock
dividends.
Noncumulative: missed dividend payments do not go
into arrears and are never paid.
→unattractive and generally has other special features (e.g.,
voting rights). 12
13
Primary Stock Markets
⚫ Primary markets: markets in which corporations raise funds
through new issues of securities, most of the time through
investment banks (e.g., Morgan Stanley, Bank of America Merrill
Lynch)
⚫ Investment banks act as distribution agents in best efforts
underwriting.
⚫ Investment banks act as principals in firm commitment
underwriting.
gross proceeds (resell to investors at a higher price) – net
proceeds (purchase from the issuer at a guaranteed price) =
underwriter’s spread
⚫ A syndicate is a group of investment banks working in concert
to issue stock; the lead underwriter is the originating house.

14
15
 Primary Stock Markets Continued
⚫ An initial public offering (IPO): the first public issue of
financial instruments by a firm.
⚫ A seasoned offering is the sale of additional securities by a
firm whose securities are already publicly traded.
⚫ Through a public sale or a private placement.
⚫ Preemptive rights: a right of existing stockholders in which
new shares must be offered to them first at a slightly lower-
than-market price, called “rights offering.”
→Can be exercised to maintain the existing stockholders’
proportional ownership. (or be sold to other investors or be
unused).
→A low-cost distribution of new shares for the issuing firm 16
 Primary Stock Markets Continued
⚫ Registration: in a public sale, the investment bank must get SEC
approval in accordance with the Securities and Exchange Act of
1934.
1. Prepare the registration statement to be file with the SEC.
2. Prepare a red herring prospectus to be sent to potential buyers.
⚫ A red herring prospectus: a preliminary version of the prospectus
that describes a new security issue.
⚫ Waiting period: the period for SEC evaluation (3 and 4)
3. SEC requests additional information or changes to the registration
statement in 20 days.
4. SEC declare whether the registration statement is effective in few
days to several months.
5. SEC registers the issue; the issuer sets the final selling price,
prints the official prospectus, and goes on roadshows.
6. Shares are offered to public. 17
 (Registered)

18
Quiet period
 ※The SEC passed a rule in 1982 allowing for shelf
registration to reduce the time and cost of registration.

Shelf registration allows firms to offer multiple issues of stock

over a two-year period with only one registration statement.
→allow firms to get stocks into the market quickly without the
time lag associated with full SEC registration!

19
Secondary Stock Markets

⚫ Secondary stock markets: the markets in which

stocks, once issued, are traded among investors.
⚫ The U.S. has several major stock markets:
⚫ New York Stock Exchange Euronext (NYSE Euronext)
⚫ Exchange was created by the merger of the NYSE Group, Inc.
and Euronext N.V. on April 4, 2007.
⚫ The NYSE Euronext Exchange was purchased by ICE in
2013.
⚫ The most well-known organized exchanges.

⚫ National Association of Securities Dealers Automated

Quotation (NASDAQ) system
20
21
22
 NYSE Euronext: The trading progress
⚫ Trading occurs at a specific place on the floor of the exchange
called a trading post.
⚫ Each stock has a special market maker called a specialist or
Designated Market Maker (DMM) that maintains liquidity for the
stock: establish fair market price for the stock and stabilize the
stock’s price at all times.→underwriters are rarely allowed to be DMM.

23
 NYSE Euronext Continued
⚫ Three types of transactions occur at trading posts:
⚫ A market order: an order to transact at the best price available
(the lowest price for purchase and the highest price for sale)
when the order reaches the trading post.
⚫ A limit order: an order to transact at a specified price.
(1) When the current price is not near the limit price, the floor
broker enters the limit order on the order book of the DMM at
the post. (2) The DMM will monitor and conduct the trade when
the price equals the limit order price. (3) If the order is not filed
by the expiration date, it is deleted from the book.
⚫ Specialists transact for their own account.
⚫ Trading licenses, which are sold at a Dutch auction and valid for
one calendar year only, are needed to make trades. 24
 Purchase of a Stock on the NYSE
⚫ Commission broker: the representative of the broker (who
contacts with the investor) at the exchange.
⚫ Floor broker: works for themselves.
⚫ These brokers can transact at a post with others without DMM
participation.

25
 current market price

limit order price

DMM completes the
limit order

26
 NYSE Euronext Continued
⚫ Program trading: the simultaneous buying and selling of
a portfolio of at least 15 different stocks valued at more
than $1 million using computer programs to initiate the
trades.
⚫ Critics: (1) increased volatility, e.g., the flash crash on

2010/05/06 (2) fat finger error, e.g., a million-sized trade

was entered as a sell billion-sized trade.
⚫ The most active program traders: investment banks.

⚫ Much of the program trading: index funds and future

contracts on various indexes.

27
 NYSE Euronext Continued

⚫ Mechanism introduced by NYSE to limit volatility:

1. (For market) Circuit breakers: an imposed halt in DJIA’s
trading that gives investors time to make informed choices
during periods of high market volatility.
2. (For individual stocks) Limit Up-Limit Down (LULD) rules

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29
 Limit Up-Limit Down
⚫ Trading is halted for 15 seconds if the price is outside the
price band:
Price band = (Reference Price) ± [(Reference price) ×
(Percentage parameter)]
※The reference price: the mean price over the past 5 minutes.
⚫ If the price does not go back into the price band, then there
will be a 5 minute trading pause.

30
 Controversial Trading Practices
⚫ Flash trading: for a fee, traders are allowed to see incoming
buy or sell orders milliseconds earlier than general market
traders.
⚫ These traders then can conduct rapid statistical analysis
with powerful computers and carry out high-frequency
trading ahead of the public market.
⚫ Pro: creates more market liquidity and the opportunity for
price improvement.
⚫ Cons: 1.Creates a market in which certain traders can
unfairly exploit others. 2.High volume of trading generated
by multiple computers can lead to events like “flash crash.”
⚫ Wash trades: the illegal act of acting as both buyer and seller
in the same transaction banned by U.S. law. 31
 Controversial Trading Practices
⚫ Naked access: allows some traders to rapidly buy and sell
stocks directly on exchanges using a broker’s computer
code without exchanges or regulators always knowing who
is making the trades.
⚫ Banned by SEC in 2010 to avoid threats on market stability.
⚫ Dark pools of liquidity: trading networks that provide liquidity
but that do not display trades on order books.
⚫ For traders (e.g., institutional traders) who wish not to reveal
their trades and trading strategies to the market.
⚫ In 2019, 39% of daily stock trading was processed through
dark pool trading.
⚫ Dark pool trades are recorded as OTC transactions.
⚫ In 2013, the SEC approved a plan for new rules requiring dark
pools to disclose detail trading activity on their platforms. 32
33
 NASDAQ and OTC Markets
⚫ Securities not sold on the organized exchanges are traded
over the counter (OTC) via an electronic market.
⚫ The OTC markets in U.S. defined broadly are: NASDAQ,
OTCBB, Pink-sheet market.
⚫ NASDAQ: the world’s first electronic market and has no
physical trading floor.
⚫ Unlike the NYSE, the NASDAQ:
⚫ Primarily a dealer market where more than 20 dealers (no
limits on it) act as market makers for a single stock.
⚫ A broker-and-dealer negotiated market.
⚫ Broker/dealer may also be a member of an exchange.
⚫ The underwriter of an issue can be the dealer in the
secondary market.
⚫ Low capital requirements for registering to be a broker/dealer. 34
 Trading Process in the NASDAQ Markets
⚫ Trading process:
1. An investor wanting to trade contacts a broker.
2. The broker contacts a dealer in the particular stock to conduct the
transaction.
3. The dealer uses the electronic communications network (ECN) to
find the dealers providing the inside quotes.
4. The dealer initiating the trade then contact the dealer providing the
best price (the lowest ask/the highest bid) and execute the order.
5. The dealer confirms the transaction with the broker and the
investor will be charged the best price plus a commission for
the broker’s service.
⚫ Online trading services: investors can trade directly with a
dealer without through a broker. 35
 NASDAQ and OTC Markets
⚫ Small order execution system (SOES): a mandatory system
provides automatic order execution for small size of orders
(<=1,000 shares)→provides liquidity for small investors.
⚫ OTC bulletin board (OTCBB): an electronic system for
brokers and dealers to get and post prices for stocks of
very small firms (penny stocks).
⚫ Not part of the NASDAQ market.
⚫ Not a formal exchange: no memberships requirements for
trading, and no listing requirements.
⚫ Penny stocks: stocks traded <$5 per share and generally
issued by high-risk firms.
⚫ Pink sheets: for the smallest stocks to be listed on, and the
smallest stocks are distributed through the National
Association of Securities Dealers (NASD). 36
⚫ Choice of market listings:
⚫ Attractiveness of NYSE listing: (1) improved marketability (2)
publicity for the firm resulting in increased sales (3) improved
access to the financial markets.
⚫ NYSE has extensive listing requirements.
⚫ NASDAQ requirements are cheaper and can be met by smaller
firms or newly registered public issues, with less active trading.
⚫ Electronic communication networks (ECNs):
⚫ Normal trading occurs between 9:30 a.m. and 4:00 p.m.
eastern standard time.
⚫ Extended-hours trading: through computerized alternative
trading systems (ATSs) also known as ECNs.
⚫ BATS (Better Alternative Trading System): newer ECNs and
the third-largest exchange based on volume.
⚫ Account for 1/3 of all transactions and almost all extended-
hours trading. 37
 Stock Market Indexes
⚫ A stock market index: the composite value of a group of
secondary market-traded stocks, e.g., Dow Jones Industrial
Average (DJIA), NYSE Composite, Standard & Poor’s 500,
NASDAQ Composite, Wilshire 5000.
⚫ Its movements provide information on movements of a broader
range of secondary market securities.
⚫ Price-weighted index, e.g., DJIA:
⚫ DJIA: composed of 30 large companies (major firms in their
industries), is the most widely reported stock market index.
⚫ The securities selected in the DJIA represents the broad stock
market.

38
39
Movements in these indexes
are highly correlated!

40
 Stock Market Indexes
⚫ Value-weighted indexes: the current market values (stock
price × number of shares outstanding) of all stocks in the
index are added together and divided by their value on a
base date.
⚫ NYSE Composite Index: 1.Established by NYSE to provide
comprehensive performance measure of the overall NYSE
market 2.Consists of all common stocks listed on the NYSE.
⚫ Standard & Poor’s 500 Index: 1.Consists of the stocks of the top
500 of the largest U.S. firms listed on the NYSE and the
NASDAQ 2.Its movements are highly correlated with those of
the NYSE Composite Index.
⚫ NASDAQ Composite Index: Consists of all stocks traded
through the NASDAQ in industrial, bank, and insurance
industries. 41
 Stock Market Indexes
⚫ Value-weighted indexes (Cont’d):
⚫ Wilshire 5000 Index: 1.Every stock included meets three
criteria: (1) its firm is headquartered in the U.S. (2) is
actively traded in a U.S.-based stock market (3) has widely
available price information 2.The broadest stock market
index: includes essentially every public firm 3.The most
accurate reflection of the overall stock market .

42
43
44
 Top 3: 1. Household sector 2.
Stock Market Participants Mutual funds 3. Foreign investors,
totally account for almost 80%!

(Foreign investors)

45
65%

52%

46
1. In almost every category, percentages have dropped!
2. U.S. stock ownership rates are highly related to income.
3. Middle-aged investors (age 30-64 years) are the most active.

- +

47
International Aspects of Stock
Markets
⚫ U.S. stock markets are the world’s largest.
⚫ European markets have increased their share of the
global market with the advent of a common currency, the
Euro since 2002, but hurt by the Euro area crisis.
⚫ Growth has strengthened in China and Pacific Basin
countries.
⚫ International stock markets allow investors to diversify by
holding stocks issued by corporations in foreign
countries.
⚫ International diversification can increase risk due to less
complete and timely information about foreign stocks as
well as foreign exchange and political risk. 48
49
50
51
 American Depository Receipts (ADRs)
⚫ ADR: a certificate that represents ownership of a foreign stock.
⚫ Created by a U.S. bank, after acquiring stock in foreign
corporations in their domestic currencies and places them with a
custodian.
⚫ The bank then issues dollar ADRs backed by the shares of the
foreign stock.
⚫ Traded in dollars in the U.S. organized exchanges.
⚫ Major attraction of ADR to U.S. investors:
⚫ Claims to foreign companies that trade on U.S. exchanges and in
USD
⚫ Lower fees than international mutual funds
⚫ Diversification of a stock portfolio
⚫ Should be careful:
⚫ Unique risks, e.g., country risk and foreign exchange risk
⚫ Not subject to strict financial reporting standards as firms in U.S. 52
 補充：存託憑證的種類－依發行地區區分

美國存託憑證 • 在美國發行與交易的的存託憑證
(ADR)

全球存託憑證 • 在美國以外地區市場（如倫敦、盧森堡及東

(GDR) 京證券交易所）發行與交易的存託憑證

台灣存託憑證 • 外國公司在台灣發行的存託憑證
(TDR)

53
※來源：謝劍平，「投資學：理論與實務」，2018 (七版)，智勝文化出版。
 補充：存託憑證的種類－依公司是否參與

54
※來源：謝劍平，「投資學：理論與實務」，2018 (七版)，智勝文化出版。
 American Depository Receipts (ADRs)
There are 3 types of ADRs:
⚫ Level 1 ADRs: (1) the most common and basic (2) trade only on
OTC market (3) have the least SEC requirements (4) not required
to meet U.S. GAAP nor issue annual reports.
⚫ Level 2 ADRs: (1) listed on the major stock exchanges and must
meet their listing requirements (if not, may be delisted and
downgraded) (2) have more regulatory requirements than level 1
(3) required to register with the SEC (4) required to meet U.S.
GAAP and issue annual reports.
⚫ Level 3 ADRs: (1) the most respected ADR level (2) must register
with the SEC (3) meet the same reporting standards as Level 2 (4)
the ADR companies are allowed to raise public capital in the U.S.
(5) required to share any news distributed within home country
with U.S. investors (i.e., the easiest one to find information).
55
 Chapter 8: Stock Markets

The End

※Main Source:
Anthony Saunders, Marcia Millon Cornett, and Otgontsetseg
Erhemjamts, “Financial Markets and Institutions”, 2022(8e),
McGraw Hill Education. 56