AAST-GSB- MBA "Investments"

How Stock Markets Work1

Introduction Most people are involved with the stock market. The insurance companies, the banks, our pension funds and profit-sharing arrangements with which we deal are all intimately concerned with the stock market. The market" is an important part of all our lives. It is the principal means through which companies raise capital to expand their operations-and the medium used by millions of investors to protect their savings from the ravages of inflation. The stock market reflects a country's prosperity and prospects. Most developing nations give top priority to the development of a stock exchange and think of it as a symbol that they have truly entered the modern, age. The world's stock exchanges, old and new, will ultimately be linked together, providing the means for both individuals and institutions to purchase and sell securities, at fair prices, almost instantaneously. The mechanism for trading stocks is truly remarkable. Investments in any dollar amount can be made from a "menu" of thousands of different stocks. This text describes this mechanism and the products that are traded. The Stock Market What the Stock Market Has to Offer "Businesses" usually evolve, over time, from one-man operations (sole proprietorships) to partnerships and ultimately to full-fledged corporations. Corporations traditionally meet their short-term cash requirements by borrowing from banks. When corporations need long-term financing, they may sell ownership interests in the company (common stocks and preferred stocks) to the public-or borrow from the public by selling bonds. There are two major subdivisions to the stock market: the primary market and the secondary market. The primary market involves only new issues, while the secondary market handles "used" items. In this text we refer to this entire market, both primary and secondary, as the well-functioning "stock market." Why Stock are Offered Stocks exist to enable companies in need of long-term financing to "sell" pieces of the business (stocks or equity securities) in exchange for cash. This is the principal method of raising business capital other than by issuing bonds. When the stocks of these corporations, which all corporations must issue, are owned by the public at large- including both private investors and institutions-they are said to be publicly held. These publicly held shares can be easily traded (sold) to other investors in the stock market, and are thus said to be liquid, or readily converted to cash.
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Chapter 1, of book How the Stock Markets Work, Second Edition, New York Institute of Finance.

ASST- MBA "Investments"

Ashraf Shamseldin

AAST-GSB- MBA "Investments"

The primary stock market is for newly issued shares (common stocks) which are sold by the issuer (the corporation in need of capital) to the investing public. Financial institutions usually serve as intermediaries in these transactions. This is, effectively, what happens when you buy a new car. The car producer produces the car, a "new issue," and then sells it to you through a dealer. You exchange cash for the car. The car producer gets the bulk of the cash, and the dealer earns a commission for his efforts in arranging the transaction. The Size of the Stock Market Many stock issues are traded on stock exchanges throughout the world, (socalled listed securities) and about many other issues are traded out side the Stock Exchange as they are not listed on such stock exchanges. The stock market also includes thousands of different investment funds (mutual funds) and thousands of different stock options to purchase stocks 2. Bond Market In addition to stock Market there are several other markets including the money market (debt instruments with less than one year to maturity) and the bond market. The bond market, where debt instruments of longer maturities are traded, is sometimes bigger than the stock market. Unlike stocks, which represent ownership, bonds represent a loan by the bondholder of the issuing company. The bondholder usually receives interest payments rather than dividends, does not have the right to vote, and is promised that, at maturity, the loan value will be repaid. A bond is a certain-income security (also known as fixed-income or constant-income), a "senior" security, and its interest payments must be in full before shareholders in that same company can receive any dividends. Investors generally purchase bonds for the stream of relatively safe, stable income. Bonds are priced differently from stocks, and the vast majority are traded outside the stock exchange. Stocks are equity (ownership) securities; bonds are debt securities. Determining the proper "mix" of these investment instruments, for various investment purposes and degrees of risk, is known as asset allocation. Dividends Many common stocks and all preferred stocks pay dividends. Most dividendpaying companies make their distributions on a quarterly basis (four times a year). The amount and timing of dividend payments are at the discretion of the corporation's board of directors. Most profitable corporations share their profits with their investors by paying them a cash dividend. A very general rule is that
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'For example, the New York Stock Exchange-this nation's largest exchange- handles an average daily trading volume of over 200 million shares. It is an extremely efficient marketplace where accurate quotations are instantly available, and buy and sell orders can be affected in a matter of moments. ASST- MBA "Investments" Ashraf Shamseldin

AAST-GSB- MBA "Investments"

one-half the profit gets paid to the shareholders, and the remaining half gets retained and reinvested in the company. Companies in an aggressive growth period might elect to reinvest most, or even all, of their profits to fuel expansion, paying only token cash dividends or even none at all. Capital Gains When a stock is purchased at a given price, and then subsequently sold at a higher price, the resultant profit is known as a capital gain. Trying for such profits over a short time span is a speculative activity known as short-term trading. Most individual and institutional investors, however, have a much longer time horizon and will hold stocks for many years. Short Selling Short selling is selling something you do not own. While the principle of "buylow, sell-high" is the essence of making capital gains, the stock market affords another method for striving for capital gains, and that is through the medium of the short sale. Risks and Rewards of Investing When we buy a stock; the most we can lose is what we paid for the stock. But how high can a stock price go? Some have been going up for years-and are still going up. Stocks therefore (at least in theory) have unlimited profit potential. Investing in the stock market has proven to be extremely rewarding over time. Although stocks go up and down, they generally have been in an uptrend for so many years. Historically stocks have "returned" (dividends and capital gains) more than 10 percent annually, more than keeping pace with inflation. That's probably their greatest attraction; they are a proven investment medium that outpaces inflation. For investors who own securities, their potential loss is their entire investment, while there is no limit (theoretically) to the amount they can make. Short sellers have very different risks and rewards. While the short seller's profit is limited, the buyer has an unlimited profit potential-but can lose his entire investment. In a broad sense, bonds and money market funds are safest, while preferred stocks have slightly more risk and common stocks are the riskiest of all. Types of Stocks Stocks are of two types: common stocks and preferred stocks. Common Stocks All corporations must issue common stock. They represent ownership in the corporation. The total number of shares that investors own at anyone time is
ASST- MBA "Investments" Ashraf Shamseldin

AAST-GSB- MBA "Investments"

known as the outstanding shares. An owner of common stock has, in effect, a piece of the business. Common stocks are a type of equity (ownership) security. If company has 1,000 shares of common stock outstanding, and you own 100 of those shares, then you are a 10 percent owner of the corporation (100 + 1,000 = 10 percent). The rights of the common stockholder vary from company to company, but normally include the following: 1. The right to vote; 2. The right to dividends; and 3. Residual rights (when a company is dissolved, many claims must be satisfied before the common stockholders can claim any "salvage" rights). Proffered Stocks Many corporations issue preferred stock, although they are under no legal obligation to do so. Preferred shares generally pay a fixed dividend which is announced when the shares are first offered in the marketplace. The Senior Aspects of Preferred Stock This type of equity security is called "preferred" for several reasons. For one, a company must pay dividends on all its preferred stock issues, in full, before it can pay anything to the common shareholders. The preferred stockholder also comes before the common stockholder with respect to salvage rights. Stock Rights Some common stocks have preemptive rights features. This means that existing shareholders will be given the first opportunity to buy any new common shares that are sold to the public. Stock Warrants While rights are usually issued on old shares, warrants are normally issued as a feature of new offerings. Warrants are essentially long-term rights. Typically, they offer holders the right to purchase common shares at a fixed-price (the subscription price) for periods of up to ten years, sometimes even longer.

ASST- MBA "Investments"

Ashraf Shamseldin