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Stocks

An instrument that signifies an ownership position (called equity) in a corporation, and represents a claim on its proportional share in the corporation's assets and profits. Ownership in the company is determined by the number of shares a person owns divided by the total number of shares outstanding. The stock of a business is divided into shares, the total of which must be stated at the time of business formation. Given the total amount of money invested in the business, a share has a certain declared face value, commonly known as the par value of a share. The par value is the minimum amount of money that a business may issue and sell shares for in many jurisdictions and it is the value represented as capital in the accounting of the business. In other jurisdictions, however, shares may not have an associated par value at all. Such stock is often called non-par stock. Shares represent a fraction of ownership in a business. A business may declare different types (classes) of shares, each having distinctive ownership rules, privileges, or share values. Ownership of shares is documented by issuance of a stock certificate. A stock certificate is a legal document that specifies the amount of shares owned by the shareholder, and other specifics of the shares, such as the par value, if any, or the class of the shares.

Types of stock
Stock typically takes the form of shares of either common stock or preferred stock. As a unit of ownership, common stock typically carries voting rights that can be exercised in corporate decisions. Preferred stock differs from common stock in that it typically does not carry voting rights but is legally entitled to receive a certain level of dividend payments before any dividends can be issued to other shareholders. Convertible preferred stock is preferred stock that includes an option for the holder to convert the preferred shares into a fixed number of common shares, usually anytime after a predetermined date. Shares of such stock are called "convertible preferred shares"

New equity issues may have specific legal clauses attached that differentiate them from previous issues of the issuer. Some shares of common stock may be issued without the typical voting rights, for instance, or some shares may have special rights unique to them and issued only to certain parties. Often, new issues that have not been registered with a securities governing body may be restricted from resale for certain periods of time. Preferred stock may be hybrid by having the qualities of bonds of fixed returns and common stock voting rights. They also have preference in the payment of dividends over common stock and also have been given preference at the time of liquidation over common stock. They have other features of accumulation in dividend.

Shareholder
A shareholder (or stockholder) is an individual or company (including a corporation) that legally owns one or more shares of stock in a joint stock company. Both private and public traded companies have shareholders. Companies listed at the stock market are expected to strive to enhance shareholder value. Shareholders are granted special privileges depending on the class of stock, including the right to vote on matters such as elections to the board of directors, the right to share in distributions of the company's income, the right to purchase new shares issued by the company, and the right to a company's assets during a liquidation of the company. However, shareholder's rights to a company's assets are subordinate to the rights of the company's creditors.

Return and Risk


ROR of a stock consists of dividends, beginning price and ending price of a stock: Return = dividends + (end. Price beg. Price) /Beg. Price The stock market is characterized by the trade-off between risk and return. The higher the risk the investor is willing and able to take, the higher the potential rewards from the

investment. Therefore, if a particular investment offers high returns, it is an indication that it will come with a high risk burden. As part of the selection process, investors determine the risk level of the stock as well as risk tolerance. Volatile returns from year to year are always accompanied with high risks.

Risk and portfolio diversification


Diversification is a risk management method that mixes a wide variety of investments within a portfolio. The rationale behind this technique contends that a portfolio of different kinds of investments will, on average, yield higher returns and pose a lower risk than any individual investment found within the portfolio. Diversification strives to smooth out unsystematic risk events in a portfolio so that the positive performance of some investments will neutralize the negative performance of others. Therefore, the benefits of diversification will hold only if the securities in the portfolio are not perfectly correlated. Maintaining a well-diversified portfolio of 25 to 30 stocks will yield the most costeffective level of risk reduction. Investing in more securities will still yield further diversification benefits. Further diversification benefits can be gained by investing in foreign securities because they tend be less closely correlated with domestic investments.

Systematic and unsystematic risk


Systematic risk is the risk inherent to the entire market or entire market segment. It is also known as "un-diversifiable risk" or "market risk."

Interest rates, recession and wars all represent sources of systematic risk because they affect the entire market and cannot be avoided through diversification. This type of risk affects a broad range of securities. Systematic risk can be mitigated only by being hedge. Even a portfolio of well-diversified assets cannot escape all risk. Unsystematic risk is Company or industry specific risk that is inherent in each investment. The amount of unsystematic risk can be reduced through appropriate diversification. It is also known as "specific risk", "diversifiable risk" or "residual risk". For example, news that is specific to a small number of stocks, such as a sudden strike by the employees of a company you have shares in, is considered to be unsystematic risk.

Difference between Systematic Risk and Unsystematic Risk


Systematic risk affects the entire market as a whole, while unsystematic risk may affect a certain company or sector. Therefore, unsystematic risk is avoidable, while systematic risk isn't. One can diversify an investment portfolio to eliminate the unsystematic risk that plagues a certain sector. However, one cannot eliminate systematic risk as its effects sweep the entire economy, as well as the market. To really anticipate systematic risk, one needs to study the dynamics of an economy and the effects of policy decisions quite deeply. While this may not help entirely eliminate systematic risk, it may help brace for it. Total Risk = unsystematic risk + systematic risk

CAPM (The Capital Asset Pricing Model):


A model that describes the relationship between risk and expected return and that is used in the pricing of risky securities.

The general idea behind CAPM is that investors need to be compensated in two ways: time value of money and risk. The time value of money is represented by the risk-free (rf) rate in the formula and compensates the investors for placing money in any investment over a period of time. The other half of the formula represents risk and calculates the amount of compensation the investor needs for taking on additional risk. This is calculated by taking a risk measure (beta) that compares the returns of the asset to the market over a period of time and to the market premium (Rm-rf).

The CAPM says that the expected return of a security or a portfolio equals the rate on a risk-free security plus a risk premium. If this expected return does not meet or beat the required return, then the investment should not be undertaken.

Security market line (SML)

Sml is the line that graphs the systematic, or market risk versus return of the whole market at a certain time, and shows all risky marketable securities.

The SML essentially graphs the results from the capital asset pricing model (CAPM) formula. The x-axis represents the risk (beta), and the y-axis represents the expected return. The market risk premium is determined from the slope of the SML. The security market line is a useful tool in determining whether an asset being considered for a portfolio offers a reasonable expected return for risk. Individual securities are plotted on the SML graph. If the security's risk versus expected return is plotted above the SML, it is undervalued because the investor can expect a greater return for the inherent risk. A security plotted below the SML is overvalued because the investor would be accepting less return for the amount of risk assumed.

Cost of equity capital


The annual rate of return that an investor expects to earn when investing in shares of a company is known as the cost of common equity. That return is composed of the dividends paid on the shares and any increase (or decrease) in the market value of the shares.

The CAPM provides a conceptual framework for determining the expected return on common stocks, and it can be used to estimate firms cost of capital. If the CAPM correctly describes market behavior, the markets expected return on a common stock is given by the security market line (SML):

Rs = Rf + Bs(Rm Rf)

The expected return on a firms stock is, by definition, its cost of equity capital. Therefore, in terms of cost of capital, the SML is:

Ke = Rf + Bs(Km Rf)

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