FINANCIAL MARKETS AND INSTITUTIONS

ULAB SCHOOL OF BUSINESS

University of Liberal Arts Bangladesh

STOCK MARKET
 Investing in Stocks
4. Right to vote for directors and on
1. Represents ownership certain issues
in a firm
5. Two types
2. Earn a return in ─ Common stock
two ways • Right to vote
─ Price of the stock rises
• Receive dividends
over time
─ Preferred stock
─ Dividends are paid to the stockholder
• Receive a fixed dividend
3. Stockholders have claim on all assets • Do not usually vote
Investing in Stocks: Sample Corporate Stock Certificate
 Common Stock Features
• Dividends:
• No guaranteed dividend rights.
• A corporation does not default if it misses a dividend payment
• Double taxation
• Residual Claim
• Common stockholders have the lowest priority claim on a
corporation’s assets in the event of bankruptcy
 Common Stock Features
• Limited liability
• Common stockholders can lose no more than their original
investment
• Voting rights
• Common stockholders control the firm’s activities indirectly by
exercising their voting rights in the election of the board of
directors
 Preferred Stock
• A hybrid security that has characteristics of both a bond and
a common stock it represents an ownership interest in the
issuing firm
• Pays a fixed periodic (dividend) payment
• Senior to common stock but junior to bonds
• Preferred stockholders cannot force the firm into bankruptcy
• Dividends paid on preferred stock are not a tax-deductible
expense
• Do not have voting rights in the firm
 Computing the Price of Common Stock
• Valuing common stock is, in theory, no different from
valuing debt securities:
─ determine the cash flows
─ discount them to the present
 Computing the Price of Common Stock:
The Gordon Growth Model
• Same as the previous model, but it assumes that dividend
grow at a constant rate, g. That is,
 Computing the Price of Common Stock:
The Gordon Growth Model
The model is useful, with the following assumptions:
• Dividends do, indeed, grow at a constant rate forever
• The growth rate of dividends, g, is less than the required
return on the equity, ke.
 Stock Returns
• The returns on a stock over one period (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 over time t – 1 to t
Dt / Pt – 1 = return from dividends paid over time t – 1 to t
 Primary Versus Secondary Markets
PRIMARY MARKET SECONDARY MARKET

-firstly issued securities -existing securites are

are traded traded

- Issuers raise new capital - Issuers do not raise new

capital
 Types of primary market issues
• Initial Public Offerings • Seasoned New Issues:
• These are stocks issued by • These are offered by
a formerly privately owned companies that already
company that is going have floated equity.
public, that is, selling stocks • Ex. A sale by IBM of new
to the public for the first shares of stock would
time. constitute a seasoned new
issue.
 IPO
• IPO - An Initial Public Offering refers to the process of offering shares of
a private corporation to the public in a new stock issuance. 
• Before IPO - As a private company, the business has grown with a relatively
small number of shareholders including early investors.
• Right stage for IPO –
– growth stage
– ability to meet listing requirements
– ability to comply with rigors of SEC regulations
– have strong fundamentals and proven profitability potential
• Advantage - IPOs provide companies with an opportunity to obtain capital
by offering shares through the primary market.
PROCESS OF ISSUING IPO
 Underwriter
• A company planning an IPO will hire an investment bank
(merchant bank/Issue manager) as an underwriter for
document preparation, filing, marketing, estimating demand,
setting the IPO price and date, and issuance.
• A company may choose only one underwriter or an
underwriting syndicate comprising several underwriters to
manage different parts of the IPO process collaboratively.
• IPO team is comprised of underwriters, lawyers, Certified Public
Accountants, and Securities and Exchange Commission experts.
 Red-herring Prospectus
• The Issue Manager prepares preliminary prospectus
(known as Red-herring Prospectus that does not mention
issue price, number of shares, and issue date).
• The prospectus includes information on the nature of the
issuer’s business, the risks involved with the security,
background on the management, financial performance etc.
• The prospectus is sent to SEC for its review and approval. It
is also sent to DSE and potential investors.
 Book-building and Roadshow
• During the review and approval process of IPO prospectus, IPO
team goes for Book-building and Roadshow.
• During book-building and roadshow, Underwriters and
executives market the share issuance to estimate demand and
establish a final offering price.
• Initially, the price of the IPO is usually set by the underwriters
during their marketing process.
• At its core, the IPO price is based on the valuation of the
company using Fundamental Analysis.
 Approved Prospectus
• Once the SEC is satisfied with the registration statement, it
registers the issue.
• At this point, the issuer sets the final selling price of the
shares, and makes the final prospectus available to the
investors.
 Listing, Subscription, and Trading
• Having consent from SEC, the Issuer applies to the Stock Exchange for listing its
securities
• The next step is opening the subscription to the IPO through designated stock
brokers / merchant bankers.
• After a successful subscription, the company distribute the allotment letter/refund
warrants electronically to the subscribers.
• After distribution of allotment/refund warrants, the application for listing filed by
the Company is placed to the Exchange
• Once the listing is approved by the Exchange, the issuer requests the depositories
(CDBL) to credit the shares to shareholders.
• The date of trading is announced by the exchange when the shares are credited and
confirmed by the CDBL.
 Flipping
• Flipping is the practice of reselling an IPO stock in the first few
days to earn a quick profit.
• It is common when the stock is discounted and soars on its first
day of trading.
• IPOs are known for having volatile opening day returns that can
attract investors looking to benefit from the discounts involved.
• Over the long-term, an IPO's price will settle into a steady value.
 Lock-Up
• When a company goes public, the underwriters make company insiders
such as officials and employees sign a lock-up agreement.
• Lock-up agreements are legally binding contracts between the
underwriters and insiders of the company, prohibiting them from selling
any shares of stock for a specified period of time.
• When lockups expire, all the insiders are permitted to sell their stock. The
result is a rush of people trying to sell their stock to realize their profit.
• This excess supply can put severe downward pressure on the stock price.
• That’s why the charts of IPOs show a steep downturn after a few months.
 Firm Commitment Vs Best Efforts Agreement

• Firm Commitment • Best Efforts Agreement

• The investment bankers purchase the • The investment banker does not
securities from the issuing company actually purchase the securities but
and then resell them to the public. agrees to help the firm sell the issue
• The issuing firm sells the securities to to the public.
the underwriting syndicate for the • They simply act as intermediary.
public offering price less a spread that • Also known as Book-building
serves as compensation to the method.
underwriters.
• Also known as Fixed Price method.
 PRIVATE PLACEMENTS
• Primary offerings also can be sold in a private placement
rather than a public offering.
• In this case, the firm (using an investment banker) sells shares
directly to a small group of institutional or wealthy investors.
• Private placements can be far cheaper than public offerings
because SEC allows corporations to make these placements
without preparing the extensive and costly registration
statements required of a public offering.
SECURITIES TRADING IN THE SECONDARY
MARKET
 Bid Price
• A bid price is a price which is offered by the buyer to buy an asset.
The bid represents demand for an asset.
• An ask price is a price which the seller is willing to accept for selling
the asset. The ask represents supply for an asset.
• A bid-ask spread is the amount by which the ask price exceeds the
bid price. It is the difference between the highest price that a buyer
is willing to pay and the lowest price that a seller is willing to accept.
• The bid-ask spread is the measure of market liquidity. Lower the
spread, higher the liquidity.
 Open Outcry Method
• Trading (Auction – bidding/asking) occur at the trading
post/pit
• Auction between floor brokers and market makers
• Verbal and hand signal communication used by floor
brokers (https://www.youtube.com/watch?v=M6mWd3EjtsQ)
• Signals and shouts made in a particular manner and
sequence convey trading information (price and number of
assets), intentions, and acceptance
 Broker in NYSE
• In the financial world, brokers are Licensed and regulated financial firm who
have the authorization and expertise to buy securities on an investor's
behalf.
• All financial market transactions (buying and selling) have to be executed
through a broker.
• Brokers charge commissions for their services.
• Brokerage firms have their own investment banking and research
departments that provide analyst recommendations, products and access to
IPOs.
• They also offer financial planning, asset management and banking services.
 Market makers in NYSE
• Firms with large amount of capital needed to serve the market-
making function.
• Designated to serve as the market maker for more than one stock.
• However, only one market maker is assigned to each stock listed on
the exchange.
• Market makers help keep the market functioning, meaning if
– you want to sell a bond, they are there to buy it.
– Similarly, if you want to buy a stock, they're there to have that stock available
to sell to you.
– In this manner, they are creating a Two-sided market.
 Cont…
• Market makers establish quotes for the bid and ask prices
• Market makers
– Buy securities at the bid price and Sell securities at the ask price
• Price takers (investors or floor brokers on behalf of investors)
– buy at the ask price and sell at the bid price
• For example, a market maker in a stock such as IBM may buy the stock at
$164 from one customer and immediately resell it at $165 to another
customer.
• The $1 difference between the buy and sell price is the bid-ask spread
and represents the market maker’s profit.
 NASDAQ
• National Association of Securities Dealers Automated Quotations exchange
• NASDAQ, the world's first electronic exchange, is a marketplace for trading
securities.
• More than 4,000 listed companies with a combined market capitalization of
more than $15 trillion
• Most of the world's technology giants, including Apple, Google, Microsoft,
Oracle, Amazon, and Intel are listed on the NASDAQ.
• Unlike the NYSE, many dealers will make a market for a single stock—that
is, quote a bid (buy) and ask (sell) price.
• There are no limits on the number of stocks a NASDAQ market maker
(dealer) can trade or on the number of market makers in a particular stock.
 Trading in NASDAQ
• When a request for a trade is received, a dealer will use the NASDAQ
electronic communications network (ECN) to find the dealers providing the
inside quotes—the lowest ask and the highest bid.
• The dealer initiating the trade will then contact the dealer offering the best
price and execute the order.
• The dealer will confirm the transaction with the investor’s broker and the
customer will be charged that quote plus a commission for the broker’s
services.
• Like exchange trading, online (Internet) trading services now allow investors
to trade directly with a securities dealer without going through a personal
broker.
 Market making in NASDAQ
• Dealers stand ready to make a market in the security at any
time—that is, they make sure that an investor can always
sell or buy a security.
• For this reason, dealers are also called market makers.
• This market making function provides desirable liquidity to
the securities.
 Basic listing requirements in NYSE
• The company must have at least 400 shareholders who own more
than 100 shares of stock,
• Have at least 1.1 million shares of publicly traded stock and
• Have a market value of public shares of at least $40 million.
• The stock price must be at least $4 a share.
• Aggregate pre-tax income of $10 million for the previous three years,
with at least $2 million in each of the two most recent years.
• There are several reasons that NYSE listing is attractive to a firm:
– Improved marketability
– Publicity for the firm
– Improved access to the financial markets
 Choice of Market Listing (NASDAQ)
• Firms that do not meet the listings requirements for NYSE
trade on the NASDAQ.
• Thus, most NASDAQ firms are
– Smaller
– Of regional interest
– Newly registered public issues with only a brief history of trading.
• Others prefer not to release the financial information
required by the exchanges for listing.
 Electronic Communication Network (ECN)

• Electronic communication networks (ECNs) are computer-based

systems that display the best available bid and ask quotes from multiple
market participants, and then automatically match and execute orders.
• It connects major brokerages and individual traders so they can trade
directly between themselves without going through a middleman and
make it possible for investors in different geographic locations to
quickly and easily trade with each other.
• An ECN makes money by charging a fee for each transaction to meet
financial obligations.
• ECNs include Instinet, NYSE Arca, DSE FlexTP etc.
 DSE FlexTP
• Dhaka Stock Exchange (DSE) has implemented Centralized
Order Management System ‘DSE‐FlexTP’ for the TREC
(Trading Right Entitlement Certificate) holders of the
Exchange to manage their orders.
• The Mobile App (DSE Mobile App) is to leverage the DSE‐
FlexTP architecture to make trading available to investors
from mobile device.
Overview of the App
 App Icons
• Watch List – Real time information of your Portfolio,
Favorite Securities and DSE Indices
• Portfolio – Real time information of your Portfolio Securities
only
• Favorites – Real time information of your Favorite Securities
and DSE Indices
• Alerts – Display your configured alerts
Securities Details
 Place Order
• Trading is allowed for ‘DSE‐Mobile Trader’ subscribers only
• Only limit orders can be placed
• You can place order in Normal (Public/Spot) board
• You must put password (login password) for placing order to
ensure security
• Your orders will be submitted directly in the market and
monitored by the assigned trader
• You can cancel or withdraw your own submitted orders but
replace/modification is allowed by the trader only
 Clearing And Settlement
• In a rolling settlement, for all trades executed on trading day (T day), the
obligations are determined on the T+1 day and settlement on T+2 basis
• Clearing is the process of determination of obligations, after which the
obligations are discharged by settlement.
• Settlement is a two way process which involves transfer of funds and
securities on the settlement date.
• Therefore, the Clearing And Settlement function by (currently
conducted by DSE) is designed to work out a) what members
(Brokerage Houses) are due to deliver and b) what members are due to
receive on the settlement date.
 Cont…
• Members are informed of their funds obligation for various settlements
through the Obligations reports. For all trades executed on the T day,
DSE CLEARING determines the cumulative obligations of each member
on the T+1 day and electronically transfers the data to the members.
• A multilateral netting procedure is adopted to determine the net
settlement obligations (delivery/receipt positions) of the members.
Accordingly, a member would have either pay-in or pay-out obligations
for funds and securities separately.
• All trades concluded during a particular trading date are settled on a
designated settlement day i.e. T+2 day. On the settlement day DSE
CLEARING accepts pay-in of securities made by members through
depositories (CDBL).
 Market Order vs. Limit Order
• A market order is an order for the broker and the market specialist
to transact at the best price available when the order reaches the
post.
• A limit order is an order to transact only at a specified price (the
limit price). When a floor or commission broker receives a limit
order, he or she will stand by the post with the order if the current
price is near the limit price.
• The specialist, who is at the post at all times when the market is
open, will monitor the current price of the stock and conduct the
trade when, and if, it equals the limit price.
 Stop orders
• Stop orders are similar to limit orders in that the trade
is not to be executed unless the stock hits a price limit.
– Stop-loss Orders: the stock is to be sold if its price falls below
a stipulated level. As the name suggests, the order lets the
stock be sold to stop further losses from accumulating.
– Stop-buy: Orders specify that a stock should be bought when
its price rises above a limit.
Figure 3.5 Price-Contingent Orders

3-53
Stock Market Index (DSE)
Index Calculation
(Price-Weighted Average)
 Index Calculation
(Market-Value-Weighted Index)
 Index Calculation
(Market-Value-Weighted Index)
 Index Calculation
(Market-Value-Weighted Index)
DSE Index Base
 Short sale
• Short sales: sales of securities you don’t own but have
borrowed from your broker
• An investor borrows a share of stock from a broker and sells
it.
• Later, the short-seller must purchase a share of the same
stock in order to replace the share that was borrowed.
• A short sale allows investors to profit from a decline in a
security’s price.
 Buying on Margin
• Broker’s Call Loans: This is a source of debt financing to
investors for buying securities at the brokerage firm.
• Buying on margin: The act of taking advantage of broker’s
call loans. Here, investor borrows part of the purchase price
of the stock from a broker.
 Margin
• The margin in the account is the portion of the purchase price
contributed by the investor; the remainder is borrowed from
the broker.
• Margin = Equity in account/Value of stock
(Equity in account = Value of stock – Loan from Broker)
• Example: (next slide)
• Margin requirement is 50% means that at least 50% of the
purchase price must be paid for in cash, with the rest borrowed.
 Margin Call
• If the percentage margin falls (due to the falling price of
securities) below the maintenance level, the broker will
issue a margin call, which requires the investor to add new
cash or securities to the margin account.
• Example: (next slide)
• If the investor does not act, the broker may sell securities
from the account to pay off enough of the loan to restore the
percentage margin to an acceptable level.
 Cost of Buying on Margin
• The brokers borrow money from banks at the call money
rate to finance margin purchases. They then charge their
clients that rate plus a service charge for the loan.
• Securities are collateral for the loan.