Financial Market Analysis

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FINANCIAL MARKET ANALYSIS

INSTRUCTION:

1. This is an individual assignment.

2. A hard copy MUST be presented to the lecturer on the due date.

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3. The APA format MUST be maintained, and a declaration of authorship must be made.

You are a Financial Analyst that has been appointed to lead a team in the production of a report

to some potential investors regarding participating in the financial market.

You are required to provide information on the following sections:

Section A – (Total 10 marks)

· An Overview of Financial Markets

· The role of the Stock Market

· Benefits of participating in the Stock Market from an investor perspective.

Section B – Select one of the following group of companies currently listed on the Jamaica Stock

Exchange (JSE) to conduct an analysis. (Total 60 marks)

Group 1

Salada Foods Ltd and Seprod Ltd

The analysis will include the following:

· A brief overview of the companies selected. (5 marks)

· Daily recordings of the trade volume, opening and closing price, percentage change in

price and whether the stock advance, decline or traded firm for each company over a two-week period, beginning March 14 – 25, 2022. (20 marks)

Use the prices recorded to form an index for each company, then construct the following:

· A price-weighted index for the two stocks and compute the percentage changes

in the index for period 1 (Week 1) and period 2 (Week 2) (10 marks)

· A value-weighted index for the two stocks and compute the percentage changes

in the index for period 1 (Week 1) and period 2 (Week 2) (10 marks)

· Explain the factors that you believe may have affected the share prices on the

market for both companies during period 1 and 2 (15 marks)

Section C – Financial Viability (Total 30 marks)

Assess the financial viability of the two companies given above by performing a company and security analysis to determine if the stocks are over-valued or under-valued based on information

gathered from:

a) The stock’s price-earnings ratio (5 marks)

b) The Price-Earnings Growth ratio (10 marks)

c) The interest rate of the country (5 marks)

d) Market capitalization to GDP (5 marks)

e) The company’s activities, and revenues and profits generated (5 marks)

(Total 100 marks)

U NI T 2 – T H E S T O C K M A R K E T

Financial Market Analysis
ACCT3602

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The Role of a Stock Market

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A stock exchange allows companies to raise funds by providing them with access to a pool of
private and institutional investors. The role of an exchange is therefore to:

 Bring companies and investors together

 Enable issuers and companies to raise new capital
 Facilitate the process of investors subscribing in shares (securities)

 Provide capital to companies and investors
 Facilitates

– trading in securities after the IPO
– buying and selling of securities between investors

 Organises and oversees a fair and efficient market

 Ensures an efficient price discovery process (the process of determining the price of the
securities in the market place)

 Provides timely and accurate trading and company disclosure information to inform
private investor trading

The Role of a Stock Market

 Central roles of a stock market:

 Making available cost-effective trading platforms.

 Bundling of liquidity by concentrating supply and demand.

 Guaranteeing the interchangeability, as well as the identical
structuring of a particular category of security.

 Ensuring the greatest possible transparency for investors.

 Providing information on prices and volume.

Benefits of the Stock Market
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 Stock markets are an integral part of the economy
 they provide unique services and benefits to corporations, individual investors and

governments.

 Benefits for Corporations
 Raising Capital: A corporation is able to make an Initial Public Offering (IPO) on

the stock exchange and gain access to many investors, as well as to supply new capital
for their business. Once listed, there is the opportunity for further issuance if needed.
Access to the stock markets also facilitates growth by merger or acquisition through
share purchases.

 Companies have many options to raise capital.

 Self financing – generation of one’s own capital from one’s own income, instead of
acquiring it from external resources

Benefits of the Stock Market
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 Bank loans – are the most
“traditional financial resources and
are normally used to finance smaller
projects.

 Fund raising options such as Private
Equity and IPOs are used to finance
extraordinary events such as
mergers and acquisitions or to
support companies during their
growth phase.

Benefits of the Stock Market
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 Benefits for Investors

 Improved Returns: Equities have no maturity date and no fixed rate of return. This makes
them a riskier investment than money market securities or bonds. What equities provide is
the prospect of a combination of income and capital gains, plus a superior rate of return. The
stock market gives the flexibility to invest small or large amounts and the choice of a vast
number of different corporations and industries in which to invest.

 Benefits for the Economy

 Putting Peoples’ Savings to Work: If individuals keep their savings in cash, or even a bank
account, there is little or no benefit to the economy. Investment in stocks, however, is a
direct investment in the success of individual businesses and helps promote stronger
economic growth.

 Measure of the Economy’s Performance: Although the health of the economy cannot be
directly correlated with the performance of the Stock Market, it is true that the performance
of share prices in general will be a good indication of its current condition and of the
confidence of individuals within that economy.

Benefits of the Stock Market
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 Corporate Governance:
 The regulations required for a corporation’s stock to be listed on the Stock Exchange

and the ongoing requirements to maintain that listing are a good way to ensure that
management standards and standards of record keeping within that corporation are
maintained at a high level.

 There have been notable exceptions, but generally record keeping of publicly quoted
companies has been shown to be better than that of private companies.

 Access to Funds for Governments:
 In addition to corporations, governments themselves may issue bonds that are

quoted on the Stock Market to raise money for infrastructure, or other major
projects. The stock exchange allows individuals to lend money to their government to
fund their programs (NOT IN JAMAICA).

Types of Stock Markets
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Primary Equity Market

 When equity shares are initially issued, they are said to be sold in the primary
market. Equity can be issued either privately (unquoted shares) or publicly via
shares that are listed on a stock exchange (quoted shares).
 Public market offering of new issues typically involves the use of an investment bank in a

process called underwriting of securities.

 Private placement market includes securities which are sold directly to investors and are
not registered with the securities exchange commission. There are different regulatory
requirements for such securities.

 In the private equity market, venture capital is often provided by investors as
‘start-up’ money to finance new, high-risk companies in return for obtaining equity
in the

company.

 In general, private placement market is viewed as illiquid. Such a lack of liquidity means that

buyers of shares may demand a premium to compensate for this unappealing feature of a
security.

Types of Stock Markets
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Primary Public Market

 Initial public offering (IPO) means issuing public equity, i.e. when
a company is engaged in offering of shares and is included in a listing
on a stock exchange for the first time.
 It allows the company to raise funds from the public.

 If a company is already listed and issues additional shares, it is called
seasoned equity offering (SEO) or secondary public offering
(SPO).

 When a firm issues equity at a stock exchange, it may decide to change
existing unquoted shares for quoted ones.
 In this case the proceeds from sale of shares are received by initial investors.

 However, when a company issues newly created shares, the raised funds are received
by the company.

Types of Stock Markets
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The Process of Going Public

 The issuing company has to develop a prospectus with detailed
information about the company operations, investments, financing,
financial statements and notes, discussion on the risks involved.
 This information is provided to potential investors for making decision in buying

large blocks of shares.

 The prospectus is registered with and approved by the Securities
Exchange Commission (SEC). A prospectus issued in Jamaica has to
be approved by the Financial Services Commission and the Companies
Office of Jamaica, and reviewed by the JSE.

 Afterwards the prospectus is sent to institutional investors, meetings
and road shows are organized in order to present the company.
 Road show is presentation by an issuer of securities to potential buyers.

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Road shows
 when the management of a company issuing securities or doing an initial public

offering (IPO) travels around the country to give presentations to analysts, fund
managers and potential investors.
 The road show is intended to generate excitement and interest in the issue or IPO, and is often

critical to the success of the offering.
 A non-deal road show occurs where executives hold discussions with current and potential

investors, but nothing is offered for sale.

 Share issues are often underwritten by banks.
 A bank, which is underwriting an issue agrees, for a fee, to buy any shares not acquired by

investors. This guarantees that the issuing company receives the funding that it expects.
 In the case of rights issues, firms sometimes avoid paying a fee to underwriters by using the

deep discount route. In a rights issue, failure to sell the new shares would result in the share
price (prior to the issue) falling below the sale price of the new shares.
 The deep discount method prices the new shares at such a low level that the market price is

extremely unlikely to fall so far.

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 The share offer price is determined by the lead underwriter, which
takes into account the prevailing market and industry conditions.

 During the road show the lead underwriter is engaged in book-
building
 a process of collecting indications of demanded number of shares by investors at

various possible offer prices.

 IPO Factors: Public equity markets play a limited role as a source of
new funds for listed corporations.
 Because of information asymmetry, companies prefer internal financing (i.e.,

retained earnings) to external financing.

 Myers and Majluf (1984) have introduced the pecking-order theory,
which states that companies adopt a hierarchy of financial
preferences.

Types of Stock Markets
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Pecking Order Theory or Pecking Order Model
 In corporate finance, this theory postulates that the cost of financing increases with

asymmetric information.
 Financing comes from three sources, internal funds, debt and new equity.

 Companies prioritize their sources of financing, first preferring internal financing, and then
debt, lastly raising equity as a “last resort”.

 This theory maintains that businesses adhere to a hierarchy of financing sources and
prefer internal financing when available, and debt is preferred over equity if external
financing is.
 Thus, the form of debt a firm chooses can act as a signal of its need for external finance.

 On the other hand, during equity markets growth and share price increase periods,
IPO market tend to increase dramatically,
 A drop in share prices is followed by decrease in net issuance of public equity.

 A large number of the issues in the late 1990s were ‘new economy’ offerings, like the
technology, media, and telecommunications sector.

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 Among other factors the economic cycle is considered to play a significant
role in a company’s decision to issue public equity.

 Equity is often used to finance long-term investments
 which fluctuate over the business cycle.

 Shiller (2003) has related the timing of equity issuance with investor
sentiment.
 Developments in investor optimism over time may have an impact on the cost of

equity, thus influencing the amount of equity issued.
 E.g., excessive increases in risk aversion resulting in falling stock market prices could

raise the cost of equity, preventing companies from new equity issues. Companies
also issue equity in order to finance the acquisition of other companies, either by
using the cash proceeds of public offerings or by issuing shares, which are
subsequently exchanged for the shares of a target company. Therefore merger and
acquisition (M&A) cycles can also be expected to correlate with equity issuance
activity.

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There are important advantages and disadvantages of initial public
offerings (IPOs).

 Advantages of IPOs:
 Possibility to obtain funds to finance investment.

 The price of a company’s shares acts as a measure of the company’s value.

 Increases of company financial independence (e.g. from banks) due to listing of a
company’s shares on a stock exchange.

 Possibility to diversify investments of current company owners by selling stakes in
the company in a liquid market.

 Increased recognition of the company name

 Improved company transparency

 A disciplining mechanism for managers

Types of Stock Markets
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Disadvantages of IPOs:

 High issuance costs due to underwriters’ commission, legal fees, and
other charges.

 High costs due to disclosure requirements.

 Risk of wider dispersed ownership.

 Separation of ownership and control which causes ‘agency problems’.

 Divergence of managers’ and outside investors’ interests.

 Information asymmetry problems between old and new shareholders.

 Risk of new shareholders focusing on short-term results.

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IPO market has received negative publicity due to several problems:
 Spinning

 occurs when investment bank allocates shares from an IPO to corporate executives.
Bankers’ expectations are to get future contracts from the same company. It is an abuse of
the underwriter’s mandate to place shares fairly.

 Laddering
 When there is a substantial demand for an IPO, brokers encourage investors to place the

first day bids for the shares that are above the offer price. This helps to build the price
upwards. Some investors are willing to participate to ensure that the brokers will reserve
some shares of the next hot IPO for them. It will result in the demand for shares in the
secondary market from investors who were not allotted shares in the IPO, thus pushing
up the stock price.

 Excessive commissions
 These are charged by some brokers when the demand for an IPO is high. Investors are

willing to pay the commissions if they can recover the costs from the return on the very
first day, especially when the offer price of the share is set significantly below the market
value.

Types of Stock Markets
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Secondary Equity Market

 Equity instruments are traded among investors in a secondary market
 no new capital is raised and the issuer of the security does not benefit directly from

the sale.

 Secondary markets are also classified into organized stock exchanges and over-the-
counter (OTC) markets.

 Apart from legal structure, numerous historical differences are found in
the operations of national stock markets. The most important
differences are in the trading procedures.
 The trading on secondary markets takes place among investors, however most often

through specialized intermediaries – stock brokers (dealers), who buy or sell securities
for their clients.

Types of Stock Markets
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 Securities’ trading in the secondary market form the means by which stocks
or bonds bought in the primary market can be converted into cash.
 The knowledge that assets purchased in the primary market can easily and cheaply be

resold in the secondary market makes investors more prepared to provide borrowers with
funds by buying in the primary market.

 Effective secondary market is an important basis of successful primary
market.
 If transaction costs are high in the secondary market the proceeds from the sale of

securities will be reduced, and the incentive to buy in the primary market would be lower.

 Also, high transaction costs in the secondary market might tend to reduce the volume of
trading and thereby reduce the ease with which secondary market sales can be executed.

 Therefore high transaction costs in the secondary market could reduce
primary market asset liquidity.
 In consequence there can be adverse effects on the level of activity in the primary market

and hence on the total level of investment in the economy.

Types of Stock Markets
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Organized Exchanges
 Stock exchanges are central trading locations, in which securities of corporations are

traded.
 These securities may include not only equity, but also debt instruments as well as derivatives.

 Equity instruments can be traded if they are listed by the organized exchange
 i.e. included in a stock exchange trading list.

 The list is comprised of instruments that satisfy the requirements set by the exchange,
including minimum earnings requirements, net tangible assets, market capitalization, and
number and distribution of shares publicly held.

 Each stock exchange specifies their set of requirements.

 Advantages of listing on the stock exchange to the corporation and its shareholders
are:
 The ability to sell shares on the stock exchange makes people more willing to invest in the

company.

 Investors may accept a lower return on the shares and the company can raise capital more
cheaply.

Types of Stock Markets
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 Stock exchange provides a market price for the shares, and forms basis for valuation
of a company.

 The information aids corporate governance, allows monitoring the management of
the company.

 Listing makes takeover bids easier, since the predator company is able to buy shares
on the stock market.

 The increased transparency may reduce the cost of capital.

 Disadvantages of Listing:
 Listing on the stock exchange is costly for the company.

 It requires a substantial amount of documentation to be prepared, e.g. audited and
prepared according to IFRS financial statements.

 It increases transparency, which may cause problems in terms of market
competition and in takeover cases.

Types of Stock Markets
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 Stock market dealers and brokers fulfil specific functions at the equity
market.
 Dealers make market in securities, maintain securities inventories and risk their

own funds.

 Brokers do not own securities but execute matching of buyers and sellers for a
specific fee.

 Dealer may function as a broker, or as market maker.
 Dealers stand ready to buy at the bid price and to sell at the ask price

 They make profit from the average spread.

 Primary Risk for Dealers
 when the stock prices are going down, dealers experience loss of value of stock

inventory.

Types of Stock Markets
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 In order to profit from different price movement directions dealers
make positioning.
 If the dealer expects the stock prices to increase, it buys the stock; taking a long

position.

 Profit is earned, if the stock is sold at a higher price.

 If a dealer expects the stock price to decline, he tries to benefit from a short
position (sell). In a short sale the security is borrowed and sold with the
expectation of buying this security back later at a lower price.

 The investor tries to sell high and buy low, profiting from the difference.

 Proceeds from a short sale cannot be used by the short-seller, and
must be deposited at the broker or margin account.

 The short-seller must pay any cash dividends to the lender of the security.

Types of Stock Markets
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 If the dealer’s forecast is wrong, the dealer must close the position at an
unfavourable price and absorb the loss.
 This creates the risk of dealer bankruptcy, and forces stock exchanges as well as

securities exchange commissions to impose specific regulations in order to prevent
this type of price manipulations.

 Security dealers are heavily levered.
 Typically the dealer’s equity forms a small percentage of the market value of his

inventory.

 Most dealers financing is in the form of debt (e.g. bank loan). Majority of dealer debt
financing is in the form of repurchase agreements

Types of Stock Markets
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There are several types of stock exchange members:

 Commission Brokers – who execute buy and sell orders for the public for a fee. This is the
largest group of market participants, acting as agents of lenders or buyers of financial securities.
They may find the best price for someone who wishes to buy or sell securities.

 Odd-lot Brokers – a group of brokers, who execute transactions of fewer than 100 shares.
These brokers break round-lots (a multiple of 100 shares) into odd-lots and vice versa for a fee.
Odd-Lot orders are not posted to the bid/ask data on exchanges

 Registered Trader – who owns a seat on a stock exchange and trades on his own account.
Large volume of trades, along with the possibility of speedy execution of orders, allow the
traders to cover their large investments into the seat of a stock exchange.

 Specialists – who are market makers for individual securities listed on an organized stock
exchange. Their purpose is to reduce variability of the securities prices. When there are too
many sell orders, the specialists have to perform the role of buyers to keep the prices from
falling for a period. When there are too many buy orders, the specialists have to perform the
role of sellers to prevent the temporary rise in prices.

Types of Stock Markets
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 Issuing Intermediary – who undertakes to issue new securities on behalf
of a borrower. An issuing house acts as an agent for the borrower in financial
markets. This task is usually carried out by investment banks

 Market-maker is an intermediary who holds stock of securities and quotes
a price at which each of the securities may be bought and sold. Market-
making is usually performed by the securities divisions of the major banks

 Arbitrageur – who buys and sells financial assets in order to make a profit
from pricing anomalies. Anomalies occur when the same asset is priced
differently in two markets at the same time. Since financial markets are well
informed and highly competitive, usually these anomalies are very small and
do not last long. Anomalies are usually known, thus there is no risk of
arbitrage, which makes it different from speculation.

 Hedger – who buys or sells a financial asset to avoid risk of devaluation of
currency, change of interest rates or prices of the securities in the market.

Types of Stock Markets
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Over-the-Counter (OTC) Market

 Over-the-counter (OTC) market is the marketplace for the trading
financial instruments by dealers, which are generally unlisted
financial instruments, via electronic means.
 These markets are networks of dealers, who make markets in individual securities.

 Common equity shares that are traded on it can be listed and unlisted shares.

 Two large segments of OTC markets can be distinguished:
 Unorganized OTC markets with unregulated trading taking place between

individuals. Typically these markets do not restrict possibilities to buy and sell
outside of organized exchanges.

 Highly organized and sophisticated OTC markets, often specializing in trading
specific company shares. Examples of organized over-the-counter markets are the
NASDAQ and upstairs markets in the United States.

Types of Stock Markets
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 Trading takes place via a computer network.

 Market makers display the prices at which they are prepared to buy
and sell, while investors trade with the market makers, usually
through brokers.

 The upstairs market is mainly used by institutional investors and
handles large buy and sell orders (block trades).
 Institutions place orders through brokers, who attempts to find a transaction

counterparty.

 In the absence of such a counterparty, the broker attempts to execute the order with
market makers.

Types of Stock Markets
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Electronic Stock Markets

 An electronic stock exchange refers to a stock bourse where the majority, if

not all, trades take place through electronic trading platforms or portals.

 Today, most stock markets around the world are electronically-traded
exchanges, where buyers and sellers meet on a virtually-created platform to

exchange various kinds of financial securities such as stocks, bonds,
currencies, commodities, and derivatives.

 They are adapted mainly to serve execution of orders to institutional

investors mainly.

 Registered and regulated electronic stock exchanges were developed from
electronic communication networks (ECN). Some electronic communication

networks (ECNs) exist along with official exchanges.

Types of Stock Markets
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 An ECN is a computer-based system of trading that allows investors to trade
securities and other financial products electronically without having physical
contact in the market.
 ECN removes middlemen when trading securities.

 The popularity of ECNs stems from the possibility to execute security trade
orders efficiently by allowing complete access to orders placed on other
organized or electronic exchanges,
 It, therefore, eliminates the practice of providing more favourable quotes exclusively to most

important clients. As a result quote spreads between the bid and ask prices are reduced.

 ECNs enhance trading of financial products between investors regardless of
their region or geographical locations.

 Trading occur on a computerized system and outside traditional
marketplaces. In the U.S. for e.g., ECNs are required to register with the SEC
as broker-dealers.

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 Since ECNs can execute orders of stocks listed and traded on
organized or other electronic exchanges, they form the increasing
competition among the stock exchanges.
 Examples of well known electronic trading systems include Instinet (acquired by

NASDAQ), Archipelago (merged into NYSE), SETS (London Stock Exchange’s
premier electronic trading system).

 As an alternative to organized stock exchanges the Alternative
Trading Systems (ATS) have developed
 It is based on the idea there is no necessity to use an intermediary in order to

conduct a transaction between two parties.

 In fact the services of a broker or a dealer are not required to execute a trade. The
direct trading of stocks between two customers without the use of a
broker or an exchange is called an ATS.

Types of Stock Markets
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 The alternative trading system (ATS) allows buyers and sellers to match up
and conduct transactions without going through an exchange.
 The network provides a platform for mutual funds and institutional traders to conduct

transactions without revealing their identity.

 There are two types of alternative trading systems (ATS):
 crossing network

 dark pools

 Crossing network is an alternative trading system that matches buy and
sell orders for execution without first routing the order to an exchange or
other displayed market. The main purpose of a crossing network is to allow
people to buy and sell outside public channels – possibly anonymously. By
bypassing public channels, sales that happen over the crossing network don’t
affect the price of the security since Brokers crossing networks don’t show an
order book.

Types of Stock Markets
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 Electronic crossing networks do not display quotes but match large buy and sell
orders of a pool of clients (dealers, brokers, institutional investors) anonymously.
These networks are batch processors that aggregate orders for execution. Market
orders are crossed once or a few times per day at prices, which are determined in
the primary market for a security. The trade price is formed as a midpoint
between bid and ask prices, observed in the primary market at a certain time.

 Crossing Networks, while often lumped together with ‘dark pools,’ proponents
of crossing networks often say they are indeed different.

 Examples of crossing networks are Liquidnet, Pipeline, ITG’s Posit, ETF One, and Goldman
Sachs’ SIGMA X.

 The dark pool gets its name because details of these trades are concealed from

the public; clouding the transactions like murky water.
 Some traders that use a strategy based on liquidity feel that dark pool liquidity should be

publicized, in order to make trading more “fair” for all parties involved.

Types of Stock Markets
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Advantages and Disadvantages

 Electronic crossing networks provide low transaction costs and
anonymity, which are important advantages for large orders of
institutional investors.
 They are specifically designed to minimize market impact trading costs.

 However, there is no trading immediacy, since the traders have to
wait until the crossing session time to execute the orders and an
offsetting order entered by other market participant.

 Thus their execution rates tend to be low. Besides, if they draw too
much order flow away from the main market, they can reduce the
quality of the prices on which they are basing their trades.

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 Dark pools are private crossing networks, which perform the traditional role
of a stock exchange and provide for a neutral gathering place at the same
time.
 Their participants submit orders to cross trades at prices, which are determined externally.

Thus they provide anonymous (“dark”) source of liquidity.

 Dark pools do not display quotes but execute transactions at externally
provided prices.
 Buyers and sellers must submit a willingness to transact at this externally provided price in

order to complete a trade.

 The key advantage of dark pools systems is that they are designed to prevent
information leakage and offer access to undisclosed liquidity.

 Please watch this video for more information
https://www.youtube.com/watch?v=hq9waP7goSc

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Program Trading

 This is simultaneous buying and selling of a large portfolio of high rated
stocks with a significant aggregated value.

 Another understanding of programme trading refers to the use of
computer system (Designated order turnaround (DOT)), which allows
traders to send orders to many trading posts at the exchange.

 Program trading is used to reduce the susceptibility of stock portfolio to
stock market movements, e.g. by selling a number of stocks which
become overpriced, or by purchasing of stocks which become under-
priced.

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 Critics of program trading state that it is one of the major reasons
for decline or rise in the stock market and increased market
volatility.

 Due to these concerns, stock exchanges implement collars
 which restrict program trading when a wide stock index changes (e.g. by 2

percent) from the closing index on the previous trading day.

 When the collars are imposed, program trading for the sell orders becomes
allowed when the last movement in the stock price was up (or “uptick”).

 Conversely, when program trading is for the buy orders, it becomes
allowed when the last movement in the stock price was down (or
“downtick”). Such restrictions are supposed to half the stabilizing
effect on the market.

Secondary Equity Market Structure
38

The mechanism by which buyers and sellers interact to determine price and
quantity of securities in the trade is called market structure.

Cash Market vs Forward Markets

 Cash markets
 stocks are traded on a cash basis and transactions have to be settled within a specified few days

period, typically, three days after the transaction.

 to increase the number of trades most cash markets allow margin trading.

 Margin trading allows the investor to borrow money or shares from a broker to finance the
transaction.

 Forward markets
 all transactions are settled at a predetermined day, e.g. at the end of a period (month).

 This is a periodic settlement system, in which a price is fixed at the time of the transaction and
remains at this value in spite of market price changes by the settlement time.

 In order to guarantee a position, a deposit is required.

 Such a system does not prevent short-term speculation.

Secondary Equity Market Structure
39

Continuous Markets and Auction Markets

 Continuous markets
 transactions take place all day and market makers are ensuring market liquidity at moment.

 Dealer market
 dealers publicly post bid and ask prices simultaneously, and these become firm commitments to make

transaction at the prices for a specific transaction volume.
 Investors are addressing the dealers offering the best price (quote).

 Auction market
 the supply and demand of securities are matched directly and the price is formed as an equilibrium price.

 An open outcry system
 allow brokers to negotiate loudly until price, which is an equilibrium of buy and sell orders, is

determined.

 Call auction
 a method of determining the market price of a security by finding the price, which balances buyers and

sellers. Such price fixing takes place periodically each day at defined time.
 In a call auction market all orders are put into an order book until an auction and are executed at a single

price. Liquidity requires that such trades take place one or several times during a day. Such trading
procedures are aimed at defining the auction price that maximizes the trading volume.

Secondary Equity Market Structure
40

Order-driven markets and Quote-driven markets

 Order – driven market – a market without active market makers, in

which buy and sell orders directly confront each other.
 Typically order-driven trading systems are computerized. If all orders at a price cannot be

executed, a priority is given to the oldest order.

 Order driven markets are highly formalized as the auction rules for matching
trades have. A group of stock exchanges worldwide (e.g. Paris, Frankfurt stock
exchanges) use electronic order-driven systems, which allow all limit orders to
be stored in the central order book.

 A new arriving order is immediately matched with the previously submitted orders from the
order book. The trader can view all submitted orders and foresee what trades will be
executed if a new order is entered. The highest limit order and the lowest limit order are in
fact the bid and ask prices of the market. One of the examples of trading platform of the
order-driven system is XETRA, used by Frankfurt stock exchange.

Secondary Equity Market Structure
41

 Quote-driven market structure or Price-driven market

 a market in which dealers (market makers) adjust their quotes continuously to reflect supply
and demand. A typical quote-driven system is applied by NASDAQ

 This is a dealer market.

 Anyone who wants to trade in a quote-driven market must trade with a dealer. Either the
investors negotiate with the dealers themselves or their brokers negotiate with the dealers.

 Quote-driven markets require little formal organisation, however require
mechanisms for publishing the dealers’ price quotations and for regulating

the conduct of dealers.

 Stock exchanges usually provide the dealers or market makers with privileged
access to certain administrative procedures or market information.

 In return for these privileges, dealers have particular obligations, i.e. to quote ‘firm’ bid and
ask prices at which they guarantee to make trades of up to specified volumes.

Secondary Equity Market Structure
42

Hybrid markets

 Hybrid market structures are the ones, which have elements of, for
example, quote driven and order-driven market structures.

 A market that integrates traditional floor trading with electronic auction
trading has been developed by NYSE (US).

 Another example is Euro-next, which uses an order-driven trading
system with a centralized electronic order book.
 Euro-next also enables small and medium-sized listed companies to hire a designated

market maker to act as ‘liquidity provider’ in their stock.

 London Stock Exchange combines electronic order-driven trading with
liquidity provision by market makers.

Secondary Equity Market Structure
43

 In reality quote-driven markets tend to be more fragmented.
 Dealers quote different bid and ask prices, information on executed orders can be

made available with some delay. As a result, order-driven markets tend to be more
transparent than quote-driven markets.

 Liquidity can be also different.
 Investors can trade immediately in continuous order-driven markets, but have to

wait for the next price fixing in a call market.

 The price, however, depends on the availability of sufficient number of orders, i.e.
liquidity.

 Thus investors may prefer to negotiate price individually with dealers in quote-
driven markets.

 In quote driven markets information about transactions may be delayed also.

U N I T 2 – T H E J A M A I C A S T O C K
E X C H A N G E

Financial Market Analysis
ACCT3602

1

The Stock Market

 The stock market is one of the most vital areas of a market economy

 it provides companies with access to capital for business expansion

 provide investors with a slice of ownership in a company and the potential of
gains based on the company’s future performance.

 Making sure we are financially secure is a vital part of how our
economy grows.

 Investing in securities is often a significant component of an
investor’s portfolio.

The Stock Market
3

 The Jamaica Stock Market is a vital link between companies needing
capital and Jamaicans with money to invest.

 When a company needs to raise money to expand, it sells stocks or
bonds to the public through the financial markets. Individuals become
investors in this company by purchasing those securities.

 As investors and part-owners in companies of their choice, they are able
to participate in the companies’ growth and development. In turn,
companies which raise capital from the sale of shares are able to
expand.

The Stock Market
4

 The number of Jamaicans who own stocks through individual investments
or through unit trusts is growing and many more participate in the stock
market through investments in retirement funds, insurance companies
and banks.

 Owning stock allows investors, large and small, to share in the world’s
economic growth and, vitality. Central to this activity is the Jamaica Stock
Exchange (JSE), where billions of dollars worth of stocks change hands
annually.

 The JSE plays a unique role in providing companies who list their
securities on the Exchange with a liquid market for the trading of those
securities; benefiting all investors.

Evolution of the Jamaican Stock Exchange (JSE)
5

 Prior to Jamaica Stock Exchange (JSE)
 Jamaicans would buy and sell shares of corporations and companies through banks, lawyers

and other individuals.
 The Kingston Stock Market

 was established in 1

9

61 under the guidance of the Bank of Jamaica, to co-ordinate the activities of
traders, or persons who bought and sold shares on behalf of individuals.

 The Jamaica Stock Exchange
 Incorporated as private limited company in August 1968 but began operations in February

1969 at the Bank of Jamaica Building.
 The first official trade on the Jamaica Stock Exchange took place on Monday, February 3,

1969.
 It relocated to its current location at 40 Harbour street, Kingston since 1998.

 The four founding members were:
 Mr. Willard Samms – Annett & Company Limited
 Mr. Raglan I. Golding – Capital Market Services (Ja) Ltd.
 Mr. Edward E. Gayle – Edward Gayle & Company Ltd.
 Mr. Anthony Lloyd – Pitfield Mckay Ross & Co Ltd.

Evolution of the Jamaican Stock Exchange (JSE)
6

 One of the roles of the JSE was to promote the development of a vibrant

capital market and to ensure orderly trading in listed securities
 That is stocks, shares or bonds that are traded on a stock exchange.

 JSE Governance Structure
 The Exchange is governed by a Council (Board of Directors) which has the following

composition:

 The Governor of the Central Bank (Bank of Jamaica) or his nominee.

 A representative of the Ministry of Finance.

 Three persons other than seat-holders.

 Upwards of ten seat-holders representing members.

 The Chairman and Deputy Chairman are elected by the Council annually.

 The General Manager /Secretary is in charge of the day-to-day operations of the Jamaica
Stock Exchange.

Evolution of the Jamaican Stock Exchange (JSE)
7

 Role of the Council (Board of Directors)
 is a self-regulatory body that monitors the activities of the stock market.

 The Council’s functions include:
 Setting guidelines and rules of operations at the Exchange to ensure that the stock

market and its broker-members operate at the highest possible standards.

 To determine the shares to be listed on the exchange.

 In this regard, the Council has the power to suspend companies which violate the rules
of the Exchange from trading, or to de–list companies which fail to meet the
requirements of the Jamaica Stock Exchange.

 The decisions of the Council are arrived at on the basis of a majority
vote.

Evolution of the Jamaican Stock Exchange (JSE)
8

 Principal Objectives of JSE are:-
 To promote the orderly development of the stock market and the Stock Exchange in

Jamaica;

 To ensure that the stock market and its Broker-members operate at the highest
standards practicable;

 To develop, apply and enforce rules designed to ensure public confidence in the
stock market and its Broker-members;

 To provide facilities for the transaction of stock market business;

 To conduct research, disseminate relevant information and maintain local and
international relationships calculated to enhance the development of the Jamaica
Stock Market.

 To educate investors/companies on all aspects of the equities market in an effort to
facilitate the entry of new investors to the stock market.

Functions of the Jamaica Stock Exchange (JSE)

 To provide an additional channel for encouraging and mobilizing
domestic savings.

 To foster the growth of the domestic financial services sector.

 To provide savers with greater opportunities to protect themselves
against inflation.

 To increase the overall efficiency of investment.

 To facilitate privatization.

 To improve the gearing of the domestic corporate sector and help reduce
corporate dependence on borrowing.

9

Evolution of the Jamaican Stock Exchange (JSE)
10

 Securities traded on the JSE include:
 Ordinary/Common shares

 Preference Shares

 Corporate Bonds

 Government Bonds are not listed on the Jamaica Stock Exchange.
 These are traded by the Bank of Jamaica in an over the counter market.

 For the first time in Jamaica’s history a US dollar share was listed on
the Jamaica Stock Exchange on Thursday, July 18, 1996.
 This was the Citizens Bank US Dollar Convertible Cumulative Redeemable Preference

Share.

Listings on the JSE
11

 The listing of securities on the Exchange
 is in the absolute discretion of the Council/Board of the Exchange which may

delegate such powers to a duly appointed committee.

 The markets in the JSE are:
 Main Market

 Junior Market

 Combined Market

 USD Market

 Bond Market

 Junior USD Market

 Private Market

JSE Main Market Listing
12

 The JSE Main Market lists ordinary and preference shares, which
represent various business sectors:
 banking and finance; manufacturing; retail; communications; insurance; leisure;

conglomerate; services and real estate.

 The criteria for listing on the JSE Main Market are as follows:

 Must be incorporated or registered and operating in a business located in a
CARICOM country.

 The total issued share and loan capital of the company must be J$200,000 or
more; the share capital portion being not less than $100,000.

 All of the issue of the security which is the subject of the request for listing is to
be issued and fully paid.

JSE Main Market Listing
13

 Ordinary Shares/Stock -The issued nominal value must be
$250,000 or more; and a minimum of 100 shares/stockholders holding
not less than 20% of the issued ordinary capital

 Irredeemable Preference Shares and/or Preference Shares
convertible into Ordinary Shares/Stock: Issued nominal value
must be $500,000 or more

 Redeemable Preference Shares: Issued nominal value of
$100,000 or more.

JSE Main Market Listing
14

 Companies incorporated or Registered in Jamaica may be listed by
one of the following methods:
 Prospectus Issue:

 an offer to the public by or on behalf of a company at a fixed price;

 Offer for Sale:
 an offer to the public, by or on behalf of a third party at a fixed price.

 Offer by Tender:
 an offer to the public by or on behalf of a company or a third party by tender;

 Placing:
 an offer through broker-members of the Exchange to sell the securities of a company to

the public;

 Introduction:
 where none of the company’s securities is being offered to the public or trading.

JSE Junior Market
15

 The JSE launched the Junior Market on April 1, 2009
 Which was designed to encourage and promote investment in Jamaica’s

entrepreneurship, employment and economic development.

 It was a collaborative efforts of the Government, the Board of the JSE, the
Financial Services Commission and Steering Committee composed of key
stakeholders.

 The Junior Market allow investors to put capital into legitimate small
and medium sized companies (SMEs)
 Their shares are traded on a special JSE platform.

 Listed on the JSE Junior Market are ordinary and preference shares
 representing various business sectors: banking and finance; manufacturing; retail;

insurance; leisure; services and real estate.

JSE Junior Market
16

Each company that wants to join the Junior Market

 Must be incorporated as a public limited company
 in Jamaica or elsewhere in the CARICOM region.

 Have no association with other listed companies, or prior
history of listing
 must demonstrate to the JSE that (a) it has not been previously listed on the Main

Board of the JSE, or on the main trading plat form of any other stock exchange,
and (b) it is not an “associate “ (including a subsidiary) of any such listed company.

 Initial Public Offering
 Each company that wants to join the Junior Market must raise a minimum of

J$50m in new funds in an initial public offering that is made, subject to a
prospectus. The initial public offering must relate to equity shares, or convertible
or other shares that have the characteristics of equity (rather than debt) securities.

JSE Junior Market
17

 Minimum and Maximum Capital, and Number of Shareholders

 Each company that is admitted to the Junior Market must have stated capital of not less than
J$50m and not more than J$500m following its initial public offer, and during its life on the
Junior Market.

 In addition, each such company must have at least 25 shareholders holding at least 20% of
the issued equity share capital in its first 5 years on the Junior Market, and at least 50
shareholders holding that proportion in its second 5 years on the Junior Market.

 Appointment of a Mentor

 Each company that wants to join the Junior Market must, unless the JSE agrees otherwise,
appoint a mentor who will act as a compliance adviser to the Board of Directors.

 The mentor must be a suitably experienced person, and he must enter into the standard form
Mentor Agreement and be approved by the JSE for the purposes of the Company’s admission
to the Junior Market.

JSE Junior Market
18

 Appointment of a Board of Directors
 Each company that wants to join the Junior Market must appoint a Board of Directors

that is suitably experienced as a collective body, to govern and represent the company.

 The JSE tracks the performance of the market by maintaining indices.
 Uses the weighted average market capitalization method to calculate its indices.

 The JSE Junior Market Index measures the performance of all the ordinary shares
listed on the Junior Market.

 Settlement is done at T+2 and daily information is disseminated on the activities of
this market through the usual channels inclusive of the JSE’s website

Combined Market
19

 The performance of all the companies with ordinary shares listed on
the JSE Main and Junior Markets is tracked by the JSE Combined
Index.
 Tracking the performance of both markets by one index will allow investors,

analysts and researchers to see the performance of the overall market at a glance

without having to look at the markets separately.

 The JSE Combined Index provides a daily indicator of the overall
performance of the market and its movement.

 The JSE Combined Index commenced on April 1, 2011.

USD Market
20

 On July 5, 2011, the Jamaica Stock Exchange, as the first in the English
Caribbean, launched the US Dollar Equities Market.
 It allows companies to list their shares in US dollars and also allow for trading and

settlement to take place in US dollar.

 This market further expands the product offerings of the JSE
 It provides additional investment options for persons interested in diversifying their

portfolios via the Exchange.

 This market is governed by the rules of the Main Market and trading
operates according to the trading rules for all the securities listed on the
JSE.

 Similar to the other markets, settlement is done at T+2 and daily
information is disseminated on the activities of this market through the
usual channels inclusive of the JSE’s website.

Bonds Market
21

 The Jamaica Stock Exchange launched the Bond Market in June 2013 as a
means of:

 Increasing the number of options available for corporations to efficiently raise capital

 Widening choices that individuals and corporate investors have to invest

 Assisting the efficiency of monetary management

 The JSE bond market is a facility where investors buy and sell debt securities,
either directly from the borrower at issue or afterwards from other investors.

 This market will facilitate the trading of bonds with the aim to increase efficiency,
transparency and liquidity of the bond market.

 Any company that is incorporated in a CARICOM country may list its fixed income securities
on the JSE Bond Market.

 Similar to the equities market, companies interested in listing their bonds will be required to
follow the requirements as outlined in the JSE Rule Book (Main Market).

Private Market
22

 The JSE Private Market (PM) platform facilitates the listing and
managing of private debt and equity issues. This facility is a first of its
kind in Jamaica.

 The benefit to companies and investors include:
 Private companies can now raise equity and/or debt capital on a regulated platform

 Seamless transfers of securities among private investors

 Efficiency in tracing changed shareholder positions

 A full suite of registrar, trustee and transfer services

 Market information on private equity and debt transactions

 Sellers will have easy access to their transaction activity and executed electronic
agreements

 Real-time reporting on sell orders which can be generated directly from the platform

JSE Platform
23

 Since January 2000, the Jamaica Stock Exchange has had an automated
trading platform, called Horizon.
 The back office operations which involves clearance and settlement was automated with the

establishment of the Jamaica Central Securities Depository in June 1998.

 Some of the benefits of automated trading are: Greater efficiencies through increased accuracy
and increased processing speed and lower operating costs. Reduced risk associated with
clearing and settling securities transactions, also shorter settlement cycles.

 Delivery versus payment – the exchange of securities and the cash to
settle.
 There has been increased global attractiveness of the Jamaican stock market through the

adoption of generally accepted international standards. The JSE has demutualized since 2009
and is listed on the Exchange.

 Its regulatory functions are now overseen by the Regulatory Market & Oversight Division
(RMOD) that is governed by Regulatory Market & Oversight Committee which comprises of
the Independent Members of the Board and they are autonomous.

Reporting Requirements of JSE listed Companies
24

 Listed companies are required to conform to provisions of the
Companies Act of Jamaica and to provide the Exchange with annual
audited financial statements with certain minimum information and
within specific time periods.
 In addition listed companies are required to submit quarterly unaudited financial

reports.

 In case of Take-Overs & Mergers, the Exchange imposes specific
obligations on the listed offeror or Offeree Company.
 The Jamaica Stock Exchange defines “Take-Over” to mean “an offer made to

shareholders, to purchase such number of equity shares of a company that,
together with the offeror’s presently-owned shares will in the aggregate exceed
50% of the outstanding shares with voting rights of the company.”

Reporting Requirements of JSE listed Companies
25

 The general principles applicable to Take-Overs and
Mergers include:
 Strict compliance with the detailed regulations.

 That stockholder is given sufficient evidence, facts and opinions upon which an
adequate judgement and decision can be reached

 No action taken by the Board of the offeree company, without the approval of
stockholders in general meeting, to frustrate a bona fide offer.

 The prevention of the creation of a false market in the shares of the offeror or
offeree company.

 Rights of control to be exercised in good faith.
 The oppression of minority shareholders is wholly unacceptable.

 All stockholders of the same class of offeree company are to be treated similarly
by offeror company.

Compensation Fund
26

 A Compensation Fund has been established in 1970 to indemnify
losses to Broker-members’ clients in certain situations.
 Member-Dealers who have lost money as a result of a defalcation or fraudulent

misuse of securities or document of title to securities or of other property, by a
member-dealer or any of his directors or employees.

 investments in Stocks and Shares of companies listed on the Jamaica Stock
Exchange and

 as of July 1, 1999, any claim in denominated money market instruments.

 The Fund does not protect against losses resulting from the rise and
fall in the market value of investments.

 Contributions are made by Broker-members based on the
consideration for equity and preferred transactions.

Compensation Fund
27

 In order to provide further protection to the investing public, the
Exchange can intervene and run and/or wind-up the affairs of a Broker-
member in certain situations where clients’ interest are in jeopardy.
 The Council of the Jamaica Stock Exchange monitors the financial situation of all

brokers.

 When the Exchange sees fit, it can act on an a priori basis to prevent a broker from
continuing to trade before a situation becomes critical.

More about JSE
28

 For more information on the Jamaica Stock Exchange, visit:

https://www.jamstockex.com/about/frequently-asked-questions-jse/

https://www.jamstockex.com/about/frequently-asked-questions-jse/

UP NEXT…………..
29

The Role
of a

Stock
Market

U N I T 2 – T H E S T O C K M A R K E T
A N D I T S O P E R A T I O N S

Financial Market Analysis
ACCT3602

1

Buying and Selling Shares

Specific to the Jamaican Stock Exchange (JSE)

 A potential investor must contact a broker to buy or sell shares
on their behalf.

 The buying/selling process begins when an order is placed with
the stockbroker for a specified number of shares in a company.

 The trade is complete when the price matches a trade that is
placed by a buying broker on the electronic trading platform with
the price placed by a selling broker. Settlement is done T +2 days.

 Trading on the Jamaica Stock Exchange is conducted on Monday
to Friday between 9:30 a.m. and 1:30 p.m. through an electronic
trading platform which was introduced in 2000.

The Jamaica Central Securities Depository
3

 In 1998 the Jamaica Central Securities Depository
(JCSD), a wholly owned subsidiary of the Jamaica Stock
Exchange was established.

 It is a facility for holding securities which enables share
transactions to be processed by book entry.

 A book entry system is an accounting system which
facilitates the change of ownership of securities
electronically between parties without the need for
movement of physical documents.

Buying and Selling Shares
4

 There are three types of orders that you can place:

 A Market Order – asks your broker to buy or sell stock at the market price.

 A Limit Order – sets the price at which you want stocks to be bought or sold.

 A Stop Order – gives an approximate buying or selling price of stock.

 When the approximate price is reached the stop order becomes a market order.

 You will then receive a contract note that states the company whose
stock you have bought or sold, the price paid or received, the
commission and other fees and the settlement date.

 You should pay your bill by the settlement date.

Placing an Order: Market Orders
5

 Market Order is the simplest and most common. It is an order to buy or sell a
security immediately at the best obtainable price.

 The investor has no control on the amount paid for the stock’s purchase or sale as the
price is set by the market.

 For example, if an investor places an order to purchase 100 shares, they receive 100 shares
at the stock’s asking price.

 It requires that the shares should be traded at the most favourable price available
which is the lowest obtainable price for a purchase, and the highest available price
for a sale shares.

 A market order poses a high slippage risk in a fast-moving market.

 If a stock is heavily traded, there may be trade orders being executed ahead of yours,
changing the price that you pay.

Placing an Order: Market Orders
6

Market-if Touched (MIT) Order

 an order that will be executed only if a security reaches (touches) a specific
price.
 For example, suppose Bob would like to purchase 100 shares of stock in Fortis, whose

share is currently trading for $25.50 but only after the stock price reaches $25.10 per share
(trigger price). Bob will place a MIT order with a broker for these 100 shares. Once stocks
of Fortis reaches $25.10 per share, the broker executes Bob’s order as a regular market
order.

 MIT is used when investors wish to delay buying or selling a security until
its price becomes more advantageous.
 A MIT buy order instructs a broker to execute the buy order once the security’s market

price has fallen to a desired price.

 A MIT sell order instructs a broker to execute the sell order once the market price has
risen to a desired price.

Placing an Order:

Limit Orders

7

Limit Orders

 Places a limit on the price at which shares can be bought or sold.
 Thus it specifies purchase or sale of shares at maximum buying price or minimum

selling price, respectively.
 i.e. lower for a buy order and higher for a sell order.

 It prevents investors from potentially purchasing or selling stocks at a
price that they do not want.
 if the market price is not in line with the limit order price, the order will not be

executed.

 A limit order can be referred to as:
 a buy limit order

 a sell limit order

Placing an Order: Limit Orders
8

 Buy limit order

 specifies that the purchase should take place only if the price is at, or below, a specified level.

 For example, consider a stock whose price is $11. An investor sets a limit order to purchase
100 shares at $10. In this scenario, only when the stock price hits $10 or lower will the trade
be executed.

 Sell limit order

 specifies a minimum selling price such that the trade should not take place unless that price,
or more, can be obtained.

 Consider the stock above. An investor sets a limit order to sell 100 shares at $12. In this
scenario, only when the stock price hits $12 or higher will the trade be executed.

 A Limit order, therefore, ensures that if the order is filled it will not be filled

at a price less favorable than your limit price, but it does not guarantee a fill.

Placing an Order: Stop Orders
9

 Stop Order or Stop-Loss Order is designed to limit or protect profits

and limit an investor’s loss on a trade.

 It involves selling of shares after the price has fallen to a specified level, or
buying after the price has risen to a certain level.

 Therefore, it ensures that a selling price is not too low, or that a buying price is no too high.

 For example, an investor is considering selling its position in a stock if it

declines to $8 from its current price of $12. The investor could place a stop
order at $8. When the stock hits $8, the sell order would be executed.

 Note that the stock will not necessarily sell at exactly $8 – it depends on the supply and
demand of the stock. If the stock price is rapidly falling, the order may be executed at a
price significantly lower than $8.

 This type of problem can be minimized by a stop-limit order.

Placing an Order: Stop Orders
10

Stop-Limit Order

 requires placing two prices – the stop price and the limit price.
 Once the stock hits the stop price, the order becomes a limit order.

 Stop-limit orders, as opposed to a stop order, guarantee a price limit. On the other
hand, a stop order guarantees an order execution but not necessarily at the stop order
price.

 For example, an investor currently owns a stock trading at $30. The
investor would like to sell the stock if it dips below $25, but only if the
stock can be sold at $24 or more. The investor sets a stop-limit order by
setting a stop price of $25 and a limit price of $24. Once the stock drops
below $25, the order becomes a $24 limit order.

Placing an Order: Timing
11

Another dimension to an order is the length of time for which it
remains in force.

 Fill-or-Kill Order

 order is to be cancelled if it cannot be executed immediately.

 Open Order, or Good-till-Cancelled Order

 order remains in force until it is specifically cancelled by the
investor.

Stock Market and its Operations
12

 When a security is traded, a dealer, operating as a market-maker,
quotes a price at which he/she is prepared to sell – the ask price – and a
price at which he/she is willing to buy – the bid price.

 In the transaction the investor pays the ask price and the dealer pays
the bid price.
 Ask price – the price at which market maker is willing to sell a security, also called

an offer price.

 Bid price – the price at which market maker is willing to buy a security.

 The ask price is always above the bid price and the difference between
the quoted bid and the ask price is called the bid–ask spread. This is
the profit of the dealer: Spread = ask price – bid price.

Stock Market and its Operations
13

 Example: Company’s shares are quoted by a dealer as bid and
ask price for $49.2 and $50.00 respectively. The bid-ask spread
in percentage is:

Spread = ($50.00 – $49.2)/ $49.2 = $0.8 / $49.2 = 1.63%

 If investor purchases the share and then immediately sells it before the
market price of the share changes, he will incur a cost of 1.63% of his
investment for the round-trip transaction.

 The market bid-ask spread is the excess of the lowest ask price
over the highest bid price and is normally smaller than the spreads
of individual market-makers.

Stock Market and its Operations
14

 The bid-ask spread of dealers can be seen as the price to be paid by
investors for his services.

 From the perspective of the dealer the spread can be seen as a
compensation for his costs and risks.
 The dealer typically holds an inventory of securities during the day to be able to sell (and

buy) immediately.

 From his return (i.e., the bid–ask spread), the dealer has to cover the costs of holding his
inventory (e.g., interest costs of financing the securities inventory) and the risks (e.g.,
prices may move while the securities are in the inventory).

 From the perspective of investors, dealers (in their role as market-makers)
provide two important services:
 possibility to execute a trade immediately from inventory, without having to wait for a

counterparty to emerge.

 maintenance of price stability in the absence of corresponding sell or buy orders.

Stock Market and its Operations
15

 By trading from their own stockholdings, dealers reduce price
fluctuations.
 The dealer costs include the administrative costs of transferring shares.

 The dealer risks arise from price fluctuations and information-based investors.

 For shares that are infrequently traded, such as shares in smaller
companies

 the risks are greater, because positions are held for longer periods between trades.

 If shares are held for a long time, the risk of losses from price falls is
greater.
 the bid-ask spreads for such shares tend to be relatively high.

Stock Market and its Operations
16

 Dealer risk is also related to the possibility of investors possessing
information that the dealer does not.
 Such investors are able to make profit at the expense of the dealer.

 Investor can sell shares to the dealer at a high price, while he is
informed about a possible fall of share price.
 As a result the dealer may suffer the loss from a fall in the share price. The bid-offer

spread is to provide the dealer with compensation for bearing this kind of
information risk.

 Dealers have a possibility to negotiate special prices for large
transactions.
 The spread can be broader for particularly large transactions (i.e., block trades) to

cover the price risk of such block trades before the dealer can sell or buy the bought
or sold securities to or from other dealers in the market.

Stock Market and its Operations
17

 The spread is influenced by the following factors:

 order costs – costs of processing orders, including clearing costs and costs of
recording transactions;

 inventory costs – include the costs of maintaining an inventory of particular
shares;

 competition – the larger the number of market makers, the greater their
competition, and the narrower is the spread;

 volume – the larger the trading volume, the more liquid are the shares, the less
risk of share price change;

 risk – the more risky are company operations, the more volatile are its shares, the
higher spread is set.

Stock Market and its Operations
18

 Several research studies showed that bid-ask spreads on specific
large stock exchanges are wider as they should be.
 Due to specific trading practice, market makers kept their profits margins wide.

 Some analysts called this phenomenon “under-the-table-payment”
for order flow or the right to execute customers’ trades.
 Order flow – the right to execute customers’ trades.

 Therefore it abuses small investors, who do not receive the best price
for their quotes.

Margin Trading
19

 Investors can borrow cash to buy securities and use the securities
themselves as collateral.

 A transaction in which an investor borrows to buy shares using the
shares themselves as collateral is called margin trading or buying
on margin.

 Investor borrows money or shares from a broker to finance a
transaction.
 Funds provided by the broker are borrowed from a bank.

 The interest rate that bank charges broker for funds for this purpose is called the
broker call rate or call money rate. The broker charges the borrowing investor
the call money rate plus a service charge.

Margin Trading
20

 Stock exchange regulations set margin requirement
 brokers cannot lend more than a specified percentage of the market value of the

securities.

 The aims of margin requirement are:
 to discourage excessive speculation

 ensure greater stability in the markets

 Margin requirement has to ensure that investors can cover their
position in case the value of their investments into shares reduces.
 the possibility of default on broker loans should also reduce

Margin Trading
21

 In order to purchase shares on margin investors have to create a
margin account with a broker.

 They will then need to pay the initial deposit of cash (initial margin)
 The amount of cash or securities that must be deposited as guarantee on a futures

position.
 The margin is a returnable deposit.

 Stock exchange regulations set initial margin requirement
 which is the proportion of the total market value of the securities that the investor

must pay as an equity share

 the remainder is borrowed from the broker

 Maintenance Margin
 the minimum margin that an investor must keep on deposit in a margin account at

all times.

Margin Trading
22

Important note:

 For securities, the definition of margin includes 3 important concepts:
 The Margin Loan – the amount of money that an investor borrows from his broker to buy

securities.

 The Margin Deposit – the amount of equity contributed by the investor toward the purchase
of securities in a margin account.

 The Margin Requirement – the minimum amount that a customer must deposit and it is
commonly expressed as a percent of the current market value.

 The Margin Deposit can be greater than or equal to the Margin
Requirement.

 We can express these as equations:

Margin Loan + Margin Deposit = Market Value of Security

Margin Deposit >= Margin Requirement

Short Selling
23

 In a short selling, investor place an order to sell a security that is not owned by
the investor at the time of sale. Investors sell the stock short (or short the stock)
when they expect decline of the stock price.
 The investor borrows the security from the broker and sells it on the open market and plans to

buy it back later for less money.

 To cover their short position, investors must subsequently purchase the stock and
return it to the party that lent the stock.
 The owner of the stock is unaffected when his shares are borrowed and is not aware that the

shares were lent.

 If the stock price declines by the time the short-seller repurchases it in the
market,
 the short seller earns a profit from the difference between the initial selling price and the

subsequent repurchase price of the stock.

 However, his profit will be less, if he has to pay to the owner of the borrowed
stock dividends, which the investor would have received if he had not borrowed
the stock.

Short Selling
24

 The risk of a short sale is that the stock price may increase over time

forcing the short-seller to pay a higher price for the stock than the price
at which it was initially sold.

 Stock markets and financial analysts provide information on level of
short sale.

 Twice a month, brokerage firms are required to report the number of
shares that have been shorted in their client accounts.

 This information is compiled for each security and then released to the
public.

 By monitoring changes in a stock’s short-interest figures, investors are
able to gauge the public’s level of pessimism toward the stock.

Short Selling
25

Several indicators are used to measure the short position on stock:

 The degree of short positions

 It is a ratio of the number of shares that are currently sold short,
divided by the total number of shares outstanding.

 Statistics shows, that most often this measure is in the range of 0.5-
2%.

 A high measure of 3% shows a large number of short positions in
the market, which may indicate that a large number of investors
expect the stock price to decline.

Short Selling
26

 Short interest ratio for specific shares
 The short interest ratio is a mathematical indicator of the average number of days it

takes for short sellers to repurchase borrowed securities in the open market;
calculated as the number of shares which are currently sold short, divided by the
average daily trading volume over a one-month period.

 The higher the ratio, the higher the level of short sales.
 A ratio of 20 or more reflects an unusually high level of short sales, indicating that many

investors believe that the stock price is currently overvalued.

 For some stock this ratio may exceed 100 at particular points in time.

 Short interest ratio for the market
 The higher the ratio, the higher the level of short selling activity in the market

overall.

 Investors, who have established a short position, quite often request a stop-buy
order to limit their losses.

Stock Trading Regulations
27

 Stock market regulations aim at ensuring fair treatment of all investors in
the market.

 Stock trading is regulated by national securities exchange commissions and
by individual stock exchanges.
 It is widely understood, that the development of financial markets and success of new issues

of securities cannot be handled without efficient and fair secondary stock markets.

 Analysis of average real returns on stock in the well developed markets
indicate that historically it has been about 6% percent higher than return on
Treasury bills, which reached on average only 1% p.a.

 The difference between the return on stocks and the risk free- rate is a
measure of risk premium on equities.
 However, the size of this risk premium is not justified by the stock market’s risk exposure if

only investors are assumed to be unreasonably averse to risk. The research has shown that
only 0.35% of an equity premium can be justified as risk premium. Such persistent
overpricing of risk premium is called an equity premium puzzle.

Stock Trading Regulations
28

 Equity premium puzzle is the persistent overpricing of risk premium on
stocks.

 If the equity premium puzzle is the result of security mispricing, then there
is an arbitrage opportunity.
 It means that investor can gain by borrowing at the Treasury bill rate and investing in stocks.

 Borrowing limitations and transaction costs may reduce this arbitrage profit, but not
eliminate it.

 The concern about the fair and ethical stock market trading require
imposing discipline on individuals and institutional investors.
 The organized stock exchanges introduce surveillance of all transactions at the exchanges.

 Computerized systems are installed to detect unusual trading of any particular stock.

 Any abnormal price or trading volume of particular stock or unusual trading practices of
market participants is investigated.

Stock Trading Regulations
29

 Additional regulations on imposing good corporate governance practice
for listed companies are imposed through introduced corporate
governance codes.

 Regulations require disclosure of financial statements, having a
majority of independent directors (not employees of the companies) on
their boards of directors.
 Such requirements are aimed at reducing existing or potential conflicts of interest

between management and minority as well as majority shareholders, focusing
management on maximizing stock value for company shareholders.

 Specific regulation concerns are related to restrictions on trading in
case of market downturns.

Stock Trading Regulations
30

 Trading halts may be imposed on particular stocks if stock exchanges
believe that market participants need more time to receive and absorb
material information, which can affect stock price.
 Such trading halts are imposed on stocks that are associated with mergers and acquisitions,

earning reports, lawsuits and other important

news.

 The purpose of them is to ensure that market has complete information before trading on the

news.

 A halt may last a few minutes, hours or several days.

 Trading is resumed after it is believed that the market has complete
information.
 This does not prevent investors from a trading loss in response to the news. However, it can

prevent from excessive optimism or pessimism about a stock, and can reduce stock market
volatility.

 Drawbacks of trading halts are related to slowing down the inevitable
adjustment of stock prices to the news.

Stock Trading Regulations
31

 Stock exchanges can impose circuit breakers, which are restrictions on
trading when stock prices or stock indexes reaches a specified threshold
level.
 Circuit breakers – automatic halts or limitations in trading that are triggered upon the

attainment of certain stipulated price moves.

 The necessity of such restriction became vivid during stock market crashes,
e.g of NYSE in October 1987 and the later ones including Flash Crash in
2010.
 When market maker swamp market with sell orders, stock prices cannot reflect the fair value

any longer and move into a freefall.

 The market experiences huge liquidity crisis, which feeds panic and exacerbates the price
decline.

 As a result of such experience, in order to provide time for market participants to regroup
and obtain backup sources of liquidity, a series of circuit breakers are put to use.

Stock Trading Regulations
32

 In February 2013, the U.S. Securities and Exchange Commission (SEC) introduced
new market-wide circuit breakers rules. The S&P 500 index was chosen as the new
benchmark, replacing the Dow Jones .
 The percentage decline of the market index is calculated based on the prior-day closing price of the

S&P 500.

 The market index percentage changes were split into three tiers.
 Level 1 tier sets up a threshold of 7% decline, level 2 circuit breaker triggers at a 13% decline, and

level 3 sets up a benchmark of a 20% slump.
 Levels 1 and 2 halt the trading for 15 minutes if a market drop occurs before 3:25 p.m. If the

decline occurs at or after 3:25 p.m., the trading continues.
 Level 3 stops the trading for the remainder of the trading day in any circumstances.

 NASDAQ and other large international exchanges impose similar circuit breakers.
 50 point collar – provision that prohibits computer assisted trading if Dow Jones Industrial

average index rises or falls by 50 points.
 250 point rule – provision that halts all trading for one hour if Dow Jones Industrial average

index falls by 250 points in a day.

Stock Trading Regulations
33

JSE Circuit Breaker Rule

 No stock should trade +/-15% from the close price or the effective close price at the
opening of the market. The effective close price is determined whenever the closing bid

is greater than the close price or whenever the closing ask is less than the close price.

 Use the closing bid as the effective close price, if the value is greater than the close price or
use the closing ask as the effective close price, if the value is less than the close price.

 However, during the day if the Circuit Breaker is triggered for a security, the security
will be halted for an hour to allow for the release, circulation and absorption of any

relevant market news and a cool down period while investors consider their options.

 After the hour has passed the security will be released for trading and the new reference price,
which is a simple average of the trigger price and the close price, will be used to determine the
trade range for the remainder of the day. The price of the trade that triggered the Circuit Breaker
should not be +/-15% outside of the original prescribed price band. The stock will not be allowed
to trade +/- 15% of the new reference price.

The Stock Market and Covid-19
34

 The market has reacted to recent unpredictability with large drops, triggering

a market wide circuit breaker four times in March 2020.

 The safeguard pauses trading for 15 minutes in hopes the market will calm.

 The U.S. Securities and Exchange Commission mandated the creation of
market-wide circuit-breakers to prevent a repeat of the Oct. 19, 1987 market

crash, in which the Dow Jones plunged 22.6%. Since then, they have only
been triggered once in 1997 before the four times March 2020.

 The S&P 500 triggered level 1 market wide circuit breakers during the

opening hour on March 9, 12 and 16 based on drops of 7% from the previous
close, and tripped later in the day on the 18th. Trading also halts on both the

Dow and the Nasdaq when a circuit-breaker is triggered on the S&P 500.

The Role of Speculation
35

 Speculation is the practice of engaging in risky financial transactions
 With an attempt to profit from fluctuations in the market value of tradable goods

such as a financial instruments

 rather than attempting to profit from the underlying financial attributes embodied in the
instrument such as capital gains, interest, or dividends.

 When investors become speculators
 they are purchasing a stock (speculative stock) with the sole purpose of selling it to

someone else at a higher price.

 At the same time, it carries an unusually high level of risk.

 The concepts of hedging and the futures market become relevant in
explaining the role of speculation in determining stock prices

Speculative Stocks
36

 There is a relationship between risk and expected return, as we have seen.
 Speculation by definition involves a short time horizon, and a speculative stock is

one with the potential to make its owners a lot of money quickly. At the same time
it carries an unusually high degree of risk.
 In other words a speculative stock has a high probability of a loss and a small probability of a

large profit.
 The potential for a large profit is the attraction.

 Some analysts consider speculative stocks to be a growth stock at the far end of the
risks spectrum.
 Most people would classify the computer company DELL (DELL, NASDAQ) as a growth stock

rather than a speculative stock.
 DELL has never paid a dividend so it clearly is not an income stock.

 A new formal computer software company also paying no dividends would
probably be considered a speculative rather than a growth stock by most investors.
 Speculative stocks tend to be relatively new companies and in recent years have been heavily

represented by electronic and technology terms.

U N I T 3 – C A P I T A L & M O N E Y
M A R K E T A N A L Y S I S

Financial Market Analysis
ACCT360

2

1

Importance of Money Markets

 The Money Market

 the component of financial markets that involves short-term
borrowing/lending, or the buying and selling of financial assets with
original maturities of one year or less.

 Are used by governments, banks, and other large institutions for the
raising of short term finance to fund short-term cash flow needs;

sometimes for loans that are expected to be paid back as early as
overnight.

 Funds borrowed from the money markets are typically used for general
operating expenses or to cover brief periods of illiquidity.

 Money markets also allow individual investors to invest small amounts of
money in a low-risk setting, usually through a money market fund.

2

Functions of the Money Market
3

 Financing Trade: Money Market plays crucial role in financing both
internal as well as international trade.

 Commercial finance is made available to the traders through bills of exchange,
which are discounted by the bill market.

 The acceptance houses and discount markets help in financing foreign trade.

 Financing Industry – Money market contributes to the growth of
industries in two ways:

 Money market helps the industries in securing short-term loans to meet their
working capital requirements through the system of finance bills, commercial
papers, etc.

 The short-term interest rates of the money market influence the long-term interest
rates of the capital market; as it serves as the benchmark.

Functions of the Money Market
4

 Self-Sufficiency of Commercial Bank – money market enables
the commercial banks to use their excess reserves in profitable
investment and become self sufficient.
 Commercial banks can earn income from its excess reserves as well as maintain

liquidity to meet the uncertain cash demand of the depositors.

 In the money market, the excess reserves of the commercial banks are invested in
near-money assets (e.g. short-term bills of exchange) which are highly liquid and
can be easily converted into cash. Thus, the commercial banks earn profits without
losing liquidity.

 In situations of emergency and commercial banks have scarce funds, they don’t have
to borrow from the central bank at higher interest rates.

 They can meet their requirements by recalling their old short-term loans from the
money market.

Functions of the Money Market
5

 Help to Central Bank:
 Though the central bank can function and influence the banking system in the

absence of a money market, the existence of a developed money market
smoothens the functioning and increases the efficiency of the central bank.

 Money market helps the central bank in two ways:
 The short-run interest rates of the money market serves as an indicator of the

monetary and banking conditions in the country and, in this way, guide the
central bank to adopt an appropriate banking policy.

 The sensitive and integrated money market helps the central bank to secure quick
and widespread influence on the sub-markets, and thus achieve effective
implementation of its policies.

The Importance of Capital Markets
6

 Capital Markets are financial markets for the buying and selling of
long-term debt or equity-backed securities.

 These markets channel the wealth of savers to those who can put it to
long-term productive use

 such as companies or governments making long-term investments.

 Capital Market securities includes:
 Stocks/Equities
 Corporate Bonds
 Long-term Government Bonds

The Importance of Capital Markets
7

 Capital market plays an important role in mobilizing saving and
channelling them into productive investments for the development of
commerce and industry.
 thereby helping capital formation and economic growth of the country.

 The capital market acts as an important link between savers and investors.
 The savers are lenders of funds while investors are borrowers of funds. The savers who do

not spend all their income are called. “Surplus units” and the borrowers are known as
“deficit units”.

 The capital market is the transmission mechanism between surplus units and deficit units.
It is a conduit through which surplus units lend their surplus funds to deficit units.

 Surplus units buy securities with their surplus funds and deficit units sells securities to raise
the funds they need.

The Importance of Capital Markets
8

 Funds flow from lenders to borrowers either directly or indirectly
through financial institutions such as banks, unit trusts, mutual
funds, etc.

 Funds flow into the capital market from individuals and financial
intermediaries which are absorbed by commerce, industry and
government.
 It thus facilitates the movement of stream of capital to be used more productively

and profitability to increase the national income.

 The borrowers issue primary securities
 which are purchased by lenders either directly or indirectly through financial

institutions.

The Importance of Capital Markets
9

 The capital market provides incentives to savers in the form
of interest or dividend and transfers funds to investors for
capital formation.

 It diverts resources from wasteful and unproductive
channels
 such as gold, jewellery, real estate, conspicuous consumption, etc. to

productive investments.

 A well-developed capital market comprising expert banking
and non-banking intermediaries brings stability in the value
of stocks and securities.
 It does so by providing capital to the needy at reasonable interest rates

and helps in minimizing speculative activities.

The Importance of Capital Markets
10

 The capital market encourages economic growth.
 The various institutions which operate in the capital market give quantitative and

qualitative direction to the flow of funds and bring rational allocation of resources.

 They do so by converting financial assets into productive physical assets. This leads to
the development of commerce and industry through the private and public sector,
thereby inducing economic growth.

 In underdeveloped or developing countries where capital is scarce, the
absence of a developed capital market is a great hindrance to capital
formation and economic growth.
 Even though people are poor, they do not have any inducements to save.

 Those who save, invest their savings in wasteful and unproductive channels, such as
gold, jewellery, real estate, conspicuous consumption, etc.

 Such countries can induce people to save more by establishing banking and non-
banking financial institutions for the existence of a developed capital market.

Importance of Capital Markets
11

 Capital market activities results in increase productivity within the
economy leading to more employment, increase aggregate
consumption and hence economic growth and development.

 It diffuses stress on the banking system by matching long-term
investments with long-term capital.

 It encourages the broader ownership of productive assets by small
savers and encourages a thrift culture that is essential for rapid
industrialization.

 It allows for risk dispersion between investors (diversifiable risks),
risks that could be realized by the help of different market
operations or market orders or derivatives.

Importance of Capital Markets
12

 It provides not only equity capital but also infrastructure capital that
has strong socio-economic benefits through development of roads,
water, housing, telecommunications, transport, etc.

 Capital markets promote public-private sector partnerships by
encouraging participation of private sector in productive investment
by closing the financial resource scarcity gap.

 It also attracts foreign portfolio investors who are critical in
supplementing the domestic savings levels; thereby facilitating
foreign inflows.

Functions of Capital Markets
13

 Link between Savers and Investors

 Encourage to Savings

 Encourage to Investments

 Promotes Economic Growth

 Stability in Security Prices
 The capital market tends to stabilise the values of stocks and securities and reduce the

fluctuations in the prices to the minimum.

 The process of stabilisation is facilitated by providing capital to the borrowers at a lower
interest rate and reducing the speculative and unproductive activities.

Primary Market

Primary Market is that market in which shares,

debentures and other securities are sold for the first

time when raising long-term capital.

This market is concerned with new issues.

 Therefore, the primary market is also called NEW ISSUE

MARKET.

14

In this market, the flow of funds is from savers to
borrowers (industries),
 it helps directly in the capital formation of the country.

The money collected from this market is generally used
by the companies to modernize their plants, machinery
and buildings, for extending business, and for setting up
new business unit.

Primary Market
15

Methods of Raising Capital in the Primary Market

 The following are the methods of raising capital in the primary market:

 Public Issue – the company invites subscription from the public
through the issue of prospectus (and issuing advertisements in news
papers).
 Public issue is of two types, namely, initial public offer (either a fresh issue

of securities or an offer for sale of existing securities or both by an unlisted
company for the first time in its life to the public), and follow-on public
offer (an offering of either a fresh issue of securities or an offer for sale to the
public by an already listed company).

 Offer For Sale – securities are offered to the public through an
intermediary such as issue houses, merchant bank, investment bank or
firm of a stock broker. The intermediary will buy from the firm at an
agreed price and then sell to the public at market prices.

16

Methods of Raising Capital in the Primary Market
17

 Private Placement – the issue of securities of a company direct to one
investor or a small group of investors.
 Generally the investors are the financial institutions or other existing companies or

selected private persons such as friends and relatives of promoters. Company law
defines a privately placed issue to be the one seeking subscription from 50 members.
In a private placement, no prospectus is issued

 Right Issue – an existing company issues shares to its existing
shareholders in proportion to the number of shares already held by
them. Thus, a right issue is the issue of new shares in which existing
shareholders are given pre-emptive rights to subscribe to the new issue
on a pro-rata basis.
 If the shareholders neither subscribe the shares nor transfer their rights, then the

company can offer the shares to public.

 Electronic-Initial Public Offer – Electronic Initial Public Offers (e-
IPOs) allow investors to bid for shares through internet.

Secondary Market

 The secondary market is that market in which the buying and

selling of the previously issued securities are done.

 The transactions of the secondary market are generally done

through the medium of stock exchange.

 The chief purpose of the secondary market is to create liquidity

in securities.

 To sell or purchase through the stock exchange requires the

services of a broker.

18

Features of Secondary Markets

It creates liquidity.

It comes after primary market.

It has a particular place.

It encourages new investments.

19

Economic and Industry Analysis
20

The following factors will affect the prices of shares on the stock market.
 Demand and Supply – The trend of the stock market trading directly

affects the price.
 When people are buying more stocks, then the price of that particular stock

increases. On the other hand, if people are selling more stocks, then the price
of that stock falls. This is also the trend in individual stocks.

 The price is directly affected by the trend of stock market trading.

 Market Cap – If you are trying to guess the worth of a company from the
price of the stock, you are making a huge mistake.
 It is the market capitalization of the company, rather than the stock, that is

more important when it comes to determining the worth of the company.
 You need to multiply the stock price with the total number of outstanding

stocks in the market to get the market cap of a company and that is the worth
of the company.

Economic and Industry Analysis
21

 Earnings Per Share – Earning per share is the profit that the company
made per share in the last quarter.

 It is mandatory for every public company to publish the quarterly report
that states the earning per share of the company.

 This is perhaps the most important factor for deciding the health of any
company

they influence the buying tendency in the market, resulting in the
increase/decrease in the price of that particular stock.

 So, if you want to make a profitable investment, you need to keep watch on
the quarterly reports that the companies publish and scrutinize the
possibilities before buying stocks of particular companies.

Economic and Industry Analysis
22

 Price-Earnings Ratio or the P/E ratio gives you a fair idea of how a
company’s share price compares to its earnings.
 If the price of the share is much lower than the earning ratio of the company, the stock is

undervalued and it has the potential to rise in the near future. On the other hand, if the price
is way higher than the actual earning of the company, then the stock is said to overvalued and
the price can fall at any point.

 However, there are many other reasons behind the fall or rise of the share
price.

 Economic Growth Data- stock prices react in a positive way if the growth
of all the sectors of the economy is consistent otherwise they will react by
falling sharply.
 Sectors such as automobiles, banking and financial services, metal and commodities, capital

goods and infrastructure depend largely on economic conditions.

 In times such as economic recession, you will get stocks cheaper than they
were in times of market highs.

Systemic and Engineering Effects on Prices
23

 News
 Positive news about a company can increase buying interest in the market while a

negative press release can ruin the prospect of a stock.

 Always remember that often times, despite amazingly good news, a stock can show
least movement. It is the overall performance of the company that matters more
than news. It is always wise to take a wait and see approach in a volatile market or
when there is mixed reaction about a particular stock.

 Dividend

 Dividends act as a signalling device for share price movement. If companies
announce dividends, generally share prices of those companies tend to
increase. An important point to note is, if the rate of dividend announced is less
than what was expected by investors, share prices would decline, whereas if
they are up to or more than expectations, share prices would increase.

Systemic and Engineering Effects on Prices
24

 Bonus Issue
 Bonus issues are additional shares distributed by the company to its shareholders. The

advantage is that, the company is able to reinvest the dividend cash for better earnings
growth while awarding their loyal shareholders. Increasing the number of outstanding
shares decreases the stock’s price; making the stock more affordable for investors.

 Company Performance
 Future expansion policies of the company, present acquisitions, the kind of management

of the company, revenues, free cash flows generated, all determine the stock prices.
 Finding companies with impressive performance, will help you emerge successful in markets

which are hard to predict.

 Investor Behaviour
 Investors will first of all look for profitable bets. They will be booking profits at every level

which can bring down stock prices. So, investor behaviour in stock markets affect stock
prices greatly.

 Stock prices see an all time high in times of bull market, while they can correct to a great
extent in a bearish market trend.

Bull vs Bear Markets
25

 A bull market is a market that is on the rise and is economically sound,
while a bear market is a market that is receding, where most stocks are
declining in value.

 Although some investors are “bearish,” the majority of investors are “bullish.”
 The stock market, as a whole, has always posted returns.

 A bear market is more dangerous to invest in as many equities lose value.
 Since it is hard to time a market bottom, most investors withdraw their money from the

markets and sit on cash until the trend reverses.

 The most recent U.S. bear market started in 2020. The stock market crashed
in March, with the Dow Jones Industrial Average and the S&P 500 Index both
falling more than 20% from their 52-week highs in February. Prior to that was
2007-2009 – down 57% over 1.4 years.

Systemic and Engineering Effects on Prices
26

 Foreign Institutional Investor Behaviour

 These are the institutions which buy and sell stocks in huge quantities.

 So, any kind of buying will be positive for stock prices and selling will affect them negatively.

 By imposing restrictions on the foreign investors, many stock exchanges across the word have
brought in more transparency and regulations for the benefit of retail investors. This also helps
you in knowing how to predict future stock prices.

 Political Conditions

 For a steady economic growth, a stable and effective government is required.

 In absence of conducive political environment, the entire stock market is expected to take a hit.

 Valuations of Stocks

 Investors consider the valuations of stocks before purchasing them and they may postpone buying
stocks if the current valuations are not good enough.

 This can affect the price of the stock in a negative manner.

Economic & Industry Influences: Inflation

 High Inflation

 slows sales and reduces profits

 higher prices will also often lead to higher interest rates

 these changes will tend to bring down stock prices.

 High inflation also causes investors to think that companies may hold back on
spending

 this encourages investors to lock in their cash from equities to more attractive, less
risky securities, like money market funds which will cause a fall in stock prices.

 Stocks can beat inflation over time because companies can raise prices to account for
rising costs brought about by inflation.

 For example, when cost of sales and wages increases due to inflation, companies can
simply pass on the higher cost to consumers by raising prices over time. When
companies increase their prices, their revenues and earnings also increase.

27

Economic & Industry Influences:
Interest Rates

 Slowly rising interest rates can have a beneficial effect on stock prices.

 Rates generally creep up when the economy is booming.

 Higher market interest rates can also create a “buyers’ boycott” of the stock
market, as more attractive investment opportunities emerge.

 For example, Treasury bonds are considered a “risk-free” asset. Many
investors will choose Treasury bonds over the stock market.

 While stocks have a higher long-term average return, they are also volatile and
carry much higher risks than Treasury bonds.

 Fewer buyers mean less money to push up stock prices.

28

Economic & Industry Influences:
Interest Rates

 Higher interest rates also increase the cost of borrowing for companies.
 This directly reduces corporate earnings.

 Furthermore, higher rates make bonds more compelling to investors
compared to stocks.
 Bonds are generally safer, and a higher rate generally increases demand for bonds and may hurt

demand for stocks.

 Higher rates increase the cost of cash.
 This makes investors more impatient with companies with high cash reserves like Apple.

Investors will demand clear, compelling plans to grow or else demand cash be returned via
share buybacks and higher dividends.

 If this doesn’t happen, stock prices in cash rich companies will go lower and stay lower than
they would if the cash was freed up.

29

Economic & Industry Influences:
Savings

 Savings, according to Keynesian economics, are what a person has left over
when the cost of his or her consumer expenditure is subtracted from the
amount of disposable income earned in a given period of time.

 For those who are financially prudent, the amount of money left over after
personal expenses have been met can be positive;

 for those who tend to rely on credit and loans to make ends meet, there is
no money left for savings.

 Savings can be used to increase income through investing in different
investment vehicles.

30

Economic & Industry Influences:
Savings

 If disposable income increases

 the resultant increase in consumption could increase corporate sales and
corporate earnings which will increase the value of individual stocks.

 The increase in individual share price valuations could then lead to a market-
wide increase in value and potentially leads to an economic boom.

 If disposable income decreases

 consumers become thriftier and the decreased consumption could then
decrease corporate sales; corporate earnings and hence the value of
individual stocks.

 This decrease in individual share price valuations could then lead to a
market-wide decrease in value and potentially leads to a depression or
recession.

31

Economic & Industry Influences:
Savings

 Increases in disposable income don’t always result in an increase in value of the
stock market, and vice versa.

 Banks offer savings accounts as means of enticing depositors to provide extra
cash so bankers can make loans.

 When banks want extra deposits

 they can raise the interest rate offered on saving accounts to attract cash

 which can contribute to a decrease in prices in the stock market

 some customers would now be interested in opening savings accounts or
depositing larger sums of money into banks rather than purchasing shares of
stock.

32

Industry Indicators

 Industry Indicators are key variables that are used by businesses to
measure their performance and success against the industry in which they
operate.

 These indicators can be used to compare a company’s performance between
periods to determine whether the company against the industry has
performed favourably, unfavourably or indifferent.

 Note again that the stock price of the companies in the same industry will
move in tandem with each other. This is because market conditions generally
affect the companies in the same industry the same way.

 But sometimes, the stock price of a company will benefit from a piece of bad
news from its competitor if the companies are competing for the same
market.

33

Overvalued or Undervalued Stocks
34

Investors may be willing to pay more for stocks with superior growth
potential, but they don’t want to overpay for a company whose growth
prospects don’t justify its current price.

P-E Ratio: A stock might be overvalued if the Price-to-Earnings Ratio is
high.
 The ratio is calculated by dividing the market value price per share by the company’s

earnings per share

 The average P/E for the S&P 500 has historically ranged from 13 to 15.
 For example, a company with a current P/E of 25, trades at 25 times earnings. The high

multiple indicates that investors expect higher growth from the company compared to the
overall market.

 A high P/E does not necessarily mean a stock is

overvalued.

 Any P/E ratio needs to be considered against the backdrop of the P/E for the

company’s industry.

Overvalued or Undervalued Stocks
35

 PEG ratio: One way to determine whether a stock may be overvalued
is to look at the price-to-earnings-growth ratio.
 The price-to-earnings-growth ratio is the estimated price-to-earnings ratio (the

current price divided by the earnings per share forecast for the next 12 months)
divided by the median long-term earnings growth forecast.

 A stock is considered to be fairly valued if the PEG ratio is 1 (in which case the P/E
equals the estimated earnings growth) and possibly overvalued if the PEG is over 1.

P/E Ratio = stock price
EPS

PEG Ratio = P/E Ratio
Earnings Growth Rate

Growth Rate = Current EPS – 1 X 100
Last EPS

Overvalued or Undervalued Stocks
36

 Cyclical industry: A stock might be overvalued if it is in a cyclical
industry and profits are at all time highs.

 Dividend yield: the dividend amount divided by the stock price.
 It tells you what percentage of your purchase price the company will return to you in

dividends. When stocks are cheap, dividend yields are high.

 Interest rates: Interest rates are important, because they determine,
amongst other things, the return investors get on government bonds.
 Government bonds are, in theory at least, the most secure way to invest your money, since

the government guarantees your returns. Therefore, the yield on government bonds is
sometimes referred to as the risk-free rate.

 If bonds yield more than stocks, investors will naturally put their money in the risk-free
bonds instead of in volatile stocks, therefore creating less demand for stocks which
inevitably results in lower stock prices.

Overvalued or Undervalued Stocks
37

 Market capitalization to GDP: Buffett’s personal favourite!

 He said that the Market Cap to GDP ratio is “…probably the best
single measure of where valuations stand at any given moment.”
 The idea is that when the market cap is higher than GDP, the stock market is

overvalued.

 If the market cap is below the GDP, the stock market is undervalued.

Liquidity and Illiquidity of Securities Market
38

 Market liquidity: is a market’s ability to facilitate an asset being sold
quickly without having to reduce its price very much (or even at all).

 Asset’s market liquidity (or simply “an asset’s liquidity”): is the
asset’s ability to sell quickly without having to reduce its price very much.

 Liquidity is about how big the trade-off is between the speed of the sale and
the price it can be sold for.
 In a relatively liquid market, the trade-off is mild: selling quickly will not reduce the price

much. In a relatively illiquid market, selling it quickly will require cutting its price by some
amount.

 Liquid asset: this has some or all of the following features: It can be sold
rapidly, with minimal loss of value, and any time within market hours.

Liquidity and Illiquidity of Securities Market
39

 Speculators and market makers are key contributors to the liquidity of a
market, or asset.
 Speculators and market makers are individuals or institutions that seek to profit from

anticipated increases or decreases in a particular market price.

 By doing this, they provide the capital needed to facilitate the liquidity.

Liquidity Risk
40

Financial institutions and asset managers that oversee portfolios are subject
to what is called “structural” and “contingent” liquidity risk.

 Structural Liquidity Risk
 sometimes called funding liquidity risk, is the risk associated with funding asset

portfolios in the normal course of business.

 This is the risk affecting or potentially affecting results or capital as a result of the Bank
being incapable of meeting its payment obligations upon maturity, without incurring
unacceptable losses

 Mismatched maturities

 Contingent Liquidity Risk
 the risk associated with finding additional funds or replacing maturing liabilities under

potential, future stressed market conditions.

 When a central bank tries to influence the liquidity (supply) of money, this process is known
as open market operations.

Characteristics of Liquid Markets
41

 The essential characteristic of a liquid market is that there are always
ready and willing buyers and sellers.

 It is similar to but distinct from market depth:
 market depth relates to the trade-off between quantity being sold and the price it can

be sold for;

 rather liquidity relates to the trade-off between speed of sale and the price it can be
sold for.

 A market may be considered both deep and liquid if there are ready
and willing buyers and sellers in large quantities.

Effects of Liquidity on Asset Value
42

 The market liquidity of assets affects their prices and expected returns.

 Investors require higher return on assets with lower market liquidity to
compensate them for the higher cost of trading these assets.
 That is, for an asset with given cash flow, the higher its market liquidity, the higher its

price and the lower is its expected return.

 Risk-averse investors require higher expected return if the asset’s
market-liquidity risk is greater.
 This risk involves the exposure of the asset return to shocks in overall market

liquidity, the exposure of the asset own liquidity to shocks in market liquidity and the
effect of market return on the asset’s own liquidity.

 Here too, the higher the liquidity risk, the higher the expected return on the asset or
the lower is its price.

Effects of Liquidity on Asset Value
43

 One example of this, is the comparison of assets with and without a
liquid secondary market.
 The liquidity discount is the reduced promised yield or expected return for such

assets, like the difference between newly issued U.S. Treasury bonds compared to off
the run treasuries with the same term to maturity.

 Initial buyers know that other investors are less willing to buy off-the-run treasuries,
so the newly issued bonds have a higher price (and hence lower yield).

The Stock Market and Liquidity
44

 The market for a stock is said to be liquid if the shares can be rapidly sold
and the act of selling has little impact on the stock’s price.
 Generally, this translates to where the shares are traded based on the level of interest that

investors have in the company.

 Another way to judge liquidity in a company’s stock is to look at the bid-to-
ask spread.
 For liquid stocks, such as Microsoft or General Electric, the spread is often just a few

pennies – much less than 1% of the price. For illiquid stocks, the spread can be much larger,
amounting to a few percent of the trading price. In today’s stock market, high-frequency
trading firms are said to contribute to nearly 50% of all liquidity.

 Liquidity positively impacts the stock market.
 When stock prices rise, it is said to be due to a convergence of extraordinarily high levels of

liquidity on household and business balance sheets, combined with a simultaneous
normalization of liquidity preferences. On the margin, this drives a demand for equity
investments.

The Futures Market and Liquidity
45

 In the futures markets, there is no assurance that a liquid market
may exist for offsetting a commodity contract at all times.
 Some future contracts and specific delivery months tend to have increasingly more

trading activity and have higher liquidity than others.

 The most useful indicators of liquidity for these contracts are the trading volume
and open interest.

 There is also dark liquidity;
 referring to transactions that occur off-exchange and are therefore not visible to

investors until after the transaction is complete.

 It does not contribute to public price discovery.

Dark Pool Liquidity
46

 Dark pool liquidity is the trading volume created by institutional orders
executed on private exchanges and which are mostly unavailable to the
public.

 The bulk of dark pool liquidity is represented by block trades facilitated
away from the central exchanges.

 It is also referred to as the “upstairs market,” “dark liquidity” or “dark
pool.

Illiquidity Asset
47

 This is an asset which is not readily saleable (without a drastic price
reduction
 and sometimes not at any price) due to uncertainty about its value or the lack of a

market in which it is regularly traded.

 The mortgage-related assets which resulted in the subprime
mortgage crisis are examples of illiquid assets, as their value was not
readily determinable despite being secured by real property.
 Before the crisis, they had moderate liquidity because it was believed that their

value was generally known.

 The risk of illiquidity need not apply only to individual investments-
whole portfolios are subject to market risk.

Role of Financial Advisor
48

 A Financial Advisor is a professional who renders financial services
to clients.

 Financial Advisors are more specific in their approach, as well as the
content of their work.
 They provide consulting and advice about an individual’s or entity’s finances as

well as help individuals and companies reach their financial goals sooner by
providing their clients with strategies and ways to create more wealth, reduce
costs, or eliminate debts.

 For example, the financial advisors work with their clients in order to get an idea
about the financial requirements of their clients, as well as finding out ways by
which to address the situation.

Role of Investment Banker
49

 This is an individual who works in a financial institution that is
 in the business primarily of raising capital for companies, governments and other

entities,

 or who works in a large bank’s division that is involved with these activities.

 Investment bankers may also provide other services
 such as mergers and acquisition advice, or advice on specific transactions, such as a

spin-off or reorganization.

 In smaller organizations that do not have a specific investment
banking arm, corporate finance staff may fulfil the duties of
investment bankers.

Role of Financial Analyst
50

 A financial analyst researches macroeconomic and microeconomic
conditions, gathers financial information along with company fundamentals
in order to make business, sector and industry recommendations to the
company.

 Traditionally, analysts use fundamental analysis principles but technical
chart analysis and tactical evaluation of the market environment are also
routine.

 Often at the end of the assessment of analyzed securities, an analyst would
provide a rating, recommending an investment action, e.g. to buy, sell, or
hold the security.

 Financial analysts are often employed by mutual and pension funds, hedge
funds, securities firms, banks, investment banks, insurance companies, and
other businesses, helping these companies or their clients make investment
decisions.

Role of Financial Analyst
51

 Financial analysts employed in commercial lending perform “balance sheet
analysis,” examining the audited financial statements and corollary data in order to
assess lending risks.

 In a stock brokerage house or in an investment bank, they read company financial
statements and analyze commodity prices, sales, costs, expenses, and tax rates in
order to determine a company’s value and project future earnings.

 In any of these various institutions, the analyst often meets with company officials
to gain a better insight into a company’s prospects and to determine the company’s
managerial effectiveness. Usually, financial analysts study an entire industry,
assessing current trends in business practices, products, and industry competition.
They must keep abreast of new regulations or policies that may affect the industry,
as well as monitor the economy to determine its effect on earnings.

 Financial analysts use spreadsheet and statistical software packages to analyze
financial data, spot trends and develop forecasts.

Qualification
52

 At an increasingly large number of firms it is preferred that analysts
earn the Chartered Financial Analyst (CFA) designation.

 There are also many regulatory requirements. For example, in the
United States, sell-side or Wall Street research analysts must register
with the Financial Industry Regulatory Authority (FINRA).

 In addition to passing the General Securities Representative Exam,
candidates must pass the Research Analyst Examination (series
86/series87) in order to publish research for the purpose of selling or
promoting publicly traded securities.

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