Download CHAPTER 10: Equity Markets

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CHAPTER 10: Equity Markets
Do you Understand? (Pg. 276)
1. What characteristics of an asset determine the type of secondary market in which it
is most likely to trade?
New issues of securities are sold in the primary market. Any subsequent transaction in
the security takes place in the secondary market. In the money market, all securities are
dealer traded debt securities, while the capital market is divided between debt (bonds and
loans) and equity markets.
2. What are the four types of secondary markets?
The four types are (1) direct search, (2) brokered, (3) dealer, and (4) auction markets.
3. Explain the differences between the OTC market, NASDAQ, and a stock exchange.
The major difference is that most stock exchanges are auction markets, whereas the OTC
market or NASDAQ is more like dealer markets. NASDAQ stands for the National
Association of Securities Dealers Automated Quotation system and it provides
continuous bid/ask information. NASDAQ is an electronic pink sheet.
4. What are the functions of market makers and specialists? How do they differ?
Market makers are dealers who regularly quote bids and ask prices in a security and
trade for their own account at these prices and at their own risk. Specialists are members
of the exchange who combine the attributes of both dealers and order clerks; they have an
obligation to maintain both bid and ask quotations at all times for listed securities. In this
respect specialist act as dealers, trading for their own account and at their own risk. They
also maintain the book of limit orders, and in this respect, they act as order clerks.
DO YOU UNDERSTAND? (Pg. 284)
1. Describe the general approach to valuing a share of stock.
First, identify the timing and the size of the cash flows. Second, decide upon the
appropriate discount rate to use in the present value calculation. Finally, apply the
discount rate to the cash flows in each period to obtain present values and sum the present
values to obtain the price of the security.
2. What cash flows are relevant to the value of stock?
Dividends and capital gains are the sources of income from holding a stock.
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3. Describe what happens to the total risk of a portfolio as the number of securities is
increased.
As the number of securities increases, the diversification effect reduces the standard
deviation of portfolio return, a measure of the portfolio’s total risk. Total risk can be
reduced, however, only to the level of systematic risk, which cannot be diversified away
because it is caused by general market movements that tend to affect all stocks similarly.
4. Suppose a firm’s stock has a beta of 1.2. What will probably happen to the value of
the stock if the market decreases by 20 percent?
The value of the stock will probably decline by (1.2) 20% = 24%. A positive beta means
that the stock is positively correlated with the market. Because the beta is greater than 1,
the stock will tend to have wider swings than the market, but in the same direction.