Financial Markets and Institutions (2-downloads)

depository receipts (ADRs). A U.S. bank buys the shares of a foreign company

and places them in its vault. The bank then issues receipts against these shares, and

these receipts can be traded domestically, usually on the NASDAQ. Trade in ADRs is

conducted entirely in U.S. dollars, and the bank converts stock dividends into U.S. cur-

rency. One advantage of the ADR is that it allows foreign firms to trade in the United

States without the firms having to meet the disclosure rules required by the SEC.

Foreign stock trading has been growing rapidly. Since 1979, cross-border trade

in equities has grown at a rate of 28% a year and now exceeds $2 trillion annually.

Interest is particularly keen in the stocks of firms in emerging economies such as

Mexico, Brazil, and South Korea.

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Chapter 13 The Stock Market

319

As the worldwide recession of 2008 demonstrated, while volatility peculiar to one

country can be reduced by diversification, the degree of economic interconnectiv-

ity between nations means that some risk always remains.

Regulation of the Stock Market

Properly functioning capital markets are a hallmark of an economically advanced

economy. For an economy to flourish, firms must be able to raise funds to take advan-

tage of growth opportunities as they become available. Firms raise funds in the cap-

ital markets, and for these to function properly investors must be able to trust the

information that is released about the firms that are using them. Markets can collapse

in the absence of this trust. The most notable example of this in the United States

was the Great Depression. During the 1920s, about $50 billion in new securities were

offered for sale. By 1932, half had become worthless. The public’s confidence in the

capital markets justifiably plummeted, and lawmakers agreed that for the economy

to recover, public faith had to be restored. Following a series of investigative hear-

ings, Congress passed the Securities Act of 1933, and shortly after the Securities

Act of 1934. The main purpose of these laws was to (1) require firms to tell the

public the truth about their businesses, and (2) require brokers, dealers, and

exchanges to treat investors fairly. Congress established the Securities and Exchange

Commission (SEC) to enforce these laws.

The Securities and Exchange Commission

The SEC Web site states the following:

The primary mission of the U.S. Securities and Exchange Commission is to pro-

tect investors and maintain the integrity of the securities markets.

3

It accomplishes this daunting task primarily by assuring a constant, timely, and accu-

rate flow of information to investors, who can then judge for themselves if a com-

pany’s securities are a good investment. Thus, the SEC is primarily focused on

promoting disclosure of information and reducing asymmetric information rather than

determining the strength or well-being of any particular firm. The SEC brings 400

to 500 civil enforcement actions against individuals and companies each year in its

effort to maintain the quality of the information provided to investors.

The SEC is organized around four divisions and 18 offices and employs about

3,100 people. One way to better understand how it accomplishes its goals is to review

the duties assigned to each division.

•  The Division of Corporate Finance is responsible for collecting the many

documents that public companies are required to file. These include annual

reports, registration statements, quarterly filings, and many others. The divi-

sion reviews these filings to check for compliance with the regulations. It

does not verify the truth or accuracy of filings. The division staff also pro-

vides companies with help interpreting the regulations and recommends

new rules for adoption.

3

www.sec.gov/about/whatwedo.shtml

.

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320

Part 5 Financial Markets

• The Division of Market Regulation establishes and maintains standards for

an orderly and efficient market by regulating the major securities market

participants. This is the division that reviews and approves new rules and

changes to existing rules.

• The Division of Investment Management oversees and regulates the invest-

ment management industry. This includes oversight of the mutual fund

industry. Just as the Division of Market Regulation establishes rules govern-

ing the markets, the Division of Investment Management establishes rules

governing investment companies.

•  The Division of Enforcement investigates the violation of any of the rules and

regulations established by the other divisions. The Division of Enforcement

conducts its own investigations into various types of securities fraud and acts

on tips provided by the SEC’s other divisions. The SEC itself can only bring

civil lawsuits; however, it works closely with various criminal authorities to

bring criminal cases when appropriate.

Later, in Chapter 20 we discuss specific instances where the SEC has addressed

fraud and violations of ethical standards.

S U M M A R Y

1. There are both organized and over-the-counter

exchanges. Organized exchanges are distinguished by

a physical building where trading takes place. The

over-the-counter market operates primarily over

phone lines and computer links. Typically, larger firms

trade on organized exchanges and smaller firms trade

in the over-the-counter market, though there are

many exceptions to this rule. In recent years, ECNs

have begun to capture a significant portion of busi-

ness traditionally belonging to the stock exchanges.

These electronic networks are likely to become

increasingly significant players in the future.

2. Stocks are valued as the present value of the divi-

dends. Unfortunately, we do not know very precisely

what these dividends will be. This introduces a great

deal of error to the valuation process. The Gordon

growth model is a simplified method of computing

stock value that depends on the assumption that the

dividends are growing at a constant rate forever.

Given our uncertainty regarding future dividends, this

assumption is often the best we can do.

3. An alternative method for estimating a stock price is

to multiply the firm’s earnings per share times the

industry price earnings ratio. This ratio can be

adjusted up or down to reflect specific characteristics

of the firm.

4. The interaction among traders in the market is what

actually sets prices on a day-to-day basis. The trader

that values the security the most, either because of

less uncertainty about the cash flows or because of

greater estimated cash flows, will be willing to pay the

most. As new information is released, investors will

revise their estimates of the true value of the security

and will either buy or sell it depending upon how the

market price compares to their estimated valuation.

Because small changes in estimated growth rates or

required return result in large changes in price, it is

not surprising that the markets are often volatile.

K E Y   T E R M S

American depository receipts

(ADRs), p. 318

ask price, p. 306

bid price, p. 306

common stockholder, p. 303

generalized dividend model, p. 309

Gordon growth model, p. 309

NASDAQ, p. 305

preferred stock, p. 303

price earnings ratio (PE), p. 311

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Chapter 13 The Stock Market