8.2 Stock and bond markets

Stock and bond markets are the lifeblood of capitalism, enabling companies to raise capital and investors to grow wealth. These markets facilitate price discovery, investment, and corporate governance, playing a crucial role in resource allocation.

Various participants, from individual investors to large institutions, engage in these markets. Stock indices like the S&P 500 and bond ratings help investors gauge market performance and assess risk, while regulations ensure fair and transparent trading.

Types of financial markets

• Financial markets play a crucial role in the capitalist system by facilitating the allocation of capital and resources
• Enable individuals, businesses, and governments to raise funds, invest savings, and manage financial risks
• Include stock markets, bond markets, money markets, derivatives markets, and foreign exchange markets

Role of stock markets

Price discovery mechanism

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• Stock markets provide a platform for buyers and sellers to interact and determine the fair value of a company's shares
• Share prices reflect the collective opinions and expectations of market participants about a company's future prospects
• Efficient price discovery helps allocate capital to the most promising and productive companies

Facilitating investment

• Stock markets allow companies to raise capital by issuing shares to the public (equity financing)
• Investors can buy shares in companies they believe will perform well, providing them with the funds to grow and expand
• Enables individuals to participate in the growth and profits of successful companies through share ownership

Corporate governance

• Stock markets promote good corporate governance practices by holding companies accountable to their shareholders
• Shareholders have the right to vote on important corporate decisions and elect the board of directors
• Threat of shareholder activism and potential takeovers encourages management to act in the best interests of shareholders

Stock market participants

Individual investors

• Also known as retail investors, they buy and sell shares for their personal investment portfolios
• Seek to grow their wealth and generate income through capital appreciation and dividends
• Can invest directly in stocks or through mutual funds and exchange-traded funds (ETFs)

Institutional investors

• Large organizations that invest on behalf of their clients or members (pension funds, insurance companies, hedge funds)
• Often have significant market influence due to the large size of their investments
• Employ professional fund managers to make investment decisions based on research and analysis

Market makers and specialists

• Market makers are firms that stand ready to buy or sell a particular stock on a regular and continuous basis at a publicly quoted price
• Specialists are responsible for maintaining a fair and orderly market in one or more specific stocks on an exchange
• Both provide liquidity to the market by ensuring there are always buyers and sellers available for a given stock

Stock market indices

Dow Jones Industrial Average

• One of the oldest and most widely followed stock market indices in the world
• Tracks the performance of 30 large, publicly-owned companies listed on the New York Stock Exchange (NYSE) and NASDAQ
• Price-weighted index, meaning higher-priced stocks have a greater influence on the index's value

S&P 500

• Market-capitalization-weighted index of the 500 largest U.S. publicly traded companies
• Represents about 80% of the total value of the U.S. stock market
• Considered a bellwether for the overall health of the U.S. economy and stock market

NASDAQ Composite

• Market-capitalization-weighted index of over 3,000 stocks listed on the NASDAQ stock market
• Known for its high concentration of technology companies (Apple, Microsoft, Amazon)
• Includes both U.S. and international companies that are listed on the NASDAQ

Global stock market indices

• FTSE 100: Represents the 100 largest companies listed on the London Stock Exchange
• Nikkei 225: Tracks the performance of 225 large companies listed on the Tokyo Stock Exchange
• DAX: Consists of the 30 largest German companies traded on the Frankfurt Stock Exchange
• MSCI Emerging Markets Index: Captures the performance of large and mid-cap companies across 26 emerging market countries

Stock valuation

Fundamental analysis

• Involves evaluating a company's financial health, management quality, competitive position, and growth prospects
• Analysts use financial statements, industry trends, and economic data to estimate a company's intrinsic value
• If the intrinsic value is higher than the current market price, the stock is considered undervalued and a good investment opportunity

Technical analysis

• Focuses on analyzing historical price and volume data to predict future stock price movements
• Technical analysts use charts, patterns, and indicators to identify trends and make trading decisions
• Based on the premise that market psychology and investor behavior can be inferred from past trading activity

Efficient market hypothesis

• Theory that states that stock prices fully reflect all available information and trade at their fair value
• Suggests that it is impossible to consistently outperform the market through stock selection or market timing
• Three forms: weak (historical prices), semi-strong (public information), and strong (all information, including insider knowledge)

Initial public offerings (IPOs)

IPO process

• An IPO is the first sale of a company's shares to the public on a stock exchange
• Companies hire investment banks to underwrite and manage the IPO process
• Shares are priced based on the company's valuation and market demand, and then allocated to investors

Underwriting and investment banks

• Investment banks act as intermediaries between the company and potential investors
• They help the company prepare the necessary documents, such as the prospectus and registration statement
• Underwriters also help determine the initial price of the shares and guarantee the sale of a certain number of shares

Pricing of IPO shares

• IPO shares are typically priced based on the company's fundamentals, growth prospects, and investor demand
• Underwriters use a process called book building to gauge interest from institutional investors and set a price range
• Final IPO price is set the night before trading begins and can be influenced by market conditions and investor sentiment

Role of bond markets

Types of bonds

• Government bonds: Issued by national governments to finance public spending and budget deficits (U.S. Treasury bonds)
• Corporate bonds: Issued by companies to raise capital for various purposes, such as expansion or debt refinancing
• Municipal bonds: Issued by state and local governments to fund public projects like infrastructure and schools

Bond issuers and investors

• Bond issuers are borrowers who seek to raise capital by issuing debt securities
• Bond investors are lenders who purchase bonds to earn interest income and diversify their portfolios
• Institutional investors (pension funds, insurance companies) are the largest participants in the bond market

Bond ratings and credit risk

• Bond ratings are assigned by credit rating agencies (Moody's, S&P, Fitch) to assess the creditworthiness of bond issuers
• Ratings range from AAA (highest quality) to C or D (default)
• Higher credit risk is associated with lower bond ratings and typically results in higher interest rates to compensate investors

Bond valuation

Coupon rate and yield

• Coupon rate is the annual interest rate paid by the bond issuer to the bondholder
• Yield is the total return an investor earns on a bond, considering the coupon payments and any capital gains or losses
• Yield to maturity (YTM) is the annual return an investor can expect if they hold the bond until it matures

Bond prices and interest rates

• Bond prices have an inverse relationship with interest rates: when rates rise, bond prices fall, and vice versa
• This is because the fixed coupon payments become less attractive when interest rates rise, causing bond prices to adjust downward
• Duration is a measure of a bond's sensitivity to changes in interest rates; longer-duration bonds are more sensitive to rate changes

Yield curve and term structure

• The yield curve is a graphical representation of the relationship between bond yields and their maturities
• A normal yield curve slopes upward, indicating that longer-term bonds have higher yields than shorter-term bonds
• The shape of the yield curve can provide insights into market expectations for future interest rates and economic growth

Primary vs secondary markets

Issuance of securities

• Primary markets are where new securities (stocks and bonds) are issued and sold to investors for the first time
• Companies and governments use primary markets to raise capital by issuing new securities through IPOs, bond offerings, or private placements
• Underwriters and investment banks play a key role in facilitating the issuance process and distributing securities to investors

Trading of securities

• Secondary markets are where previously issued securities are bought and sold among investors
• Stock exchanges (NYSE, NASDAQ) and bond markets (over-the-counter) are examples of secondary markets
• Secondary markets provide liquidity for investors, allowing them to buy or sell securities at any time based on market prices

Market regulation

Securities and Exchange Commission (SEC)

• The SEC is the primary regulator of the U.S. securities markets, responsible for protecting investors and maintaining fair, orderly, and efficient markets
• Enforces federal securities laws, oversees stock exchanges and market participants, and requires public companies to disclose financial information
• Aims to prevent fraudulent activities, insider trading, and market manipulation

Insider trading and market manipulation

• Insider trading involves buying or selling securities based on material, non-public information that can affect the stock price
• Market manipulation refers to practices that artificially influence security prices or trading volume (pump and dump schemes, spoofing)
• Both insider trading and market manipulation are illegal and can result in severe penalties, including fines and imprisonment

Disclosure requirements

• Public companies are required to regularly disclose financial and operational information to investors through filings with the SEC
• Key disclosure documents include annual reports (Form 10-K), quarterly reports (Form 10-Q), and current reports (Form 8-K)
• Disclosures help investors make informed decisions and promote transparency and accountability in the securities markets

Global integration of financial markets

Cross-border investing

• Globalization has led to increased integration of financial markets, allowing investors to diversify their portfolios across countries and asset classes
• Cross-border investing involves buying and selling securities in foreign markets, either directly or through mutual funds and ETFs
• Provides access to a wider range of investment opportunities and can help mitigate country-specific risks

Currency exchange rates

• When investing in foreign securities, investors must consider the impact of currency exchange rate fluctuations on their returns
• A strengthening home currency can reduce the value of foreign investments, while a weakening home currency can enhance returns
• Investors can hedge currency risk using derivatives (forwards, futures, options) or by investing in currency-hedged funds

Emerging markets and frontier markets

• Emerging markets are countries with developing economies and financial markets that are becoming more integrated with the global system (China, India, Brazil)
• Frontier markets are less developed than emerging markets and are often characterized by lower liquidity, higher volatility, and greater political risk (Vietnam, Kenya, Argentina)
• Investing in emerging and frontier markets can offer higher growth potential but also carries greater risks than developed markets