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Wednesday, July 16, 2008


The future of stock exchanges

The future of stock trading appears to be electronic, as competition is continually growing between the remaining traditional New York Stock Exchange specialist system against the relatively new, all Electronic Communications Networks, or ECNs. ECNs point to their speedy execution of large block trades, while specialist system proponents cite the role of specialists in maintaining orderly markets, especially under extraordinary conditions or for special types of orders.

The ECNs contend that an array of special interests profit at the expense of investors in even the most mundane exchange-directed trades. Machine-based systems, they argue, are much more efficient, because they speed up the execution mechanism and eliminate the need to deal with an intermediary.

Historically, the 'market' (which, as noted, encompasses the totality of stock trading on all exchanges) has been slow to respond to technological innovation. Conversion to all-electronic trading could erode/eliminate the trading profits of floor specialists and the NYSE's "upstairs traders."

William Lupien, founder of the Instinet trading system and the OptiMark system, has been quoted as saying "I'd definitely say the ECNs are winning... Things happen awfully fast once you reach the tipping point. We're now at the tipping point."

Congress mandated the establishment of a national market system of multiple exchanges in 1975. Since then, ECNs have been developing rapidly.

One example of improved efficiency of ECNs is the prevention of front running, by which manual Wall Street traders use knowledge of a customer's incoming order to place their own orders so as to benefit from the perceived change to market direction that the introduction of a large order will cause. By executing large trades at lightning speed without manual intervention, ECNs make impossible this illegal practice, for which several NYSE floor brokers were investigated and severely fined in recent years. Under the specialist system, when the market sees a large trade in a name, other buyers are immediately able to look to see how big the trader is in the name, and make inferences about why s/he is selling or buying. All traders who are quick enough are able to use that information to anticipate price movements.

ECNs have changed ordinary stock transaction processing (like brokerage services before them) into a commodity-type business. ECNs could regulate the fairness of initial public offerings (IPOs), oversee Hambrecht's OpenIPO process, or measure the effectiveness of securities research and use transaction fees to subsidize small- and mid-cap research efforts.

Some, however, believe the answer will be some combination of the best of technology and "upstairs trading" — in other words, a hybrid model.

Trading 25,000 shares of General Electric stock (recent quote: $34.76; recent volume: 44,760,300) would be a relatively simple e-commerce transaction; trading 100 shares of Berkshire Hathaway Class A stock (recent quote: $139,700.00; recent volume: 850) may never be. The choice of system should be clear (but always that of the trader), based on the characteristics of the security to be traded.

Even with ECNs forming an important part of a national market system, opportunities presumably remain to profit from the spread between the bid and offer price. That is especially true for investment managers that direct huge trading volume, and own a stake in an ECN or specialist firm. For example, in its individual stock-brokerage accounts, "Fidelity Investments runs 29% of its undesignated orders in NYSE-listed stocks, and 37% of its undesignated market orders through the Boston Stock Exchange, where an affiliate controls a specialist post."

Fidelity says these arrangements are governed by a separate brokerage "order-flow management" team, which seeks to obtain the best possible execution for customers, and that its execution is highly rated.

Other types of exchanges

In the 19th century, exchanges were opened to trade forward contracts on commodities. Exchange traded forward contracts are called futures contracts. These commodity exchanges later started offering future contracts on other products, such as interest rates and shares, as well as options contracts. They are now generally known as futures exchanges.


Stock exchanges originated as mutual organizations, owned by its member stock brokers. There has been a recent trend for stock exchanges to demutualize, where the members sell their shares in an initial public offering. In this way the mutual organization becomes a corporation, with shares that are listed on a stock exchange. Examples are Australian Securities Exchange (1998), Euronext (merged with New York Stock Exchange), NASDAQ (2002), the New York Stock Exchange (2005), Bolsas y Mercados Españoles, and the São Paulo Stock Exchange (2007).

Listing requirements

Listing requirements are the set of conditions imposed by a given stock exchange upon companies that want to be listed on that exchange. Such conditions sometimes include minimum number of shares outstanding, minimum market capitalization, and minimum annual income.

Requirements by stock exchange

Companies have to meet the requirements of the exchange in order to have their stocks and shares listed and traded there, but requirements vary by stock exchange:

  • London Stock Exchange: The main market of the London Stock Exchange has requirements for a minimum market capitalization (£700,000), three years of audited financial statements, minimum public float (25 per cent) and sufficient working capital for at least 12 months from the date of listing.
  • NASDAQ Stock Exchange: To be listed on the NASDAQ a company must have issued at least 1.25 million shares of stock worth at least $70 million and must have earned more than $11 million over the last three years.
  • New York Stock Exchange: To be listed on the New York Stock Exchange (NYSE), for example, a company must have issued at least a million shares of stock worth $100 million and must have earned more than $10 million over the last three years.
  • Bombay Stock Exchange: Bombay Stock Exchange (BSE) has requirements for a minimum market capitalization of Rs.250 Million and minimum public float equivalent to Rs.100 Million.

The main stock exchanges

Major stock exchanges

Major stock exchanges

Twenty Major Stock Exchanges In The World: Market Capitalization & Year-to-date Turnover at the end of October 2007
Region ↓ Stock Exchange ↓ Market Value
(trillions of US dollars) ↓ Total Share Turnover
(trillions of US dollars) ↓
Africa Johannesburg Securities Exchange $0.940 $0.349
Americas NASDAQ $4.39 $12.4
Americas São Paulo Stock Exchange $1.40 $0.476
Americas Toronto Stock Exchange $2.29 $1.36
Americas/Europe NYSE Euronext $20.7 $28.7
Asia-Pacific Australian Securities Exchange $1.453 $1.003
South Asia Bombay Stock Exchange $1.61 $0.263
Asia-Pacific Hong Kong Stock Exchange $2.97 $1.70
Asia-Pacific Korea Exchange $1.26 $1.66
South Asia National Stock Exchange of India $1.46 $0.564
Asia-Pacific Shanghai Stock Exchange $3.02 $3.56
Asia-Pacific Shenzhen Stock Exchange $0.741 $1.86
Asia-Pacific Tokyo Stock Exchange $4.63 $5.45
Europe Frankfurt Stock Exchange (Deutsche Börse) $2.12 $3.64
Europe London Stock Exchange $4.21 $9.14
Europe Madrid Stock Exchange (Bolsas y Mercados Españoles) $1.83 $2.49
Europe Milan Stock Exchange (Borsa Italiana) $1.13 $1.98
Europe Moscow Interbank Currency Exchange (MICEX) $0.9652 $0.4882
Europe Nordic Stock Exchange Group OMX1 $1.38 $1.60
Europe Swiss Exchange $1.33 $1.58

Note 1: includes the Copenhagen, Helsinki, Iceland, Stockholm, Tallinn, Riga and Vilnius Stock Exchanges
Note 2: latest data available is at the end of June 2007
Note 3: latest data available is at the end of September 2007

* Sources: World Federation of Exchanges - Statistics/Monthly
* Remarks: There are 2 pending major mergers: NASDAQ with OMX; and London Stock Exchange with Milan Stock Exchange

Major stock exchanges

Major stock exchanges

Twenty Major Stock Exchanges In The World: Market Capitalization & Year-to-date Turnover at the end of October 2007
Region ↓ Stock Exchange ↓ Market Value
(trillions of US dollars) ↓ Total Share Turnover
(trillions of US dollars) ↓
Africa Johannesburg Securities Exchange $0.940 $0.349
Americas NASDAQ $4.39 $12.4
Americas São Paulo Stock Exchange $1.40 $0.476
Americas Toronto Stock Exchange $2.29 $1.36
Americas/Europe NYSE Euronext $20.7 $28.7
Asia-Pacific Australian Securities Exchange $1.453 $1.003
South Asia Bombay Stock Exchange $1.61 $0.263
Asia-Pacific Hong Kong Stock Exchange $2.97 $1.70
Asia-Pacific Korea Exchange $1.26 $1.66
South Asia National Stock Exchange of India $1.46 $0.564
Asia-Pacific Shanghai Stock Exchange $3.02 $3.56
Asia-Pacific Shenzhen Stock Exchange $0.741 $1.86
Asia-Pacific Tokyo Stock Exchange $4.63 $5.45
Europe Frankfurt Stock Exchange (Deutsche Börse) $2.12 $3.64
Europe London Stock Exchange $4.21 $9.14
Europe Madrid Stock Exchange (Bolsas y Mercados Españoles) $1.83 $2.49
Europe Milan Stock Exchange (Borsa Italiana) $1.13 $1.98
Europe Moscow Interbank Currency Exchange (MICEX) $0.9652 $0.4882
Europe Nordic Stock Exchange Group OMX1 $1.38 $1.60
Europe Swiss Exchange $1.33 $1.58

Note 1: includes the Copenhagen, Helsinki, Iceland, Stockholm, Tallinn, Riga and Vilnius Stock Exchanges
Note 2: latest data available is at the end of June 2007
Note 3: latest data available is at the end of September 2007

* Sources: World Federation of Exchanges - Statistics/Monthly
* Remarks: There are 2 pending major mergers: NASDAQ with OMX; and London Stock Exchange with Milan Stock Exchange

The role of stock exchanges

Stock exchanges have multiple roles in the economy, this may include the following:

Raising capital for businesses

The Stock Exchange provides companies with the facility to raise capital for expansion through selling shares to the investing public.[2]

Mobilizing savings for investment

When people draw their savings and invest in shares, it leads to a more rational allocation of resources because funds, which could have been consumed, or kept in idle deposits with banks, are mobilized and redirected to promote business activity with benefits for several economic sectors such as agriculture, commerce and industry, resulting in a stronger economic growth and higher productivity levels and firms.

Facilitating company growth

Companies view acquisitions as an opportunity to expand product lines, increase distribution channels, hedge against volatility, increase its market share, or acquire other necessary business assets. A takeover bid or a merger agreement through the stock market is one of the simplest and most common ways for a company to grow by acquisition or fusion.

Redistribution of wealth

Stocks exchanges do not exist to redistribute wealth. However, both casual and professional stock investors, through dividends and stock price increases that may result in capital gains, will share in the wealth of profitable businesses.

Corporate governance

By having a wide and varied scope of owners, companies generally tend to improve on their management standards and efficiency in order to satisfy the demands of these shareholders and the more stringent rules for public corporations imposed by public stock exchanges and the government. Consequently, it is alleged that public companies (companies that are owned by shareholders who are members of the general public and trade shares on public exchanges) tend to have better management records than privately-held companies (those companies where shares are not publicly traded, often owned by the company founders and/or their families and heirs, or otherwise by a small group of investors). However, some well-documented cases are known where it is alleged that there has been considerable slippage in corporate governance on the part of some public companies (Pets.com (2000), Enron Corporation (2001), One.Tel (2001), [[Sunbeam Products|Sunbeam]] (2001), Webvan (2001), Adelphia (2002), MCI WorldCom (2002), or Parmalat (2003), are among the most widely scrutinized by the media).

Creating investment opportunities for small investors

As opposed to other businesses that require huge capital outlay, investing in shares is open to both the large and small stock investors because a person buys the number of shares they can afford. Therefore the Stock Exchange provides the opportunity for small investors to own shares of the same companies as large investors.

Government capital-raising for development projects

Governments at various levels may decide to borrow money in order to finance infrastructure projects such as sewage and water treatment works or housing estates by selling another category of securities known as bonds. These bonds can be raised through the Stock Exchange whereby members of the public buy them, thus loaning money to the government. The issuance of such bonds can obviate the need to directly tax the citizens in order to finance development, although by securing such bonds with the full faith and credit of the government instead of with collateral, the result is that the government must tax the citizens or otherwise raise additional funds to make any regular coupon payments and refund the principal when the bonds mature.

Barometer of the economy

At the stock exchange, share prices rise and fall depending, largely, on market forces. Share prices tend to rise or remain stable when companies and the economy in general show signs of stability and growth. An economic recession, depression, or financial crisis could eventually lead to a stock market crash. Therefore the movement of share prices and in general of the stock indexes can be an indicator of the general trend in the economy.

History of stock exchanges

In 11th century France the courtiers de change were concerned with managing and regulating the debts of agricultural communities on behalf of the banks. As these men also traded in debts, they could be called the first brokers.

Some stories suggest that the origins of the term "bourse" come from the Latin bursa meaning a bag because, in 13th century Bruges, the sign of a purse (or perhaps three purses), hung on the front of the house where merchants met.

House Ter Beurze in Bruges
House Ter Beurze in Bruges

However, it is more likely that in the late 13th century commodity traders in Bruges gathered inside the house of a man called Van der Burse, and in 1309 they institutionalized this until now informal meeting and became the "Bruges Bourse". The idea spread quickly around Flanders and neighbouring counties and "Bourses" soon opened in Ghent and Amsterdam.

The house of the Beurze family on Vlamingstraat Bruges was the site of the worlds first stock Exchange, circa 1415. The term Bourse is believed to have derived from the family name Beurze.

In the middle of the 13th century, Venetian bankers began to trade in government securities. In 1351, the Venetian Government outlawed spreading rumors intended to lower the price of government funds. There were people in Pisa, Verona, Genoa and Florence who also began trading in government securities during the 14th century. This was only possible because these were independent city states ruled by a council of influential citizens, not by a duke.

The Dutch later started joint stock companies, which let shareholders invest in business ventures and get a share of their profits - or losses. In 1602, the Dutch East India Company issued the first shares on the Amsterdam Stock Exchange. It was the first company to issue stocks and bonds. In 1688, the trading of stocks began on a stock exchange in London.

Stock exchange

A stock exchange, share market or bourse is a corporation or mutual organization which provides "trading" facilities for stock brokers and traders, to trade stocks and other securities. Stock exchanges also provide facilities for the issue and redemption of securities as well as other financial instruments and capital events including the payment of income and dividends. The securities traded on a stock exchange include: shares issued by companies, unit trusts and other pooled investment products and bonds. To be able to trade a security on a certain stock exchange, it has to be listed there. Usually there is a central location at least for recordkeeping, but trade is less and less linked to such a physical place, as modern markets are electronic networks, which gives them advantages of speed and cost of transactions. Trade on an exchange is by members only. The initial offering of stocks and bonds to investors is by definition done in the primary market and subsequent trading is done in the secondary market. A stock exchange is often the most important component of a stock market. Supply and demand in stock markets is driven by various factors which, as in all free markets, affect the price of stocks (see stock valuation).

There is usually no compulsion to issue stock via the stock exchange itself, nor must stock be subsequently traded on the exchange. Such trading is said to be off exchange or over-the-counter. This is the usual way that bonds are traded. Increasingly, stock exchanges are part of a global market for securities.

Floor broker

A floor broker is a member of an exchange who is an employee of a member firm and executes orders, as agent, on the floor of the exchange for clients. The floor broker receives an order via teletype machine from his firm's trading department and then proceeds to the appropriate trading post on the exchange floor. There he joins other brokers and the specialist in the security being bought or sold and executes the trade at the best competitive price available. On completion of the transaction the customer is notified through his registered representative back at the firm and the trade is printed on the consolidated ticker tape which is displayed electronically around the country. A floor broker should not be confused with a Floor Trader who trades as a principal for his or her own account, rather than as a broker.

floor trader

A floor trader is a member of a stock or commodities exchange who trades on the floor of that exchange for his or her own account. The floor trader must abide by trading rules similar to those of the exchange specialists who trade on behalf of others. The term should not be confused with Floor broker. Floor Traders are occasionally referred to as Registered Competitive Traders, Individual Liquidity Providers or locals.

A Floor Trader checking market prices

Market maker

A market maker is a firm who quotes both a buy and a sell price in a financial instrument or commodity, hoping to make a profit on the turn or the bid/offer spread.

In foreign exchange trading, where most deals are conducted Over-the-Counter and are, therefore, completely virtual, the market maker sells to and buys from its clients. Hence, the client's loss and the spread is the market-maker firm's profit, which gets thus compensated for the effort of providing liquidity in a competitive market. This extra liquidity reduces transaction costs and therefore facilitates trades for the clients, who would otherwise have to accept a worse price or even not be able to trade at all. Most foreign exchange trading firms are market makers and so are many banks, although not in all currency markets.

Most stock exchanges operate on a matched bargain or order driven basis. In such a system there are no designated or official market makers, but market makers nevertheless exist. When a buyer's bid meets a seller's offer or vice versa, the stock exchange's matching system will decide that a deal has been executed.

In the United States, the New York Stock Exchange (NYSE) and American Stock Exchange (AMEX), among others, have a single exchange member, known as the "specialist," who acts as the official market maker for a given security. In return for a) providing a required amount of liquidity to the security's market, b) taking the other side of trades when there are short-term buy-and-sell-side imbalances in customer orders, and c) attempting to prevent excess volatility, the specialist is granted various informational and trade execution advantages.

Other U.S. exchanges, most prominently the NASDAQ Stock Exchange, employ several competing official market makers in a security. These market makers are required to maintain two-sided markets during exchange hours and are obligated to buy and sell at their displayed bids and offers. They typically do not receive the trading advantages a specialist does, but they do get some, such as the ability to naked short a stock, i.e., selling it without borrowing it. In most situations, only official market makers are permitted to engage in naked shorting.

On the London Stock Exchange (LSE) there are official market makers for many securities (but not for shares in the largest and most heavily traded companies, which instead use an automated system called TradElect). Some of the LSE's member firms take on the obligation of always making a two way price in each of the stocks in which they make markets. It is their prices which are displayed on the Stock Exchange Automated Quotation system, and it is with them that ordinary stockbrokers generally have to deal when buying or selling stock on behalf of their clients.

Proponents of the official market making system claim market makers add to the liquidity and depth of the market by taking a short or long position for a time, thus assuming some risk, in return for hopefully making a small profit. On the LSE one can always buy and sell stock: each stock always has at least two market makers and they are obliged to deal.

This contrasts with some of the smaller order driven markets. On the Johannesburg Securities Exchange, for example, it can be very difficult to determine at what price one would be able to buy or sell even a small block of any of the many illiquid stocks because there are often no buyers or sellers on the order board. However, there is no doubting the liquidity of the big order driven markets in the U.S.

Unofficial market makers are free to operate on order driven markets or, indeed, on the LSE. They do not have the obligation to always be making a two way price but they do not have the advantage that everyone must deal with them either.

Tuesday, July 8, 2008

Accounting for treasury stock

On the balance sheet, treasury stock is listed under shareholder equity as a negative number.

One way of accounting for treasury stock is with the cost method. In this method, the paid-in capital account is reduced in the balance sheet when the treasury stock is bought. When the treasury stock is sold back on the open market, the paid-in capital is either debited or credited if it is sold for more or less than the initial cost respectively.

Another common way for accounting for treasury stock is the par value method. In the par value method, when the stock is purchased back from the market, the books will reflect the action as a retirement of the shares. Therefore, common stock is debited and treasury stock is credited. However, when the treasury stock is resold back to the market the entry in the books will be the same as the cost method.

In either method, any transaction involving treasury stock cannot increase the amount of retained earnings. If the treasury stock is sold for more than cost, then the paid-in capital treasury stock is the account that is increased not retained earnings. In auditing financial statements, it is a common practice to check for this error to detect possible attempts to "cook the books".

Buying back shares


If efficient market theory is correct, a company buying back its stock should have no effect at all on its stock price. If the market fairly prices a company's shares at $50/share, and the company buys back 100 shares for $5000, it now has $5000 less cash but there are 100 fewer shares outstanding; the net effect should be that the value per share is unchanged. However, buying back shares does improve certain per-share ratios, such as price/earnings (earnings per share is increased due to fewer shares outstanding), but that is only because valuing a company's shares according to those ratios is not accurate when a company is holding a lot of cash. If a company's shares are underpriced, then a company can benefit its other shareholders by buying back shares. If a company's shares are overpriced, then a company is actually hurting its remaining shareholders by buying back stock.


One other reason for a company to buy back its own stock is to reward holders of stock options. Option holders are hurt by dividend payments, since, typically, they are not eligible to receive them. A share buyback program may increase the value of remaining shares (if the buyback is executed when shares are underpriced); if so, option holders benefit. A dividend payment short term always decreases the value of shares after the payment, so, on the day shares go ex-dividend, option holders always lose. Finally, if the sellers into a corporate buyback are actually the option holders themselves, they may directly benefit from temporarily unrealistically favorable pricing.

After buyback

The company can either retire the shares (however, retired shares are not listed as treasury stock on the company's financial statements) or hold the shares for later resale. Buying back stocks reduces the number of outstanding shares. To see this, note that accompanying the decrease in the number of shares outstanding is a reduction in company assets, in particular, cash assets, which are used to buy back shares.

Limitations of treasury stock

  • Treasury stock does not pay a dividend
  • Treasury stock has no voting rights
  • Total treasury stock can not exceed the maximum proportion of total capitalization specified by law in the relevant country

When shares are repurchased, they may either be canceled or held for reissue. If not canceled, such shares are referred to as treasury shares. Technically, a repurchased share is a company's own share that has been bought back after having been issued and fully paid.

The possession of treasury shares does not give the company the right to vote, to exercise pre-emptive rights as a shareholder, to receive cash dividends, or to receive assets on company liquidation. Treasury shares are essentially the same as unissued capital and no one advocates classifying unissued share capital as an asset on the balance sheet, as an asset should have probable future economic benefits. Treasury shares simply reduce ordinary share capital.

Treasury stock

A treasury stock or reacquired stock is stock which is bought back by the issuing company, reducing the amount of outstanding stock on the open market ("open market" including insiders' holdings).

Stock repurchases are often used as a tax-efficient method to put cash into shareholders' hands, rather than pay dividends. Sometimes, companies do this when they feel that their stock is undervalued on the open market. Other times, companies do this to provide a "bonus" to incentive compensation plans for employees. Rather than receive cash, recipients receive an asset that might appreciate in value faster than cash saved in a bank account. Another motive for stock repurchase is to protect the company against a takeover threat.

The United Kingdom equivalent of treasury stock as used in the United States is treasury share. Treasury stocks in the UK refers to government bonds or gilts.

Outstanding stock

Outstanding stock is common stock that has been authorized and issued by a corporation and purchased by investors. It has voting rights and represents ownership in the corporation by the person or institution that holds the stock. It should be distinguished from treasury stock, which is common stock that has been repurchased by the corporation or that is authorized, but not yet issued (i.e., still held in the corporate "treasury").

Friday, July 4, 2008

Common types

There are various types of preferred stocks that are common to many corporations:

  • Cumulative preferred stock - If the dividend is not paid, it will accumulate for future payment.
  • Non-cumulative preferred stock - Dividend for this type of preferred stock will not accumulate if it is unpaid. Very common in TRuPS and bank preferred stock, since under BIS rules, preferred stock must be non-cumulative if it is to be included in Tier 1 capital.
  • Convertible preferred stock - This type of preferred stock carries the option to convert into a common stock at a prescribed price.
  • Exchangeable preferred stock - This type of preferred stock carries the option to be exchanged for some other security upon certain conditions.
  • Participating preferred stock - This type of preferred stock allows the possibility of additional dividend above the stated amount under certain conditions.
  • Perpetual preferred stock - This type of preferred stock has no fixed date on which invested capital will be returned to the shareholder, although there will always be redemption privileges held by the corporation. Most preferred stock is issued without a set redemption date.
  • Putable preferred stock - These issues have a "put" privilege whereby the holder may, upon certain conditions, force the issuer to redeem shares.


Preferred shares are more common in private or pre-public companies, where it is more useful to distinguish between the control of and the economic interest in the company. Government regulations and the rules of stock exchanges may discourage or encourage the issuance of publicly traded preferred shares. In many countries banks are encouraged to issue preferred stock as a source of Tier 1 capital. On the other hand, the Tel Aviv Stock Exchange prohibits listed companies from having more than one class of capital stock.

A single company may issue several classes of preferred stock. For example, a company may undergo several rounds of financing, with each round receiving separate rights and having a separate class of preferred stock; such a company might have "Series A Preferred", "Series B Preferred", "Series C Preferred" and common stock.

In the United States there are two types of preferred stocks: straight preferreds and convertible preferreds. Straight preferreds are issued in perpetuity (although some are subject to call by the issuer under certain conditions) and pay the stipulated rate of interest to the holder. Convertible preferreds--in addition to the foregoing features of a straight preferred--contain a provision by which the holder may convert the preferred into the common stock of the company (or, sometimes, into the common stock of an affiliated company) under certain conditions, among which may be the specification of a future date when conversion may begin, a certain number of common shares per preferred share, or a certain price per share for the common.

There are income tax advantages generally available to corporations that invest in preferred stocks in the United States that are not available to individuals.

Some argue that a straight preferred stock, being a hybrid between a bond and a stock, bears the disadvantages of each of those types of securities without enjoying the advantages of either. Like a bond, a straight preferred does not participate in any future earnings and dividend growth of the company and any resulting growth of the price of the common. But the bond has greater security than the preferred and has a maturity date at which the principal is to be repaid. Like the common, the preferred has less security protection than the bond. But the potential of increases of market price of the common and its dividends paid from future growth of the company is lacking for the preferred. One big advantage that the preferred provides its issuer is that the preferred gets better equity credit at rating agencies than straight debt, since it is usually perpetual. Also, as pointed out above, certain types of preferred stock qualifies as Tier 1 capital. This allows financial institutions to satisfy regulatory requirements without diluting common shareholders. Said another way, through preferred stock, financial institutions are able to put on leverage while getting Tier 1 equity credit.

Suppose that an investor paid par ($100) today for a typical straight preferred. Such an investment would give a current yield of just over 6%. Now suppose that in a few years 10-year Treasuries were to yield 13+% to maturity, as they did in 1981; these preferreds would yield at least 13%, which would knock their market price down to $46, for a 54% loss. (In all probability, they would yield some 2% more than the Treasuries--or something like 15%, which would take the market price down to $40, for a 60% loss.)

The important difference between straight preferreds and Treasuries (or any investment-grade Federal agency or corporate bond) is that the bonds would move up to par as their maturity date is approached, whereas the straight preferred, having no maturity date, might remain at these $40 levels (or lower) for a very long time.

Advantages of straight preferreds posited by some advisers include higher yields and tax advantages (currently yield some 2% more than 10-year Treasuries, rank ahead of common stock in the case of bankruptcy, dividends are taxable at a maximum 15% rather than at ordinary income rates, as in the case of bond interest).


Unlike common stock, preferred stock usually has several rights attached to it:

  • The core right is that of preference in the payment of dividends and upon liquidation of the company. Before a dividend can be declared on the common shares, any dividend obligation to the preferred shares must be satisfied.
  • The dividend rights are often cumulative, such that if the dividend is not paid it accumulates from year to year.
  • Preferred stock may or may not have a fixed liquidation value, or par value, associated with it. This represents the amount of capital that was contributed to the corporation when the shares were first issued. [3].
  • Preferred stock has a claim on liquidation proceeds of a stock corporation, equivalent to its par or liquidation value unless otherwise negotiated. This claim is senior to that of common stock, which has only a residual claim.
  • Almost all preferred shares have a negotiated fixed dividend amount. The dividend is usually specified as a percentage of the par value or as a fixed amount. For example Pacific Gas & Electric 6% Series A preferred. Sometimes, dividends on preferred shares may be negotiated as floating i.e. may change according to a benchmark interest rate index such as LIBOR.
  • Some preferred shares have special voting rights to approve certain extraordinary events (such as the issuance of new shares or the approval of the acquisition of the company) or to elect directors, but most preferred shares provide no voting rights associated with them. Some preferred shares only gain voting rights when the preferred dividends are in arrears for a substantial time.
  • Usually preferred shares contain protective provisions which prevent the issuance of new preferred shares with a senior claim. Individual series of preferred shares may have a senior, pari-passu or junior relationship with other series issued by the same corporation.
  • Occasionally companies use preferred shares as means of preventing hostile takeovers, creating preferred shares with a poison pill or forced exchange/conversion features that exercise upon a change in control.

The above list, although including several customary rights, is far from comprehensive. Preferred shares, like other legal arrangements, may specify nearly any right conceivable. Preferred shares in the U.S. normally carry a call provision, enabling the issuing corporation to repurchase the share at its (usually limited) discretion.

Some corporations contain provisions in their charters authorizing the issuance of preferred stock whose terms and conditions may be determined by the board of directors when issued. These "blank check" preferred shares are often used as takeover defense (see also poison pill). These shares may be assigned very high liquidation value that must be redeemed in the event of a change of control or may have enormous supervoting powers.

Preferred stock

Preferred stock, also called preferred shares or preference shares, is typically a higher ranking stock than voting shares, and its terms are negotiated between the corporation and the investor.

Preferred stock usually carry no voting rights but may carry superior priority over common stock in the payment of dividends and upon liquidation. Preferred stock may carry a dividend that is paid out prior to any dividends to common stock holders. Preferred stock may have a convertibility feature into common stock. Preferred stockholders will be paid out in assets before common stockholders and after debt holders in bankruptcy. Terms of the preferred stock are stated in a "Certificate of Designation".

Voting share

A voting share (also called common stock or ordinary share) is a stock giving a stockholder the right to vote on matters of corporate policy and the composition of the members of the board of directors.

Voting shares are in contrast to preferred shares, which may have different voting, dividend, or other rights.

Tuesday, July 1, 2008

Stock price fluctuations

The price of a stock fluctuates fundamentally due to the theory of supply and demand. Like all commodities in the market, the price of a stock is directly proportional to the demand. However, there are many factors on the basis of which the demand for a particular stock may increase or decrease. These factors are studied using methods of fundamental analysis and technical analysis to predict the changes in the stock price. A recent study shows that customer satisfaction, as measured by the American Customer Satisfaction Index (ACSI), is significantly correlated to the stock market value. Stock price is also changed based on the forecast for the company and whether their profits are expected to increase or decrease.


Selling stock is procedurally similar to buying stock. Generally, the investor wants to buy low and sell high, if not in that order (short selling); although a number of reasons may induce an investor to sell at a loss, e.g., to avoid further loss.

As with buying a stock, there is a transaction fee for the broker's efforts in arranging the transfer of stock from a seller to a buyer. This fee can be high or low depending on which type of brokerage, full service or discount, handles the transaction.

After the transaction has been made, the seller is then entitled to all of the money. An important part of selling is keeping track of the earnings. Importantly, on selling the stock, in jurisdictions that have them, capital gains taxes will have to be paid on the additional proceeds, if any, that are in excess of the cost basis.


There are various methods of buying and financing stocks. The most common means is through a stock broker. Whether they are a full service or discount broker, they arrange the transfer of stock from a seller to a buyer. Most trades are actually done through brokers listed with a stock exchange, such as the New York Stock Exchange.

There are many different stock brokers from which to choose, such as full service brokers or discount brokers. The full service brokers usually charge more per trade, but give investment advice or more personal service; the discount brokers offer little or no investment advice but charge less for trades. Another type of broker would be a bank or credit union that may have a deal set up with either a full service or discount broker.

There are other ways of buying stock besides through a broker. One way is directly from the company itself. If at least one share is owned, most companies will allow the purchase of shares directly from the company through their investor relations departments. However, the initial share of stock in the company will have to be obtained through a regular stock broker. Another way to buy stock in companies is through Direct Public Offerings which are usually sold by the company itself. A direct public offering is an initial public offering in which the stock is purchased directly from the company, usually without the aid of brokers.

When it comes to financing a purchase of stocks there are two ways: purchasing stock with money that is currently in the buyer's ownership, or by buying stock on margin. Buying stock on margin means buying stock with money borrowed against the stocks in the same account. These stocks, or collateral, guarantee that the buyer can repay the loan; otherwise, the stockbroker has the right to sell the stock (collateral) to repay the borrowed money. He can sell if the share price drops below the margin requirement, at least 50% of the value of the stocks in the account. Buying on margin works the same way as borrowing money to buy a car or a house, using the car or house as collateral. Moreover, borrowing is not free; the broker usually charges 8-10% interest.

Arbitrage trading

Although it makes sense for some companies to raise capital by offering stock on more than one exchange, a keen investor with access to information about such discrepancies could invest in expectation of their eventual convergence, known as an arbitrage trade. In today's era of electronic trading, these discrepancies, if they exist, are both shorter-lived and more quickly acted upon. As such, arbitrage opportunities disappear quickly due to the efficient nature of the market


A stock exchange is an organization that provides a marketplace for either physical or virtual trading shares, bonds and warrants and other financial products where investors (represented by stock brokers) may buy and sell shares of a wide range of companies. A company will usually list its shares by meeting and maintaining the listing requirements of a particular stock exchange. In the United States, through the inter-market quotation system, stocks listed on one exchange can also be bought or sold on several other exchanges, including relatively new so-called ECNs (Electronic Communication Networks like Archipelago or Instinet).

In the USA stocks used to be broadly grouped into NYSE-listed and NASDAQ-listed stocks. Until a few years ago there was a law that NYSE listed stocks were not allowed to be listed on the NASDAQ or vice versa.

Many large non-U.S companies choose to list on a U.S. exchange as well as an exchange in their home country in order to broaden their investor base. These companies have then to ship a certain amount of shares to a bank in the US (a certain percentage of their principal) and put it in the safe of the bank. Then the bank where they deposited the shares can issue a certain amount of so-called American Depositary Shares, short ADS (singular). If someone buys now a certain amount of ADSs the bank where the shares are deposited issues an American Depository Receipt (ADR) for the buyer of the ADSs.

Likewise, many large U.S. companies list themselves at foreign exchanges to raise capital abroad.

Means of financing

Financing a company through the sale of stock in a company is known as equity financing. Alternatively, debt financing (for example issuing bonds) can be done to avoid giving up shares of ownership of the company. Unofficial financing known as trade financing usually provides the major part of a company's working capital (day-to-day operational needs). Trade financing is provided by vendors and suppliers who sell their products to the company at short-term, unsecured credit terms, usually 30 days. Equity and debt financing are usually used for longer-term investment projects such as investments in a new factory or a new foreign market. Customer provided financing exists when a customer pays for services before they are delivered, e.g. subscriptions and insurance

Shareholder rights

Although ownership of 51% of shares does result in 51% ownership of a company, it does not give the shareholder the right to use a company's building, equipment, materials, or other property. This is because the company is considered a legal person, thus it owns all its assets itself. This is important in areas such as insurance, which must be in the name of the company and not the main shareholder.

In most countries, including the United States, boards of directors and company managers have a fiduciary responsibility to run the company in the interests of its stockholders. Nonetheless, as Martin Whitman writes:

...it can safely be stated that there does not exist any publicly traded company where management works exclusively in the best interests of OPMI [Outside Passive Minority Investor] stockholders. Instead, there are both "communities of interest" and "conflicts of interest" between stockholders (principal) and management (agent). This conflict is referred to as the principal/agent problem. It would be naive to think that any management would forgo management compensation, and management entrenchment, just because some of these management privileges might be perceived as giving rise to a conflict of interest with OPMIs.

Even though the board of directors runs the company, the shareholder has some impact on the company's policy, as the shareholders elect the board of directors. Each shareholder typically has a percentage of votes equal to the percentage of shares he or she owns. So as long as the shareholders agree that the management (agent) are performing poorly they can elect a new board of directors which can then hire a new management team. In practice, however, genuinely contested board elections are rare. Board candidates are usually nominated by insiders or by the board of the directors themselves, and a considerable amount of stock is held and voted by insiders.

Owning shares does not mean responsibility for liabilities. If a company goes broke and has to default on loans, the shareholders are not liable in any way. However, all money obtained by converting assets into cash will be used to repay loans and other debts first, so that shareholders cannot receive any money unless and until creditors have been paid (most often the shareholders end up with nothing).


The owners of a company may want additional capital to invest in new projects within the company. They may also simply wish to reduce their holding, freeing up capital for their own private use.

By selling shares they can sell part or all of the company to many part-owners. The purchase of one share entitles the owner of that share to literally share in the ownership of the company, a fraction of the decision-making power, and potentially a fraction of the profits, which the company may issue as dividends.

In the common case of a publicly traded corporation, where there may be thousands of shareholders, it is impractical to have all of them making the daily decisions required to run a company. Thus, the shareholders will use their shares as votes in the election of members of the board of directors of the company.

In a typical case, each share constitutes one vote. Corporations may, however, issue different classes of shares, which may have different voting rights. Owning the majority of the shares allows other shareholders to be out-voted - effective control rests with the majority shareholder (or shareholders acting in concert). In this way the original owners of the company often still have control of the company.


A shareholder (or stockholder) is an individual or company (including a corporation) that legally owns one or more shares of stock in a joint stock company. Companies listed at the stock market are expected to strive to enhance shareholder value.

Shareholders are granted special privileges depending on the class of stock, including the right to vote (usually one vote per share owned) on matters such as elections to the board of directors, the right to share in distributions of the company's income, the right to purchase new shares issued by the company, and the right to a company's assets during a liquidation of the company. However, shareholder's rights to a company's assets are subordinate to the rights of the company's creditors.

Shareholders are considered by some to be a partial subset of stakeholders, which may include anyone who has a direct or indirect equity interest in the business entity or someone with even a non-pecuniary interest in a non-profit organization. Thus it might be common to call volunteer contributors to an association stakeholders, even though they are not shareholders.

Although directors and officers of a company are bound by fiduciary duties to act in the best interest of the shareholders, the shareholders themselves normally do not have such duties towards each other.

However, in a few unusual cases, some courts have been willing to imply such a duty between shareholders. For example, in California, USA, majority shareholders of closely held corporations have a duty to not destroy the value of the shares held by minority shareholders.

The largest shareholders (in terms of percentages of companies owned) are often mutual funds, and especially passively managed exchange-traded funds.


During Roman times, the empire contracted out many of its services to private groups called publicani. Shares in publicani were called "socii" (for large cooperatives) and "particulae" which were analogous to today's Over-The-Counter shares of small companies. Though the records available for this time are incomplete, Edward Chancellor states in his book Devil Take the Hindmost that there is some evidence that a speculation in these shares became increasingly widespread and that perhaps the first ever speculative bubble in "stocks" occurred.

The first company to issue shares of stock after the Middle Ages was the Dutch East India Company in 1606. The innovation of joint ownership made a great deal of Europe's economic growth possible following the Middle Ages. The technique of pooling capital to finance the building of ships, for example, made the Netherlands a maritime superpower. Before adoption of the joint-stock corporation, an expensive venture such as the building of a merchant ship could be undertaken only by governments or by very wealthy individuals or families.

Economic historians find the Dutch stock market of the 1600s particularly interesting: there is clear documentation of the use of stock futures, stock options, short selling, the use of credit to purchase shares, a speculative bubble that crashed in 1695, and a change in fashion that unfolded and reverted in time with the market (in this case it was headdresses instead of hemlines). Dr. Edward Stringham also noted that the uses of practices such as short selling continued to occur during this time despite the government passing laws against it. This is unusual because it shows individual parties fulfilling contracts that were not legally enforceable and where the parties involved could incur a loss. Stringham argues that this shows that contracts can be created and enforced without state sanction or, in this case, in spite of laws to the contrary.