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The economics of financial markets

The integration and deregulation of financial markets brought about an avalanche of new financial instruments. The most important of these are option contracts and futures contracts, and in fact many of the other instruments are derivatives of these two products. The modern origin of these instruments is decidedly American. The first option contracts were on common stock and began trading on the Chicago Board Option Exchange on April 26, 1973. The first financial futures contracts covered foreign exchange and were introduced in the international monetary market on May 16, 1972.

The explosion since then in these types of contracts, the instruments they cover, the uses they are put to, the market efficiency considerations they evoke, and other factors has been phenomenal. Today there are about 60 major futures and options markets, covering mostly stocks, bonds and currencies. These markets are not independent, but rather are interconnected (e. g. , Singapore and Chicago, and London and Chicago) with sophisticated electronic networks allowing traders in one country to trade on the other’s exchange with the right of offset.

This privilege allows one trader to buy (sell) on one exchange and sell (buy)–offset–on the other exchange. Considering the time differences among Europe, the Far East,

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and the United States, these linkages between the exchanges allow for a continuous market where trading can effectively take place around the clock. This development is similar to that in the spot market for currencies, for example; here trading takes place 24 hours a day and is similar to the interlisting of common stocks on the various exchanges in the world.

One exchange has taken the lead in extending trading hours on the road to 24hour trading. On September 16, 1987, the Philadelphia Stock Exchange became the first U. S. securities exchange to initiate evening trading sessions in foreign currency options. By April 1988, the evening session accounted for “more than $20 billion in underlying trading value. ” On January 20, 1989, the Philadelphia Stock Exchange also introduced the early morning trading session. Trading now begins at 4:30 A. M. and continues until 2:30 P. M.

Evening trading then commences at 6:00 P. M. and ends at 10:00 P. M. The exchange, as a result, is now open for 14 hours of trading–the longest of any exchange. The other innovations deal not only with new instruments but also with new ways to underwrite them (e. g. , shelf registration) and with new ways to unbundle traditional services, allowing for greater flexibility in producing better profit figures and for further blurring of the investment banking/banking function. One of the more interesting new innovations was proposed to the SEC in late 1988.

It involved the unbundling of a stock unit into a 30-year bond paying interest equal to the current stock dividend, a share of preferred stock entitling the holder to any dividends declared by the company in excess of the current dividend, and a stock appreciation certificate giving the holder the right to purchase the company’s stock for cash in 30 years for the principal amount of the bond and the preferred stock. This unbundling provides a good defense against hostile takeover and has wide-ranging implications, the full nature of which has yet to be fully examined and understood.

The unbundled stock unit is, however, a hedging tool against takeover risk and is not unlike the other instruments or structures that fundamentally hedge against other risks, such as foreign exchange risk, interest rate risk, portfolio risk, etc. So, what gives a piece of paper, known as common stock, value? What makes an investor exchange cash, which can be used to purchase almost anything, for a share of common stock, which in and of itself can purchase nothing? The physical stock certificate has no purchasing power.

There must be some expected reward or future benefit that will entice investors to part with their money in exchange for the stock certificate. Exactly what does the investor get by buying the share of common stock? The answer is obvious. The investor acquires a claim on all future benefits that are transferred from the corporation to the investor. The only benefit that can be transferred from the corporation to the investor is distributions, usually cash dividends. Stockholders rarely receive physical assets, such as a corporate-owned car or plant, from the corporation.

The motivation to purchase a share of common stock is the expectation of a return high enough to warrant undertaking the risk associated with the ownership of that particular share of common stock. The motivation to sell the share is the expectation of a rate of return no longer high enough to warrant undertaking the risk associated with the ownership of that particular share of common stock. The relationship between the expected rate of return and risk changes, motivating investors to purchase or sell the share.

Skeptics respond that the share of common stock can be purchased for capital-gain potential in addition to future dividends. The price at which the common stock may be sold in the future is always a function of the claim on future benefits, namely dividends, expected to be received by the new purchaser. A corporation that will never, with iron-clad certainty, distribute any of its earnings or assets to its stockholders must, with certainty, have a common stock that has no value other than the piece of paper on which it is printed. Most stock certificates are not works of art and, therefore, have no value as a piece of paper.

Investors also run the risk, particularly in common stocks, that adverse events might occur during the wait. The dividends actually received might be lower than the dividends expected when the common shares were bought. The common stock price will probably be lower if this occurs. The future claim on dividends is infinite. Investors can own the shares forever. The shares are never intended to be redeemed. The expected life of the corporation is perpetuity. Publicly-traded companies rarely plan to remain in business for a limited number of years and then dissolve.

Buying a share of common stock really means investors must forecast expected dividends infinitely into the future. If investors could perfectly foresee the future dividends, they could readily calculate the intrinsic value of the common shares at any particular discount rate. Such foresight is not possible. The required rate of return that compensates shareholders for the lost interest and risk of the wait discounts future dividends to the present. The lost interest can be measured by the yield to maturity on a U. S. Treasury bond.

The specific maturity varies among investors. However, long-term bond yields are probably the best proxy for lost interest since their maturities are closest to the assumed, infinite life of the common stock. Expected dividends beyond the long-term bond maturity have little impact on the present value of the common share at almost any historically-observed required rate of return discount. There is no impact on the current common stock price because those dividends are expected so far in the future. The required rate of return must be increased beyond the long-term U. S.

Treasury Bond yield to include the risk that expected dividends might not be received. The required rate of return is the discount rate used to calculate the present value of the expected dividends. The required rate of return reflects all risks associated with common share ownership. The expanded required rate of return for individual common stock is developed throughout subsequent chapters to include the major categories of risk that must be considered. The current common stock price is the present value of the market consensus, expected dividends discounted to the present value by the required rate of return.

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