Stock Market- Islamic Capital Markets Class

Stock market

1. Islamic Capital Markets Chapter 8 Equity Markets

2. *Primary and Secondary Markets Primary market = financial market in which newly issued securities are sold. Secondary market = financial market in which previously owned securities are sold.

3. Introduction Definition of Stock Market: History, Modern Approach and Common Terms Computing the Price of Common Stock How the Market Sets Stock Prices The Theory of Rational Expectations The Efficient Market Hypothesis Behavioral Finance

4. The Evolution of Stocks In the days when these European nations (esp. Netherlands, then England) were exploring the New World to acquire spices. Investing in one ship was risky Merchants decide to invest in several ships (allocating the risk) Also, one ship doesn’t require wealthy merchants. Several middle-income merchants may finance a huge ship. Formation of large companies. Liquidity: Ability to convert an asset into cash. It was important for merchants to convert goods into cash easily. Transferability: Ability to Change Ownership Stock exchanges invented.

5. How Companies List in Stock Markets Initial Public Offering (IPO) Sufficient paid-up capital Good Earnings Track Regulatory Obligations (SPK and BIST; like equity/capital ratio) Differs according to markets There are three parts in BIST. (Star-market, Main-market and sub-market) Private Placement: A sale of stocks, bonds, or securities directly to a private investor , rather than as part of a public offering Advantages Disadvantages Access to equity Capital Increased disclosure requirements. More monitoring of firm’s activities by external stakeholders. Lower cost of Funds Need to meet additional regulatory requirements Increases liquidity of shares Potential for hostile takeover and loss of control Makes diversification possible for owners. Incur listing and other periodic costs.

6. Shareholders’ Rights An equity investment as represented by the stock can also be passed on to one’s children as inheritance Residual claim represents shareholder’s claim on the assets would come last. If firm bankrupts, first bondholder (debtor) paid off from the liquidated assets. Voting right (Board Membership) Profit (Dividends)

7. Equity Ownership and Shariah Compliance Mudarabah type contract (PLS contract) Rab al-Mal provides the capital Mudarib operates the business Either shareholder makes profit or loss with his/her share. No fixed returns. Even though stock market contract is free from riba , there are other conditions which required to meet for any stock to be claimed as Helal . Next chapter

8. The Valuation of Common Stock The basic principle in finance is that an asset’s value should be the present value of all future cash flows derived from the asset Different from bonds There is no fixed returns. Dividends are not compulsory Stocks have no maturity Underlying logic that value should equal present value of future cash flows is the same, the pricing models are different.

9. One-Period Valuation Model The required rate of return (RRR) is  the minimum amount an investor or company seeks, or will receive, when they embark on an investment or project .

10. One-Period Valuation Model- Example Assume price of the Intel Stock. 12% return of the investment. Intel pays 0.16 per year in dividends. Forecast the share price of $60 at the end of year 1. = 0.14$ + 53.57 $ = 53.71 $ On the basis of your analysis, you find that the present value of all cash flows from the stock is $53.71 If stock is currently priced at 50$ per share, you would choose to buy it.  

11. Generalized Dividend Valuation Model The value of stock today is the present value of all future cash flows The price of the share is determined only by the present value of the future dividend stream. For example, the present value of a share of stock that sells for $50 seventy-five years from now, using a 12% discount rate, is just one cent This reasoning implies that the current value of a share of stock can be calculated as simply the present value of the future dividend stream.  

12. Generalized Dividend Valuation Model- Implications The generalized dividend model states that the price of a stock is determined only by the present value of the dividends and that nothing else matters. However : Many stocks do not pay dividends, so how is it that these stocks have value? Buyers of the stock expect that the firm will pay dividends someday. Most of the time a firm institutes dividends as soon as it has completed the rapid growth phase of its life cycle The generalized dividend valuation model requires that we compute the present value of an infinite stream of dividends, a process that could be difficult, to say the least. Therefore, simplified models have been developed to make the calculations easier . Gordon Growth Model- Constant Dividend Growth

13. Gordon Growth Model Dividends assumed to continue growing at a constant rate “forever”. The growth rate is assumed to be less than the required return on equity.

14. Gordon Growth Model - Example

15. How to Explain Gordon Model? Monetary Policy If CB lowers interest rates investors likely to buy stock shares. lowers because investors accept a lower required rate of return on an investment in equity Example: Interest rate = 3 percent Stock Shares Exp = 5 percent Similarly, low interest rates may stimulate the economy Growth rate in dividends, g, is likely to be increase. 2008 crisis increased due to uncertainty. Also, g decreases as investors Believed in low dividends.  

16. How the Market Sets Prices - Example Different Investors have different expectations Assume you go to auto auction Mazda Miata that you like and test it. You decide that 5.000 $ is a fair price. Assuming pay some repair bills. Another buyer tests and decides to value 7.000 $ Assuming he can fix himself at a nominal cost. Result: Other buyer buys price 5.000 $+ x$. For instance 5.100 $

17. How the Market Sets Prices • The price is set by the buyer willing to pay the highest price • The market price will be set by the buyer who can take best advantage of the asset • Superior information about an asset can increase its value by reducing its risk

18. How the Market Sets Prices You: Listened Market analysts. Jennifer: Talks with insiders Bud: Friend of CEO of company. New information is released about a firm, expectations change, and with them, prices change.

19. Theories About Stockholders’ Incentives There are several models to analyze the behaviour of the stockholders (investors) Adaptive Expectations Rational Expectations Behavioral Finance Adaptive Expectations: Before 1970s, economists regularly viewed expectations as formed from past experience only. This theory failed due to focusing just only previous data.

20. Theory of Rational Expectations John Muth , Rational Expectations. Expectations will be identical to optimal forecasts using all available information Example: A worker leaves his job. The forecast does not have to be perfectly accurate to be rational As there is bound to be some randomness in Joe’s driving time regardless of driving conditions, an optimal forecast will never be completely accurate. Even though a rational expectation equals the optimal forecast using all available information, a prediction based on it may not always be perfectly accurate It takes too much effort to make the expectation the best guess possible Best guess will not be accurate because predictor is unaware of some relevant information

21. Formal Statement of the Theory Expectations in financial markets are equal to optimal forecasts using all available information.

22. Implications of Theory 1. If there is a change in the way a variable moves , the way in which expectations of the variable are formed will change as well Interest rate example 2. The forecast errors of expectations will , on average, be zero and cannot be predicted ahead of time The incentives for equating expectations with optimal forecasts are especially strong in financial markets. The application of the theory of rational expectations to financial markets: Efficient Market Hypothesis

23. Efficient Markets- Application of Rational Expectations The efficient market hypothesis views expectations of future prices as equal to optimal forecasts using all currently available information. In other words, the market’s expectations of future securities prices are rational, so that Unfortunately, we cannot observe either or in the short run , so the rational expectations equations by themselves do not tell us much about how the financial market behaves. It is possible to understand long run supply demand analysis .      

24. Efficient Markets • Current prices in a financial market will be set so that the optimal forecast of a security’s return using all available information equals the security’s equilibrium return • In an efficient market, a security’s price fully reflects all available information The academic field of finance explores the factors (risk and liquidity, for example) that influence the equilibrium returns on securities. For our purpose, it is sufficient to know that we can determine the equilibrium return and thus determine the expected return with the equilibrium condition

25. Rationale An extremely important factor in this reasoning is that NOT everyone in a financial market must be well informed about a security or have rational expectations for its price to be driven to the point at which the efficient market condition holds .

26. Evidence in Favor of Market Efficiency • Having performed well in the past does not indicate that an investment advisor or a mutual fund will perform well in the future Informing winning team by manipulating • If information is already publicly available , a positive announcement does not, on average, cause stock prices to rise Stock prices will respond to announcements only when the information being announced is new and unexpected . • Stock prices follow a random walk The efficient market hypothesis leads to the conclusion that such an investor (and almost all of us fit into this category) should not try to outguess the market by constantly buying and selling securities . • Technical analysis cannot successfully predict changes in stock prices

27. Evidence Against Market Efficiency • Small-firm effect Theory that predicts that smaller firms, or those companies with a small market capitalization, tend to outperform larger companies. • January Effect A seasonal increase in stock prices in the first month of each year. • Market Overreaction • Excessive Volatility • Mean Reversion A financial theory that suggests asset prices will eventually return to their long-term mean or average. • New information is not always immediately incorporated into stock prices

28. Application Investing in the Stock Market • Recommendations from investment advisors cannot help us outperform the market • A hot tip is probably information already contained in the price of the stock • Stock prices respond to announcements only when the information is new and unexpected • Conclusion: A “buy and hold” strategy is the most sensible strategy for the small investor

29. Behavioral Finance Behavioral finance uses psychology-based arguments to explain investor behavior. Doubts about the efficiency of financial markets, triggered by the stock market crash of 1987, Nobel Prize winner Robert Shiller Irrational financial decision making that leads to market bubbles and panics is explained using cognitive theories from psychology in combination with conventional finance theories Bitcoin example Residents in country with high inflation leads more financial activities.

30. Regulatory Restrictions on Trading Rules to check Price manipulation Insider trading rules Front Loading: Brokers who receive a large customer buy order purchase the stock/asset for their accounts before executing the customer’s order Syndicated Price Ramping: A group of individuals acting in concert either ramp up or ramp down the price of a stock or asset Rules against Speculative excess Regulations Changes to margin requirements: The value of buy back of sold shares on the same day will be restricted to percent of the value of shares sold Up-tick rules: dictate that a sell order cannot be placed at a price lower than the current price. (5$ increments) Position limits: the maximize size that an individual account can hold at any given time. Rules to Prevent Investor Panic Circuit Brakers (10% in BIST) Major policy announcements after Friday working hours.

31. Summary Summarized the concept of Equity Finance. No fix returns General terms and definitions discussed. Pricing a stock share analyzed. General Theories Underlying in Conventional Finance Efficient Market Hypothesis Behavioral Finance Regulatory Restrictions