finance

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Role and function of stock market

The stock market is a sector of the financial market. It is a public market where stocks and bonds are traded at a fixed price. It is an organization which provides facilities to trade stocks and securities. Participants in the stock market range from individual investors to companies. Both investors with small and huge funds trade on the stock market. The stock market can have people who are traders that bid for stocks or a network of computers where trades are made electronically. It is the most important market to corporate investment and it is also a good predictor of the business cycle and the components of gross domestic product. Corporate investors and private individual trade in the stock market. The stock market help investors evaluate the quality of past management decision. The stock market provides facilities for the issue of redemption of securities, capital events and payment of income. Examples of the securities traded on the stock exchange include shares, bonds, derivatives and unit trust. The role of the stock market promotes economic growth and employment.

The companies that trade on the stock exchange are listed on the stock exchange. The initial sales of stocks and bonds is done in the primary market while, subsequent trading is done in the secondary market. The supply and demand of stock determines the price of stock. Derivatives and bonds are usually traded over the counter.

The London stock exchange is an example of stock market. It is owned by the London stock exchange group. The London stock exchange is one of the oldest stock market.

The trading of stocks and bonds by investors began in the London stock exchange many years ago.

The London stock exchange is the market for trading long term securities. It is an organization where stockbrokers and traders buy and sell shares and security. The London stock exchange provide facilities for the issue of redemption of securities as well as other financial instrument and capital events including the payment of income and dividends (Wikipedia). All companies that want to trade on the London stock exchange must be listed on the London stock exchange. The London stock exchange is developing its market in covered warrants. Covered warrants are tradable securities on the London stock exchange. The holder of a covered warrant has the right to sell or buy at a specific price at a particular date. The risk on covered warrant is minimal. The stock exchange is the most important component of the stock market. The London stock exchange does not deal with the general public. There are over two hundred registered stockbrokers who act as intermediaries for the public. The London stock exchange brokers charge a flat fee or a percentage from its customers.

There are two types of trading procedures on the London stock exchange namely;

SEAQ: This is the stock exchange automated quotation system. This is a quote driven system. Market makers compete amongst themselves through the stockbrokers to the public. Trading is done by phone or online.

SETS: This is the stock exchange electronic trading service. This is an order driven system. Stock brokers trade automatically through an electronic trading book. The role of market makers is eliminated. The SETS is limited to the ftse 100 and some companies on the ftse 250. The stock exchange electronic trading service deals is done through a broker. This useful for private investors as there is no minimum order size. The London stock exchange SETS orders are either 'at best' which means deals are carried out at the best overall price or through 'execute and eliminate' which means immediate execution or through 'fill or kill' which means trade is done exactly as the terms specified or nothing at all is done and it can also be done by 'limit' which means trade are set for prices no worse than a particular amount within a period of ninety days. The market is regarded as a semi-strong market because its share price adjusts to new information that is made public quickly.

Role of the London stock exchange

The London stock exchange is owned by the London stock exchange group plc. The London stock exchange manages share, bond and account receivable listings and efficient services for share issuers. Investors also have the opportunity to buy and sell from companies in which they are shareholders. Stock exchange play a vital role in the economy, this may include:

  • The stock exchange helps companies to raise capital expand their businesses or improve on the existing business through selling of shares.
  • The London stock exchange offers a trading platform for brokers around the world to buy and sell securities.
  • The London exchange helps Individual share holders dispose off their shares for money in the secondary market of the stock market.
  • The London stock exchange encourages savings of idle funds which promotes business activity resulting in a stronger economy with higher productivity.
  • The stock exchange facilitates Profit sharing through capital gains.
  • The London stock exchange must ensure an orderly fair efficient market for dealing in financial securities.
  • The London stock exchange must ensure that prices of shares is fair, information about quoted firms must be accessible.
  • The stock exchange is a place where Government raises money through bonds.
  • London stock exchange is an indicator of the British economic strength and development.
  • London stock exchange provides information that can affect the prices of stock.
  • The London stock exchange promotes corporate governance through management standards and efficiency in other to satisfy the demand of shareholders.
  • The London stock exchange creates opportunity for investors with small funds. Investors can buy whatever they can afford.
  • The London stock exchange facilitates takeover bids and mergers.
  • The London stock exchange provides an excellent opportunity for debt issuers to access a large pool of capital.
  • The London stock exchange provides investors the ability to quickly and easily sell their securities.
  • The London stock exchange provide an efficient information service, made up of price indications, relevant companies histories, the true financial position of the company and their market position.

Stocks and securities can be traded through different types of market in the London stock exchange. These include the primary market, secondary market, alternative investment market (AIM) and over the counter.

Primary market: Primary market provides companies the opportunity to raise funds by selling initial shares to the public through initial public offer or through private placement. New shares are sold in the private market. Companies and the government can raise capital through the sale of shares and bonds in the private market. The methods used by the primary market in raising funds are initial public offer, placing and preference issue.

Features of primary markets:

  • The primary market is the market where shares and bonds are sold for the first time.
  • The shares are traded directly to the investors by the company
  • Certificates are issued to investors.
  • The primary market is the market for companies to raise long term equity.

Secondary market: Previously issued shares, bonds are sold in the secondary market. Shares that are sold after initial public offer and placing are sold in the secondary market. Secondary market transfers shares from one investor to another.

Secondary market provides better price discovery. It is also found to have a positive relationship to real firm performance. Secondary markets have real economic value and also provides corporate governance through increased market liquidity (Tadesse,2005,page64). It gives investors risk pooling and risk sharing facilities (Tadesse,2005,page65).

It gives investors risk pooling and risk sharing facilities (Tadesse,2005,page65). The effective use of the secondary market for corporate control activities like take over which requires that the market is liquid (Tadesse,2005,page69).

The effective use of the secondary market for corporate control activities like take over which requires that the market is liquid (Tadesse,2005,page69). Secondary market helps investors to achieve diversification. Investors can invest in various companies to reduce risk. Secondary market is the market where investors resell their shares to raise funds.

The more stocks that are traded the more liquid the market.

Listing requirements of the London stock exchange

The uk listing authority is a part of the financial service authority. The financial service authority is the regulatory body of the London stock exchange. The uk listing requirements include:

  • The size of issued capital
  • Directors must sign an agreement which commits the board to a high standard of behavior and reporting level to shareholders.
  • Directors must prepare a prospectus for shareholders.
  • Companies must have a minimum of three years of operating account.
  • Companies need a bank or broker to advice and reassure the uk listing authority of the companies quality.
  • Directors are obliged to continuously give the market any price sensitive information as soon as possible.
  • Directors are obliged to disclose information fully.
  • Directors must follow guide lines in buying and selling their companies shares.
  • Financial record
  • Trading history
  • Acceptability of board members
  • Minimum public float of 25%(Wikipedia)

Alternative investment market (AIM): Alternative investment market is a market where smaller companies float their shares. The regulation is flexible and there no particular requirement for capitalization. The companies listed on the alternative investment market are high risk companies and so, it is not advisable for investors that are not well informed about the market to invest in it. The investor base is mostly wealthy people. Alternative investment market has a lot of tax advantages for investors compared to the other markets. Some of the rules on the London stock exchange do not apply to the companies that trade on the alternative investment market. Companies that trade on the alternative investment market are relatively small and highly risky.

Listing requirements of the alternative investment market

Companies listed on the alternative investment market must issue notification without delay of any new developments which are not public knowledge concerning a change in:

  • Its financial condition;
  • Its sphere of activity;
  • The performance of its business;
  • Its expectations of its performance, which, if made public, would be likely to lead to a substantial movement in the price of its AIM securities (Lipman &Bird,2009,pp 4).
  • There is no minimum capitalization required for companies.
  • Companies listed under the alternative investment market must report matters like change in directors, and any price sensitive information.
  • There is no minimum financial track record required.

Over the counter (OTC): It is a form of market where companies trade shares on bargain by an intermediary. Stocks of bankrupt companies are traded over the counter. Derivatives and bonds are also traded over the counter.

The London stock exchange market indices

  • Ftse 30 index-the first thirty companies highly capitalized and most prestigious companies in the uk.
  • Ftse 100 index -
  • Ftse 250 index-the first two hundred and fifty highly capitalized companies in uk
  • Ftse 350 index-
  • Ftse all share index
  • Ftse fledgling index
  • Ftse tech mark index
  • Ftse aim all share index

Stock valuation

The value of a stock can be known through the financial statement of the company, using the different financial ratios to calculate the true position of the company. Price patterns can be used to know the value of a stock. Stocks on the London stock exchange are quoted in pounds and pence with just a few quoted in euro. The price of shares is always in pence. Stock valuation provides liquidity for investment hoping that the existing state of affairs of the company continues. It can also be calculated using discounted cash flow methods.

Some investors are termed bullish because they have overrated the price of stock than the usual aggregate and some investors are bearish because they push the prices of stock lower than the usual aggregate. All these sometimes affect the value of stock. A sudden change in the dividend policy of a company can also cause a volatile change in share price. Other factors like profit margin or dividend can also affect stock valuation. Efficient market hypothesis can also affect the value of stocks. Efficient market hypothesis requires that agents have rational expectations.

Stock valuation necessary stability and liquidity for investment assuming that the existing state of affairs will continue indefinitely.

Types of stock

There are two main types of stock namely:

  • Preferred stock
  • Ordinary stock

Preferred stock: Holders of preferred stock are paid dividend before other shareholders and dividends are paid at par. Preferred stock shareholders can claim liquidation proceeds of the company they have invested in. Companies can use preferred stock to prevent take over .Preferred stock holders have no voting rights. Preferred stock is also called preference stock or preference shares. It can be converted to common or ordinary shares. Certificate of designation is issued to investors that buy preference shares. Preference share might have a fixed liquidation value attached to it when first bought. The dividend of the preference shares is mostly fixed at a particular percentage of the par value.

Types of preferred stock

  • Prior preferred stock
  • Convertible preferred stock
  • Preference preferred stock
  • Participating preferred stock

Ordinary stock: Ordinary stock is also known as common stock or ordinary shares. Ordinary shareholders have the right to vote and they are paid dividend after the preference shareholders. In the case of liquidation, ordinary shareholders receive funds after preference shareholders. Ordinary shareholders have the benefit of increased dividend or capital gains as it is not fixed. Shares certificate is issued to investors that invest in ordinary shares.

All companies that trade on the London stock exchange must be listed. There are rules to be followed before a company is listed.

Bond valuation

Bond valuation is the process of determining a good price for a bond. The value of a bond is the present value of the cash flow it will generate. The government bond is a risk free investment with a low interest rate. There are other types of bond:

  • A callable bond allows the issuer to buy back the bond at a particular price and date.
  • A putt able bond allows the holder to demand redemption at a particular price and at a predetermined date.
  • A convertible bond allows the holder to convert the bond to stock at a predetermined price and at a certain time.
  • An exchangeable bond allows the holder to convert bonds in to the stock of a different company at a particular price and at a future date.

Holders of bond collect coupon and hold it to maturity, market volatility is not relevant. Both interest and principal are paid at a predetermined date. Bond holders who buy and sell before maturity are exposed to risk from changing interest rate. The value of bond reduces when interest rate increases and when interest rate reduces the value of bond increases .Bonds are traded over the counter.

The financial service authority: The financial service authority is a non governmental organization that regulates the financial industry.

The stock exchange is regulated by the financial service authority. The financial service authority is accountable to the treasury ministers and through them to the parliament (wikipedia). The statutory objectives of the financial service authority are;

  • Monitoring of the market, brokers and intermediaries.
  • The financial service authority forces stockbrokers to inform clients of the charges been made.
  • Prevention of financial crime.
  • Sustaining confidence in the market.
  • All transactions must be done with authorization.
  • It leaves no room for inconsistencies and improves accountability.
  • Creating awareness for the public regarding the risk associated with each investment.
  • It also provides adequate protection for the investors.

The financial service authority cannot be seen as totally perfect as it serves as a regulatory body for other societies like the building society, and it has only one customer care unit to serve all the customers. It has been criticized to have low customer satisfaction.

The financial service authority has no representative of consumer group and it claims to be protecting the consumer group. The financial service authority is reactive instead of proactive (Wikipedia).

The financial service authority's objective is being regulated by some principles which are;

  • The financial service authority must use its resources economically and efficiently.
  • The financial service authority must ensure that companies do not take unrealistic risk.
  • The financial service authority must not intrude in to companies business.
  • The restrictions that the financial service authority imposes on the companies must be proportionate to the benefit.
  • The financial service authority must be innovative.
  • The financial service authority must cooperate with overseas regulators to monitor the global market effectively.
  • The financial service authority must minimize adverse competition between companies.
  • The financial service authority must ensure that retail markets of financial products and services work efficiently.
  • The financial service authority must raise levels of confidence and capability amongst retail consumers.
  • The financial service authority acts has the uk authority.

References

  • Lipman, FD, & Bird, T 2009, 'Securities registration of small companies: what can we learn from the british'?, INSIGHTS, vol.23, no.7,pp.1-11.
  • Solomon, T 2005, 'The governance role of secondary markets', Nova science publisher, inc, New york.