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.
This concept is captured in Equation below:
P = ∑t = 1, ∞ Et(1 - Λ) / (1 + r)t where the symbols in Equation stand for:
P = current share price of the common stock;
∑ t =1, ∞ = the sum of the future from now to infinity;
E t = the expected future earnings in each future year t;
Λ = the percentage of the earnings retained. Thus 1 Λ is the payout rate. The numerator of the Equation valuation framework is the expected dividend in each year t. Since A is assumed stable, it drops it from the equation to focus on earnings, the source of dividends;
r = the required rate of return used to discount the future expected earnings, implying dividends, to the common share price (present value).
As for Foreign Exchange Market (FXM), over the years it has undergone major structural changes. The changes that are taking place are attributed to institutional developments, as well as technological advances. Those changes had a significant impact on various dimensions of the market, such as the way trading is done, competition, the size of the market, and the efficiency of the market. It is therefore necessary to provide an update of the environment in which the currency prices are determined. The most important change in the FXM in recent years is the evolution of an independent cross market in which non-dollar rates are determined based on free supply and demand forces. The evolution of an independent cross market offered more products and more opportunities to traders and therefore increased the volume of trading volume of the market as well.
The term Foreign Exchange market simply means the exchange of one national currency for another. FX rates are the equalizing prices that link different national currencies. When prices are determined by free market forces, they are subject to change, depending on the performance of the economy and on the economic policies of the government in a particular country. Changes in these prices can, and do significantly affect the value of cash flows in trading transactions, as well as the implicit values of foreign claims, investments, and obligations. Over the past two decades, an important development has been the growth of multinational enterprises, companies that do business in other countries. As a result, there has been an increase in the volume of import-export, and other related transactions. In addition, over the past decade, a dramatic increase in international financial investment was observed especially in Euromarkets.
Consequently there was an increasing need for FX, that is, exchanging one currency for another to settle transactions and claims that arose from the above developments. Another factor that contributed to a dramatic increase for FX over the years is increased in demand for speculative activity. Although the purpose of the FXM is to facilitate trade and financial investment, market participants use the market more for speculation than anything else. Finally, the FX liberalization policies of industrialized countries' central banks has also led to an increase of FX trading. Over the past 10 years Germany, Great Britain, and Japan had undergone a series of loosened FX restrictions and regulations, thus liberating trade even more.
Although it is impossible to determine and isolate the effect of any of the above developments on the volume of FX turnover, we can definitely conclude that due to the reasons set forth above, there has been a dramatic increase in the demand and supply for FX..
The FXM, is by far the largest financial market in the world. The market is estimated to be in the range of $640 billion a day, as reported by the Bank of England, in its 1989 FX review, to $700 billion a day. Unlike other financial markets, the FXM has no physical location where trading takes place. It is an over-the-counter market and is based on telecommunications systems. The unique characteristic of the FXM is that it is a global market, and that trading is continuous 24 hours a day. Market participants are located around the world, and they trade using the most advanced telecommunications systems technology can offer. A transaction can take place, at any time of the day or night, between two parties that are located.
A nation's balance of payments has an important effect on the exchange rate of its currency. Bills of exchange, drafts, checks, and telegraphic orders are the principal means of payment in international transactions. The rate of exchange is the price in local currency of one unit of foreign currency and is determined by the relative supply and demand of the currencies in the foreign exchange market. Buying or selling foreign currency in order to profit from sudden changes in the rate of exchange is known as arbitrage. The chief demand for foreign exchange within a country comes from importers of foreign goods, purchasers of foreign securities, government agencies purchasing goods and services abroad, and travelers.
References:
- Angell Robert J., and Alonzo L. Redmon. "Inflation-indexed Treasuries: How Good Are They?" AAII Journal ( April 1998).
- Bolten Steven E., and Robert A. Weigand. "The Generation of Stock Market Cycles." The Financial Review ( February 1998).
- Graham Michael D. "Selection of Market Multiples in Business Valuation." Business Valuation Review ( March 1990)
- Hickman, W Braddock, 1952, "Trends and cycles in corporate bond financing," National Bureau of Economic Research, occasional paper, No. 37
- Ibbotson Associates. Stocks, Bonds, Bills and Inflation, 1999 Yearbook. Chicago, IL
- Liebowitz Martin L., and William S. Krasker. "The Persistence of Risk: Stocks versus Bonds over the Long Term." Financial Analysts Journal ( November/December 1988).
- Malkiel Burton G. "Equity Yields, Growth and the Structure of Share Prices." American Economic Review ( December 1963)
- Paul Keller, "The Market Approaches Critical Mass," Euromoney ( January 1989):67-73
- Roll Richard. "U.S. Treasury Inflation-indexed Bonds: The Design of a New Security." Journal of Fixed Income ( December 1996).
- Solnik Bruno. "The Relationship Between Stock Prices and Inflationary Expectations." Journal of Portfolio Management ( spring 1992).
