THE LIQUIDITY PREMIUM THEORY:Essential Characteristics of Common Stock

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Money & Banking MGT411

Lesson 18

THE LIQUIDITY PREMIUM THEORY

Bonds

Liquidity Premium Theory

Stocks

Essential Characteristics

Process

Measuring Level of a Stock Market

Valuing Stocks

The Liquidity Premium Theory

Risk is the key to understanding the slope of the yield curve

The yield curve's upward slope is due to long-term bonds being riskier than short-term

bonds

Bondholders face both inflation and interest-rate. The longer the term the greater the

inflation and interest-rate risk

Inflation risk increases over time because investors, who care about the real return, must

forecast inflation over longer periods.

Interest-rate risk arises when an investor's horizon and the bond's maturity do not match. If

holders of long-term bonds need to sell them before maturity and interest rates have

increased, the bonds will lose value

Including risk in the model means that we can think of yield as having two parts:

Risk-free and

Risk premium

i1t + i1et +1 + i1et + 2 + .... + i1et + n -1

int = rp n +

Pure expectations theory

Risk premium

Figure: Relationship between the Liquidity Premium and Expectations Theories

Liquidity Premium Theory Yield curve

Liquidity

premium

Expectations Theory Yield curve

(If short term interest rates are expected to remain

constant)

Time to maturity

Money & Banking MGT411

Again, we arrive at the same three conclusions about the term structure of interest rates

Interest rates of different maturities tend to move together.

Yields on short-term bonds are more volatile than those on long-term bonds.

Long-term yields tend to be higher than short-term yields

Stocks: An Introduction

Stocks provide a key instrument for holding personal wealth as well as a way to diversify,

spreading and reducing the risks that we face

For companies, they are one of several ways to obtain financing.

Additionally,

Stocks and stock markets are one of the central links between the financial world and the real

economy.

Stock prices are fundamental to the functioning of a market-based economy

They indicate the value of the companies that issued the stocks and,

They allocate scarce investment resources

The firms deemed most valuable in the marketplace for stocks are the ones that will be able to

obtain financing for growth. When resources flow to their most valued uses, the economy

operates more efficiently

Most people see stock market as a place where fortunes are easily made or lost, and they recoil

at its unfathomable booms and busts.

Great American Depression (1929)

Post-September 11, 2001 scenario

Pakistan stock market on roller-coaster-ride (March 2005)

What happens in reality?

Stock prices tend to rise steadily and slowly, and

Collapse rarely when normal market mechanisms are out of alignment

For most people the experience of losing or gaining wealth suddenly is more memorable than

the experience of making it gradually.

By being preoccupied with the potential short-term losses associated with crashes, we lose sight

of the gains we could realize if we took a longer-term view

Essential Characteristics of Common Stock

Stocks, also known as common stock or equity, are shares in a firm's ownership

From their early days, stocks had two important characteristics that today are taken for granted:

The shares are issued in small denominations and

The shares are transferable

Until recently, stockowners received a certificate from the issuing company, but now it is a

computerized process where the shares are registered in the names of brokerage firms that hold

them on the owner's behalf

The ownership of common stock conveys a number of rights

A stockholder is entitled to participate in the shares of the enterprise, but this is a residual claim

i.e. meaning the leftovers after all other creditors have been paid.

Stockholders also have limited liability,

Even if a company fails, the maximum amount that the stockholder can lose is the initial

investment

Stockholders are entitled to vote at the firm's annual meeting including voting to elect (or

remove) the firm's board of directors

Following are some salient features of stock trading

1. An individual share represents only a small fraction of the value of the company that

issued it

2. A large number of shares are outstanding

3. Prices of individual shares are low, allowing individuals to make relatively small

investments

Money & Banking MGT411

4. As residual claimants, stockholders receive the proceeds of a firm's activities only after

all other creditors have been paid

5. Because of limited liability, investor's losses cannot exceed the price they paid for the

stock; and

6. Shareholders can replace managers who are doing a bad job

Measuring the Level of the Stock Market

Stocks are one way in which we choose to hold our wealth, so when stock values rise we get

richer and when they fall we get poorer

These changes affect our consumption and saving patterns, causing general economic activity to

fluctuate

We need to understand the dynamics of the stock market, in order to

Manage our personal finances and

See the connections between stock values and economic conditions

Stock market indexes

Designed to give us a sense of the extent to which stock prices are going up or down

Tell us both how much the value of an average stock has changed, and how much total wealth

has gone up or down

Provide benchmarks for performance of money managers, comparing how they have done to the

market as a whole

Every major country in the world has a stock market, and each of these markets has an index

For the most part, these are value-weighted indices

To analyze the performance of these different markets it is useful to look at percentage changes,

but percentage change isn't everything

The Dow Jones Industrial Average

The Standard & Poor's 500 Index

NASDAQ Composite index

Financial Times Stock Exchange 100 Index

Hang Seng 100

Nikkei 225

KSE 100 Index

The KSE100

It contains a representative sample of common stock that trade on the Karachi Stock Exchange.

The KSE stocks that comprise the index have a total market value of around Rs. 1,197 Billion

compared to total market value of Rs. 1,365 Billion for over 679 stocks listed on the Karachi

Stock Exchange.

This means that the KSE100 Index represents 88 percent of the total market capitalization of the

Karachi Stock Exchange, as of February, 2004

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