Key Concepts in Stock and Foreign Exchange Markets

Common Stock

Represents ownership in a company, with voting rights and variable dividends.

Preferred Stock

No voting rights but receives fixed dividends before common shareholders.

Dividend

A portion of a company's profits paid to shareholders.

Dividend Yield

Dividend per share divided by stock price; shows return from dividends.

Equity

Ownership stake in a company; represents shareholders' claims after debts are paid.

Efficient Markets Hypothesis (EMH)

The idea that stock prices reflect all available information, making it impossible to consistently 'beat the market.'

Financial Arbitrage

Profiting from price differences of the same asset in different markets (buy low, sell high instantly).

Gordon Growth Model / Dividend Discount Model

A formula for valuing a stock based on expected future dividends and required return: P = D1 / (r - g) where P = price, D1 = next year's dividend, r = required return, g = dividend growth rate.

Over-the-Counter (OTC) Market

A decentralized market where stocks and other securities are traded directly between parties rather than on a formal exchange.

Random Walk Theory

Suggests stock price movements are unpredictable and follow no clear pattern.

Required Return on Equities

The minimum return investors expect from a stock, considering risk and alternative investments.

Stock Exchange

A marketplace where stocks and other securities are bought and sold (e.g., NYSE, NASDAQ).

Stock Market Index

Measures the overall performance of a group of stocks (e.g., S&P 500, Dow Jones).

Supply and Demand Shifters for Stocks

Demand increases when investors expect higher earnings or lower risk. Supply increases if companies issue more stock.

Growth of Dividends & Fundamentals

Stocks with higher expected dividend growth and strong fundamentals (profitability, revenue growth) tend to be valued higher.

Expected Capital Gains

Investors consider both dividends and expected price increases when valuing stocks.

Price Changes Due to Required Return on Equity

If required return (r) increases, stock prices fall. If risk decreases, required return falls, boosting stock prices.

Appreciation of Currency

A currency gains value relative to another (e.g., USD rises against EUR).

Depreciation of Currency

A currency loses value relative to another.

Arbitrage (Foreign Exchange Context)

Buying currency in one market and selling in another for profit due to exchange rate differences.

Direct Quotation

Domestic currency per unit of foreign currency (e.g., USD/GBP = 1.30 means 1 GBP = $1.30).

Indirect Quotation

Foreign currency per unit of domestic currency (e.g., GBP/USD = 0.77 means $1 = 0.77 GBP).

Exchange Rate Risk

The uncertainty of future exchange rate movements affecting international transactions and investments.

Foreign Exchange Market

The global marketplace for buying and selling currencies.

Interest-Rate Parity (IRP)

The idea that interest rate differences between two countries should equal the expected change in exchange rates.

Nominal Exchange Rate

The current market rate of currency exchange.

Real Exchange Rate

Adjusted for price level differences (inflation) between countries.

Purchasing Power Parity (PPP)

Theory stating that exchange rates should adjust to equalize the purchasing power of different currencies (e.g., $1 should buy the same amount of goods in the U.S. as the equivalent in GBP in the UK).

Relationship Between Exchange Rates and Real GDP

A weaker domestic currency boosts exports (cheaper for foreign buyers), increasing GDP. A stronger currency reduces exports but makes imports cheaper.

Effect of Arbitrage and Foreign Exchange Rates on Bond Yields

Higher interest rates attract foreign investors, increasing demand for the currency and strengthening its value.

Determinants of Foreign Exchange Rates

Interest rates, inflation rates, economic stability, and trade balances influence exchange rates.