Econ 2050 Money and Finance - Equity Markets Complete Study Guide

Historical Origins and Evolutionary Milestones of Equity Markets

• Foundations of the Modern Joint-Stock Model

  • The United Dutch Chartered East India Company (VOC): Recognised as the first true prototype of the modern, perpetual, limited, and joint-stock company. It was the largest private enterprise of the $17th$ century.

  • Secondary Markets and the First Exchange: VOC shares were traded in a secondary market, which facilitated the creation of the world’s first stock market in Amsterdam.

  • Credit and Equity Linkage: The Amsterdam Exchange Bank established a critical link between credit and stock markets by accepting VOC shares as collateral for loans.

  • Corporate Governance: The concept of a ‘Board’ to represent shareholder interests emerged from corporate governance reforms within the VOC.

  • Replication: The VOC model was subsequently replicated by England’s East India Company, which had a globally significant impact.

• Timeline of Key International and Australian Developments

  • $1680$: ‘Jonathan’s Coffee House’ in Change Alley, London, began issuing a weekly list of stock and commodity prices for stockbrokers. At this time, approximately $150$ joint-stock companies existed in England.

  • $1792$: The ‘Buttonwood Agreement’ was signed by $24$ stockbrokers and merchants on Wall Street, New York, establishing rules for securities dealing.

  • $1801$: The London Stock Exchange (LSE) was formalised.

  • $1817$: The New York Stock and Exchange was formalised.

  • $1829$: In Australia, over-the-counter (OTC) trading began for the shares of the Bank of New South Wales (now Westpac).

  • $1830s$: The New York Stock Exchange (NYSE) became a critical tool for aggregating capital for American railroads, which became the dominant business for the exchange.

  • $1867$: The introduction of the ‘Ticker Tape’ allowed common prices to be transmitted to investors across different locations.

  • $1871$: The Sydney Stock Exchange was established.

  • $1895$: New NYSE rules required listed companies to publish annual reports to improve transparency.

  • $1896$: The ‘Dow Jones Industrial Average’ (DJIA), the first prominent stock index, was published by the Wall Street Journal. Its initial value was $40.7$. (By April $2026$, it reached $49,149$).

• Crashes, Regulations, and Deregulation

  • $1907$: The largest stock market crash to that date occurred in October, eventually ended by the intervention of J.P. Morgan.

  • $1923$ - $1929$: A significant bull market on Wall Street led into the Great Crash of October $1929$. Share prices plummeted by $89\%$ from the peak and did not recover to their $1929$ levels until $1954$.

  • $1934$: The Securities and Exchange Commission (SEC) was created in the United States to regulate securities trading.

  • $1975$: The era of fixed commissions for brokers ended, triggering a new era of competition. Australia followed with similar deregulation in $1984$.

  • $1987$: On Black Monday, the NYSE experienced its largest one-day fall, dropping $508\,\text{points}$ or $22.6\%$. This led to the introduction of ‘circuit breakers’ to pause trading during extreme volatility.

  • $1990$: Open pit trading ended in Australia, transitioning to electronic systems.

  • $1991$: The Australian Securities Commission (later ASIC) was created for regulatory oversight.

  • $2000$: The Dot.Com bubble burst.

  • $2008$ - $2009$: The Global Financial Crisis (GFC) triggered the ‘Great Recession’.

  • $2020s$: This era has been defined by the Covid-19 pandemic and political divisions, alongside the rise of the ‘Magnificent Seven’ tech stocks and a sustained bull market.

Types of Equity Securities

• Ordinary Shares (Stock)

  • Definition: The fundamental form of corporate ownership.

  • Residual Claims: Ordinary shareholders rank last in the event of a company’s liquidation or wind-up.

  • Dividends: No special dividend rights; payments are based on company performance.

  • Voting Rights: Usually follows the ‘one share, one vote’ principle. In practice, many shareholders utilize proxy voting.

  • Dividend Imputation (Australia, $1987$): A tax system that prevents double taxation on company profits. It makes dividends more tax-effective for shareholders and reduces the tax bias that previously favoured debt over equity in corporate fundraising.

• Preference Shares

  • Definition: Ownership stakes that provide specific advantages over ordinary shares, making them resemble debt instruments.

  • Priorities: Preference shareholders receive dividends before ordinary shareholders (often as a fixed obligation similar to interest) and have a higher claim on assets during liquidation.

  • Types of Preference Shares:

    • Non-participating: Dividends remain constant even if the firm’s returns exceed expectations.

    • Participating: Allows shareholders to receive higher dividends if the company performs exceptionally well.

    • Redeemable: The company has the right to buy back these shares, sometimes at a fixed redemption date.

    • Irredeemable: The company does not have a buy-back right at a set date.

    • Convertible: Can be converted into ordinary shares at a predetermined ratio at the discretion of the issuer or holder.

    • Adjustable Rate: Dividend payments are periodicially adjusted in line with changes in market interest rates.

Primary Equity Markets: Issuance and Capital Raising

• Mechanisms of New Equity Issues

  • Underwriting and Agents: Investment banks often act as agents, underwriters, or market-makers. The underwriter ensures the issuer receives the required capital (for a fee) by agreeing to take on the risk of the market.

  • Initial Public Offerings (IPOs): Primary method for start-ups or private companies to ‘go public’.

    • Book Building: Investment banks call for bids from major institutions for blocks of shares to determine a likely public offering price.

    • Notable IPO Examples: Saudi Aramco ($25.6\,\text{B}$, $2019$), Alibaba Group ($21.8\,\text{B}$, $2014$), SoftBank Corp ($21.4\,\text{B}$, $2018$), Visa ($18.1\,\text{B}$, $2008$), Meta ($16.0\,\text{B}$, $2012$).

    • Direct Listings: Example: Spotify.

    • Special Purpose Acquisition Companies (SPACs): Examples: Virgin Galactic Holdings, Nikola.

  • Private Placements: Direct negotiations organized by investment banks with large institutional investors.

• Alternative Capital Raising Methods

  • Dividend Reinvestment Schemes (DRS): Investors receive additional shares instead of cash dividends. In Australia, these remain taxable similarly to cash dividends.

    • Example Calculation:

      • Current Holdings: $10,000\,\text{shares}$

      • Dividend: $17\,\text{cents}\text{/share}$

      • Gross Dividend: $10,000 \times 0.17 = \$1,700$

      • Market Value: $\$8.50\text{/share}$

      • DRS Discount ($2\%$): $\$8.50 \times 0.98 = \$8.33$

      • New Shares Received: $\frac{\$1,700}{\$8.33} \approx 204\,\text{shares}$

      • Total Holding Post-DRS: $10,204\,\text{shares}$

  • Rights Issues: Existing shareholders are offered the opportunity to buy new shares at a discount relative to the market price, usually proportional to their current holding.

    • Renounceable Rights: These rights can be sold to other parties on the market.

    • Non-renounceable Rights: These rights cannot be sold; the shareholder must either exercise them or let them lapse.

Secondary Equity Markets and High-Frequency Trading

• Function of Secondary Markets

  • Secondary markets involve the trading of previously issued securities. Most Australians interact with this market via the Australian Securities Exchange (ASX).

  • Capital Accumulation: These markets provide liquidity, allowing equity holders to convert stock into money quickly and at minimal cost.

• High Frequency Trading (HFT)

  • Mechanism: Uses ultra-fast fibre-optic cables and computer algorithms to execute trades in millionths of a second (near light-speed) to pre-empt other market participants.

  • Controversy and Risks:

    • Market Confidence: Concerns that the market is ‘rigged’ against standard investors.

    • Stability: Critics fear that the complexity and volume of HFT could cause events like the ‘flash crash’.

  • Arguments in Favour: Proponents argue HFT adds liquidity, depth, and enhances ‘price discovery’.

  • Note: The movie The Hummingbird Project (2019) explores this topic.

Stock Indices, Index Funds, and ETFs

• Construction and Utility of Indices

  • Selection Criteria: Stocks are included based on market capitalisation, industry sectors (financials, resources, etc.), or the full list of companies.

  • Utilities: Provide historical perspectives, serve as a yardstick for portfolio performance, and act as forecasting tools for investment decisions.

  • Weighting Methods:

    • Price-Weighted: Sum of share prices divided by a ‘divisor’. (Example: DJIA used a divisor of $12$ for its original $12$ stocks; it now uses a ‘Dow Divisor’ for its $30$ stocks).

    • Market-Value Weighted: Weight of each company determined by multiplying its shares by market price.

• Key Global and Local Indices

  • S&P/ASX 200: The premier Australian index; market-weighted, containing the $200$ largest/most liquid stocks, representing $86\%$ of the market (as of April $2026$).

  • All Ordinaries (All Ords): Broader index in Australia representing the top $500$ companies ($93\%$ of market cap).

  • NASDAQ: Market-weighted index across three categories (industrial, banks, insurance).

  • S&P 500: $500$ leading US companies (~$80\%$ of US market cap).

  • FTSE 100: Top $100$ LSE companies (~$80\%$ of market cap).

  • Hang Seng: Top $33$ HKEX companies (~$70\%$ of market cap).

• Index Funds and ETFs

  • Origins: First Index Fund created in $1976$ by Jack Bogle (Vanguard). First ETF was the SPDR (‘Spider’) in $1992$ tracking the S&P 500.

  • Growth: Global ETF assets under management reached $US\$7.7\,\text{trn}$ by the end of $2020$, with approximately $8,000$ varieties.

  • Justifications: Diversification, lower costs, and long-term growth.

  • Major Providers: SPDR, i-shares (Blackrock), and Vanguard.

  • Specialized ETF Risks:

    • Synthetic ETFs: Use derivative contracts (like swaps) instead of holding underlying assets. This introduces counterparty risk.

    • Leveraged ETFs: Use debt and derivatives to amplify returns, inheriting the risks of high leverage.

• Future Consideration: The potential impact of share tokenisation on trading and counterparty risks.