LECTURE NOTES ON STOCK MARKET: CHAPTER 8

1. Stock Market Overview

 What is a Stock Market?
The stock market is a public marketplace where buyers and sellers trade
company shares and other securities like bonds. It is fundamental to capital
formation for companies and investment opportunities for individuals.
2. Stock Market Securities
 Common Stock:
Common stock represents ownership in a company and typically comes with
voting rights. Investors in common stocks benefit from dividends (if declared)
and capital appreciation. However, they are last in line during liquidation,
meaning they bear more risk.
 Preferred Stock:
Preferred stockholders have a higher claim on dividends and assets during
liquidation than common stockholders. They usually do not have voting rights,
but their dividends are generally fixed and paid out before common stock
dividends.
3. Primary and Secondary Markets
 Primary Market:
In the primary market, companies issue new shares or securities directly to
investors (e.g., through Initial Public Offerings or IPOs). This is how businesses
raise capital to fund operations, expansion, or new projects.
 Secondary Market:
Once shares are issued in the primary market, they are traded between investors
in the secondary market (e.g., stock exchanges like the Philippine Stock
Exchange). This is where the majority of stock trading occurs, providing liquidity
and price discovery.

4. Stock Market Indexes

 Stock market indexes (like the PSEi in the Philippines or the S&P 500 globally)
are benchmarks that track the performance of a group of stocks. They give
investors a snapshot of the overall market or a particular sector’s performance,
helping assess trends and compare individual stock performance.
Detailed Lecture Notes on Stock Market Indexes
Introduction:
Stock market indexes are an essential tool for understanding market trends and
gauging the overall performance of a set of stocks. They provide a simplified
representation of a specific market segment or the entire stock market. For investors,
analysts, and students of finance, stock market indexes are vital benchmarks for
assessing economic performance and making investment decisions.

What is a Stock Market Index?

Page 1 of 11
A stock market index is a statistical measure that reflects the performance of a group
of selected stocks, representing either the whole market or a specific sector within the
market. The purpose of an index is to provide a snapshot of the market or sector's
overall movement, helping investors track market trends over time.
Think of it as a barometer: just like a barometer measures air pressure and gives us an
idea of the weather, a stock market index measures the movement of selected stocks
and gives us an idea of the "financial weather" – how well a segment of the economy is
doing.

How Stock Market Indexes are Constructed:

1. Selection of Stocks:
o Stocks are chosen based on certain criteria, which can include market
capitalization (the total value of all shares of a company), industry sector,
trading volume, or other factors that reflect the overall market's condition.
o In the Philippines, for instance, the Philippine Stock Exchange Index
(PSEi) includes 30 of the largest and most actively traded companies in
the country, representing a wide array of industries from banking to
telecommunications.
2. Weighting of Stocks:
o Most indexes are market-cap weighted, meaning that companies with
a larger market capitalization (share price multiplied by the number of
shares) have a more significant impact on the index's performance.
o Other indexes might be price-weighted, where the influence of each
stock depends on its price (e.g., the Dow Jones Industrial Average in the
U.S.).

Key Examples of Stock Market Indexes:

1. Philippine Stock Exchange Index (PSEi):
o Description: The PSEi is the main index that tracks the performance of
the top 30 companies listed on the Philippine Stock Exchange (PSE).
These companies are from various sectors like financials (e.g., BDO
Unibank), industrial (e.g., San Miguel Corporation), and services (e.g.,
PLDT).
o Real-life Example: In March 2020, during the onset of the COVID-19
pandemic, the PSEi fell by almost 40%, from around 7,300 points in
January to under 4,500 points by mid-March. This drop reflected investors'
concerns over the economic impact of the pandemic on Philippine
businesses. However, by 2021, as the economy started to recover and
vaccines were rolled out, the PSEi began to rise again, reflecting renewed
investor confidence.
2. S&P 500 (U.S.):

Page 2 of 11
 o Description: The S&P 500 is one of the most widely followed stock
market indexes in the world. It tracks the performance of 500 of the
largest companies listed on U.S. stock exchanges. Companies like Apple,
Microsoft, and Amazon are key components of this index.
o Real-life Example: In early 2020, the S&P 500 experienced a sharp
decline due to the global pandemic, dropping by 34% from its peak in
February 2020. However, by the end of the year, the index had not only
recovered but reached new highs, driven by the surge in technology
stocks and the resilience of the U.S. economy.
3. Nikkei 225 (Japan):
o Description: The Nikkei 225 is a price-weighted index that tracks the
performance of 225 of the largest publicly traded companies in Japan.
These include companies like Toyota, Sony, and Softbank.
o Real-life Example: Following the 2011 earthquake and tsunami in Japan,
the Nikkei 225 dropped significantly due to concerns about the damage to
the Japanese economy. However, it gradually recovered in the following
years as reconstruction efforts and government policies helped restore
investor confidence.

Types of Stock Market Indexes:

1. Broad Market Indexes:
o These indexes represent the entire stock market or a large portion of it.
o Example: The Philippine Stock Exchange Composite Index (PSEi)
is a broad market index that gives an overview of the largest companies in
the Philippines.
2. Sector Indexes:
o These indexes focus on specific sectors or industries.
o Example: The PSE Financials Index in the Philippines tracks the
performance of the financial sector, including banks and other financial
institutions.
3. Global Indexes:
o These indexes track stocks across multiple countries and regions.
o Example: The MSCI World Index tracks large and mid-cap stocks
across 23 developed markets, giving investors an idea of global economic
trends.

Why Stock Market Indexes are Important:

1. Benchmarking Performance:
o Stock indexes provide a standard for comparing individual stock
performance. Investors often compare their portfolio’s returns with that of

Page 3 of 11
 a benchmark index like the PSEi to assess whether they are outperforming
or underperforming the market.
o Real-life Example: If an investor holds a diversified portfolio of
Philippine stocks and the PSEi grows by 10% in a year while their portfolio
grows by only 6%, it suggests that their stock selection might have
underperformed the broader market.
2. Understanding Market Sentiment:
o Indexes reflect the general sentiment of investors. When an index rises, it
indicates that the market is generally optimistic. When it falls, it often
reflects concerns or pessimism about the economy.
o Real-life Example: The steep decline in the S&P 500 and PSEi during
the COVID-19 pandemic showed widespread pessimism about the global
economy. Conversely, the rise of these indexes in 2021 and 2022 reflected
growing optimism about economic recovery.
3. Investment Products Based on Indexes:
o Many financial products, such as Exchange Traded Funds (ETFs) and
Index Mutual Funds, are built to mirror the performance of a stock
index. This allows investors to invest in an entire market or sector without
picking individual stocks.
o Real-life Example: The PSEi ETF in the Philippines mirrors the
performance of the PSEi index, giving investors exposure to the 30 largest
companies in the country through one investment product.

Real-Life Applications for Students:

1. Investing in Index Funds:
o Students who are learning about personal finance and investments can
use stock market indexes to inform their investment decisions. For
instance, instead of trying to pick individual stocks, investing in an index
fund that tracks the PSEi or S&P 500 provides exposure to the overall
market with lower risk and less research.
2. Tracking Economic Conditions:
o By following the movements of stock indexes, students can get a better
understanding of how macroeconomic factors (like interest rates, inflation,
and global events) influence stock markets. For example, when the
Federal Reserve (U.S. Central Bank) raises interest rates, stock markets
like the S&P 500 often react by dropping, as higher borrowing costs can
slow economic growth.

5. Participants in the Stock Market

Page 4 of 11
  Investors and Traders:
Individuals or institutions buying and selling stocks. Investors typically focus on
long-term growth, while traders look for short-term profits.
 Brokers and Dealers:
Brokers act as intermediaries, executing buy or sell orders for clients, while
dealers buy and sell stocks for their own accounts.
6. Economic Indicators
 Indicators such as GDP growth, inflation, unemployment rates, and interest rates
have a direct influence on stock prices. A healthy economy generally leads to
rising stock prices, while economic downturns lead to falling prices.

Lecture Notes on Economic Indicators and Their Impact on Stock Markets

I. Introduction to Economic Indicators

 What are Economic Indicators? Economic indicators are statistical metrics
used to assess the overall health of an economy. They are key signals that help
investors, policymakers, and analysts predict future economic trends and make
informed decisions. These indicators can influence stock prices and investor
sentiment by providing insights into the economy's growth, stability, and future
potential.

II. Types of Economic Indicators

Economic indicators are usually categorized into three main types based on how they
relate to the business cycle:
1. Leading Indicators
o Indicators that change before the economy starts to follow a particular
trend. These indicators are used to predict future movements in the
economy.
o Examples:
 Stock market performance (itself can be a leading indicator of
economic growth or recession).
 Manufacturing activity (e.g., the Purchasing Managers' Index
(PMI)).
 New housing starts and building permits.
2. Lagging Indicators
o Indicators that change after the economy has already begun to follow a
particular trend. These help confirm economic patterns.
o Examples:
 Unemployment rate.

Page 5 of 11
  Corporate profits.
 Consumer price index (CPI) for inflation.
3. Coincident Indicators
o Indicators that move at the same time as the economy. These provide
real-time data about the current state of the economy.
o Examples:
 Gross Domestic Product (GDP).
 Employment levels.
 Personal income.

III. Key Economic Indicators and Their Impact on Stock Markets

Let’s break down some of the most important economic indicators that significantly
impact stock markets.

1. Gross Domestic Product (GDP)

 Definition: GDP is the total monetary value of all goods and services produced
within a country over a specific time period (usually quarterly or yearly).
 Impact on Stock Markets:
A growing GDP generally signals a healthy economy, which is positive for stock
markets. When GDP grows, companies typically report better earnings, which
attracts investors and drives stock prices up. Conversely, shrinking GDP signals
economic contraction, which can lead to lower corporate earnings and falling
stock prices.
Real-life Example:
During the COVID-19 pandemic, many economies, including the Philippines,
experienced a sharp decline in GDP due to lockdowns and disruptions in business
activity. The Philippine GDP contracted by 9.5% in 2020—the largest annual decline
since 1946. This significant drop contributed to a major sell-off in the Philippine Stock
Exchange (PSE), where the PSE index (PSEi) plunged from around 7,800 points in
early 2020 to a low of about 4,600 points in March 2020.

2. Inflation Rate (Measured by CPI)

 Definition: Inflation is the rate at which the general level of prices for goods
and services is rising, and subsequently, purchasing power is falling. CPI
(Consumer Price Index) is a common measure of inflation.
 Impact on Stock Markets:
Moderate inflation is typically seen as a sign of a growing economy, but high
inflation can negatively impact the stock market. High inflation reduces consumer
purchasing power, increases the cost of borrowing, and squeezes corporate profit
margins. As a result, investors may sell stocks, leading to declining stock prices.

Page 6 of 11
Real-life Example:
In 2023, the Philippines experienced elevated inflation rates, reaching over 8% in the
early months. This contributed to rising input costs for businesses, especially in
industries reliant on imported goods like fuel. Companies in sectors like manufacturing
and retail faced shrinking profit margins, which led to weaker stock performance,
particularly in consumer discretionary sectors, as investors feared reduced profitability.

3. Unemployment Rate
 Definition: The unemployment rate measures the percentage of the total
workforce that is actively looking for work but unable to find employment.
 Impact on Stock Markets:
A rising unemployment rate typically signals economic distress. Higher
unemployment leads to lower consumer spending, which affects company
revenues and profits. This can cause stock prices to fall, especially in consumer-
driven sectors like retail and hospitality.
Real-life Example:
During the height of the COVID-19 pandemic in 2020, the Philippines saw
unemployment rise to 17.7% in April 2020 due to widespread lockdowns and business
closures. This spike in unemployment resulted in reduced consumer demand and
negatively impacted companies across sectors, leading to sharp declines in stock prices,
especially in retail, transportation, and services industries.

4. Interest Rates
 Definition: Interest rates are the cost of borrowing money, typically set by
central banks (e.g., the Bangko Sentral ng Pilipinas (BSP) in the Philippines).
The key rate, known as the policy rate, influences lending and borrowing across
the economy.
 Impact on Stock Markets:
Lower interest rates make borrowing cheaper, encouraging consumer and
business spending. This tends to boost stock markets as companies can invest in
growth, and consumers have more disposable income. Higher interest rates, on
the other hand, increase borrowing costs, which can slow down business
expansion and reduce consumer spending, negatively impacting stock prices.
Real-life Example:
In 2018, the BSP raised interest rates several times in response to rising inflation.
These rate hikes made it more expensive for companies to finance expansion through
debt, and as a result, many sectors, including real estate and consumer goods, saw
declines in their stock prices due to fears of reduced growth.

5. Consumer Confidence Index (CCI)

 Definition: The Consumer Confidence Index measures how optimistic or
pessimistic consumers feel about the economy’s prospects. High consumer
confidence suggests that consumers are likely to spend more, while low
confidence indicates that they may cut back on spending.

Page 7 of 11
  Impact on Stock Markets:
High consumer confidence leads to more spending, boosting corporate earnings
and stock prices, particularly in consumer-oriented sectors like retail, travel, and
entertainment. Low consumer confidence can lead to lower spending, hurting
company revenues and stock prices.
Real-life Example:
In 2019, the Philippines' Consumer Confidence Index was high due to strong economic
growth and low unemployment. This optimism led to a boom in consumer spending,
particularly in sectors like real estate, retail, and automotive, which saw stock prices rise.
However, in 2020, consumer confidence plummeted due to the pandemic, leading to
sharp drops in stocks tied to discretionary spending, such as tourism and luxury goods.

IV. Summary: Why Are Economic Indicators Important for Investors?

Economic indicators provide vital information about the current and future state of the
economy. Stock prices often move in anticipation of or in response to changes in these
indicators. Therefore, understanding these metrics can help investors predict market
trends and make better-informed decisions about when to buy or sell stocks.

7. Market Efficiency
 The Efficient Market Hypothesis (EMH) suggests that stock prices always
reflect all available information, making it impossible to consistently outperform
the market through stock selection or market timing. While debated, this theory
highlights the importance of informed investing.
8. Stock Market Regulations
 Stock markets are regulated by government agencies to protect investors, ensure
fair trading practices, and promote transparency. In the Philippines, the
Securities and Exchange Commission (SEC) regulates the market to
prevent fraud and manipulation.
9. International Aspects of Stock Markets
 Stock markets are interconnected globally. Events in major markets like the U.S.
or China can impact the Philippine stock market due to investor sentiment,
capital flows, and economic interdependence.
10. Capital Asset Pricing Model (CAPM)
 CAPM is a financial model used to determine the expected return of an asset,
taking into account its risk relative to the market (measured by beta) and the
risk-free rate of return. This model helps investors assess the potential risk and
reward of an investment.

Capital Asset Pricing Model (CAPM) – Detailed Lecture Notes

Introduction to CAPM

Page 8 of 11
The Capital Asset Pricing Model (CAPM) is a financial theory that attempts to
explain the relationship between the expected return of an asset and its risk. It’s widely
used in finance to determine a theoretically appropriate required rate of return for an
investment, given the investment's risk and the time value of money.
CAPM was introduced by William Sharpe in the 1960s and remains a cornerstone of
modern portfolio theory. It helps investors make informed decisions by quantifying the
risk-reward relationship.

What does this mean?

 The CAPM model helps investors calculate the required rate of return (also
called the expected return) on a particular stock or investment.
 It shows that the required return equals the risk-free rate plus a risk premium.
The risk premium is the additional return investors demand for taking on risk,
calculated by multiplying the stock's beta with the market risk premium.

Breaking Down the Components

1. Risk-Free Rate (Rf)
o This is the return on an investment with zero risk. Usually, long-term
government bonds or treasury bills are used as proxies for the risk-free
rate. In the Philippines, this could be the return on the Philippine
Treasury bills.
o Real-life example: If a government treasury bill yields 4%, this is
considered the risk-free rate.
2. Market Return (Rm)

Page 9 of 11
 o This is the average return expected from the stock market as a whole. In
the Philippine context, the Philippine Stock Exchange index (PSEi) is
often used to gauge the market's average return. If the PSEi returns 8%
annually, that is the market return.
o Real-life example: If over a year, the PSEi goes from 6,000 points to
6,480, the market return would be 8% [(6,480 - 6,000)/6,000].
3. Beta (β)
o Beta is a measure of a stock’s volatility relative to the market. A beta of
1 means the stock is expected to move with the market. A beta greater
than 1 means it’s more volatile than the market, while a beta less than
1 means it’s less volatile.
o Real-life example:
 PLDT Inc. may have a beta of 0.9, indicating it is slightly less
volatile than the market.
 Jollibee Foods Corporation (JFC) could have a beta of 1.2,
suggesting it’s more volatile than the market.
4. Market Risk Premium (Rm - Rf)
o The market risk premium is the difference between the expected
return of the market and the risk-free rate. This is essentially the extra
return an investor demands for investing in the stock market instead of a
risk-free asset.
o Real-life example:
 If the PSEi is expected to return 8% and the Philippine Treasury
bills offer 4%, the market risk premium would be 4% (8% -
4%).

Application of CAPM: Real-Life Example

Let’s take an example of a Philippine company like Ayala Corporation. Suppose an
investor is considering investing in Ayala’s stock. Using CAPM, we can calculate the
required rate of return on Ayala Corporation's stock.
 Risk-free rate (Rf): 4% (Philippine Treasury bills)
 Beta (β): 1.1 (Ayala Corporation's stock is slightly more volatile than the market)
 Market return (Rm): 8% (estimated return of the PSEi)
Now, using the CAPM formula:
Expected Return=4%+1.1×(8%−4%)\text{Expected Return} = 4\% + 1.1 \times (8\%
- 4\%)Expected Return=4%+1.1×(8%−4%)
Expected Return=4%+1.1×4%=4%+4.4%=8.4%\text{Expected Return} = 4\% + 1.1
\times 4\% = 4\% + 4.4\% = 8.4\%Expected Return=4%+1.1×4%=4%+4.4%=8.4%
Thus, according to CAPM, the required rate of return on Ayala Corporation's stock is
8.4%. This means investors should only invest in Ayala Corporation if they expect to
earn at least 8.4% on their investment, given the stock’s risk profile.

Page 10 of 11
CAPM and Investment Decisions
The CAPM provides a benchmark for making investment decisions. If an investment’s
expected return is higher than the CAPM-required return, it might be considered a
good investment because the return justifies the risk. Conversely, if the expected return
is lower than the CAPM-required return, the investment may not be worth the risk.
 Real-life scenario:
Imagine a tech company in the Philippines that is highly volatile, like Converge
ICT Solutions, Inc., with a beta of 1.5. According to CAPM, investors would
demand a higher return from Converge than from more stable stocks like PLDT,
which may have a beta closer to 1. This ensures that investors are compensated
for the additional risk they take on with more volatile stocks.

Limitations of CAPM
While CAPM is widely used, it has limitations:
1. Assumptions of Market Efficiency: CAPM assumes that all investors have
access to the same information and that markets are perfectly efficient. However,
in reality, markets can be inefficient, and some investors have access to better or
more timely information than others.
2. Single-factor Model: CAPM only considers one type of risk (systematic risk
measured by beta). In reality, there are many other factors affecting stock
returns, such as company-specific risks, macroeconomic variables, or political
risks.
3. Historical Data: Beta is typically calculated based on historical data, but past
performance is not always a reliable predictor of future risk.
4. Risk-Free Rate Variability: The assumption of a constant risk-free rate is not
always realistic, as it can change due to economic or policy shifts.

Conclusion: Why CAPM is Important

The Capital Asset Pricing Model (CAPM) is a crucial tool for understanding the
trade-off between risk and return. It helps investors make rational investment decisions
by quantifying the risk associated with a particular stock and comparing it to a
theoretical required return.
By using CAPM, investors can:
 Assess whether an asset is over- or under-valued.
 Make informed decisions about which stocks to include in their portfolio.
 Understand the risk associated with different types of assets in comparison to
the overall market

Page 11 of 11