Are you thinking about investing in stocks to make some extra income? Are you unsure about how the stock market works? Well, today we are going to dig deep into the stock market and talk about what is a stock market, its history, its functions, and how stock market works including how stock prices are determined.
What is a Stock Market?
Stock markets are defined as the forum which brings together investors and facilitates them in buying and selling public equities, commonly known as shares or stocks. The stock market is a broad term and it comprises both primary and secondary markets with a combination of over-the-counter (OTC), stock exchanges, and electronic transfer.
Depending on the confidence and perceptions of investors, the stock market can be classified as a bull or bear market. In simple terms, a bull or bullish market is where investors are investing heavily in stocks because of their expectations of higher profits in the future. On the contrary, a bear or bearish market is one where investors are trying to discard their shares as they expect a loss in the future.
History of the Stock Market
The idea of developing a stock market originated in 1531 when an institution nearly reflecting stock markets was developed in Antwerp, Belgium. However, there was no trade of stocks rather the institution was used as a forum where brokers and lenders deal in government, business, and individual debt issues.
However, things changed in the 1600s as Britain, France, Netherlands, and other European countries chartered voyages to East Indies. Soon they realized that overseas trade with Asia was not only expensive but also risky because of the danger of ship loss, the sinking of ships, and pirate attacks. Therefore, limited liability corporations were set up to raise finance from the investors who in return would get a share of the profit.
Another amazing development was the establishment of the first-ever public limited company. In 1599, merchants of European countries formed a corporation that would restrict each member’s liability to the amount invested by him. This was appreciated by the Queen of England who granted a fifteen-year charter of trade to the corporation commonly known as East India Company. With growing success and power in trade, the company launched its IPO and became the first company to issue shares in history. This set the foundation of ever-growing stock markets.
Functions of Stock Market
Transaction of Shares
The primary and most important purpose of the stock market is to bring buyers and sellers on a single platform where they could trade shares depending on the market-clearing price determined by the market forces of demand and supply.
Ensure Fair dealings and Safety of Transactions
The stock market provides safety, security, and fair dealing while performing transactions. This is because only listed public companies are traded. To ensure that the stock market is safe for investors, stock market authorities verify the integrity of the corporation before listing it on the trade list. Moreover, those companies listed on the trade list are bound to follow certain rules and regulations in order to continue stock trading. This ensures safety and security for both buyer and seller of the shares.
Economic Indicator
The stock market serves as a reliable indicator of the economic condition of a country. Any changes, ranging from the balance of payment (BOP) to government borrowing, in the economic conditions, are reflected by the stock market. If the economy is at its boom, stock prices would rise as with economic progress investors confidence increases. On the contrary, a recession stage of the economy results in a fall in stock prices. Due to the cause and effect relationship between the economy and stock prices, the stock market is rightly referred to as the pulse of the economy.
Capital Formulation in an Economy
The capital formulation is another key function of the stock market. Being a public limited company listed on a stock market provides an opportunity for corporations to expand their operations which would be financed from capital generated from shares. From an investor’s point of view, the purchase of shares would not only benefit them from dividends but also from capital gain which results from selling shares at a higher price than what it originally cost.
Moreover, since the stock market reflects the economic conditions, a healthy stock market index can bring in foreign direct investment leading to a boost in the economy and more capital formulation.
Inculcates the Habit of Savings and Investment
The stock market investment is one of the ways of managing money as it provides attractive stock investment opportunities. This encourages people to save and invest in valuable assets rather than heavily spending on luxurious non-valuable items. Thus, the stock market inculcates the habit to save and invest more.
How stock market works?
Stock markets, under a defined set of regulations, operate both as primary and secondary markets. The stock market, operating as a primary market, assists companies to sell their shares for the first time to the general people through a process called IPO (Initial Public Offering). In order to execute an IPO, the company must be registered as a public limited company and must have an authorized number of shares that it can issue.
Commonly, public companies issue a proportion of the authorized share capital. Hence, the IPO enables the issuing company to raise large amounts of capital for expansion purposes. On the other side, investors to whom shares are issued would hold these for their preferred duration in an expectation of an increase in share prices. During this time span, investors/shareholders would receive annual dividends, a proportion of the profits earned by the company. The stock market in return would charge a service fee from the company and its financial partners.
This ends the role of stock markets as the primary market. The actual fun takes place in the secondary market.
After the IPO, the stock market serves as the platform for regular buying and selling of shares which constitutes the secondary market. For each activity in the secondary market, stock market authorities charge fees from both seller and buyer. Along with facilitating regular trade of shares, it is also responsible for ensuring price transparency, liquidity, and safety of transactions. Moreover, it also maintains all the news, announcements, and financial details of companies to provide transparency to the investors and maintains indicators such as S&P 500, KSE 100, and Nasdaq 100 index to measure the movement of the stock market.
How Stock Prices Are Determined?
There are numerous ways in which stock prices are determined but the most commonly used method is through auction in which buyers and sellers interact. The buyers place a bid which is the maximum price they are willing to pay. By contrast, sellers place an offer which is the price sellers are willing to accept. This, therefore, demonstrates the law of demand and supply. So when the bid and offer price equate, trade takes place. So how does this actually happen? Similar to the price mechanism in the goods market, the stock market uses the same fundamentals in driving share prices. For prices to remain in equilibrium, the number of buyers must be equal to the number of sellers.
However, an imbalance would put pressure on prices and create two scenarios.
Scenario 1: Demand exceeds Supply. If the number of buyers exceeds the number of sellers then this would lead to an increase in bid price from the buyers so they can obtain their desired shares. Similarly, seeing the opportunity to sell shares at higher prices sellers would also raise their ask price to the point where it matches the bid price. Hence, a transaction would take place.
Scenario 2: Supply exceeds demand. If the sellers of shares exceed the buyers then sellers would reduce their ask price. Seeing this opportunity more buyers would enter the market which would increase the bid price up to the point where both bid and ask price meet, hence increasing the share prices and resulting in a trade.
Since there are hundreds and thousands of buyers and sellers in the market with different evaluations of particular shares so when they trade, it leads to minute-by-minute changes in stock prices. Hence, the stock market plays a vital role in supervising this minute-by-minute process, leading to smooth transactions between the two parties.
Conclusion
The stock market plays a vital role in evaluating the performance of a company. Such a setting bridges the gap between investors and organizations by eliminating the information asymmetry. The Stock Market, through its functions of making capital more accessible, has enabled large organizations such as Microsoft, Facebook, Google, Amazon, and many more to establish their mark globally. Not only has it positively impacted corporations but also enabled economies as a whole to grow rapidly and develop.
