Equity - markets and volatility:

Before we go on to discuss equity markets, let us discuss the role that equity markets play in the economy. We shall use the term stock market and stock exchange interchangeably. What does a stock exchange do? It provides the regulation of company listings, a price formation mechanism, the supervision of trading, authorisation of members, settlement of transactions and  publication of trade data and prices.

Equity markets consist of primary markets and secondary markets. The primary market is the market for new issues of shares, where shares are initially offered to the public. The secondary market, on the other hand, is the market for already- issued financial assets. The main difference between the two markets is that in the secondary market the issuer of the share does not receive funds from the buyer.

Rather, the existing issue changes hands in the secondary market, and funds flow from the new buyer of the share to the original buyer. Equity capital is ownership capital. It is the shareholders who collectively own the company. They undertake the risks, but also earn the rewards of ownership. The amount of capital that a company can issue is the authorised capital. The amount of capital that a company actually offers to investors is the  issued capital.  The part of capital subscribed by investors is called the paid-up capital. The par value is the face value of the share. When the issue price is greater than the par value, the difference is called the equity premium. The book value of an equity share is equal to:

(paid-up capital + reserves and surplus) /( number of equity shares outstanding).

The market value of an equity share is the price at which it is traded in the market. We now turn to some valuation ratios.  Valuation ratios indicate how investors assess the stock in the equity markets. These are thus indicators the performance of the issuing firm. The important valuation ratios are: the price-earnings ratio, the yield, and the ratio of market value to book value.

Price-earnings ratio: it is defined as the market price per share divided by earnings per share. The earnings per share ratio is just the after-tax profit less preference dividend divided by the number of outstanding equity shares. The price-earnings ratio reflects risk characteristics, investor sentiments, the degree of liquidity, and growth prospects.

Yield: this measures the rate of return  earned by shareholders. It is defined as:

Yield = (Dividend + price change) / Initial price. We can break this into two parts:

{ Dividend / Initial price}  +  {price change / Initial price}

The first term denotes the dividend yield, while the second term is the capital gains or losses yield. Usually companies with low  growth prospects offer a high dividend yield while the capital gains yield is low. It is the converse with regard to companies with high growth prospects.