A corporate bond tells the investor exactly when they will receive each cash flow and how much it will be, subject to the firm surviving. An equity share makes no such promise: dividends are declared at the board's discretion, capital gain is uncertain, and the equity holder sits last in the capital structure in default. In exchange for bearing this uncertainty, equity investors historically earn a return above the risk-free rate — the equity risk premium — which is the most important single quantity in long-run asset pricing.
This note establishes the equity landscape: the two classes of shares, how dividends work, how stock indices aggregate individual equities into a single tradeable benchmark, and how the price of a stock index futures contract is determined by no-arbitrage. The futures pricing formula — where is the continuous dividend yield — is the simplest example of the cost-of-carry model that drives all of Topics 5 and 6.
Learning objectives. By the end of this note you should be able to:
- distinguish common shares (ordinary shares) from preferred shares, describing the cash-flow and voting-rights differences;
- explain the dividend mechanics: declaration date, ex-dividend date, record date, payment date;
- define the equity risk premium (ERP) and explain why it exists;
- describe how price-weighted and cap-weighted indices are constructed and identify the major global indices;
- derive the stock index futures pricing formula by no-arbitrage;
- describe index arbitrage and the role of program trading.
In this lesson
- Common and preferred shares
- Dividend mechanics
- The equity risk premium
- Stock index construction
- Stock index futures pricing
- Index arbitrage
- Hedging an equity portfolio with index futures
Before you start
The full lesson, with worked examples and exercise solutions, is for members.
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