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Understand economics at your own pace: step-by-step guided courses, and exercises to practice.
How does the stock market work?
Not one market, but a set of them — where a price settles no scarcity of the day, but a bet on the future.
capitalisation = number of shares × priceProblem / motivation
Every day we hear “the market went up” or “the market crashed”. But what exactly is it, and why do these prices move all the time?
First word to put back in place: the stock exchange is not ONE market, it is a SET of markets. Think not of a stall, but of a covered hall sheltering several of them under one roof — a roof that is now made of servers rather than the trading pit where prices used to be shouted. Each family of SECURITIES has its own market there: the one for SHARES (a share = a part of a company, course “Share or bond?”), the one for BONDS (a piece of the loan that YOU, a saver, make to a company or a state — course “Bond prices and interest rates”), and others, more technical, left aside here.
And each of those markets has two floors: the NEW ISSUES floor, where the company (or the state) creates securities and collects the money — this is how the stock market finances the economy — and the SECOND-HAND floor, where savers sell existing securities to each other. Add that there are several venues — Paris, Frankfurt, New York — and the account is complete: “the market” of the French news, the one that rises and crashes, is shorthand for ONE of all those markets — shares already issued, traded in Paris.
Now a difference in kind, to be taken on board before we start: a financial market does NOT work like a fruit and vegetable market. On the stall, the price settles the scarcity of the day for a good about to be consumed. On the stock market, it settles a BET on the future: what a security is worth is what participants expect it to yield. The consequence, placed at the centre of finance by the American economist Eugene Fama in 1970 — the EFFICIENCY hypothesis: if the price already reflects available information, then what is known is ALREADY in it, and only a SURPRISE can move it. A company can announce record profits without its price shifting by a cent: they were expected. (A hypothesis, not a law — the Limits step comes back to this.)
That leaves the two real questions. Why do prices there move all the time? Because information arrives continuously: each piece of news moves expectations, and therefore the buy and sell orders that are waiting. And what does “THE market went up” mean, in the singular, when hundreds of securities each move their own way? There is a thermometer that sums it all up: the INDEX — the CAC 40 of the newspapers. This course builds both answers, with a single formula as its keystone: market capitalisation.
Assumptions
In your view, which assumptions are needed for this model to hold? Jot down your ideas — no lead is wrong, this is your worksheet.
Your worksheet is still empty. Go for it: propose at least one idea.
0 idea(s) proposedFormalization
Let's start with the price of ONE share. At every moment, orders are waiting: “I buy at €49”, “I sell at €51”… A piece of news lands — good results, a contract won — and buyers flock in: at the displayed price there are no longer enough sellers, buyers outbid each other, and the last trade closes higher — the price RISES. Bad news: the reverse. (The register that ranks these orders is called the order book.) There is supply and demand, stock-market version: it is the waiting orders that make the price, not the completed trades. And why does a piece of news move those orders? Because the previous price already contained what was known: it only moves on what is LEARNED (assumption 3) — hence “good results” in the sense of better THAN EXPECTED.
The price does not tell you the size: a €10 share of a giant company is not “less” than a €60 share of a small one. To compare, we multiply: capitalisation = number of shares × price. A company with 2 million shares quoted at €50 “capitalises” €100 million. And the formula turns over: capitalisation ÷ number of shares = price (exercise 2 has you do it).
That leaves reading “THE market went up”. Hundreds of securities each move their own way: we sum them up in a BASKET. Take a few companies, add up their capitalisations, and follow that total day after day by setting it at 100 to start with: index = today's basket ÷ starting basket × 100. At 103.5, “the market gained 3.5%”. The CAC 40 does exactly that with 40 large companies on the Paris exchange — each weighing its capitalisation (strictly, the part actually in circulation; hold on to the idea: the BIG ones weigh heavily, the small ones almost nothing).
The whole course sits there: a share price is born of the waiting orders; capitalisation turns it into a size; the index weighs those sizes to sum up a whole market in one number. The solving step runs the complete machine on a mini-market of three companies — and you will see an index GO UP on a day when two shares out of three do not. Click each term:
Solving / calculation
A mini-market of three companies: Alpha (2 million shares at €50), Beta (1 million at €60), Gamma (4 million at €10). Let's build the index, live through a trading day, then try it yourself.
- Three capitalisations — note: Gamma has 4 times more shares than Beta, and yet weighs less
Alpha: 2m × 50 = €100m | Beta: 1m × 60 = €60m | Gamma: 4m × 10 = €40m - The starting basket, and its base 100
100 + 60 + 40 = €200mindex = 100 - A day goes by: good results for Alpha (+10%), Beta disappoints (−5%), Gamma does not move
Alpha: 2m × 55 = €110m | Beta: 1m × 57 = €57m | Gamma: €40m - The evening basket, and the index
110 + 57 + 40 = €207m → 207 ÷ 200 × 100index = 103.5 - Reading it — the newspaper headline
one rise, one fall, one still“The market gains 3.5%”
“The market went up 3.5%” — when only one share in three went up. The secret is in the weights: Alpha weighs half the basket (€100m out of 200), and its rise crushes Beta's fall. An index follows the BIG ones; it does not tell you what each share is doing — still less yours. Move the three prices around: the index recomputes itself, and the reading tells you who is pulling it.
index = (capA + capB + capC) ÷ €200m × 100Set the three prices (the numbers of shares do not move: no issue today): capitalisations, basket and index follow. Try to push the index up while lowering Alpha — good luck.
Economic interpretation
Markets on two floors, a price born of orders, a weighted thermometer: you now have everything you need to read a market page — and to understand what it is for.
The new-issues floor finances: by issuing shares or bonds, the company (or the state) collects fresh money to invest. The second-hand floor makes that financing POSSIBLE: it is because you can sell your security at any moment — LIQUIDITY — that you agree to buy new issues. Without a second-hand market, nobody would lend to a company for ten years. The two floors are the two faces of the same service; to choose YOUR security, the course “Share or bond?” compares the two families.
Results better than expected, a contract won, a scandal, and above all INTEREST RATES: when the central bank raises them, new bonds pay more — savings arbitrate. Concretely: a share promising €5 of dividend a year is paid less for on the day an effortless investment pays more — the same future €5, compared with something better, is worth less today. This is the DISCOUNTING of the course “Bond prices and interest rates”, applied to shares; the course “Valuing a share: the Gordon-Shapiro model” (the price of a share = the sum of its discounted future dividends) puts it into a formula. Each piece of news thus moves what buyers are willing to pay, hence the orders, hence the price. And remember the word “expected” from the start: it is never the LEVEL of a piece of news that makes the movement, it is its gap to what was anticipated (assumption 3) — rising profits can make a price FALL if the market hoped for more. That is what lies behind the phrase “the market had already priced in the news”.
The price is that of the LAST trade — the one two strangers have just agreed on. Capitalisation extends it by convention to every share: a useful figure, but a fragile one — it can leap or melt away without the company having changed anything, at the mercy of hopes (Limits step: bubbles and crashes).
“The CAC 40 loses 2%”: the weighted basket of the 40 large Paris stocks is worth 2% less than yesterday — probably dragged by a few heavyweights, as in our solving step. What it does NOT say: that every share fell, nor that “France” has lost anything — the index measures a basket of listed companies, not the country's economy.
Limits / critiques
Exercises
A company has 8 million shares quoted at €25 each. Capitalisation (in €m)?
A share is quoted at €40. Far more BUY orders arrive than there are securities offered for sale at that price. What happens?
You buy a share in a large company on the market from another saver. Does the company receive your money?
True or false: a company whose capitalisation reaches €100m has €100m available to invest.
A company publishes record profits — exactly the ones analysts had been announcing for weeks. Most likely effect on its price?
A company capitalises €300m with 6 million shares. What is the price of one share (in €)?
A basket of two companies: A capitalises €150m, B €50m (index on base 100 for €200m). The next day, A gains 2% and B loses 6%. What does the index do (change in %)?
True or false: if the CAC 40 rises, all the shares in the CAC have risen.
The central bank sharply raises its rates. Most likely effect on share prices?