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  • 1. Chapter 18. The Common Stock Market
    • Types of markets
    • Trading mechanics
    • Stock market indexes
    • Pricing efficiency
  • 2. Common stock
    • equity security
      • ownership
      • entitled to distributed earnings
      • entitled to share of assets
  • 3. I. Type of Markets
    • exchanges
    • OTC trading of
      • unlisted stocks & listed stocks
    • direct trading
  • 4. Exchanges
    • physical location for trading
    • trading by members
      • own a seat on the exchange
    • stock traded on exchange are listed stocks
  • 5. NYSE
    • the “Big Board”
    • about 2800 listed U.S. companies
      • & 450 non-U.S. companies
    • $18 trillion market value (2/04)
    • 1366 seats (fixed)
      • seat price $2 million 2002
      • 10/2003 $1.35 million
  • 6.
    • stocks trade at post on the trading floor
      • 20 posts, trading about 100 stocks
    • each stock has one specialist
      • 10 specialist firms, 470 specialists
      • each specialist has 5-10 stocks
      • process trades from floor brokers (5%) and electronically (95%)
  • 7. role of the specialist
    • MUST maintain a fair and orderly market for stock
    • act as buyer or seller as needed (10% of trades)
    • match buyers and sellers
    • maintain order priority
  • 8. the future of the specialist
    • may be phased on with next 5-10 years
    • recent SEC fines for improper trading for several major firms
  • 9. AMEX
    • merged w/ Nasdaq 1998
    • specializes in equity derivative securities and closed-end funds
  • 10. Regional exchanges
    • stocks may be listed on both NYSE and regional exchange
    • 5 regional exchanges
    • cheaper seat prices
  • 11. OTC markets
    • electronic network of dealers all over the world
    • ECNs
      • electronic communication networks
    • more than one dealer per stock
      • not obligated to make a market
  • 12. Nasdaq
    • not the only OTC system, but the largest
    • over 4000 companies listed
      • mkt. value $2 trillion (2/28/03)
    • leader in daily share volume
    • over 500 dealers
    • listing requirements
  • 13.  
  • 14. II. Trading Mechanics
    • types of orders
    • short selling
    • buying on the margin
    • institutional trading
  • 15. Types of orders
    • instructions from investors to brokers
    • market order
      • buy/sell order to be executed at best price
      • -- get lowest price for buy order
      • -- get highest price for sell order
  • 16.
    • market order (cont.)
      • market orders given priority in trading
      • no guarantee of execution price
      • -- price could rise/fall from time order is placed to time it is executed
  • 17.
    • limit order
      • buy/sell order where investor specifies price range
      • “ buy at $50 or less”
      • “ sell at $52 or more”
      • specialist records orders in
      • limit order book
  • 18.
      • investor sets reservation price
      • BUT
      • no guarantee that limit order will be executed
  • 19.
    • stop order
      • order lies dormant
      • turns into market order when certain price (“the stop”) is reached
      • “ buy if price rises to $60”
      • “ sell if price falls to $58”
      • -- stop loss order
  • 20.
    • investor does not have to watch market
      • but in a volatile market stop could be triggered prematurely
      • -- end up trading unnecessarily
  • 21.
    • stop limit order
      • turns into limit order when stop is reached
      • “ buy if price rises to $60, but only is executed at $65 or less”
  • 22.
    • market if touched order
      • turns into market order if certain price is reached
      • “ buy if price falls to $55”
      • “ sell if price rises to $62”
  • 23. how long is an order good?
    • fill or kill order
      • executed when reaches trading floor, or canceled
    • good until canceled/open order
      • is good indefinitely
  • 24. order size
    • round lots
      • lots of 100 shares
    • odd lots
      • less than 100 shares
      • more difficult to trade
    • block trades
      • 10,000 shares or $200,000 value
  • 25. short selling
    • sale of borrowed stock
    • profit from belief that stock price is too high will fall soon
    • how?
      • borrow stock through broker
      • sell stock
      • buy and return later
  • 26.
    • short selling could further destabilize falling prices
      • tick test rules on exchange
    • short sales allowed if
      • uptick or zero uptick in price for previous trades:
      • $20.75, $21 (uptick)
      • $20.75, $20.75 (zero upick)
      • $20.75, $20 (downtick)
  • 27.
    • so short sellers
      • believe price will fall and SOON
      • but price not currently falling
      • face unlimited losses if price rises
  • 28. Buying on the margin
    • buyer borrows part of purchase price of stock, using stock as collateral
      • borrow at call money rate
    • Fed sets initial margin requirement
      • minimum cash payment
      • 50% since 1975
  • 29.
    • if stock price falls
      • collateral worth less
      • if collateral worth only 125% of loan (maintenance margin)
      • -- margin call
      • -- owner must put up more cash or sell stock
      • margin calls can worsen stock crash
  • 30. example
    • 1000 shares, $20 per share
      • $20,000 cost
      • $10,000 cash, borrow $10,000
    • leverage
      • gains/losses on $20,000 capital
      • but tied up only $10,000 capital
  • 31.
    • if prices falls to $12,
      • value of stock $12,000
      • below 125% of $10,000 loan
      • get a margin call
  • 32. Institutional trading
    • vs. retail trades
      • institutional trades are larger
      • special execution
      • over 50% of NYSE share volume
  • 33. block trades
    • large # shares in one stock
    • executed in “upstairs” market
      • other firms directly take other side of trade
    • remainder executed on trading floor or Nasdaq (downstairs)
  • 34. program trades
    • large # shares, different stocks
    • used by mutual funds for asset allocation
    • want
      • low commissions
      • prevent frontrunning
  • 35. what is frontrunning?
    • brokers trade ahead of program trade
      • to benefit from anticipated price movements
      • due to large trade
  • 36. example
    • broker buys ahead of large buy order
      • broker buys first
      • large buy order pushes up price
      • broker’s holdings increase in value
    • result
      • frontrunning starts to push up price, so firm does not get best price
  • 37. agency basis
    • brokers bid for trade by commission
    • low commission, but
    • frontrunning likely
  • 38. agency incentive agreement
    • set benchmark value for trade
      • based on last day’s prices
    • if broker does better
      • gets commission + bonus
    • higher commission, but
    • frontrunning less likely
  • 39. III. Stock market indicators
    • measure average performance of a group of stocks
    • different indexes are highly correlated:
      • DJIA & S&P 500 .991 (1990s)
      • DJIA & NYSE .95
  • 40. indexes differ due to
    • stocks included in the index
    • weighting of stocks
      • equal, price, value
    • average
      • arithmetic
      • geometric
  • 41. stock exchange index
    • includes all stocks listed on exchange
    • NYSE Composite
    • Nasdaq Composite
    • (both value weighted)
  • 42. subjectively selected index
    • organization picks group of stocks to measure
    • Dow Jones Industrial average
    • S&P 500
  • 43. DJIA
    • price weighted
    • 30 large blue chip companies
      • cross section of industries
      • leaders
    • large movements in DJIA may halt trading on NYSE
  • 44. S&P 500
    • 500 large blue chip companies
    • value weighted
    • most popular benchmark for index funds
  • 45. objectively selected index
    • inclusion of stock based on objective criteria
      • market value
    • Wilshire 5000
      • all publicly traded stocks
    • Russell 2000
      • largest 3000 companies, then take
      • smallest 2000 of those
  • 46. IV. Pricing Efficiency of the Stock Market
    • what information is reflected in current stock prices?
      • what implications does this have for active vs. passive investment strategies?
  • 47. 3 levels of price efficiency
    • what are they?
    • implication?
    • evidence for U.S. stock markets?
  • 48. Weak form efficiency
    • current stock prices reflect
      • information about past prices
      • and trading history
  • 49. implication
    • if markets are weak-form efficient
      • using past price/trading pattern to predict future stock prices will not work
      • so, technical analysis will fail to beat the market
  • 50. evidence
    • U.S. stock market is weak-form efficient
    • technical analysts do not beat the market
      • especially after trading costs
  • 51. Semi strong form efficiency
    • current stock prices reflect
      • all publicly available information
      • relevant to stock
      • -- economic data
      • -- financial statements
  • 52. implication
    • using public info to predict future stock prices will not work
      • fundamental analysis will fail to beat market
  • 53. evidence
    • mixed
    • Yes
      • most actively managed portfolios do not outperform randomly selected portfolios
  • 54.
    • No.
      • certain pricing anomalies persist for long periods of time
      • January effect
      • size effect
  • 55. Strong form efficiency
    • current stock prices reflect all information
      • public and private
  • 56. implication
    • impossible to predict future stock prices
      • stock prices are a random walk
  • 57. evidence
    • U.S. stock market is not strong form efficient
    • why?
      • corporate insiders consistently outperform market
      • & they have access to private info
  • 58. active strategy
    • using fundamental or technical analysis to select stocks to buy/sell
    • growth, sector, value funds
    • trading on this info increases
      • trading costs
      • tax consequences
    • odds of working are low
  • 59. passive strategy
    • believe market is efficient, just capture long-run returns of market
    • buy-and-hold diversified portfolio
      • index funds
    • lower expenses, defer taxes
    • index funds outperform most actively managed funds