Understanding Markets by Jimmy Gentry

Understanding Markets
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Jan. 2, 2012

Donald W. Reynolds National Center
For Business Journalism
At Arizona State University
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James K. Gentry, Ph.D.
Clyde M. Reed Teaching Professor
School of Journalism and Mass Communications
University of Kansas
[email_address]
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Risk-Return Relationship Strictly Financials

Basic Types of Risk
Systematic or market
Unsystematic or nonmarket. Also called “business risk.” Can be diversified away.

Specific Types of Risk
Financial risk, credit risk, default risk
Market risk
Interest rate risk
Purchasing power or inflation risk
Event risk
Exchange-rate or foreign exchange risk
Liquidity risk
Political or sovereign risk
Tax risk

Types of Businesses
Sole proprietorship
Partnership
Corporation
Limited liability
Greater access to capital
Permanency
Flexibility
Double taxation

Types of Structures
Private corporations
Public corporations
Non-profits
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Types of Investments
Stocks
Bonds
Other
Options, futures, commodities, real estate, collectibles, currencies
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Types of Markets
Equity: Stocks
Credit: Bonds, debt or fixed income
Others
Derivatives (such as options and futures), commodities, real estate, collectibles, currencies
Historically, the amount of long-term debt financing issued in the U.S. greatly exceeds the volume of equity financing

Stock
Stockholders want:
Stock price to increase
Dependable dividend stream
Increase in size of dividend
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Types of Stock
Common stock
Preferred stock
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Common Stock
Risk: Lose your money if company falters
Reward: Owners share in success when company does well
Appreciation
Dividends
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Dividends
Represent a return on capital invested by shareholders.
Board must declare dividend for it to be paid.
Dividend payment is not a business expense. It is an after-tax expense.
Usually relationship between company’s age and size, and the dividends it pays.
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Preferred Stock
Reduced risk but reward may be limited
Dividend amount is stated and is paid before dividends on common
If company is liquidated, holders are preferred over common holders.
Dividends don’t necessarily increase if company prospers.
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Bond
Bond is debt a company owes
Individual or company “loans” money to the company by buying a bond
Bond pays interest over a fixed period of time
Principal is repaid to the lender or holder of the bond at end of the term
Interest rate is typically fixed when the bond is sold (i.e., fixed income security)
Interest rate is comparable to what other bonds, with that rating, are paying
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Bond Terminology
Interest rate: Fixed percentage of the bond’s purchase price that is paid annually to the bond holder
Yield: Return on investment if bond is held to maturity. Equals interest rate. If bond is traded before maturity date, yield could change although interest rate stays the same.
Par value: Dollar amount paid for bond at time of issue
Maturity date: When bond comes due
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Issuers Prefer Bonds
When companies need to raise money, they can issue stock or sell bonds
They often prefer bonds, in part because issuing more stock can dilute the value of shares investors already own
Bonds also may have income tax advantages
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A Quasi-Bond?
Is preferred stock debt (i.e., a bond) in disguise?
Preferred holders have a “guaranteed” dividend. Is that like the fixed interest rate of a bond?
Why do investors pick common, preferred or bonds?
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Risk and Reward Strictly Financials

Yield Curve Yield Maturity Strictly Financials

Equity or Securities Markets
Primary market
Go public
Private placement
Secondary market
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Going Public
Entrepreneurs have an idea. Company grows with an investment from the private equity market (venture capital).
Owners decide to “go public.”
Register with SEC to make an initial public offering (IPO).
Investment bankers typically underwrite the offering through a syndicate.
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Going Public (cont.)
Company prepares a prospectus, which is a detailed analysis of the company’s financial history, its products and services, as well as management’s background and experience.
Prospectus should identify and assess risk factors the company faces.
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IPO Terms
Prospectus
Road show
Quiet period
Lockup period
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Shelf Registration
Firm can file one registration statement for a relatively large block of stock and sell parts over a two-year period
This can reduce red tape and costs, and because stock can be sold directly to institutional investors, can eliminate the underwriting fee
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Private Placement
New issues can be sold in large lots to a small group of buyers. Allows start-up firms to show appeal by raising capital on their own.
Additional shares later can be offered through an underwriter.
Many debt issues are placed privately, usually to large buyers such as insurance companies .
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Secondary Offering
If company already is public, it can sell more stock through a secondary offering.
Causes dilution
Major owners sell their shares. They get the funds so no dilution.
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Wall Street
Got its name from a wall of brush and mud built by early settlers to protect the city of New York from attacks (1609)
Site of New York’s first organized stock trading
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New York Stock Exchange
In March 1792, Wall Street leaders met to establish an improved auction market
In May 1792, 24 men signed an agreement to trade securities only among themselves, maintain fixed commission rates and avoid other auctions
Considered the origination of NYSE
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NYSE (cont.)
Until March 2006, was owned by 1,366 seat-holding members
Highest price ever paid for a seat was $4 million
Price was determined by auction.
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NYSE Members
Floor brokers
House brokers
Independent brokers
Specialists
Manage auction process
Execute orders for brokers
Serve as catalysts
Provide capital
Stabilize prices
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In The Day, Buy or Sell Order
Tell your broker or “registered representative” to buy or sell a stock at the current price, or market price. Called a market order.
If you name the price to buy or sell, you’re making a limit order.
Tell your broker to buy or sell once the price hits a specific price, you’re placing a stop order at a stop price.
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Trading on the NYSE Floor
Trading occurs in the “Big Room”
Numerous stations, each with a roughly figure-eight shape, with counters and screens above. Called “trading posts.”
Each counter is a “specialist’s” post
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NYSE Floor (cont.)
Order comes to the booth that is rented by a brokerage house
Floor broker takes order to appropriate specialist’s post
Specialist keeps a list of unfilled orders. Processes orders as prices move.
Specialist’s job is to maintain an orderly market in the stock (match buyers/sellers)
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NYSE Floor (cont.)
Stocks or groups of stocks are traded at trading posts near the specialists’ positions.
Floor brokers can use a specialist or trade between themselves, called trading in the “crowd”
Terminals display the stock’s activity.
After every trade, a reporter records the stock symbol, price and initiating broker.
Successful trades are confirmed.
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NYSE Floor (Then & Now) Strictly Financials

Round or Odd Lots
Round lots: Buying or selling stock in multiples of 100 shares
Odd lots: Buying or selling stock in other quantities
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Who Holds Your Stock?
Virtually all investors leave shares in their brokerage account in what’s called the street name . Investor retains beneficial ownership , though.
This offers safe storage.
You can get tangible certificates if you want them. Typically, you must pay for them.
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Super DOT System
Designated Order Turnaround
Allows orders to be transmitted electronically to specialist.
Now makes up a substantial percentage of NYSE trading, particularly smaller orders
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American Stock Exchange
Non-members of NYSE couldn’t afford office space so traded in the street
1842: New York Curb Exchange
By late 1870s known as “curbstone brokers” and their market was known as the Curb.
Merged with NASDAQ in 1998
Acquired by NYSE Euronext in 2009
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NASDAQ
National Association of Securities Dealers Automated Quotations system
NASDAQ is a computer network with no physical location for trading
Uses a multiple market maker system, not the specialist system
About 4,000-plus companies
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Trading on the NASDAQ
Trading is through an open market, multiple dealer system, with many market makers competing to handle each transaction.
The computer network checks for matches, which can be handled instantly.
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In Which Market?
In general, but with exceptions:
NYSE: Oldest, largest, best known
AMEX: Smaller, younger
NASDAQ: Youngest, least experienced
Some of NYSE’s most actively traded stocks are also quoted on the NASDAQ
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ECNs
Electronic Communications Networks
Are basically Web sites that allow investors to trade directly with one another
Archipelago and Instinet were best known
BATS Trading
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NYSE - Archipelago Marriage
Merged in March 2006 to create NYSE Group, Inc., a publicly-held company.
Largest merger ever between securities exchanges.
Combined leading equities market with most successful electronic exchange.
Archipelago: low fees, user-friendly technology
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NYSE Euronext
Merged April 2007
Operates world’s largest, most liquid exchange with diverse products and services
Six equities exchanges in five countries and six derivatives exchanges
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Deutsche Borse Seeks To Buy NYSE Euronext
Been working on a deal since early 2011.
Would create world’s largest trading entity.
European regulators are forcing the companies to sell assets because of competitive concerns.
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NYSE ‘Hybrid Market’
Floor trading and automated trading
Specialists or Archipelago strengths
Why? Customers’ desire for faster access to liquidity and greater anonymity
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NASDAQ Response
NASDAQ acquired Instinet Group Inc., another ECN
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Exchanges v. OTC Market
Stocks in almost 10,000 companies aren’t listed on any exchanges.
They are traded “over the counter” (OTC)
Typically handled by phone or computer
Generally, comparatively inexpensive and infrequently, or “thinly,” traded
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BATS Global Markets
Newer exchange, founded in 2005
Located in Kansas City
Competes on technology and cost
Developed its own software platform
Also offers an options trading platform
An ECN
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U.S Equities Market Share
NYSE 27.5%
Arca, 14%
Floor, 13.5%
NASDAQ, 21.5%
BATS, 12%
September 2011
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Stock Market Participants and the Role of an Exchange

Direct Edge
Another ECN
Has exchange status
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Dark Pools
Also “Dark Liquidity” or “Dark Pool Liquidity”
Lightly regulated trading not open to the public.
Mostly involves block trades by institutions away from public exchanges so trades are anonymous.
Main advantage to institutional investors: Can buy or sell in large blocks without other investors knowing since neither size of trade or trader’s identity are revealed. Prices are reported after trades completed.
Also means some market participants are disadvantaged since they can’t see trades executed and prices paid so this market is not transparent.
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High-Frequency Trading
Also known as “high-speed trading.’
Electronic trading strategies driven by statistics and algorithms.
WSJ reported in October that by some measures, such firms make up 5 of every 10 stock trades in the U.S. each day.
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High-Frequency Trading
Research has shown that algorithmic trading broadly makes prices less volatile and reduces the overall cost of trading.
These firms’ ability to buy and sell large blocks of securities in fractions of a second has raised fears that ordinary investors are being left behind.
Is drawing criticism.
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Cyclical, Income, Growth
Cyclical: Highly dependent on the state of the economy. When things slow, earnings and stock price fall. When economy recovers, earnings and stock prices rise.
Income: Stocks that pay dividends regularly.
Growth: Pay little or no dividend while profits are reinvested.
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Stock Ownership Strictly Financials

Institutional Investors
Organizations that invest their own assets or pool those it holds in trust for others.
Examples: Investment companies (including mutual funds), pension systems, insurance companies, universities and banks.
Trade regularly and in tremendous volume.
Must buy or sell at least 10,000 shares for a transaction to be an “institutional trade.”
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Changing Attitudes
Institutional investors who own large blocks of stock are increasingly demanding a say in corporate management.
Socially or environmentally conscious individual shareholders also are becoming more involved.
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Stock Market Averages
Dow Jones Industrial Average: Best known and most widely reported market indicator
Made up of 30 industrial companies
Dow Jones Transportation Average: 20 airlines, railroads and trucking companies
Dow Jones Utility Average: 15 gas, electric and power companies
Dow Jones 65 Composite Average: all 65 companies in the other three averages
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Stock Market Indexes
NYSE Composite Index: All stocks traded on the NYSE.
Standard & Poor’s 500 Index: Broad base of 500 stocks. Considered benchmark for large-stock investors.
NASDAQ Stock Market Composite Index: Stocks traded through its electronic system. Often more volatile because of types of companies it covers.
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Market Indexes (cont.)
AMEX Composite: Companies on the AMEX.
Russell 2000: Follows smallest two-thirds of the 3,000 largest U.S. companies. Includes many IPOs of past few years. Benchmark for small-company stocks.
Value-Line: 1,700 common stocks.
Wilshire 5000: Broadest index, including nearly all stocks traded in U.S. markets.
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Reg FD, Disclosure and Guidance
Regulation Fair Disclosure, October 2000
Bars public issuers from selectively revealing material nonpublic information to securities analysts, broker-dealers, investment advisers, and institutional investors, before disclosing it to the public.
Tension: Guidance vs. disclosure
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Blue-Chip Stock
Company with national reputation for quality, reliability and ability to be profitable in good or bad times
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Bulls and Bears
Bulls: Persons who think prices or values will rise. In general, being optimistic.
Bears: Persons with a pessimistic market outlook.
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Selling Short
Selling a security not owned by seller
Investor borrows stock and sells it for later delivery.
Seller hopes to buy the stock later at a lower price, thereby making a profit, which comes from difference between price at sale and price at later purchase.
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Margin
Buying on margin: Borrowing money from broker to buy securities.
Federal Reserve regulates margin. Today investor can borrow up to 50 percent of the price of the stock.
Broker requires a minimum balance and can issue a “margin call” if stock’s value declines.
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Classes of Stock
Some firms have more than one class
Primarily done to assure control of the firm by one group, such as Ford Motor Company’s Class B, which isn’t publicly traded (held by family) but has 40 percent of voting power, although it represents less than 10 percent of total shares outstanding.
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Stock Split
If stock price increases significantly, a company might do a split to lower the price, which it expects to stimulate trading.
In a split, more shares are available but total market value is still the same.
Price may move up after split, therefore increasing the value of your stock.
Reverse split: Exchange more shares for fewer, say 10 for five. To boost share price.
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Arbitrage
Simultaneous purchase and sale of an asset to profit from a differential in the price. Usually takes place on different exchanges or marketplaces.
Ex: Buy stock in company on one exchange at one price and sell stock in the same company on another exchange at a different price.
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Insider Trading
Buying and selling of company stock by officers, directors, employees, family members, etc. Person or trust owning 10 percent or more of a company's stock also considered an "insider."
SEC calls them "insiders" because of access to early and potentially key company events.
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Option
On an organized exchange, the right to buy or sell securities, commodities, etc. at some point for an agreed upon amount.
In a company, stock options are granted to corporate executives and others as part of their compensation packages.
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Warrant
Type of security, usually issued with a bond or preferred stock, that entitles holder to buy a proportionate amount of common stock at a specified price, usually higher than the market price at time of issuance, for a period of time.
Also called a Subscription Warrant
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Global Marketplace
Stocks are traded around the clock, around the world. There’s a market open somewhere, 24 hours a day, Monday through Friday.
Growing number of multinational companies on several exchanges.
Tendency of investors to buy in many markets, not just their own.
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American Depositary Receipts
A bank buys and deposits actual foreign securities with another bank (called a depositary), which then issues certificates in the U.S. that represent (and are backed) by the deposited securities.
Depositary handles day-to-day interactions with ADR holders.
Advantages: As U.S. securities, ADRs are subject to U.S. regulations and protections.
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ADRs (cont.)
Priced in dollars and dividends paid in U.S. dollars.
ADR prices follow closely (but not necessarily 1:1) the underlying foreign security, based on supply and demand.
Very few U.S. banks are depositaries. Bank of New York is largest with more than 50 percent of all ADR issues.
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Tracking Global Markets
Wall Street Journal tracks 24 national stock markets outside the U.S. with 32 indexes.
Worldwide market performance is compared by looking at percentage change.
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Why International
Rewards
Diversification, capital gains, dividends, country’s currency rises against dollar
Risks
Tax treatments differ by country, accounting and trading rules can be different, converting dividends can add expenses, distance and language barriers
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Credit or Debt Markets
Historically, the amount of long-term debt financing issued in the U.S. greatly exceeds the volume of equity financing
Short-term or “money market”
Bond market
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Money Market
Commercial paper
Bankers’ acceptance
Repurchase agreements
Certificates of deposit
Municipal notes
Treasury bills
Money market mutual funds
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Terminology
Bills – Maturity dates up to one year
Notes – Maturity dates of two to 10 years
Bonds – 10 years or longer
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Who Issues Bonds
Issued by U.S. companies
Issued by the U.S. Treasury
Issued by federal, state and local government agencies
Issued by overseas companies and governments. When sold in dollars, are sometimes called Yankee Bonds.
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Issuers Prefer Bonds
When companies need to raise money, they can issue stock or sell bonds
They often prefer bonds, in part because issuing more stock tends to dilute the value of shares investors already own
Bonds also may have income tax advantages
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Treasury Issues
Life, or term, is fixed at time of issue
Treasury bill: One year or less
Treasury note: One to 10 years
Treasury bond: 10 years or more
Generally, the longer the term the higher the interest rate
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Uses of Bonds
Corporations use bonds:
To raise capital to pay for expansion or modernization
To cover operating expenses
To finance corporate takeovers or other changes in management structure
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Uses of Bonds (cont.)
U.S. Treasury uses bonds:
To finance a wide range of government activities
To pay off (actually refinance) the national debt
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Uses of Bonds (cont.)
States, cities, counties and towns issue bonds:
To pay for a wide variety of public projects
To supplement their operating budgets
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How Bonds Are Sold
Issuing bonds has similarities to an IPO
Bonds are sold at par, or face value, in units of $1,000
After issue, bonds trade in secondary market and are bought and sold through brokers
Government bonds are directly available through a Federal Reserve Bank program called Treasury Direct or through a broker
Most municipals are sold through a broker
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How Bonds Are Traded
Most already-issued bonds are traded over the counter
Bonds also can be purchased from the inventory of a brokerage firm that might make a market in the bonds
Commissions and markups
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Bonds Then and Today
Until 1983, all bondholders received certificates
Some of these Bearer Bonds had coupons attached to the certificate
To collect interest, investor detached the coupon and exchanged it for cash. Hence, the bond interest rate is called the Coupon Rate.
Today most new bonds are called Book Entry bonds and are registered electronically
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Rating Bonds
Standard & Poor’s, Moody’s Investors Services and Fitch are best known
Corporate, international and municipal bonds are rated
Credit ratings influence interest rates
If a company’s rating is downgraded, investors demand a higher yield
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Bond Rating Code
Aaa/AAA: Best quality
Aa/AA: High quality
A/A: High-medium quality
Baa/BBB: Medium quality
Ba/BB: Some speculative element
B/B: Future default risk
Caa/CCC: Poor quality, default danger
Ca/CC: Highly speculative
C/C: Lowest rated, poor prospects
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Understanding Markets by Jimmy Gentry

by Reynolds Center for Business Journalism

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