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Chapter 16 Learning Objectives (part 1 of 3)
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Chapter 16 Learning Objectives (part 1 of 3)

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  • 1. Chapter 16
  • 2. Learning Objectives (part 1 of 3)
    • Discuss why financial markets exist and the benefit they provide to society
    • Explain the difference between the primary and secondary market
    • Describe the IPO process and the role of DPOs
    • Describe the different places where securities are traded, the different listing standards, and the different methods of trading
    • Name the more common of the stock market indices
  • 3. Learning Objectives (part 2 of 3)
    • Distinguish between the types of brokers and brokerage firms
    • Decide whether to order out stock or leave it in street name
    • Analyze the benefits of DPPs and DRIPs
    • Define the most common types of orders used in trading securities and explain the advantages and disadvantages of each
    • Describe how buying on margin works.
  • 4. Learning Objectives (part 3 of 3)
    • Explain the process of selling short
    • Describe how dollar cost averaging works
    • Describe how to experiment in the market without actually investing cash
    • Discuss the protections available to an investor
    • Describe pyramid schemes and Ponzi schemes
  • 5. Financial Markets
    • They exist to facilitate the transfer of money from people with more cash than they currently need to people with less cash than they currently need
    • The more efficient they are, the more opportunities for economic growth in a society
  • 6. Primary vs. Secondary Markets
    • Primary Markets
      • Newly issued securities sold by the issuer (e.g., a company sells bonds to pay for a manufacturing plant)
      • Usually no commission to buyer (seller pays full commission)
    • Secondary Markets
      • Issuer not involved, all trades between investors
  • 7. IPOs and DPOs
    • Initial Public Offering
      • Firm sells stock to public for the first time
      • Firm assisted by an investment banker
      • Transaction covered by Security Act of ’33
      • Seller usually under prices slightly
    • Direct Public Offering
      • Firms attempt to bypass investment banker and sell stock directly to the public
  • 8. Where are stocks traded?
    • National Exchanges
      • New York Stock Exchange (NYSE)
      • American Stock Exchange (AMEX)
    • Regional Stock Exchanges
      • Midwest Stock Exchange
      • Pacific Coast Stock Exchange
    • Over the counter market (OTC)
      • NASDAQ
  • 9. Listing Standards
    • Toughest for national exhanges
    • For NYSE:
      • At least 2,000 round-lot holders in the U.S., or
      • At least 2,200 shareholders and a six-month average monthly volume of 100,000 shares, or
      • At least 500 total shareholders and an average twelve-month volume of 1,000,000 shares.
  • 10. Methods of Trading
    • Specialist (e.g., used on NYSE)
      • Assigned specific stocks
      • Required to make markets move smoothly and to make continuous quotes available
    • Dealers (e.g., used in the OTC)
      • Can have multiple dealers per stock
    • Both specialists and dealers use bid-asked spreads
  • 11. Stock Market Indexes
    • Dow Jones Industrial Average (DJIA)
      • Dollar-weighted index
      • Contains only 30 stocks
    • Standard & Poor 500 (S&P 500)
      • Value weighted index
    • NYSE Composite Index
    • NASDAQ Composite
    • Wilshire 5000
  • 12. Types of brokerage firms (1 of 2)
    • Distinction becoming blurred over time
    • Full-service brokers
      • Customer deals with one specific broker
      • Substantial services offered
      • Highest commission rates
      • Broker’s income based on annual commission volume generated
      • Emphasis on office location
  • 13. Types of brokerage firms (2 of 2)
    • Discount brokers
      • All brokers respond to all accounts
      • Fewer services offered
      • Brokers are salaried
      • Few actual offices
  • 14. Ordering out vs. street name
      • Ordering out (taking possession)
        • Direct communications from company (including dividends)
        • Occasional direct benefits
      • Street Name (leave at brokerage)
        • No worry if lost or destroyed
        • Immediacy of selling
        • Simplification of tax information
  • 15. Direct Purchase Plan
    • Similar to IPO, buy stock directly from company but stock has active market
    • Must leave stock in account with company
    • Great for dollar averaging programs
    • Ideal for new (young) investors
  • 16. Dividend Reinvestment Program
    • Like a dollar averaging program
    • Shares must be on deposit with the company
    • Still must declare dividends as taxable income
    • Causes loss of portfolio diversification over time
    • Great for new (young) investors
  • 17. Types of Orders for Trading (1 of 2)
    • Market Order
      • Will be immediately executed
      • No certainty as to price
      • If a trade is a good idea, then “just do it”
  • 18. Types of Orders for Trading (2 of 2)
    • Limit order
      • Specify price lower than market for buy
      • Specify price higher than market for sell
      • Execution NOT guaranteed
      • Price guaranteed IF trade occurs
      • “ Penny wise, pound foolish”
  • 19. Buying on margin (1 of 3)
    • Computing the initial margin:
      •   Buy 100 shares of stock at $10 per share
      •   100 shrs x $10 price = $1,000 total purchase
      • $1,000 total purchase x 60% initial margin rate =
      • $600 minimum initial cash provided
    • $1,000 total cash
    • - 600 minimum initial cash
    • = 400 maximum initial loan
  • 20. Buying on margin (2 of 3)
    • The Effect of Buying on Margin:
    • ROE = ROA / m
    • where
    • ROE = investor’s return on equity,
    • ROA = the return on the investment itself, and m = initial margin rate
  • 21. Buying on margin (3 of 3)
    • Buy 100 shares at $10 per share & stock goes to $15 per share =>
    •   ROA = ($1500 - $1000) / $1000 = +50%
    • If buy stock on 60% margin (& ignore interest charges) =>
    • Initial investment = $600
    • Profit = $500 ($1,500 - $1,000)
    • ROE = $500 / $600 = 83.33%
    • Note: 83.33% = 50% / .60
  • 22. Mechanics for selling a stock short (1 of 2))
    • TODAY:
    •  
    • Investor places an order to sell (short) stock that is not owned
    •  
    • Broker borrows the stock from someone else
    •  
    • Broker sells the stock to someone who has no clue that the stock being acquired is a short sale (i.e., being shorted)
  • 23. Mechanics for selling a stock short (2 of 2)
    • IN THE FUTURE:
    • Investor decides to close out the position and places an order to buy the stock
    • Broker buys the stock from someone who has no clue the stock is being bought to cover a short sale
    • Broker returns the stock to whoever loaned it for the short sale
  • 24. Dollar Averaging (1 of 2)
    • Commit to a program of buying a fixed dollar amount of an investment at predefined intervals (e.g., first of each month)
    • This forces one to buy MORE shares when price low (and stock unattractive), and to buy LESS shares when price high (and stock looks great)
  • 25. Dollar Averaging (2 of 2)
    • This has the effect of reducing the average purchase price over time (as compared to buying a fixed number of shares on the same intervals)
    • Ideal if purchases made out of income
    • Poor strategy if have all of cash today, unless it is the only strategy that one would follow to invest
  • 26. Playing the Market for Fun
    • Can always do it “on paper”
      • Time consuming and most people lose interest in a few days
      • More interesting if done as a class game with extra credit points to the winners
    • Several Internet sites allow one to construct and update a portfolio
  • 27. Protections for Investors
    • If brokerage firm fails => Securities Investor Protection Corporation (SIPC)
    • If investor the victim of deception, fraud, etc. =>
      • Arbitration (if signed a binding agreement when opened account)
      • National Association of Security Dealers
      • Securities and Exchange Commission
  • 28. Pyramid Schemes
    • Partnerships or distributorships are sold (along with a product)
    • Each seller of a partnership gets a percentage of the buyer’s revenues
    • Great for the initial partners, not so good for the later partners
  • 29. Ponzi Schemes
    • Principal of initial investors is used to pay incredible “returns” to these investors
    • Word-of-mouth by early investors brings in new investors
    • Money from later investors used to pay returns to the early investors.
    • All Ponzi schemes eventually collapse