the differences between exchanges, NASDAQ, and other markets;
the globalization of securities markets;
securities market regulations;
the role of stockbrokers;
Key Topics (continued)
types of security transactions and associated cost;
margin transactions and the reasons investors use them; and
short selling motives and procedures.
Security Markets and Transactions
Securities markets are forums that allow buyers and sellers of securities to make transactions quickly and at a fair price.
Securities markets can be classified as:
money markets in which short term securities are bought and sold
capital markets in which long term securities such as stocks and bonds are bought and sold in several different ways.
The primary market is one in which new issues of securities are sold to the public.
Security Markets and Transactions (continued)
The Securities and Exchange Commission (SEC) regulates all securities offerings and markets.
An initial public offering (IPO) is the first public sale of a company's stock.
A public offering is the sale of a firm's securities to the general public.
A rights offering is an offer of shares of stock to existing shareholders on a pro rata basis.
A private placement is the sale of new securities directly to selected groups of investors, without SEC registration.
The investment banker
the financial intermediary that purchases new securities from the issuing firm at an agreed upon price and resells them to the public. They also advise firms with with regard to major financial decisions.
The act of underwriting
the role of the investment banker in bearing the risk of reselling at a profit the securities purchased from an issuing corporation at an agreed upon price.
Investment Banker (continued)
The underwriting syndicate
a group formed by an investment banker to spread the financial risk associated with underwriting new securities.
The selling group
a large number of brokerage firms that join and accept responsibility for selling a certain portion of a new security issue.
The market in which securities are traded among investors after they have been issued is the secondary market.
Stock exchanges are centralized institutions on which transactions are made in securities listed on those exchanges.
NASDAQ is a computer based national market on which transactions are made in securities listed in their market.
Over-the-counter (OTC) markets are outside the stock exchanges and generally include only very small companies, that cannot qualify for listing, and all government and most corporate bond issues.
Organized Exchanges (1 of 3)
Organized security exchanges
centralized institutions in which the supply of and demand for certain securities are brought together.
The New York Stock Exchange (NYSE)
the dominant exchange in the U.S. About 3,000 companies accounting for about 3,300 stocks and 1,750 bond issues are listed on the NYSE.
Organized Exchanges (2 of 3)
Some stocks may be listed on more than one exchange, having a dual listing.
Trading activity is carried out by members on the floor of the NYSE.
All transactions are made through an auction process, and it is the job of the specialist , a stock exchange member who specializes in making transactions in one or more stocks, to buy and sell in order to provide a continuous, fair, and orderly market in those securities assigned to him or her.
Organized Exchanges (3 of 3)
Listing policies for companies wishing to list their shares on the NYSE are quite stringent. Prior to listing the companies must file documents and audited statements with the SEC, who must approve all security offerings, and who also regulates the NYSE.
Listing Requirements (1 of 3)
The company pays a listing fee and must have:
a minimum of 2,000 shareholders with 100 or more shares; a minimum of 1.1 million publicly held shares; at least $10 million in earnings before taxes in each of the preceding 3 years; and a minimum of $100 million in stockholder’s equity
Listing Requirements (2 of 3)
Companies may be de-listed, which means they may be removed from listing. This generally occurs when the listing requirements are violated, and it is not possible for the company to rectify the situation.
The American Stock Exchange (AMEX) is the second largest exchange in the US, has less stringent listing requirements, and currently has about 770 listed stocks.
Listing Requirements (3 of 3)
Regional exchanges typically list 100 - 500 securities and handle about 4% in dollar volume of all shares traded on organized exchanges.
Options exchanges are those where options are listed and traded, such as the Chicago Board Options Exchange (CBOE) as well as the NYSE, AMEX, the Pacific and the Philadelphia Stock Exchange.
Futures exchanges are those on which commodity and financial futures are traded, such as Chicago Board of Trade (CBT). Others are the New York Mercantile Exchange, the Chicago Mercantile Exchange, the London International Financial Futures Exchange, and many others.
The National Association of Securities Dealers Automated Quotation System (NASDAQ) is unlike the exchanges mentioned above.
NASDAQ is not a physical place but rather an automated linking of dealers often referred to as market makers to buyers and sellers of securities.
Most government and corporate bonds are traded OTC, as are many common stocks of small companies.
Third and Fourth Markets
The third market facilitates over-the-counter transactions made in exchange-listed securities
The fourth market transactions are made directly between large institutional buyers and sellers.
Trading hours of securities markets have been expanded in recent years both on the NYSE as well as for NASDAQ-listed securities.
General Market Conditions
Bull markets are favorable markets normally associated with rising prices, investor optimism, economic recovery, and government stimulus.
Bear markets are unfavorable markets, normally associated with falling prices, investor pessimism, economic slowdown, and government constraint.
Globalization of Securities
Investors and firms look beyond the markets of their home countries in order to diversify and search for international business opportunities. Diversification means the inclusion of a number of different investment vehicles in a portfolio to increase returns and/or reduce risk.
Importance of International Markets
There are now organized exchanges in more than 100 countries worldwide, not only in major developed countries but also in emerging markets in Latin America, Africa, Southeast Asia, and Central and Eastern Europe.
The most important exchanges outside the US are located in London, Frankfurt, Paris, and Tokyo.
Importance of International Markets (continued)
International investment performance has lured investors to go overseas. Many countries have had higher performances than the US market.
Investors can compare activity on U.S. and foreign exchanges by following market indexes that track the performance of those exchanges (look in the Wall Street Journal's section C under "World Stock Markets“).
International Investing (1 of 4)
Investing in foreign securities can be accomplished either directly or indirectly.
Direct investment can be achieved by buying American Depository Receipts (ADRs) which are dollar-denominated receipts for the stocks of foreign companies that are held in the vaults of US banks, and are traded on the NYSE, AMEX, or NASDAQ.
International Investing (2 of 4)
The most widely used method of investing internationally today is done indirectly through mutual funds specializing in foreign securities.
On the debt side, Yankee bonds, which are dollar denominated debt securities issued by foreign governments and corporations and traded in the US, are popular securities. For example, Mitsubishi issues dollar-denominated bonds in the U.S.
International Investing (3 of 4)
Risks of investing internationally are numerous.
Trade policies, labor laws, and taxation may affect operating conditions.
Lack of familiarity with foreign economic and political environments can make an analyst's job daunting, not to mention the increasing number of countries now involved.
International Investing (4 of 4)
Currency exchange rate indicates the relationship between two currencies at a specific date.
Currency exchange risk is the risk caused by varying exchange rates between the currencies of two countries.
Review problems 77, 104, 105, 106 and 107 in Volume II, Investments
Regulation of securities markets has been made necessary to protect investors and to meet the needs of the financial marketplace as it grows in size and complexity.
The Securities Act of 1933
The Securities Act of 1933 was passed by Congress to ensure full disclosure of information about new security issues.
The prospectus is a portion of a security registration statement that details the key aspects of the issue, the issuer, and its management and financial position.
The red herring is a preliminary prospectus made available to prospective investors after a registration statement's filing but before its approval.
The Securities Exchange Act of 1934
The Securities Exchange Act of 1934 established the SEC as the federal agency in charge of administering the federal securities laws.
The act also gave the SEC the power to regulate exchanges, markets, disclosure requirements of new and current securities, and all participants in the markets.
The Maloney Act of 1938
The Maloney Act of 1938 is an amendment to the Securities Exchange Act of 1934
It provided for the establishment of self-regulatory trade associations, such as the National Association of Securities Dealers (NASD).
The Investment Company Act of 1940 and The Investment Advisers Act of 1940
The Investment Company Act of 1940 is designed to protect those purchasing mutual fund shares.
The Investment Advisers Act of 1940 was passed to protect investors against potential abuses by persons advising investors about security investments.
The Securities Acts Amendments of 1975 and The Insider Trading and Fraud Act of 1988
The Securities Acts Amendments of 1975
Added by Congress to develop a competitive national system for trading securities, such as abolishing fixed commission schedules.
The Insider Trading and Fraud Act of 1988
Helps define insider trading as being the illegal use of material nonpublic information about a company to make profitable securities transactions. Insider trading cases have heightened the public's awareness of ethics, and the financial community continues to develop ethical standards of conduct.
Review problems 113, 114, 115 and 117 in Volume II, Investments
Basic Types of Investment Transactions
transactions in which investors buy securities in the hope that they will increase in value and be sold at a later date for a profit. These transactions are the most common.
uses borrowed funds to purchase securities and is used to magnify returns by reducing the amount of capital that the investor must put up. Margin transactions are handled through a special margin account.
Margin Accounts (1 of 4)
Using margin magnifies returns when security prices increase, but magnifies losses when prices fall.
Advantage: the potential for magnified returns and the ability to gain diversification for small investors.
Disadvantages: it magnifies losses and there is an interest cost on borrowed funds. Margin rates are generally 1-3% above the prime rate.
Margin Accounts (2 of 4)
Margin requirements are set by the Federal Reserve Board.
The initial margin stipulates the amount of money (or equity) which must be provided by the investor at the time of purchase.
Maintenance margin, usually lower than the initial margin, is the minimum amount of equity investors must have in their margin accounts at all times.
Margin Accounts (3 of 4)
Margin trading employs financial leverage (with an investor's equity serving as a base) which is the use of debt financing to magnify investment returns
restricted account - a margin account whose equity is less than the initial margin requirement; the investor may not make further margin purchases and must bring the margin back to the initial level when securities are sold.
Margin call is a notification of the need to bring the equity of an account whose margin is below the maintenance level up to the initial margin level or have margin holdings sold to reach this point.
Margin Accounts (4 of 4)
Margin = ( value of securities - debit balance )
value of securities
= V – D
where the value of securities is simply the current market price and the debit balance is the amount borrowed.
The basic margin formula changes as the current market price changes, but the debit balance does not change.
Since most margin transactions are for a short period of time, annualized return on invested capital is used to measure transaction benefits. Return on invested capital equals:
income rec’d - loan interest + value at sale - value at purchase
amount of equity invested
This return can be annualized by multiplying it by the equivalent number of periods in a year.
Uses of Margin Trading
There are two uses of margin trading: increasing transaction percentage returns, and Pyramiding investment holdings.
To increase transaction returns, one uses margin, hoping for the price to increase. If it increases enough to cover the interest on the borrowed funds, returns are magnified.
Pyramiding involves using any margin (equity) in an account, in excess of the required margin, to purchase additional securities
Short Selling (1 of 3)
Short selling is the selling of borrowed securities with the expectation of being able to purchase the securities back later at a lower price. Investors make money when prices drop.
Short sellers, however, have no current income as dividends belong to the lender. If prices go up, the losses go up as well.
Short selling always involves borrowed securities. The lender is either the investor's broker or another individual investor.
Short Selling (2 of 3)
Brokerage firms are the principal source of borrowed securities and lend securities from their own portfolios or from street name accounts (securities owned by other clients but registered to a brokerage house).
Lenders of securities for short sale are protected from loss because the broker keeps on depositing all proceeds. In addition, short sellers must meet margin requirements to cover any increases in price or dividends.
Short Selling (3 of 3)
Short sales are generally made for speculative purposes. Prior to the enactment of The Taxpayer Relief Act of 1997, short sales were commonly used to hedge existing profits and defer capital gains into a different fiscal year (short against the box). This is no longer allowed. A gain must be recognized when the borrowed shares are sold, not when the short sale is later covered.
Short Sales Issues
Two issues related to short sales
A short sale can only be executed on an uptick, or a zero tick that follows an uptick
The short seller is responsible to the lender of the security for any dividends paid during the short sale period.
This is probably a non-issue, as the price of the security tends to fall by the dividend amount when the stock goes ex-dividend.