INVESTOR PARTICIPATION IN THE FINANCIAL MARKETS
STUDENT LEARNING OBJECTIVES
After reading Chapter 6, students should be able to answer the following questions:
1. How should investors choose a broker?
2. What are the various types of orders placed by investors?
3. What is cybertrading?
4. What are block trades and program trading?
5. Who regulates the financial markets and protects investors?
SUGGESTIONS FOR USE AND TEACHING TIPS
The material covered in Chapter 6 is mostly descriptive and non-technical. It also has a
practical, real world orientation to it. While we believe students should read the entire
chapter, how much of it you want to cover in class depends on student backgrounds
and your course objectives. You may not feel it necessary to devote very much class
time to topics such as how to choose a brokerage firm and the kinds of orders investors
Chapter 6 provides ample opportunities to discuss some of the ethical issues that arise
in investment decisions. The material on securities regulation, for example, leads to a
natural discussion of such topics as insider trading and fiduciary responsibilities. We’ve
included in Chapter 6 several questions from prior CFA exams that deal with ethical and
professional behavior standards for investment advisors. One of the Internet exercises
ask students to visit the AIMR Website and write a brief report on the ethical and
professional standards that bind all CFAs.
Some more specific suggestions and tips include:
• Make sure students understand the major differences between the types of
brokerage firms. One point to stress is the fact that brokers at full service firms
work mainly on commission—the more you trade the more they make. Also,
point out that discount firms and even many cyber firms provide customers with
extensive amounts of information. They just don’t provide “advice,” per se.
• Students should realize that trading today on even the NYSE today is highly
automated. Buy and sell orders are essentially matched electronically and
executed with minimal human contact.
• It’s worth spending a little time on the issue of margin buying. The amount of
margin debt has risen sharply over the past few years and many worry that
these investors don’t fully understand or appreciate the risks associated with
buying securities on margin.
• Many students will likely have heard of program trading. Point out that the term
program trading is used very loosely on Wall Street. On the street program
trading essentially means any computerized trading system where buy and sell
decisions are based on predetermined rules. A good question to ask students to
encourage discussion is the relationship between program trading and volatility,
and whether or not restrictions should be placed on program trades.
• Make sure students understand the overall goal of federal securities regulation.
Regulation isn’t designed to pass judgment on the value of an investment, but
rather regulation is designed to insure that all relevant information be disclosed
to investors in a full and fair manner.
• A good question to ask students is why it is in the interest of all participants for
the markets to be perceived as being fair. What would happen if investors
started to believe that the markets were someone rigged? Also, ask why it
appears as though federal regulation and industry self-regulation often have the
I. Choosing a broker
A. Types of brokerage firms
1. Full service firms
2. Discount firms
3. Deep discount firms
4. Cyber (electronic) brokers
B. Buying securities without a broker
1. Dividend reinvestment plans
2. No-load stock purchase programs
II. Types of orders
A. Market order
2. How it is executed on the NYSE
3. How it is executed on Nasdaq
4. Spreads and decimal pricing
5. Clearing procedures
B. Limit orders
C. Stop (or stop-loss) orders
D. Margin transactions
1. What is a margin transaction
2. Initial and maintenance margin requirements
3. Margin calls
4. Risk/return characteristics of margin transactions
E. Short sales
III. Cyber trading
A. History of cyber trading
B. Advantages and disadvantages of cyber trading
1. Low cost
2. Easy, 24 hour access
3. Delays in order execution
4. Margin calls are not required
C. Day trading
IV. Block trades and program trading
A. Block trades
2. The creation of block houses and the third market
B. Program trading
1. Wall Street definition
2. Index arbitrage
3. Circuit breakers employed by NYSE
V. Investor protection
A. Importance of investor confidence
B. Government regulation in the United States
1. The Securities & Exchange Commission
2. Regulatory philosophy
a. Full and fair disclosure
c. Insider trading
3. State regulation
C. Securities regulation in other countries
1. Modeled on U.S. regulation
D. Industry self regulation
1. Professional rules of conduct
a. NASD rules
b. AIMR standards
c. Arbitration and discipline procedures
2. Market surveillance
INVESTMENT INSIGHT BOX - Picking a Stockbroker
The Investment Insight box lists some practical tips for choosing a broker. Selecting a
broker and a brokerage firm are important decisions and can have a great deal of
influence over the success of any investment program. Unfortunately, many investors
don’t spend the necessary time when choosing a broker.
One of the most important things to stress to students is the way in which brokers are
various firms are compensated. Brokers who work for full service firms are
compensated primarily on commission. While we’re not suggesting all investors avoid
full service firms, that’s an important point to keep in mind.
INVESTMENT PROFILE – The “Average” Investor
The Investment profile provides interesting results from a recent survey describing the
average investor. Not surprisingly, it shows that families with higher income, older, and
homeowners are likely to have more money in the stock market. Perhaps, it might be
fun to ask the students if this profile changed in the downturn of 2001-02. Ask why?
INVESTMENT INSIGHT BOX - Improving the Quality of Company Boards
Corporate scandals involving public companies have also generated more interest
among institutional investors to actively comment on the corporate governance of many
companies they invest in. For example CalPERS, one of the nation’s largest public
employees’ retirement system, issues a list of firms that need changes in their corporate
governance. CalPERS wanted JDS Uniphase to separate people holding the jobs of
chairman and chief executive as well as for the company’s directors to be re-elected at
the same time instead of the staggered elections currently used. Five other firms on
their list are Gemstar-TV Guide International, Inc., Manugistics Group Inc., Midway
games, Inc., Parametric Technology, and Xerox Corp.
• Examine any one of the following companies and see which one(s) of the listed
criteria in the Investment Insight Box does the company violate?
• Is it easy to determine whether the board has independent directors? Why or
• How can they improve the corporate board to protect the rights and interests of
ANSWERS TO END OF CHAPTER EXERCSISES
1. You would owe your broker $15,000 for the stock (500 shares x $30) along with a
commission of $112.50. If this was a market order, settlement occurs three
business days following the trade, or on Thursday, January 8.
2. It would have been transmitted to the floor of the NYSE. Assuming no sell orders
for $28 or less were present at the time, the order would have been left with the
Gap specialist. The specialist would fill the order when, and if, the price of Gap
drops to $28 or below.
3. The initial margin requirement would be 50 percent of the initial value of the
stock, or $7,500. The initial margin is the amount of cash you have to put up.
4. You would face a margin call when your margin is down to 30 percent, or less of
the value of the securities. Assuming the stock was purchased for $30, you
would face a margin call once the price dropped below approximately $21.43.
5. If the price of Gap rose from $30 to $50, your return would equal 65 percent if
you paid cash for the stock. If you bought the stock on margin, your return would
equal ($10,000 - $337.50)/$7,500 = 128.8 percent. (You end up paying $337.5
in interest on the margin loan. It is 4.5 percent of the amount borrowed.)
1. There are four types of brokerage firms: full service firms, discount firms, deep
discount firms, and cyber brokers. An investor who needs help making
investment decisions, and has confidence in the quality of the advice being
given, should probably use the services of a full service firm. Investors who
make their own investment decisions should use either a discount or deep
2. Yes. A dividend reinvestment plan allows the investor to use cash dividends to
purchase additional shares of stock directly from the company, avoiding
3. If you wanted to buy a NYSE listed stock your order would be transmitted to the
floor of the exchange to the post where the stock is traded. If no sellers are
present the specialist would fill the order from his or her inventory. If sellers were
present, an auction would take place. An order to purchase a Nasdaq stock
would involve your broker reviewing the “ask” prices for all the stock’s market
makers. Your broker would place an order with the market maker offering the
lowest ask price.
4. Limit order establish maximum prices, if you’re buying, or minimum prices if
you’re selling. A stop-loss order establishes a trigger price for a stock. If the
stock price declines below the trigger price, the stop-loss order becomes a
market order to sell.
5. The initial margin equals 50% of ($100 x 200 sh) or $10,000. If the price rises to
$110, it adds $2,000 (($110-$100)x200sh) to the initial margin, $12,000. If the
price declines to $90, it reduces by $2,000 (($90-$100)x200sh) from the initial
6. The investor would face a margin call at about $77 per share ($76.92); the stock
would be sold—and the loan repaid—if the investor failed to meet the margin call.
7. Online trading has expanded in recent years for a number of reasons. Online
services are available 24 hours a day, seven days a week, and online trading
firms generally charge low commissions. Day trading involves sitting in front of a
computer screen and, using computer software and a fast Internet connection,
looking for short term trends in stock prices. Day traders buy stocks they think
are about to rise and sell stocks they think are about to fall. Day traders may buy
and sell the same stock several times each day.
8. A block trade involves an order to buy or sell 10,000 or more shares. Program
trading involves computerized buy and sell programs. Orders are executed
automatically if certain conditions are met. Both have increased in recent years
due to the growth of institutional investors and mutual funds.
9. The Securities & Exchange Commission (SEC) is primarily responsible for
federal regulation of the securities markets. It was established in 1934 as part of
the government’s effort to restore order and investor confidence in the financial
markets in the wake of the 1929 stock market crash.
10. The SEC doesn’t pass judgment on the investment merit of securities, rather it
requires that potential investors be told all relevant information about securities.
That is what is meant by full and fair disclosure. An illegal trading practice is
buying or selling a security on the basis of inside information, information not
available to the public.
Critical Thinking Exercises
1. This exercise is fairly straightforward and students should need little guidance
from you to complete it. What students should find is that many large, well
known stocks have large short positions. In addition, stocks that have seen
substantial price increases over short periods of time often have large short
2. Pick a company that is currently in the “news” and check out its web site.
Compare the information on the company web site to what is reported in the
newspapers such as the Wall Street Journal. Do you feel information provided
by companies are more or less than the news media?