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  1. 1. Organization and Functioning of Securities Markets + Market Indexes Chapter 4 & 5 of Reilly & Brown
  2. 2. What is a market? <ul><li>Brings buyers and sellers together to aid in the transfer of goods and services </li></ul><ul><li>Does not require a physical location </li></ul><ul><li>Does not have to own the goods and services involved </li></ul><ul><li>Buyers and sellers both benefit from the existence of the market </li></ul>
  3. 3. Characteristics of a Good Market <ul><li>Transparency </li></ul><ul><ul><li>Availability of timely and accurate information about past transaction </li></ul></ul><ul><ul><li>Info on Price, volume, supply and demand, etc. </li></ul></ul><ul><li>Liquidity </li></ul><ul><ul><li>marketability </li></ul></ul><ul><ul><li>price continuity </li></ul></ul><ul><ul><li>depth </li></ul></ul><ul><li>Internal efficiency </li></ul><ul><ul><li>Lower transaction cost </li></ul></ul><ul><li>External efficiency – prices quickly reflect new information </li></ul>
  4. 4. Organization of the Securities Market <ul><li>Primary markets </li></ul><ul><ul><li>Initial Public Offerings (IPOs) and other New issues are sold </li></ul></ul><ul><li>Secondary markets </li></ul><ul><ul><li>Trading of already issued securities takes place. </li></ul></ul>
  5. 5. Investment Banks Make Primary Markets <ul><li>Initial public offerings (IPOs) occur when corporations and governments issue new securities into the primary market </li></ul><ul><li>Sometimes corporations and governments with existing securities raise additional capital by issuing a new issue of seasoned securities </li></ul><ul><li>Investment bankers find buyers for both IPOs and seasoned new issues </li></ul>
  6. 6. Investment Bankers’ Functions <ul><li>Each public offering has four steps </li></ul><ul><ul><li>Consulting with the issuer </li></ul></ul><ul><ul><li>Carrying out administrative duties </li></ul></ul><ul><ul><li>Underwriting the issue </li></ul></ul><ul><ul><li>Distributing the securities to investors </li></ul></ul>
  7. 7. Secondary Market <ul><li>Once securities are issued in the primary market, they can begin trading in the secondary market </li></ul><ul><li>Types of secondary markets </li></ul><ul><ul><li>Organized exchange run by dealers (NYSE) </li></ul></ul><ul><ul><li>Electronic market in which dealers compete with one another (Nasdaq) </li></ul></ul><ul><ul><li>Electronic communication networks </li></ul></ul>
  8. 8. Why Secondary Markets Are Important <ul><li>Provides liquidity to investors who acquire securities in the primary market </li></ul><ul><li>Helps determine market pricing for new issues </li></ul>
  9. 9. NYSE <ul><li>New York Stock Exchange ( ) lists approximately </li></ul><ul><ul><li>3000 common and preferred stocks issued by American corporations </li></ul></ul><ul><ul><li>300 foreign stocks </li></ul></ul><ul><ul><li>250 American Depository Receipts (ADRs) </li></ul></ul><ul><ul><li>Also trades bonds </li></ul></ul>
  10. 10. NYSE <ul><li>Each stock traded on the NYSE is assigned a specialist who must </li></ul><ul><ul><li>Continuously post bid and ask prices for the stocks in which they make a market </li></ul></ul><ul><ul><li>Stand at assigned posts on the trading floor </li></ul></ul><ul><ul><li>Act as market-makers (dealer) </li></ul></ul><ul><ul><ul><li>Always ready to buy at their bid price and sell at their ask (or offer) price </li></ul></ul></ul><ul><ul><ul><ul><li>Invest their own capital (risky) but may earn a return </li></ul></ul></ul></ul><ul><ul><li>Execute orders for others (broker) </li></ul></ul><ul><ul><li>Earn the bid-ask spread on every transaction </li></ul></ul>
  11. 11. Decimalization <ul><li>A tick represents the minimum amount by which a price can change </li></ul><ul><ul><li>The tick size is now 1 ¢ since the exchanges instituted decimalization </li></ul></ul><ul><ul><li>Expected to reduce the bid-ask spread and trading costs </li></ul></ul>
  12. 12. NYSE Listing Requirements <ul><li>To be listed on the NYSE must have </li></ul><ul><ul><li>A minimum taxable annual income of $2.5 million </li></ul></ul><ul><ul><li>A minimum net tangible assets of $18 million </li></ul></ul><ul><ul><li>A minimum of 1.1 million shares of publicly held stock with a minimum market value of $18 million </li></ul></ul><ul><ul><li>A minimum number of 2,000 investors owning round-lots (100 shares) </li></ul></ul><ul><ul><li>One specialist </li></ul></ul>
  13. 13. NYSE Operations <ul><li>NYSE has 1,366 members who must own a seat on the exchange </li></ul><ul><ul><li>Almost all members are either specialists or floor brokers </li></ul></ul>
  14. 14. Floor Brokers <ul><li>Buy and sell securities for the clients of brokerage houses or for their own accounts </li></ul><ul><li>Order process </li></ul><ul><ul><li>Broker receives order via phone from the brokerage </li></ul></ul><ul><ul><li>Walks to trading floor and executes transaction at the specialist’s post </li></ul></ul><ul><ul><li>Phones brokerage and provides confirmation </li></ul></ul>
  15. 15. Specialists <ul><li>Accepts obligation to make a fair and orderly market by </li></ul><ul><ul><li>Selling shares out of their own inventory if there are more buy orders than sell orders (or by raising the price of the security they control) </li></ul></ul><ul><ul><li>Buying shares for their own inventory if there are more sell orders than buy orders (or by lowering the price of the stock) </li></ul></ul><ul><li>Keeps a limit order book (LOB) for each stock in which they make a market </li></ul>
  16. 16. NYSE <ul><li>Uses Super Designated Order Turnaround (SuperDOT) system </li></ul><ul><ul><li>Routes small market orders and limit orders directly from member firms to specialists </li></ul></ul><ul><ul><ul><li>Bypasses floor brokers </li></ul></ul></ul><ul><ul><ul><li>Specialists usually let PCs execute SuperDOT transactions automatically </li></ul></ul></ul>
  17. 17. Nasdaq Market <ul><li>Electronic, over-the-counter (OTC) market </li></ul><ul><li>Lists over 15% of the world’s stock market capitalization </li></ul><ul><ul><li>Over 6,400 common and preferred stocks </li></ul></ul><ul><ul><li>About 320 foreign stocks </li></ul></ul><ul><ul><li>About 140 ADRs </li></ul></ul>
  18. 18. Third U.S. Market <ul><li>Third market—subset of OTC market where exchange-listed stocks are traded </li></ul><ul><ul><li>Competes with organized exchanges </li></ul></ul><ul><ul><ul><li>Offers cost savings in the form of better bid-ask prices </li></ul></ul></ul><ul><ul><li>Nasdaq and regional stock exchanges are the core of the third market </li></ul></ul>
  19. 19. Fourth U.S. Market <ul><li>Fourth market—a network of market-makers, block traders and institutions </li></ul><ul><ul><li>Bypass normal dealer services and negotiate directly with each other </li></ul></ul><ul><ul><li>Instinet (short for Institutional Network) has operated in the fourth market since 1970 </li></ul></ul>
  20. 20. Exchange Membership <ul><li>Specialist </li></ul><ul><li>Commission brokers </li></ul><ul><ul><li>Employees of a member firm who buy or sell for the customers of brokerage firms </li></ul></ul><ul><li>Floor brokers </li></ul><ul><ul><li>Independent members of an exchange who act as broker for other members </li></ul></ul><ul><li>Registered traders </li></ul><ul><ul><li>Use their membership to buy and sell for their own accounts </li></ul></ul>
  21. 21. Trading on Margin <ul><li>When opening a new account with a brokerage firm, can have either </li></ul><ul><ul><li>Cash account </li></ul></ul><ul><ul><ul><li>Must pay cash for securities </li></ul></ul></ul><ul><ul><li>Margin account </li></ul></ul><ul><ul><ul><li>Offers ability to buy securities on credit </li></ul></ul></ul><ul><ul><ul><li>Money put forth by investor serves as a down payment </li></ul></ul></ul><ul><ul><ul><li>Amount investors may borrow is controlled by the Federal Reserve Board of Governors </li></ul></ul></ul><ul><ul><ul><ul><li>For example, the Fed may stipulate a 60% margin, meaning the investor must put forth at least 60% of the purchase price </li></ul></ul></ul></ul>
  22. 22. Trading on Margin <ul><li>Federal Reserve’s margin requirements for stocks </li></ul><ul><ul><li>Varied from 10% (1929) to 100% (1940) </li></ul></ul><ul><ul><li>In recent years has been 50% </li></ul></ul><ul><li>Margin requirements are different for different types of securities </li></ul>
  23. 23. Margin Transactions <ul><li>Buy 200 shares of Widget at $50/share = $10,000 </li></ul><ul><li>Borrow 50% (initial margin) of investment ($5,000) </li></ul><ul><li>If price increases to $60/share, position </li></ul><ul><ul><li>Value is $12,000 </li></ul></ul><ul><ul><li>Less - $5,000 borrowed </li></ul></ul><ul><ul><li>Leaves $7,000 equity for a </li></ul></ul><ul><ul><li>Margin=$7,000/$12,000 = 58% </li></ul></ul><ul><li>What is your rate of return with and without margin? </li></ul>
  24. 24. Margin Transactions <ul><li>If price decreases to $40/share, position </li></ul><ul><ul><li>Value is $8,000 </li></ul></ul><ul><ul><li>Less - $5,000 borrowed </li></ul></ul><ul><ul><li>Leaves $3,000 equity for a </li></ul></ul><ul><ul><li>$3,000/$8,000 = 37.5% equity position </li></ul></ul><ul><li>What is your rate of return with and without margin? </li></ul>
  25. 25. <ul><li>If maintenance margin =25%, then, at what per share price of Widget (P*) would you receive a margin call? </li></ul>Margin Call
  26. 26. Short sales <ul><li>Sell overpriced stock that you don’t own and purchase it back later (at a lower price) </li></ul><ul><li>Borrow the stock from another investor (through your broker) </li></ul><ul><li>Three technical points of short sales </li></ul><ul><ul><li>Short sale can only be made on an uptick trade; </li></ul></ul><ul><ul><li>The short sellers must pay any dividends due to investors who lent the stock; </li></ul></ul><ul><ul><li>Short sellers must post the same margin as buyers of the stock </li></ul></ul>
  27. 27. Types of Trading Orders <ul><li>Market order—order to buy or sell ASAP at the current market price </li></ul><ul><ul><li>Simplest, most common order type </li></ul></ul><ul><ul><li>Executed immediately with virtual certainty </li></ul></ul><ul><li>Limit order—order to buy or sell with a limit </li></ul><ul><ul><li>Limit as to the maximum price paid for a buy order </li></ul></ul><ul><ul><li>Limit as to the minimum price received for a sell order </li></ul></ul><ul><ul><ul><li>If order cannot be immediately transacted, it is recorded in the market-maker’s limit order book and held for possible future execution </li></ul></ul></ul><ul><ul><ul><ul><li>Order may never be executed if limit price is not reached </li></ul></ul></ul></ul><ul><ul><ul><ul><li>May attach a time frame to the limit order </li></ul></ul></ul></ul>
  28. 28. Types of Trading Orders <ul><li>Stop orders </li></ul><ul><ul><li>To buy (sell) at prices greater (lower) than the current market price </li></ul></ul><ul><ul><li>Activated when (if) the market price reaches the stop price </li></ul></ul><ul><ul><ul><li>Once activated becomes a market order </li></ul></ul></ul><ul><ul><li>Dangers with stop orders </li></ul></ul><ul><ul><ul><li>Execution price cannot be known in advance </li></ul></ul></ul><ul><ul><li>Variation on stop order </li></ul></ul><ul><ul><ul><li>Stop limit orders </li></ul></ul></ul><ul><ul><ul><ul><li>When stop order is activated it becomes a limit order rather than a market order </li></ul></ul></ul></ul>
  29. 29. Why construct Market Indexes? <ul><li>Judge the performance of investment managers. </li></ul><ul><li>Form indexed portfolios. </li></ul><ul><li>Perform research on the macroeconomic factors that affect security prices. </li></ul><ul><li>Analyze relationship between investment returns across borders. </li></ul><ul><li>Perform technical and fundamental analysis of the entire equity class of assets. </li></ul><ul><li>Serve as the “market portfolio” for measuring beta and systematic risk. </li></ul>
  30. 30. Differentiating Factors in Constructing Market Indexes <ul><li>What does the index represent? </li></ul><ul><ul><li>Source </li></ul></ul><ul><ul><li>Size </li></ul></ul><ul><ul><li>Breadth </li></ul></ul><ul><li>Computational procedure </li></ul><ul><ul><li>Simple average </li></ul></ul><ul><ul><li>Geometric average </li></ul></ul><ul><li>Weighting sample members </li></ul><ul><ul><li>price-weighted series </li></ul></ul><ul><ul><li>value-weighted series </li></ul></ul><ul><ul><li>unweighted (equally weighted) series </li></ul></ul>
  31. 31. Dow Jones Industrial Average (DJIA) <ul><li>Begun in 1884 with 11 stocks </li></ul><ul><li>Price-weighted average of thirty (since 1928) large well-known industrial stocks, leaders in their industry. </li></ul><ul><li>Total the current price of the 30 stocks and divide by a divisor (adjusted for stock splits and changes in the sample) </li></ul>
  32. 32. Example of Change in DJIA Divisor When a Sample Stock Splits <ul><li>After Three-for One </li></ul><ul><li>Before Split Split by Stock A </li></ul><ul><li>Prices Prices </li></ul><ul><li>A 30 10 </li></ul><ul><li>B 20 20 </li></ul><ul><li>C 10 10 </li></ul><ul><li>60 3 = 20 40 X = 20 </li></ul><ul><li>X = 2 (New Divisor) </li></ul>
  33. 33. Impact of Differently Priced Shares on a Price-Weighted Indicator Series <ul><li>PERIOD T+ 1 </li></ul><ul><li>Period T Case A Case B </li></ul><ul><li>A 100 110 100 </li></ul><ul><li>B 50 50 50 </li></ul><ul><li>C 30 30 33 </li></ul><ul><li>Sum 180 190 183 </li></ul><ul><li>Divisor 3 3 3 </li></ul><ul><li>Average 60 63.3 61 </li></ul><ul><li>% Change 5.5% 1.7% </li></ul>
  34. 34. Criticism of the DJIA <ul><li>Sample used is limited </li></ul><ul><li>Introduces a downward bias in DJIA by reducing weighting of fastest growing companies whose stocks split </li></ul><ul><li>Biased toward the behavior of the highest priced securities </li></ul><ul><li>It represents the performance of a portfolio of an equal number of shares in each of the stocks in DJIA. </li></ul>
  35. 35. Value-Weighted Series <ul><li>The Standard & Poor’s (S&P), New York Stock Exchange (NYSE), American Stock Exchange (AMEX), NASDAQ, Financial Times Actuaries (London) and Tokyo Exchange Price Index (Japan) </li></ul>
  36. 36. Value-Weighted Series <ul><li>where: </li></ul><ul><li>Index t = index value on day t </li></ul><ul><li>P t = ending prices for stocks on day t </li></ul><ul><li> N t = number of outstanding shares on day t </li></ul><ul><li>P 0 = ending price for stocks on base day 0 </li></ul><ul><li>N 0 = number of outstanding shares on base day 0 </li></ul>
  37. 37. Example Total 105 100 10000 C 33 35 20000 B 11 10 100000 A Mkt V2 Price 2 Mkt V1 Price 1 Shares Stock
  38. 38. Example 2810000 2700000 Total 1050000 105 1000000 100 10000 C 660000 33 700000 35 20000 B 1100000 11 1000000 10 100000 A Mkt V2 Price 2 Mkt V1 Price 1 Shares O Stock
  39. 39. Example <ul><li>Index 2 = </li></ul><ul><li>%  Index= </li></ul>
  40. 40. Unweighted Price Indicator Series <ul><li>All stocks carry equal weight regardless of price or market value </li></ul><ul><li>May be used by individuals who invest the same dollar amount in each stock in the sample </li></ul><ul><li>Some use arithmetic average of the percent price changes for the stocks in the index </li></ul>
  41. 41. Unweighted Price Indicator Series <ul><li>Value Line and the Financial Times Ordinary Share Index (London) compute a geometric mean of the holding period returns and derive the holding period yield from this calculation </li></ul>
  42. 42. Example Total 105 100 C 33 35 B 11 10 A Price 2 Price 1 Stock
  43. 43. Example <ul><li>If the index on Day 1 is 200, index on day 2 would be: </li></ul><ul><li>%  Index= </li></ul>
  44. 44. Additional Example Stock C split 2 for 1 between T=1 and T=2. 400 55 200 110 200 100 C 200 45 200 45 200 50 B 100 95 100 95 100 90 A Q 2 P 2 Q 1 P 1 Q 0 P 0
  45. 45. Price-Weighted Average <ul><li>Index 0 =(90+50+100)/3=80 </li></ul><ul><li>Index 1 =(95+45+110)/3=83.3 </li></ul><ul><li>R 1 =(83.3/80)-1=4.17% </li></ul><ul><li>ND=(95+45+55)/83.3=2.34 </li></ul><ul><li>Index 2 =(95+45+55)/2.34=83.3 </li></ul>
  46. 46. Value-Weighted Index <ul><li>MV 0 =(90x100+50x200+100x200)=39000 </li></ul><ul><li>MV 1 =(95x100+45x200+110x200)=40500 </li></ul><ul><li>R 1 =(40500/39000)-1=3.85% </li></ul><ul><li>MV 2 =(95x100+45x200+55x400)=40500 </li></ul>
  47. 47. Equal Weighted Index <ul><li>R A =(95/90)-1=5.56% </li></ul><ul><li>R B =(45/50)-1=-10% </li></ul><ul><li>R C =(110/100)-1=10% </li></ul><ul><li>R 1 =(5.56%-10%+10%)/3=1.85% </li></ul><ul><li>R 1 = </li></ul>