Chapter 16
Learning Objectives  (part 1 of 3) <ul><li>Discuss why financial markets exist and the benefit they provide to society </l...
Learning Objectives  (part 2 of 3) <ul><li>Distinguish between the types of brokers and brokerage firms </li></ul><ul><li>...
Learning Objectives  (part 3 of 3) <ul><li>Explain the process of selling short </li></ul><ul><li>Describe how dollar cost...
Financial Markets <ul><li>They exist to facilitate the transfer of money from people with more cash than they currently ne...
Primary vs. Secondary Markets <ul><li>Primary Markets </li></ul><ul><ul><li>Newly issued securities sold by the issuer (e....
IPOs and DPOs <ul><li>Initial Public Offering </li></ul><ul><ul><li>Firm sells stock to public for the first time </li></u...
Where are stocks traded? <ul><li>National Exchanges </li></ul><ul><ul><li>New York Stock Exchange (NYSE) </li></ul></ul><u...
Listing Standards <ul><li>Toughest for national exhanges </li></ul><ul><li>For NYSE: </li></ul><ul><ul><li>At least 2,000 ...
Methods of Trading <ul><li>Specialist (e.g., used on NYSE) </li></ul><ul><ul><li>Assigned specific stocks </li></ul></ul><...
Stock Market Indexes <ul><li>Dow Jones Industrial Average (DJIA) </li></ul><ul><ul><li>Dollar-weighted index </li></ul></u...
Types of brokerage firms (1 of 2) <ul><li>Distinction becoming blurred over time </li></ul><ul><li>Full-service brokers </...
Types of brokerage firms (2 of 2) <ul><li>Discount brokers </li></ul><ul><ul><li>All brokers respond to all accounts </li>...
Ordering out vs. street name <ul><ul><li>Ordering out (taking possession) </li></ul></ul><ul><ul><ul><li>Direct communicat...
Direct Purchase Plan <ul><li>Similar to IPO, buy stock directly from company but stock has active market </li></ul><ul><li...
Dividend Reinvestment Program <ul><li>Like a dollar averaging program </li></ul><ul><li>Shares must be on deposit with the...
Types of Orders for Trading (1 of 2) <ul><li>Market Order </li></ul><ul><ul><li>Will be immediately executed </li></ul></u...
Types of Orders for Trading (2 of 2) <ul><li>Limit order </li></ul><ul><ul><li>Specify price lower than market for buy </l...
Buying on margin (1 of 3) <ul><li>Computing the initial margin: </li></ul><ul><ul><li>  Buy 100 shares of stock at $10 per...
Buying on margin (2 of 3) <ul><li>The Effect of Buying on Margin: </li></ul><ul><li>ROE =  ROA / m </li></ul><ul><li>where...
Buying on margin (3 of 3) <ul><li>Buy 100 shares at $10 per share & stock goes to $15 per share => </li></ul><ul><li>  ROA...
Mechanics for selling a stock short (1 of 2))   <ul><li>TODAY: </li></ul><ul><li>  </li></ul><ul><li>Investor places an or...
Mechanics for selling a stock short (2 of 2)   <ul><li>IN THE FUTURE: </li></ul><ul><li>Investor decides to close out the ...
Dollar Averaging (1 of 2) <ul><li>Commit to a program of buying a fixed dollar amount of an investment at predefined inter...
Dollar Averaging (2 of 2) <ul><li>This has the effect of reducing the average purchase price over time (as compared to buy...
Playing the Market for Fun <ul><li>Can always do it “on paper” </li></ul><ul><ul><li>Time consuming and most people lose i...
Protections for Investors <ul><li>If brokerage firm fails => Securities Investor Protection Corporation (SIPC) </li></ul><...
Pyramid Schemes <ul><li>Partnerships or distributorships are sold (along with a product) </li></ul><ul><li>Each seller of ...
Ponzi Schemes <ul><li>Principal of initial investors is used to pay incredible “returns” to these investors </li></ul><ul>...
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Chapter 16 Learning Objectives (part 1 of 3)

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Chapter 16 Learning Objectives (part 1 of 3)

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

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