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  1. 1. The Global Stock Market Chapter 6
  2. 2. Background <ul><li>A variety of different stock markets exist </li></ul><ul><ul><li>For instance, Germany’s market is over 400 years old while Tanzania’s began in 1998 </li></ul></ul><ul><ul><li>Macedonia has only two companies trading on its stock exchange while India has 5,840 </li></ul></ul><ul><ul><li>The market capitalization of the U.S. is $10 trillion while that of Guatemala is only $2 billion (in U.S. dollars) </li></ul></ul><ul><li>Many stock markets also trade other financial instruments </li></ul><ul><li>Consolidations are merging stock markets and technology is pulling national markets together </li></ul>
  3. 3. The Global Stock Market <ul><li>Aggregate market capitalization of equity shares in the world grew from $9.6 trillion in 1990 to over $35 trillion in 2000 </li></ul><ul><ul><li>An average rate of 14.8% annually </li></ul></ul><ul><li>Financial capital is very mobile </li></ul><ul><ul><li>In 1990 the Tokyo Stock Exchange was 30.5% of the global market but only 12.7% in 1999 </li></ul></ul><ul><ul><li>North America increased its share of the world equity market from 28.0% (1990) to 50.28% (1999) </li></ul></ul>
  4. 4. The Global Stock Market <ul><li>Technological advances are automating experienced stock exchange employees out of jobs </li></ul><ul><li>Stock markets are active in every time zone </li></ul>
  5. 5. Brokerage Services <ul><li>Brokers </li></ul><ul><ul><li>Sales people (earning a commission) employed by dealers </li></ul></ul><ul><ul><li>Have no money invested in the dealer’s security inventory </li></ul></ul><ul><ul><li>Help create markets by buying and selling from employer’s inventory </li></ul></ul><ul><li>Brokerage firms extend credit (margin accounts) to clients </li></ul><ul><ul><li>Enables client to do more securities trading </li></ul></ul>
  6. 6. Brokerage Services <ul><li>Types of stock brokerage services </li></ul><ul><ul><li>Full-service </li></ul></ul><ul><ul><ul><li>Take buy and sell orders </li></ul></ul></ul><ul><ul><ul><li>Extend margin credit to customers </li></ul></ul></ul><ul><ul><ul><li>Hold clients’ securities in safe keeping </li></ul></ul></ul><ul><ul><ul><li>Collect cash dividends </li></ul></ul></ul><ul><ul><ul><li>Provide free investment research </li></ul></ul></ul><ul><ul><ul><li>Perform ‘hand-holding’ services </li></ul></ul></ul><ul><ul><ul><ul><li>Pleasant telephone conversations </li></ul></ul></ul></ul><ul><ul><ul><ul><li>Investment counseling </li></ul></ul></ul></ul><ul><ul><ul><ul><li>Birthday cards </li></ul></ul></ul></ul><ul><ul><ul><li>All paid for by clients’ trading commissions </li></ul></ul></ul><ul><ul><ul><ul><li>Range from $30 - $150 for one common stock transaction </li></ul></ul></ul></ul><ul><ul><ul><li>Examples </li></ul></ul></ul><ul><ul><ul><ul><li>Merrill Lynch </li></ul></ul></ul></ul><ul><ul><ul><ul><li>Goldman Sachs </li></ul></ul></ul></ul><ul><ul><ul><ul><li>PaineWebber </li></ul></ul></ul></ul><ul><ul><ul><ul><li>Morgan Stanley Dean Witter </li></ul></ul></ul></ul><ul><ul><ul><ul><li>Salomon Smith Barney </li></ul></ul></ul></ul>
  7. 7. Brokerage Services <ul><ul><li>Discount Brokers </li></ul></ul><ul><ul><ul><li>Simply take orders </li></ul></ul></ul><ul><ul><ul><li>Offer little or no investment advice </li></ul></ul></ul><ul><ul><ul><li>No ‘hand-holding’ services provided </li></ul></ul></ul><ul><ul><ul><li>Little opportunity for churning </li></ul></ul></ul><ul><ul><ul><li>Lower commissions </li></ul></ul></ul><ul><ul><ul><ul><li>Range from $20 to $50 </li></ul></ul></ul></ul><ul><ul><ul><li>Examples </li></ul></ul></ul><ul><ul><ul><ul><li>Charles Schwab & Company </li></ul></ul></ul></ul><ul><ul><ul><ul><li>Quick & Reilly </li></ul></ul></ul></ul><ul><ul><ul><ul><li>Muriel Siebert </li></ul></ul></ul></ul><ul><ul><ul><ul><li>Jack White & Company </li></ul></ul></ul></ul><ul><ul><ul><ul><li>Fidelity Investments </li></ul></ul></ul></ul><ul><ul><ul><ul><li>Vanguard Brokerage Services </li></ul></ul></ul></ul>
  8. 8. Brokerage Services <ul><ul><li>Electronic brokers </li></ul></ul><ul><ul><ul><li>Take buy and sell orders via Internet </li></ul></ul></ul><ul><ul><ul><li>No ‘hand-holding’ services </li></ul></ul></ul><ul><ul><ul><li>May provide investment research </li></ul></ul></ul><ul><ul><ul><ul><li>May or may not be free </li></ul></ul></ul></ul><ul><ul><ul><li>Low commissions </li></ul></ul></ul><ul><ul><ul><ul><li>Range from almost free to $35 a trade </li></ul></ul></ul></ul><ul><ul><ul><li>Examples </li></ul></ul></ul><ul><ul><ul><ul><li>Discover Brokerage </li></ul></ul></ul></ul><ul><ul><ul><ul><li>DLJdirect </li></ul></ul></ul></ul><ul><ul><ul><ul><li>E*Trade </li></ul></ul></ul></ul><ul><ul><ul><ul><li>Archipelago </li></ul></ul></ul></ul><ul><ul><ul><ul><li>Bloomberg Tradebook </li></ul></ul></ul></ul><ul><ul><ul><ul><li>Accutrade </li></ul></ul></ul></ul><ul><ul><ul><ul><li>Ameritrade </li></ul></ul></ul></ul><ul><ul><ul><ul><li>Charles Schwab </li></ul></ul></ul></ul><ul><ul><ul><ul><li>SURETRADE </li></ul></ul></ul></ul><ul><ul><ul><ul><li>Wall Street Access </li></ul></ul></ul></ul><ul><ul><ul><ul><li> </li></ul></ul></ul></ul>
  9. 9. Transacting <ul><li>When making a trade, the investor must specify </li></ul><ul><ul><li>Type of order </li></ul></ul><ul><ul><li>Whether or not margin will be involved </li></ul></ul>
  10. 10. 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>
  11. 11. Types of Trading Orders <ul><li>Stop orders </li></ul><ul><ul><li>To buy (sell) are written 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><ul><li>Investor may be whip-sawed in volatile market </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>
  12. 12. Types of Trading Orders <ul><li>Scale order </li></ul><ul><ul><li>Requires buying or selling part of the order at each price as market prices change </li></ul></ul><ul><ul><ul><li>Cumbersome and not all brokers accept them </li></ul></ul></ul><ul><li>Fill or kill (FOK) order </li></ul><ul><ul><li>Specifies price at which order must be filled or order is immediately canceled </li></ul></ul><ul><li>Good till canceled order </li></ul><ul><ul><li>Remains in effect until canceled </li></ul></ul><ul><ul><ul><li>Day order—must be filled on the day order is issued </li></ul></ul></ul><ul><ul><ul><li>Market on close order—can only be executed at the day’s closing price </li></ul></ul></ul>
  13. 13. 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>
  14. 14. 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>
  15. 15. How Margin Works <ul><li>Example: You wish to purchase 100 shares of XYZ Company for a price of $100 per share. The initial margin requirement is 50%. </li></ul><ul><ul><li>Purchase price is $100 x 100 shares = $10,000 </li></ul></ul><ul><ul><ul><li>You put forth 50%, or $5,000 </li></ul></ul></ul><ul><ul><ul><li>Borrow the remaining $5,000 from your broker </li></ul></ul></ul><ul><ul><ul><ul><li>Broker charges you the brokers’ call rate for a margin loan </li></ul></ul></ul></ul>
  16. 16. How Margin Works <ul><li>Assume that the market value of the stock rises to $150 a share </li></ul><ul><ul><li>Your total profit will be $50 a share times 100 shares, or $5,000, ignoring interest (on margin loan), taxes and commissions </li></ul></ul><ul><ul><ul><li>Your return is 100%: Profit of $5,000  Investment of $5,000 </li></ul></ul></ul><ul><ul><ul><ul><li>If you had not used margin, you could have only afforded 50 shares, and your profit would only have been $2,500 </li></ul></ul></ul></ul><ul><ul><ul><ul><ul><li>Your return would have been 50%: Profit of $2,500  Investment of $5,000 </li></ul></ul></ul></ul></ul>
  17. 17. How Margin Works <ul><li>Assume that the market value of the stock falls to $50 a share </li></ul><ul><ul><li>Current market value of the investment is now only $5,000 (which exactly equals the amount that was borrowed from the broker) </li></ul></ul><ul><ul><li>Your total loss will be $50 a share times 100 shares, or $5,000, ignoring interest (on margin loan), taxes and commissions </li></ul></ul><ul><ul><ul><li>Your return is -100%: Loss of $5,000  Investment of $5,000 </li></ul></ul></ul><ul><ul><ul><ul><li>If you had not used margin, you could have only afforded 50 shares, and your loss would only have been $2,500 </li></ul></ul></ul></ul><ul><ul><ul><ul><ul><li>Your return would have been -50%: Loss of $2,500  Investment of $5,000 </li></ul></ul></ul></ul></ul>
  18. 18. Maintenance Margin <ul><li>If a margined portfolio decreases sufficiently in value, investor will receive a margin call </li></ul><ul><ul><li>Investor must put up more margin money ASAP </li></ul></ul><ul><ul><li>Otherwise, broker liquidates enough of the investor’s securities to bring account up to the required minimum margin </li></ul></ul><ul><ul><ul><li>Easy for broker to do because investor with a margined account must keep securities at the broker’s office as collateral for their loan </li></ul></ul></ul><ul><li>The NYSE has a maintenance margin requirement of 25% </li></ul><ul><ul><li>Investor’s equity cannot fall below 25% of the account’s market value </li></ul></ul><ul><ul><li>Or, investor’s loan amount cannot exceed 75% of the account’s market value </li></ul></ul>
  19. 19. Maintenance Margin <ul><li>Continuing the example, if you had purchased $10,000 of stock with a 50% margin, you would face a margin call when </li></ul><ul><ul><li>Market value of stock dropped below $6,666.67 </li></ul></ul><ul><ul><ul><li>Because your loan of $5,000 cannot exceed 75% of the market value of portfolio </li></ul></ul></ul><ul><ul><ul><ul><li>75% × X = $5,000 </li></ul></ul></ul></ul><ul><ul><ul><ul><li>X = $6,666.67 </li></ul></ul></ul></ul><ul><li>Some brokers set a higher maintenance margin than the 25% minimum </li></ul>
  20. 20. 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>
  21. 21. Investment Banks <ul><li>A few thousand investment banking firms exist in the U.S., including </li></ul><ul><ul><li>Merrill Lynch & Co. </li></ul></ul><ul><ul><li>Morgan Stanley Dean Witter </li></ul></ul><ul><ul><li>Lehman Brothers </li></ul></ul><ul><ul><li>Credit Suisse First Boston </li></ul></ul><ul><ul><li>Goldman, Sachs & Co. </li></ul></ul><ul><ul><li>Salomon Smith Barney </li></ul></ul><ul><ul><li>Bear Stearns Cos. </li></ul></ul><ul><ul><li>Paine Webber </li></ul></ul>
  22. 22. 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>
  23. 23. Consulting <ul><li>The investment bank that serves as the IPO’s originator must analyze the client’s needs and suggest a financing plan </li></ul><ul><ul><li>What type of security should be issued? </li></ul></ul><ul><ul><li>How much financing is needed? </li></ul></ul><ul><ul><li>When should the new securities be issued? </li></ul></ul><ul><li>The originator will also manage </li></ul><ul><ul><li>The underwriting syndicate </li></ul></ul><ul><ul><ul><li>Ranges from 5 to 200 investment banking firms that share the financing and underwriting risk </li></ul></ul></ul><ul><ul><li>The selling group </li></ul></ul><ul><ul><ul><li>Investment banks and brokerage firms that sell the securities to investors </li></ul></ul></ul>
  24. 24. Administration <ul><li>Deals with legal issues associated with an IPO </li></ul><ul><li>Helps obtain necessary government permissions </li></ul><ul><li>Has the prospectus printed </li></ul><ul><li>Makes public announcements </li></ul>
  25. 25. Underwriting <ul><li>An underwriter guarantees the issuer will receive a pre-specified amount of cash for the new securities </li></ul><ul><ul><li>Days or weeks from the time the underwriter buys the securities from the issuer till they sell the securities to the investors are very risky to underwriter </li></ul></ul><ul><ul><ul><li>Market conditions may fluctuate and underwriter may lose money on the securities because they have to sell them at a lower price </li></ul></ul></ul><ul><li>It is important to set the ‘right’ price for an IPO </li></ul><ul><ul><li>If price is too high, underwriters may not be able to sell securities </li></ul></ul><ul><ul><li>If price is too low, issuer may find it costly to issue securities </li></ul></ul>
  26. 26. Distribution <ul><li>Investment banker may sell securities to a wide group of investors </li></ul><ul><ul><li>Or may act as intermediary between issuer and buyer in a private placement </li></ul></ul><ul><li>The difference between the investment banker’s cost and the sale price is known as the spread </li></ul><ul><ul><li>Ranges from 5 – 16% for stocks </li></ul></ul><ul><ul><li>About 4% for bonds </li></ul></ul>
  27. 27. Electronic Investment Bankers <ul><li>There are several investment banking firms offering internet services </li></ul><ul><ul><li>DLJdirect </li></ul></ul><ul><ul><li>Freidman, Billings, Ramsey Group </li></ul></ul><ul><ul><li>E*Offering </li></ul></ul><ul><ul><li>OpenIPO </li></ul></ul><ul><ul><li>E-InvestmentBank </li></ul></ul><ul><ul><li>Wit Capital </li></ul></ul><ul><li>Vary in size and sophistication </li></ul>
  28. 28. Full Disclosure <ul><li>In U.S. the SEC requires most primary issues be accompanied by a prospectus </li></ul><ul><ul><li>10 to 20 page document that fully discloses, among other items </li></ul></ul><ul><ul><ul><li>Purpose for which the proceeds of the issue will be spent </li></ul></ul></ul><ul><ul><ul><li>Offering price to the public </li></ul></ul></ul><ul><ul><ul><li>Offering price for special groups, in any </li></ul></ul></ul><ul><ul><ul><li>Underwriter’s fees </li></ul></ul></ul><ul><ul><ul><li>Net proceeds to the issuer </li></ul></ul></ul><ul><ul><ul><li>Information on the issuer’s products, history and location </li></ul></ul></ul><ul><ul><ul><li>Names and remuneration of officers </li></ul></ul></ul><ul><ul><ul><li>Detailed statement of capitalization </li></ul></ul></ul><ul><ul><ul><li>Detailed financial statements </li></ul></ul></ul><ul><ul><ul><li>Details about any pending litigation </li></ul></ul></ul>
  29. 29. Full Disclosure <ul><li>Approval of a prospectus by the SEC does not mean the investment is a good value, but that all the necessary information required by the SEC has been disclosed </li></ul><ul><li>Full disclosure allows investors to estimate value of new securities </li></ul>
  30. 30. 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>
  31. 31. 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>
  32. 32. 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>
  33. 33. Decimalization <ul><li>A tick represents the minimum amount by which a price can change </li></ul><ul><ul><li>Prior to 1997 the tick was 1/8 but then became 1/16 </li></ul></ul><ul><ul><ul><li>However the tick size is now 1 ¢ since the exchanges instituted decimalization </li></ul></ul></ul><ul><ul><ul><ul><li>Expected to reduce the bid-ask spread and trading costs </li></ul></ul></ul></ul>
  34. 34. 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>
  35. 35. NYSE Operations <ul><li>Approximately 460 specialists with about 8 stocks assigned to each specialist’s trading post </li></ul><ul><li>About 1,500 trading booths with telephones surround the perimeter of the trading floor </li></ul><ul><ul><li>Allows for order transmission and confirmation between brokers’ offices and exchange floor </li></ul></ul><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>
  36. 36. 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>
  37. 37. 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>
  38. 38. Limit Order Book <ul><li>Today is kept on a computer </li></ul><ul><li>Records buy and sell orders from potential traders </li></ul><ul><ul><li>Outlines the supply and demand curves that determine market price of security </li></ul></ul><ul><ul><ul><li>Helps specialists earn trading profits </li></ul></ul></ul>2 Gabelli 3/8 3 McGovern 1/4 4 Jacoby 1 Sullivan 1/8 3 Dalton 9 Mirandi 4 Wentz 0/8 BID: $42 and ?/8
  39. 39. NYSE <ul><li>NYSE has lagged behind other organizations in terms of technology </li></ul><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>
  40. 40. Block Trades <ul><li>A single transaction involving 10,000 or more shares </li></ul><ul><li>Increased steadily throughout the 1960s-1980s but leveled off in the 1990s </li></ul><ul><li>Specialists are not involved in block trades that occur outside the NYSE by block positioners </li></ul><ul><ul><li>Special brokers/dealers that line up multiple buyers for a large block </li></ul></ul><ul><ul><li>Some large investment banks have a block positioning department </li></ul></ul><ul><ul><ul><li>Have the capital to carry a large block for a few days and the connections to distribute it </li></ul></ul></ul><ul><ul><ul><li>The upstairs market </li></ul></ul></ul><ul><ul><li>Economies of scale lead to small commissions per share </li></ul></ul>
  41. 41. 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>
  42. 42. Nasdaq Market <ul><li>National Association of Securities Dealers Automated Quotations (Nasdaq) is the communications network that services the OTC market </li></ul><ul><ul><li>About 61,000 computer terminals are connected to Nasdaq’s mainframe via phone lines </li></ul></ul><ul><ul><ul><li>Can obtain current bid and ask prices for all Nasdaq stocks </li></ul></ul></ul><ul><ul><ul><ul><li>Updated continuously by about 540 competing Nasdaq market-makers (dealers) </li></ul></ul></ul></ul><ul><ul><li>Investor’s broker can access the system to find the best bid/ask price for a security </li></ul></ul><ul><ul><ul><li>Broker then calls dealer to execute transaction as trades cannot be executed via Nasdaq computer </li></ul></ul></ul>
  43. 43. Nasdaq Market <ul><li>Centralizes a geographically dispersed market into a mainframe computer </li></ul><ul><li>When a broker or dealer inquires about a security’s price, bid-ask quotes are instantly provided even if the dealers are many miles apart </li></ul><ul><li>Designed to handle up to 20,000 stocks </li></ul><ul><ul><li>Currently lists about 6,500 actively traded stocks </li></ul></ul><ul><li>In 1999 Nasdaq merged with AMEX </li></ul><ul><li>Nasdaq plans to cross-list stocks with various international exchanges </li></ul><ul><ul><li>Positioning itself to more effectively compete with NYSE </li></ul></ul>
  44. 44. CQS, ITS and Law of One Price <ul><li>SEC requires that the Consolidated Quotation System (CQS) report current transactions for NYSE, OTC, AMEX, regional U.S. stock exchanges and the third market </li></ul><ul><ul><li>Helps investors find the best prices </li></ul></ul><ul><ul><li>CQS cannot perform executions </li></ul></ul><ul><ul><ul><li>SEC urged NYSE to create the Intermarket Trading System (ITS) </li></ul></ul></ul><ul><ul><ul><ul><li>Electronic trading network linking various U.S. markets </li></ul></ul></ul></ul><ul><ul><ul><li>Nasdaq supplemented ITS with an electronic communications network called Primex </li></ul></ul></ul><ul><ul><ul><ul><li>Gives faster access to NYSE-listed stocks </li></ul></ul></ul></ul><ul><ul><ul><li>Combining CQS with ITS and Primex allows arbitrageurs to enforce the law of one price </li></ul></ul></ul>
  45. 45. Non-Nasdaq National Quotation Bureau (NQB) <ul><li>To be included in Nasdaq’s national daily list, a stock must have </li></ul><ul><ul><li>At least two market makers </li></ul></ul><ul><ul><li>A minimum of 1,500 stockholders </li></ul></ul><ul><ul><li>Significant investor interest </li></ul></ul><ul><li>A stock not meeting these requirements are listed with the National Quotation Bureau (NQB) </li></ul><ul><ul><li>NQB lists 3,600 stocks, some of which are not actively traded </li></ul></ul><ul><ul><ul><li>Includes </li></ul></ul></ul><ul><ul><ul><ul><li>Domestic U.S. micro-cap stocks </li></ul></ul></ul></ul><ul><ul><ul><ul><li>Shares in foreign corporations that cannot be listed on an organized exchange </li></ul></ul></ul></ul><ul><ul><ul><ul><li>ADRS and GDRs for stocks that do not meet the accounting standards for listing on an organized exchange </li></ul></ul></ul></ul>
  46. 46. 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><ul><ul><ul><li>For instance, in 1999 Chicago Stock Exchange (CHX) traded over 90% of the NYSE-listed stocks </li></ul></ul></ul><ul><ul><ul><ul><li>Majority of CHX’s trading volume is from dual listings </li></ul></ul></ul></ul><ul><ul><ul><ul><li>CHX pays for order flow </li></ul></ul></ul></ul><ul><ul><ul><ul><ul><li>Specialists take a penny or so (per share) from their bid-ask spread and give it to brokers to encourage brokers to execute their orders on the CHX rather than NYSE </li></ul></ul></ul></ul></ul>
  47. 47. 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><ul><ul><ul><li>Has computer terminals in over 5,000 subscribers’ offices </li></ul></ul></ul><ul><ul><ul><ul><li>Millions of shares are traded in secrecy daily via Instinet </li></ul></ul></ul></ul><ul><ul><ul><ul><li>Commissions range from 2 ¢ to 8¢ a share </li></ul></ul></ul></ul>
  48. 48. Order Crossing Networks <ul><li>An electronic communication network that tries to match buy and sell orders </li></ul><ul><ul><li>The price may be </li></ul></ul><ul><ul><ul><li>The last reported price from an organized exchange </li></ul></ul></ul><ul><ul><ul><li>Midway between the current bid-ask prices on an organized exchange </li></ul></ul></ul><ul><li>Traders may pay a fixed annual fee to use alternative market systems </li></ul><ul><ul><li>Variable trading costs are zero </li></ul></ul><ul><li>Rapid executions are possible if the other half of the transaction is already present in network </li></ul><ul><li>Offers anonymity </li></ul><ul><li>Sometimes the network is not operating when it is needed </li></ul><ul><li>Or the other half of the transaction is unavailable </li></ul>
  49. 49. Order Crossing Networks <ul><li>Instinet operates the Crossing Network and competes with Investment Technology Group’s (ITG) Portfolio System for Institutiional Trading (POSIT) </li></ul><ul><li>Bloomberg runs Tradebook—a continuous matching system mainly for Nasdaq stocks </li></ul><ul><ul><li>In 1999 Bloomberg & ITG created SuperECN </li></ul></ul><ul><ul><ul><li>Offers a crossing network with a larger order flow </li></ul></ul></ul><ul><li>Other crossing networks include </li></ul><ul><ul><li>Investor’s Liquidity Network by Fidelity Investors </li></ul></ul><ul><ul><li>E-Crossnet is for European stocks </li></ul></ul>
  50. 50. Electronic Order Working Systems <ul><li>Electronic order working systems </li></ul><ul><ul><li>Screen telecommunication networks, capture current market information and use it to make ongoing transactions </li></ul></ul><ul><ul><li>Needs the following information </li></ul></ul><ul><ul><ul><li>Securities that are to be traded </li></ul></ul></ul><ul><ul><ul><li>Limit order prices </li></ul></ul></ul><ul><ul><ul><li>Quantities available at different prices </li></ul></ul></ul><ul><ul><ul><li>Binding time limits </li></ul></ul></ul><ul><ul><ul><li>Markets where the securities are traded </li></ul></ul></ul><ul><ul><ul><li>Any additional information </li></ul></ul></ul>
  51. 51. Electronic Order Working Systems <ul><li>Various EOWS include </li></ul><ul><ul><li>QuantEX by Investment Technology Group </li></ul></ul><ul><ul><li>Order Management System by Instinet </li></ul></ul><ul><ul><li>Lattice Trading System by Credit Suisse First Boston </li></ul></ul><ul><ul><li>REDIBook </li></ul></ul><ul><ul><li>Archipelago Exchange </li></ul></ul>
  52. 52. Electronic Stock Exchanges <ul><li>Arizona Stock Exchange (AZX) </li></ul><ul><ul><li>Formed in 1990 in Phoenix </li></ul></ul><ul><ul><li>Periodic call market </li></ul></ul><ul><ul><ul><li>Automated auction process that attempts to equate the supply and demand for a broad list of common stocks at a few specified times each trading day </li></ul></ul></ul><ul><ul><ul><ul><li>Client submits order as if it were a limit order </li></ul></ul></ul></ul><ul><ul><ul><ul><li>The limit order book is open to all participants, but anonymity of participants is maintained </li></ul></ul></ul></ul><ul><ul><li>Each time an auction occurs, the AZX computer calculates supply and demand curves for each security being auctioned </li></ul></ul><ul><ul><ul><li>The intersection of the curve determines the security’s market clearing price </li></ul></ul></ul><ul><ul><ul><ul><li>All sell (buy) orders below (above) the market clearing price are matched </li></ul></ul></ul></ul><ul><ul><li>On a daily basis, about two dozen institutional investors used the AZX system, trading several hundred thousand shares </li></ul></ul>
  53. 53. Electronic Stock Exchanges <ul><li>European Association of Securities Dealers Automated Quotations (EASDAQ) </li></ul><ul><ul><li>Based in Brussels </li></ul></ul><ul><ul><li>Nasdaq acquired EASDAQ in 2001 </li></ul></ul><ul><ul><li>Lists and trades about 50 technology stocks </li></ul></ul><ul><li>Primex </li></ul><ul><ul><li>Patterned after NYSE </li></ul></ul><ul><ul><li>Takes a customer’s buy or sell order to the NYSE and other competing exchanges in search of best available price </li></ul></ul><ul><ul><li>Allows users to haggle for the best prices </li></ul></ul>
  54. 54. Electronic Stock Exchanges <ul><li>Tradepoint </li></ul><ul><ul><li>Conducts auctions for U.K. equities </li></ul></ul><ul><ul><li>Operates with a transparent order book </li></ul></ul><ul><li>Jiway </li></ul><ul><ul><li>Stockbrokers can transact with each other in over 6,000 European and American stocks </li></ul></ul><ul><ul><li>Auctions off the right to be the designated market-maker for each stock in its system to member firms </li></ul></ul><ul><ul><li>Provides custody services, etc . </li></ul></ul>
  55. 55. Electronic Stock Exchanges <ul><li>European Alliance </li></ul><ul><ul><li>Informal alliance of eight stock exchanges, including </li></ul></ul><ul><ul><ul><li>London Stock Exchange </li></ul></ul></ul><ul><ul><ul><li>Amsterdam Stock Exchange </li></ul></ul></ul><ul><ul><ul><li>Brussels Stock Exchange </li></ul></ul></ul><ul><li>Reg ATS Exchanges </li></ul><ul><ul><li>SEC rule that allows alternative trading systems in the U.S. to register as stock exchanges </li></ul></ul><ul><ul><li>Exchanges must </li></ul></ul><ul><ul><ul><li>report their prices via the Consolidated Quotation System </li></ul></ul></ul><ul><ul><ul><li>Operate as a self-regulating organization </li></ul></ul></ul><ul><ul><ul><li>Participate in the intermarket trading system </li></ul></ul></ul>
  56. 56. The Twenty-First Century <ul><li>In 1999 NYSE and Nasdaq announced that they are interested in reorganizing as for-profit corporations </li></ul><ul><ul><li>Would allow them to raise outside capital in order to obtain better technology </li></ul></ul><ul><li>In 2000 Merrill Lynch started an electronic brokerage subsidiary—the last full-service brokerage in U.S. to do so </li></ul><ul><li>In 2000 several companies submitted a joint proposal to SEC to establish a central limit order book </li></ul><ul><ul><li>Would reduce market fragmentation and increase transparency within U.S. </li></ul></ul>
  57. 57. The Twenty-First Century <ul><li>Electronic technology will continue to accelerate change </li></ul><ul><ul><li>Trading volume will increase as transaction costs fall </li></ul></ul><ul><ul><li>There will be pressure on stock exchanges and ECNs to consolidate </li></ul></ul><ul><li>A global market will eventually emerge </li></ul>
  58. 58. Liquidity <ul><li>Perfectly liquid assets are highly marketable </li></ul><ul><ul><li>Do not suffer from a decline in price if they are liquidated quickly </li></ul></ul><ul><ul><ul><li>For example, the U.S. dollar is perfectly liquid whereas most real estate is not because </li></ul></ul></ul><ul><ul><ul><ul><li>To quickly sell a house, seller must offer a price discount </li></ul></ul></ul></ul><ul><ul><ul><ul><li>Real estate brokers commonly have commissions of 6% of the property value </li></ul></ul></ul></ul>
  59. 59. Liquidity Continuum <ul><li>Assets categorized from most liquid to least liquid </li></ul><ul><ul><li>U.S. dollar bills </li></ul></ul><ul><ul><li>U.S. Treasury bonds </li></ul></ul><ul><ul><li>NYSE-listed stocks and large Nasdaq stocks (such as Microsoft) </li></ul></ul><ul><ul><li>Nasdaq stocks </li></ul></ul><ul><ul><li>Corporate bonds </li></ul></ul><ul><ul><li>Most municipal bonds </li></ul></ul><ul><ul><li>Most real estate </li></ul></ul><ul><ul><li>Art objects and collectibles </li></ul></ul>Investors pay a liquidity premium for the convenience of owning liquid assets.
  60. 60. Liquidity in Securities Markets <ul><li>A liquid securities market possesses the following qualities </li></ul><ul><ul><li>Depth—buy-sell orders exists both above and below the price at which the security is transacting </li></ul></ul><ul><ul><ul><li>A market lacking depth is shallow </li></ul></ul></ul><ul><ul><li>Breadth—when a large amount of buy-sell orders as described above exist </li></ul></ul><ul><ul><ul><li>Markets lacking breadth are called thin markets </li></ul></ul></ul><ul><ul><li>Resiliency—if new orders occur in response to price changes due to temporary order imbalances </li></ul></ul>
  61. 61. Transaction Costs <ul><li>Direct transaction costs </li></ul><ul><ul><li>Brokers’ commissions </li></ul></ul><ul><ul><li>Income taxes </li></ul></ul><ul><ul><li>Transfer fees </li></ul></ul><ul><ul><li>Custodial fees </li></ul></ul><ul><ul><li>Outlays for research information </li></ul></ul><ul><li>Indirect transaction costs </li></ul><ul><ul><li>Bid-ask spread—determined by the cost of market-making expenses such as </li></ul></ul><ul><ul><ul><li>Interest expense for financing inventory of securities </li></ul></ul></ul><ul><ul><ul><li>Risk premium for investing capital </li></ul></ul></ul><ul><ul><ul><li>Administrative costs </li></ul></ul></ul>
  62. 62. Transaction Costs <ul><li>Indirect transaction costs </li></ul><ul><ul><li>Market impact </li></ul></ul><ul><ul><ul><li>Buying (selling) tends to bid up (down) the price of a security </li></ul></ul></ul><ul><ul><ul><ul><li>Large transactions tend to move prices more than smaller transactions </li></ul></ul></ul></ul><ul><ul><li>Opportunity cost (implicit) </li></ul></ul><ul><ul><ul><li>Decay of information value of a trade incurred when market moves against a trader waiting to trade </li></ul></ul></ul><ul><ul><ul><ul><li>Tends to increase with time between decision to trade and the actual execution of the trade </li></ul></ul></ul></ul>
  63. 63. Transaction Costs <ul><li>Total transactions costs can range from less than 1% of the value to much of the investor’s return (in countries with high capital gains taxes) </li></ul><ul><ul><li>The cost of transaction varies inversely with the market’s liquidity </li></ul></ul><ul><ul><ul><li>Large cap stocks are usually more actively traded than small cap </li></ul></ul></ul><ul><ul><ul><ul><li>Thus, small cap stocks generally have a higher transaction cost </li></ul></ul></ul></ul><ul><ul><ul><li>Large industrialized nations generally have lower transaction costs because </li></ul></ul></ul><ul><ul><ul><ul><li>The stock markets are more active </li></ul></ul></ul></ul><ul><ul><ul><ul><li>More political stability </li></ul></ul></ul></ul><ul><ul><ul><ul><li>More efficient legal systems </li></ul></ul></ul></ul>
  64. 64. The Bottom Line <ul><li>Small and large stock markets provide varying degrees of liquidity </li></ul><ul><li>Institutional investors may use block positioners to execute large trades </li></ul><ul><li>Full-service brokers charge high commissions </li></ul><ul><li>Discount brokers, electronic brokers or ECNs offer less costly services </li></ul><ul><li>Most trades are market orders, however other order types exist </li></ul>
  65. 65. The Bottom Line <ul><li>Investors may buy on margin—effectively borrowing money from their brokerage </li></ul><ul><ul><li>Margin trading enhances gains and losses </li></ul></ul><ul><li>Investment bankers assist their clients in raising money in the primary market </li></ul><ul><ul><li>Organizing distribution syndicates </li></ul></ul><ul><ul><li>Underwriting the issue </li></ul></ul><ul><ul><li>Distributing the securities </li></ul></ul>
  66. 66. The Bottom Line <ul><li>NYSE is the largest stock market in the world </li></ul><ul><ul><li>Continuous auction market </li></ul></ul><ul><ul><li>Specialists </li></ul></ul><ul><li>NASDAQ is a large electronic market </li></ul><ul><li>ECNs involve several different categories of market technology </li></ul><ul><li>Technology is </li></ul><ul><ul><li>Increasing the array of brokerage services </li></ul></ul><ul><ul><li>Increasing the competition between brokerage </li></ul></ul><ul><ul><li>Reducing transaction costs </li></ul></ul><ul><ul><li>Speeding executions </li></ul></ul><ul><ul><li>Creating new types of stock exchanges </li></ul></ul><ul><ul><li>Altering the IPO process </li></ul></ul><ul><ul><li>Integrating the world’s stock markets into a global one </li></ul></ul>