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Chapter 1Web Extension 1B

A Closer Look at the Stock Markets

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Topics in Web Extension

Stock indexes Regulation Overview of investment banking Stock trading

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Stock Indexes

Stock indexes try to measure some aspect of the market

The differ with respect to: Composition (types of stock in the

index) Weighting (how the individual stocks

are aggregated into an index)

(More . .)

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Index Composition

Replicate a particular exchange Measure a country’s most

important stocks Measure a particular business

sector Measure a particular investment

“style” Measure an international region(More . .)

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Composition by Exchange

NYSE Composite Nasdaq Composite

(More . .)

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Composition by Business Sector Many different index providers, such as:

Dow Jones Amex Morgan Stanley

Many different sectors, such as: Airlines Biotechnology Chemicals Consumer retailers Technology

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Composition by “Style” Two important investment styles are by

the size of the firm and by its growth prospects. Growth is measure by high-expected sales growth and high price-book ratios (value stocks have lower growth and lower price-book ratios)

Examples: Russell 1000 Growth Russell Midcap Value

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Composition by International Region

Morgan Stanley Capital International (MSCI) EAFE (Europe, Asia, Far East) Index Emerging Markets Index Pacific Index

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Stock Weighting in Indexes

Price weighted DJIA

Market-value weighted S&P500 Nasdaq Composite

Equally weighted Value Line Index

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Regulation of Securities Markets

Government Regulation– such as SEC.

Insider trading oversight (SEC) Margin oversight (Federal Reserve) Self-regulation– such as NASD.

Circuit Breakers– automatic halt in trading if stock prices have exceptional changes.

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Public vs. Private Offerings Public offerings: registered with the

SEC and sale is made to the investing public.

Shelf registration (Rule 415, since 1982) allows firms to register an offering and sell parts of the offering over time.

Private offering: Sale to a limited number of sophisticated investors not requiring the protection of registration.- Dominated by institutions.- Very active market for debt securities.- Not as active for stock offerings.

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Investment Banking and Security Offerings Underwritten vs. “Best Efforts”

Underwritten: firm commitment on proceeds to the issuing firm.

Best Efforts: no firm commitment. Negotiated vs. Competitive Bid

Negotiated: issuing firm negotiates terms with investment banker. Usually a 7% spread.

Competitive bid: issuer structures the offering and secures bids (more common in bonds than stocks).

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Initial Public Offerings

Initial Public Offerings (IPOs) Underpricing—Average increase is

14% on first day. Performance– Underperforms similar

stock during three years after IPO.

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Costs of Trading Commission: fee paid to broker for

making the transaction Spread: cost of trading with dealer

Bid: price dealer will buy from you Ask: price dealer will sell to you Spread: ask - bid

“Price Impact”– Large sales or purchase might cause prices to change.

“Payment for Order Flow”– Exchange will pay brokers to direct orders to them.

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The Specialist at the NYSE Handles around 10-20 stocks (one per

specialist) Stocks trade at the “specialist’s post” “Makes a market” by matching

buyers/seller and by buying/selling from own inventory

Goal is to “maintain a fair and orderly market” so that price changes are smooth

Specialist loses money when smoothing the market, but makes it back during normal conditions

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Trading Away from Exchanges

Third Market– trading listed stocks but not through exchange Institutional market: to facilitate

trades of larger blocks of securities. Involves services of dealers and

brokers Fourth Market– institutions trading

with institutions No middleman involved in the

transaction

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Margin Trading

Investor uses only a portion of own capital for an investment.

Borrows remaining component. Margin arrangements differ for

stocks and futures.

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Stock Margin Trading Maximum initial margin

Currently 50% Set by the Fed

Maintenance margin Minimum level of equity margin if

prices change Margin call

Call for more equity funds

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Short Sales Mechanics Opening a short position:

Borrow stock through a dealer. Sell it Deposit proceeds and margin in

account. Closing out the position:

Buy the stock Return to the party from which it was

borrowed.

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Short Sales Purposes and Features Purpose: to profit from a decline in

the price of a stock or security. Must pay the broker the equivalent

of any dividends paid by the stock “Uptick” restrictions– can only sell

short when the ask price of a stock is higher than the last transaction

Unlimited loss potential