Understanding markets - Reynolds Week 2011
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Understanding Markets
Strictly Financials
Jan. 4, 2011
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Donald W. Reynolds National Center For Business Journalism
At Arizona State University
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James K. Gentry, Ph.D. Clyde M. Reed Teaching Professor School of Journalism and Mass
Communications University of Kansas [email protected]
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Risk-Return Relationship
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5Strictly Financials
Basic Types of Risk
Systematic Unsystematic
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Specific Types of Risk Business risk Financial risk (credit or default risk) Market risk Interest rate risk Purchasing power risk Event risk Exchange-rate risk (foreign
exchange risk) Liquidity risk
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Types of Businesses Sole proprietorship Partnership Corporation
Limited liability Greater access to capital Permanency Flexibility Double taxation
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Types of Structures Private corporations Public corporations Non-profits
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Types of Investments Stocks Bonds Other
Options, futures, commodities, real estate, collectibles, currencies
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Types of Markets Equity: Stocks Credit: Bonds, debt or fixed income Others
Derivatives (such as options and futures), commodities, real estate, collectibles, currencies
Historically, the amount of long-term debt financing issued in the U.S. greatly exceeds the volume of equity financing
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Stock
Stockholders want: Stock price to increase Dependable dividend stream Increase in size of dividend
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Types of Stock
Common stock Preferred stock
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Common Stock
Risk: Lose your money if company falters
Reward: Owners share in success when company does well Appreciation Dividends
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Dividends Represent a return on capital invested
by shareholders. Board must declare dividend for it to be
paid. Dividend payment is not a business
expense. It is an after-tax expense. Usually relationship between company’s
age and size, and the dividends it pays.
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Preferred Stock Reduced risk but reward may be limited Dividend amount is stated and is paid
before dividends on common If company is liquidated, holders are
preferred over common holders. Dividends don’t necessarily increase if
company prospers.
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Bond Bond is debt a company owes Individual or company “loans” money to
the company by buying a bond Bond pays interest over a fixed period of
time Principal is repaid to the lender or holder of
the bond at end of the term Interest rate is typically fixed when the
bond is sold (i.e., fixed income security) Interest rate is comparable to what other
bonds, with that rating, are payingStrictly Financials
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Bond Terminology Interest rate: Fixed percentage of the bond’s
purchase price that is paid annually to the bond holder
Yield: Return on investment if bond is held to maturity. Equals interest rate. If bond is traded before maturity date, yield could change although interest rate stays the same.
Par value: Dollar amount paid for bond at time of issue
Maturity date: When bond comes due
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A Quasi-Bond? Is preferred stock debt (i.e., a bond) in
disguise? Preferred holders have a “guaranteed”
dividend. Is that like the fixed interest rate of a bond?
Why do investors pick common, preferred or bonds?
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Risk and Reward
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Yield CurveYield
Maturity
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Equity or Securities Markets
Primary market Go public Private placement
Secondary market
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Going Public Entrepreneurs have an idea. Company
grows with an investment from the private equity market (venture capital).
Owners decide to “go public.” Register with SEC to make an initial
public offering (IPO). Investment bankers typically
underwrite the offering through a syndicate.
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Going Public (cont.)
Company prepares a prospectus, which is a detailed analysis of the company’s financial history, its products and services, as well as management’s background and experience.
Prospectus should identify and assess risk factors the company faces.
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IPO Terms
Prospectus Road show Quiet period Lockup period
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Secondary Offering
If company already is public, it can sell more stock through a secondary offering. Causes dilution
Major owners sell their shares. They get the funds so no dilution.
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Wall Street
Got its name from a wall of brush and mud built by early settlers to protect the city of New York from attacks (1609)
Site of New York’s first organized stock trading
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New York Stock Exchange In March 1792, Wall Street leaders
met to establish an improved auction market
In May 1792, 24 men signed an agreement to trade securities only among themselves, maintain fixed commission rates and avoid other auctions
Considered the origination of NYSEStrictly Financials
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NYSE (cont.)
Until March 2006, was owned by 1,366 seat-holding members
Highest price ever paid for a seat was $4 million
Price was determined by auction.
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NYSE Members Floor brokers
House brokers Independent brokers
Specialists Manage auction process Execute orders for brokers Serve as catalysts Provide capital Stabilize prices
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In The Day, Buy or Sell Order Tell your broker or “registered
representative” to buy or sell a stock at the current price, or market price. Called a market order.
If you name the price to buy or sell, you’re making a limit order.
Tell your broker to buy or sell once the price hits a specific price, you’re placing a stop order at a stop price.
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Trading on the NYSE Floor
Trading occurs in the “Big Room” Numerous stations, each with a
roughly figure-eight shape, with counters and screens above. Called “trading posts.”
Each counter is a “specialist’s” post
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NYSE Floor (cont.) Order comes to the booth that is rented
by a brokerage house Floor broker takes order to appropriate
specialist’s post Specialist keeps a list of unfilled orders.
Processes orders as prices move. Specialist’s job is to maintain an orderly
market in the stock (match buyers/sellers)
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NYSE Floor (cont.) Stocks or groups of stocks are traded at
trading posts near the specialists’ positions. Floor brokers can use a specialist or trade
between themselves, called trading in the “crowd”
Terminals display the stock’s activity. After every trade, a reporter records the
stock symbol, price and initiating broker. Successful trades are confirmed.
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NYSE Floor (Then & Now)
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Round or Odd Lots
Round lots: Buying or selling stock in multiples of 100 shares
Odd lots: Buying or selling stock in other quantities
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Super DOT System
Designated Order Turnaround Allows orders to be transmitted
electronically to specialist. Now makes up a substantial
percentage of NYSE trading, particularly smaller orders
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American Stock Exchange Non-members of NYSE couldn’t
afford office space so traded in the street
1842: New York Curb Exchange By late 1870s known as “curbstone
brokers” and their market was known as the Curb.
Merged with NASDAQ in 1998 Acquired by NYSE Euronext in 2009
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NASDAQ
National Association of Securities Dealers Automated Quotations system
NASDAQ is a computer network with no physical location for trading
Uses a multiple market maker system, not the specialist system
About 4,000-plus companies
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Trading on the NASDAQ
Trading is through an open market, multiple dealer system, with many market makers competing to handle each transaction.
The computer network checks for matches, which can be handled instantly.
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To Be Listed NYSE: Minimum 1.1 million publicly
held shares; $40 million minimum market capitalization.
NASDAQ: Qualitative and quantitative requirements for national and small cap markets
AMEX: Minimum 500,000 publicly held shares; minimum $3 million market cap
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In Which Market?
In general, but with exceptions: NYSE: Oldest, largest, best known AMEX: Smaller, younger NASDAQ: Youngest, least experienced Some of NYSE’s most actively traded
stocks are also quoted on the NASDAQ
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ECNs
Electronic Communications Networks
Are basically Web sites that allow investors to trade directly with one another
Archipelago and Instinet were best known
BATS TradingStrictly Financials
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NYSE - Archipelago Marriage Merged in March 2006 to create NYSE
Group, Inc., a publicly-held company. Largest merger ever between
securities exchanges. Combined leading equities market
with most successful electronic exchange.
Archipelago: low fees, user-friendly technology
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NYSE Euronext
Merged April 2007 Operates world’s largest, most
liquid exchange with diverse products and services
Six equities exchanges in five countries and six derivatives exchanges
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NYSE ‘Hybrid Market’
Floor trading and automated trading
Specialists or Archipelago strengths
Why? Customers’ desire for faster access to liquidity and greater anonymity
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NASDAQ Response
NASDAQ acquired Instinet Group Inc., another ECN
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Exchanges v. OTC Market
Stocks in almost 10,000 companies aren’t listed on any exchanges.
They are traded “over the counter” (OTC)
Typically handled by phone or computer
Generally, comparatively inexpensive and infrequently, or “thinly,” traded
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BATS
Newer exchange Located in Kansas City Competes on technology and cost Also offers an options trading
platform An ECN
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BATS (cont.)
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Direct Edge
Another ECN Has exchange status
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Cyclical, Income, Growth Cyclical: Highly dependent on the state
of the economy. When things slow, earnings and stock price fall. When economy recovers, earnings and stock prices rise.
Income: Stocks that pay dividends regularly.
Growth: Pay little or no dividend while profits are reinvested.
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Stock Ownership
56.9 million households owned stock in 2005
Compares with 54.1 million in ’02 and 40 million in ’95
Due mainly to spread of mutual funds, 401(k) plans, etc.
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Institutional Investors Organizations that invest their own assets or
pool those it holds in trust for others. Examples: Investment companies (including
mutual funds), pension systems, insurance companies, universities and banks.
Trade regularly and in tremendous volume. Must buy or sell at least 10,000 shares for a
transaction to be an “institutional trade.”
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Changing Attitudes
Institutional investors who own large blocks of stock are increasingly demanding a say in corporate management.
Socially or environmentally conscious individual shareholders also are becoming more involved.
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Stock Market Averages Dow Jones Industrial Average: Best known
and most widely reported market indicator Made up of 30 industrial companies Dow Jones Transportation Average: 20
airlines, railroads and trucking companies Dow Jones Utility Average: 15 gas, electric
and power companies Dow Jones 65 Composite Average: all 65
companies in the other three averages
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Stock Market Indexes NYSE Composite Index: All stocks traded
on the NYSE. Standard & Poor’s 500 Index: Broad
base of 500 stocks. Considered benchmark for large-stock investors.
NASDAQ Stock Market Composite Index: Stocks traded through its electronic system. Often more volatile because of types of companies it covers.
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Market Indexes (cont.) AMEX Composite: Companies on the
AMEX. Russell 2000: Follows smallest two-
thirds of the 3,000 largest U.S. companies. Includes many IPOs of past few years. Benchmark for small-company stocks.
Value-Line: 1,700 common stocks. Wilshire 5000: Broadest index, including
nearly all stocks traded in U.S. markets.
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Reg FD, Disclosure and Guidance Regulation Fair Disclosure, October
2000 Bars public issuers from selectively
revealing material nonpublic information to securities analysts, broker-dealers, investment advisers, and institutional investors, before disclosing it to the public.
Tension: Guidance vs. disclosure
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Blue-Chip Stock
Company with national reputation for quality, reliability and ability to be profitable in good or bad times
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Bulls and Bears
Bulls: Persons who think prices or values will rise. In general, being optimistic.
Bears: Persons with a pessimistic market outlook.
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Selling Short
Selling a security not owned by seller Investor borrows stock and sells it for
later delivery. Seller hopes to buy the stock later at
a lower price, thereby making a profit, which comes from difference between price at sale and price at later purchase.
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Margin
Buying on margin: Borrowing money from broker to buy securities.
Federal Reserve regulates margin. Today investor can borrow up to 50 percent of the price of the stock.
Broker requires a minimum balance and can issue a “margin call” if stock’s value declines.
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Classes of Stock
Some firms have more than one class Primarily done to assure control of the
firm by one group, such as Ford Motor Company’s Class B, which isn’t publicly traded (held by family) but has 40 percent of voting power, although it represents less than 10 percent of total shares outstanding.
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Stock Split If stock price increases significantly, a
company might do a split to lower the price, which it expects to stimulate trading.
In a split, more shares are available but total market value is still the same.
Price may move up after split, therefore increasing the value of your stock.
Reverse split: Exchange more shares for fewer, say 10 for five. To boost share price.
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Arbitrage
Simultaneous purchase and sale of an asset to profit from a differential in the price. Usually takes place on different exchanges or marketplaces.
Ex: Buy stock in company on one exchange at one price and sell stock in the same company on another exchange at a different price.
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Insider Trading
Buying and selling of company stock by officers, directors, employees, family members, etc. Person or trust owning 10 percent or more of a company's stock also considered an "insider."
SEC calls them "insiders" because of access to early and potentially key company events.
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Option
On an organized exchange, the right to buy or sell securities, commodities, etc. at some point for an agreed upon amount.
In a company, stock options are granted to corporate executives and others as part of their compensation packages.
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Warrant
Type of security, usually issued with a bond or preferred stock, that entitles holder to buy a proportionate amount of common stock at a specified price, usually higher than the market price at time of issuance, for a period of time.
Also called a Subscription Warrant
Strictly Financials
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Global Marketplace
Stocks are traded around the clock, around the world. There’s a market open somewhere, 24 hours a day, Monday through Friday.
Growing number of multinational companies on several exchanges.
Tendency of investors to buy in many markets, not just their own.
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American Depositary Receipts A bank buys and deposits actual foreign
securities with another bank (called a depositary), which then issues certificates in the U.S. that represent (and are backed) by the deposited securities.
Depositary handles day-to-day interactions with ADR holders.
Advantages: As U.S. securities, ADRs are subject to U.S. regulations and protections.
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ADRs (cont.) Priced in dollars and dividends paid
in U.S. dollars. ADR prices follow closely (but not
necessarily 1:1) the underlying foreign security, based on supply and demand.
Very few U.S. banks are depositaries. Bank of New York is largest with more than 50 percent of all ADR issues.
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Tracking Global Markets
Wall Street Journal tracks 24 national stock markets outside the U.S. with 32 indexes.
Worldwide market performance is compared by looking at percentage change.
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Why International
Rewards Diversification, capital gains, dividends,
country’s currency rises against dollar Risks
Tax treatments differ by country, accounting and trading rules can be different, converting dividends can add expenses, distance and language barriers
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Credit or Debt Markets
Historically, the amount of long-term debt financing issued in the U.S. greatly exceeds the volume of equity financing
Short-term or “money market” Bond market
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Money Market
Commercial paper Bankers’ acceptance Repurchase agreements Certificates of deposit Municipal notes Treasury bills Money market mutual funds
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Terminology
Bills – Maturity dates up to one year
Notes – Maturity dates of two to 10 years
Bonds – 10 years or longer
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Who Issues Bonds
Issued by U.S. companies Issued by the U.S. Treasury Issued by federal, state and local
government agencies Issued by overseas companies and
governments. When sold in dollars, are sometimes called Yankee Bonds.
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Issuers Prefer Bonds
When companies need to raise money, they can issue stock or sell bonds
They often prefer bonds, in part because issuing more stock tends to dilute the value of shares investors already own
Bonds also may have income tax advantages
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Treasury Issues
Life, or term, is fixed at time of issue
Treasury bill: One year or less Treasury note: One to 10 years Treasury bond: 10 years or more Generally, the longer the term the
higher the interest rate
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Uses of Bonds
Corporations use bonds: To raise capital to pay for expansion
or modernization To cover operating expenses To finance corporate takeovers or
other changes in management structure
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Uses of Bonds (cont.)
U.S. Treasury uses bonds: To finance a wide range of
government activities To pay off (actually refinance) the
national debt
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Uses of Bonds (cont.)
States, cities, counties and towns issue bonds: To pay for a wide variety of public
projects To supplement their operating
budgets
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How Bonds Are Sold Issuing bonds has similarities to an IPO Bonds are sold at par, or face value, in
units of $1,000 After issue, bonds trade in secondary
market and are bought and sold through brokers
Government bonds are directly available through a Federal Reserve Bank program called Treasury Direct or through a broker
Most municipals are sold through a broker
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How Bonds Are Traded
Most already-issued bonds are traded over the counter
Bonds also can be purchased from the inventory of a brokerage firm that might make a market in the bonds
Commissions and markups
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Bonds Then and Today Until 1983, all bondholders received
certificates Some of these Bearer Bonds had coupons
attached to the certificate To collect interest, investor detached the
coupon and exchanged it for cash. Hence, the bond interest rate is called the Coupon Rate.
Today most new bonds are called Book Entry bonds and are registered electronically
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Rating Bonds Standard & Poor’s, Moody’s Investors
Services and Fitch are best known Corporate, international and municipal
bonds are rated Credit ratings influence interest rates If a company’s rating is downgraded,
investors demand a higher yield
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Bond Rating Code Aaa/AAA: Best quality Aa/AA: High quality A/A: High-medium quality Baa/BBB: Medium quality Ba/BB: Some speculative element B/B: Future default risk Caa/CCC: Poor quality, default danger Ca/CC: Highly speculative C/C: Lowest rated, poor prospects
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