FIN221: Lecture 2 Notes Securities Markets Chapters 4 and 5 Chapter 4 Charles P. Jones, Investments: Analysis and Management, Eighth Edition, John Wiley & Sons Prepared by G.D. Koppenhaver, Iowa State University The Role of Financial Markets Help firms and governments raise cash by selling claims against themselves Provide a place where investors can act on their beliefs Help allocate cash to where it is most productive Help lower the cost of exchange Markets in New Securities New securities are issued in a primary market Initial public offerings versus seasoned new issues Issue facilitated by investment banker Specialists in advice, design, and sales Intermediaries between issuer and investor Investment Banking Client advice includes type and features of security, offer price, and timing of sale Underwriting services: Risk of selling to investors assumed from issuer Coordinates marketing by helping issuer register securities, issue prospectus, and sell securities Investment Banking Rule 415 (shelf rule) allows certain issuers to sell new securities over time after filing a single registration Reduces issuance cost A private placement means new securities are sold directly to investors, bypassing the open market Registration not required
Secondary Markets Markets where investors trade previously issued securities Auction markets involve bidding in a specific physical location Brokers represent investors for a fee Others trade for their own account Negotiated markets consist of decentralized dealer network Stock Exchanges NYSE is a secondary, auction market in equity shares Not-for-profit organization of members Listing requirements for traded firms Specialists assigned to each traded equity to make a market in that stock AMEX and regional exchanges list smaller firms, have less volume than NYSE Over-the-counter Markets Network of dealers standing ready to either buy or sell securities at specified prices Dealers profit from spread between buy and sell prices Handle unlisted securities NASDAQ: Competing dealers make markets in OTC stocks Third and Fourth Markets Third Market: Over-the-counter transactions in securities listed on organized exchanges Fourth market: Trading network among investors interested in buying and selling large blocks of stock Brokers, dealers bypassed so costs low Electronic or telephone network Foreign Markets US equity markets account for a third of world s stock market capitalization Many different equity markets exist Emerging market: Stable political system, low regulation, low standardization in trading activity Risks: Illiquidity, lack of information, political uncertainty Equity Market Indicators Provide a composite report of market behavior on a given day Dow Jones Industrial Average Composed of 30 blue-chip stocks Price-weighted index: Essentially adds the prices of 30 stocks, divides by 30 Adjusted for stock splits, stock dividends Oldest, most well-known measure
Equity Market Indicators Standard & Poor s Composite Index Composed of 500 large firm stocks Expressed as index number relative to a base index value of 10 (1941-43) Value-weighted index: Prices and shares outstanding considered Indicates how much the average equity value of the 500 firms in the index has increased relative to the base period Equity Market Indicators NYSE and NASDAQ Composite Indices Value-weighted indices of broad markets Nikkei 225 Average Price-weighted index of 225 actively-traded stocks on the Tokyo Stock Exchange Bond Markets Secondary bond market is primarily an over-the-counter network of dealers NYSE features an automated bond system to execute orders. Mostly corporate bonds, thinly traded Treasury and agency bonds actively trade in dealer markets Municipal bonds less actively traded Market Developments Growth of institutional trading associated with: Block trading of stocks (transactions of at least 10,000 shares) Affects market structure and operation Negotiated, not fixed, commissions Evolution of National Market System Centralized system for price and activity reporting, order routing and sequencing Copyright 2002 John Wiley & Sons, Inc. All rights reserved. Reproduction or translation of this work beyond that permitted in Section 117 of the 1976 United States Copyright Act without the express written permission of the copyright owner is unlawful. Request for further information should be addressed to the Permissions Department, John Wiley & Sons, Inc. The purchaser may make back-up copies for his/her own use only and not for distribution or resale. The Publisher assumes no responsibility for errors, omissions, or damages, caused by use of these programs or from the use of the information contained herein. How Securities Are Traded Chapter 5 Charles P. Jones, Investments: Analysis and Management, Eighth Edition, John Wiley & Sons Prepared by G.D. Koppenhaver, Iowa State University
Brokerage Operations Brokerage firms earn commissions on executed trades, sales loads on mutual funds, profits from securities sold from inventory, underwriting fees and administrative account fees Full-service brokers offer order execution, information on markets and firms, and investment advice Discount brokers offer order execution Account Types Cash account: Investor pays 100% of purchase price for securities Margin account: Investor borrows part of the purchase price from the broker Asset management account: automatic reinvestment of excess cash balances in money market fund Account Types Cash management account Checks can be written against account s assets Instant loans at a markup to call money rate based on the account s assets Wrap account: Brokers match investors with outside money managers All costs, fees wrapped into one Fees and Costs Brokerage commissions differ by security, broker, and investor Institutional investors have greatest negotiating power Dividend reinvestment plans permit reinvestment of dividends in additional stock Avoids commissions, administrative fees Orders in Auction Markets Most NYSE volume from matched public buy and sell orders Specialists act as both brokers and dealers in the stocks assigned to them Maintain the limit order book Keep a fair and orderly market by providing liquidity NYSE Automation SuperDot: An electronic order recording, reporting, routing, and matching system Specialist s Electronic Book records and reports limit and market orders Preopening buy and sell orders matched and imbalance reported to specialist Members send orders directly to specialist for execution and confirmation
Orders in OTC Markets Dealers ready to either buy or sell Bid price is highest offer price to buy Ask price is lowest price willing to sell Ask price - Bid price >0 (dealer spread) Makes a market in the security More than one dealer for each security in over-the-counter markets Types of Orders Market orders: Authorizes immediate transaction at best available price Limit orders: Specifies a particular market price before a transaction is authorized Stop orders: Specifies a particular market price at which a market order is authorized Settlement Most settlement dates are three business days after the trade date Legal ownership transferred and financial arrangements settled with brokerage firm Book-entry system reduces costs Transfer of securities and funds between exchange members facilitated by a clearinghouse Regulation SEC Act of 1934 created the Securities and Exchange Commission Administers all securities law Monitors public securities transactions Requires issuer registration for public offers Investigates indications of violations such as insider trading Securities Investor Protection Act of 1970: insures accounts Regulation Stock exchanges are also self-regulated In own self-interest to regulate and monitor member behavior NYSE circuit-breakers attempt to reduce volatility NASD: Trade association that regulates OTC brokers and dealers Margin Accounts To open margin account, exchanges set minimum required deposit of cash or securities Investor then pays part of investment cost, borrows remainder from broker Margin is percent of total value that cannot be borrowed from broker Cash: 100% loan value; securities: 50%
Margin Accounts Federal Reserve sets the minimum initial margin on securities Unchanged since 1974 at 50% Actual margin at any time cannot go below the maintenance margin level set by exchanges, brokers Investor s equity changes with price Margin call when equity below maintenance level Short Selling Investor borrows stock from broker or held in street name accounts Borrowed security sold in open market, to be repurchased later at an expected price lower than sale price Investor liable for declared dividends Short sale proceeds held by broker Demand loan of stock