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The Global Stock Market

The Global Stock Market. Chapter 6. Background. A variety of different stock markets exist For instance, Germany’s market is over 400 years old while Tanzania’s began in 1998 Macedonia has only two companies trading on its stock exchange while India has 5,840

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The Global Stock Market

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  1. The Global Stock Market Chapter 6 Chapter 6: The Global Stock Market

  2. Background • A variety of different stock markets exist • For instance, Germany’s market is over 400 years old while Tanzania’s began in 1998 • Macedonia has only two companies trading on its stock exchange while India has 5,840 • The market capitalization of the U.S. is $10 trillion while that of Guatemala is only $2 billion (in U.S. dollars) • Many stock markets also trade other financial instruments • Consolidations are merging stock markets and technology is pulling national markets together Chapter 6: The Global Stock Market

  3. The Global Stock Market • Aggregate market capitalization of equity shares in the world grew from $9.6 trillion in 1990 to over $35 trillion in 2000 • An average rate of 14.8% annually • Financial capital is very mobile • In 1990 the Tokyo Stock Exchange was 30.5% of the global market but only 12.7% in 1999 • North America increased its share of the world equity market from 28.0% (1990) to 50.28% (1999) Chapter 6: The Global Stock Market

  4. The Global Stock Market • Technological advances are automating experienced stock exchange employees out of jobs • Stock markets are active in every time zone Chapter 6: The Global Stock Market

  5. Brokerage Services • Brokers • Sales people (earning a commission) employed by dealers • Have no money invested in the dealer’s security inventory • Help create markets by buying and selling from employer’s inventory • Brokerage firms extend credit (margin accounts) to clients • Enables client to do more securities trading Chapter 6: The Global Stock Market

  6. Brokerage Services • Types of stock brokerage services • Full-service • Take buy and sell orders • Extend margin credit to customers • Hold clients’ securities in safe keeping • Collect cash dividends • Provide free investment research • Perform ‘hand-holding’ services • Pleasant telephone conversations • Investment counseling • Birthday cards • All paid for by clients’ trading commissions • Range from $30 - $150 for one common stock transaction • Examples • Merrill Lynch • Goldman Sachs • PaineWebber • Morgan Stanley Dean Witter • Salomon Smith Barney Chapter 6: The Global Stock Market

  7. Brokerage Services • Discount Brokers • Simply take orders • Offer little or no investment advice • No ‘hand-holding’ services provided • Little opportunity for churning • Lower commissions • Range from $20 to $50 • Examples • Charles Schwab & Company • Quick & Reilly • Muriel Siebert • Jack White & Company • Fidelity Investments • Vanguard Brokerage Services Chapter 6: The Global Stock Market

  8. Brokerage Services • Electronic brokers • Take buy and sell orders via Internet • No ‘hand-holding’ services • May provide investment research • May or may not be free • Low commissions • Range from almost free to $35 a trade • Examples • Discover Brokerage • DLJdirect • E*Trade • Archipelago • Bloomberg Tradebook • Accutrade • Ameritrade • Charles Schwab • SURETRADE • Wall Street Access • CyberCorp.com Chapter 6: The Global Stock Market

  9. Transacting • When making a trade, the investor must specify • Type of order • Whether or not margin will be involved Chapter 6: The Global Stock Market

  10. Types of Trading Orders • Market order—order to buy or sell ASAP at the current market price • Simplest, most common order type • Executed immediately with virtual certainty • Limit order—order to buy or sell with a limit • Limit as to the maximum price paid for a buy order • Limit as to the minimum price received for a sell order • If order cannot be immediately transacted, it is recorded in the market-maker’s limit order book and held for possible future execution • Order may never be executed if limit price is not reached • May attach a time frame to the limit order Chapter 6: The Global Stock Market

  11. Types of Trading Orders • Stop orders • To buy (sell) are written at prices greater (lower) than the current market price • Activated when (if) the market price reaches the stop price • Once activated becomes a market order • Dangers with stop orders • Execution price cannot be known in advance • Investor may be whip-sawed in volatile market • Variation on stop order • Stop limit orders • When stop order is activated it becomes a limit order rather than a market order Chapter 6: The Global Stock Market

  12. Types of Trading Orders • Scale order • Requires buying or selling part of the order at each price as market prices change • Cumbersome and not all brokers accept them • Fill or kill (FOK) order • Specifies price at which order must be filled or order is immediately canceled • Good till canceled order • Remains in effect until canceled • Day order—must be filled on the day order is issued • Market on close order—can only be executed at the day’s closing price Chapter 6: The Global Stock Market

  13. Trading on Margin • When opening a new account with a brokerage firm, can have either • Cash account • Must pay cash for securities • Margin account • Offers ability to buy securities on credit • Money put forth by investor serves as a down payment • Amount investors may borrow is controlled by the Federal Reserve Board of Governors • For example, the Fed may stipulate a 60% margin, meaning the investor must put forth at least 60% of the purchase price Chapter 6: The Global Stock Market

  14. Trading on Margin • Federal Reserve’s margin requirements for stocks • Varied from 10% (1929) to 100% (1940) • In recent years has been 50% • Margin requirements are different for different types of securities Chapter 6: The Global Stock Market

  15. How Margin Works • Example: You wish to purchase 100 shares of XYZ Company for a price of $100 per share. The initial margin requirement is 50%. • Purchase price is $100 x 100 shares = $10,000 • You put forth 50%, or $5,000 • Borrow the remaining $5,000 from your broker • Broker charges you the brokers’ call rate for a margin loan Chapter 6: The Global Stock Market

  16. How Margin Works • Assume that the market value of the stock rises to $150 a share • Your total profit will be $50 a share times 100 shares, or $5,000, ignoring interest (on margin loan), taxes and commissions • Your return is 100%: Profit of $5,000  Investment of $5,000 • If you had not used margin, you could have only afforded 50 shares, and your profit would only have been $2,500 • Your return would have been 50%: Profit of $2,500  Investment of $5,000 Chapter 6: The Global Stock Market

  17. How Margin Works • Assume that the market value of the stock falls to $50 a share • Current market value of the investment is now only $5,000 (which exactly equals the amount that was borrowed from the broker) • Your total loss will be $50 a share times 100 shares, or $5,000, ignoring interest (on margin loan), taxes and commissions • Your return is -100%: Loss of $5,000  Investment of $5,000 • If you had not used margin, you could have only afforded 50 shares, and your loss would only have been $2,500 • Your return would have been -50%: Loss of $2,500  Investment of $5,000 Chapter 6: The Global Stock Market

  18. Maintenance Margin • If a margined portfolio decreases sufficiently in value, investor will receive a margin call • Investor must put up more margin money ASAP • Otherwise, broker liquidates enough of the investor’s securities to bring account up to the required minimum margin • Easy for broker to do because investor with a margined account must keep securities at the broker’s office as collateral for their loan • The NYSE has a maintenance margin requirement of 25% • Investor’s equity cannot fall below 25% of the account’s market value • Or, investor’s loan amount cannot exceed 75% of the account’s market value Chapter 6: The Global Stock Market

  19. Maintenance Margin • Continuing the example, if you had purchased $10,000 of stock with a 50% margin, you would face a margin call when • Market value of stock dropped below $6,666.67 • Because your loan of $5,000 cannot exceed 75% of the market value of portfolio • 75% × X = $5,000 • X = $6,666.67 • Some brokers set a higher maintenance margin than the 25% minimum Chapter 6: The Global Stock Market

  20. Investment Banks Make Primary Markets • Initial public offerings (IPOs) occur when corporations and governments issue new securities into the primary market • Sometimes corporations and governments with existing securities raise additional capital by issuing a new issue of seasoned securities • Investment bankers find buyers for both IPOs and seasoned new issues Chapter 6: The Global Stock Market

  21. Investment Banks • A few thousand investment banking firms exist in the U.S., including • Merrill Lynch & Co. • Morgan Stanley Dean Witter • Lehman Brothers • Credit Suisse First Boston • Goldman, Sachs & Co. • Salomon Smith Barney • Bear Stearns Cos. • Paine Webber Chapter 6: The Global Stock Market

  22. Investment Bankers’ Functions • Each public offering has four steps • Consulting with the issuer • Carrying out administrative duties • Underwriting the issue • Distributing the securities to investors Chapter 6: The Global Stock Market

  23. Consulting • The investment bank that serves as the IPO’s originator must analyze the client’s needs and suggest a financing plan • What type of security should be issued? • How much financing is needed? • When should the new securities be issued? • The originator will also manage • The underwriting syndicate • Ranges from 5 to 200 investment banking firms that share the financing and underwriting risk • The selling group • Investment banks and brokerage firms that sell the securities to investors Chapter 6: The Global Stock Market

  24. Administration • Deals with legal issues associated with an IPO • Helps obtain necessary government permissions • Has the prospectus printed • Makes public announcements Chapter 6: The Global Stock Market

  25. Underwriting • An underwriter guarantees the issuer will receive a pre-specified amount of cash for the new securities • 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 • Market conditions may fluctuate and underwriter may lose money on the securities because they have to sell them at a lower price • It is important to set the ‘right’ price for an IPO • If price is too high, underwriters may not be able to sell securities • If price is too low, issuer may find it costly to issue securities Chapter 6: The Global Stock Market

  26. Distribution • Investment banker may sell securities to a wide group of investors • Or may act as intermediary between issuer and buyer in a private placement • The difference between the investment banker’s cost and the sale price is known as the spread • Ranges from 5 – 16% for stocks • About 4% for bonds Chapter 6: The Global Stock Market

  27. Electronic Investment Bankers • There are several investment banking firms offering internet services • DLJdirect • Freidman, Billings, Ramsey Group • E*Offering • OpenIPO • E-InvestmentBank • Wit Capital • Vary in size and sophistication Chapter 6: The Global Stock Market

  28. Full Disclosure • In U.S. the SEC requires most primary issuesbe accompanied by a prospectus • 10 to 20 page document that fully discloses, among other items • Purpose for which the proceeds of the issue will be spent • Offering price to the public • Offering price for special groups, in any • Underwriter’s fees • Net proceeds to the issuer • Information on the issuer’s products, history and location • Names and remuneration of officers • Detailed statement of capitalization • Detailed financial statements • Details about any pending litigation Chapter 6: The Global Stock Market

  29. Full Disclosure • 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 • Full disclosure allows investors to estimate value of new securities Chapter 6: The Global Stock Market

  30. Secondary Market • Once securities are issued in the primary market, they can begin trading in the secondary market • Types of secondary markets • Organized exchange run by dealers (NYSE) • Electronic market in which dealers compete with one another (Nasdaq) • Electronic communication networks Chapter 6: The Global Stock Market

  31. NYSE • New York Stock Exchange (www.nyse.com) lists approximately • 3000 common and preferred stocks issued by American corporations • 300 foreign stocks • 250 American Depository Receipts (ADRs) • Also trades bonds Chapter 6: The Global Stock Market

  32. NYSE • Each stock traded on the NYSE is assigned a specialist who must • Continuously post bid and ask prices for the stocks in which they make a market • Stand at assigned posts on the trading floor • Act as market-makers (dealer) • Always ready to buy at their bid price and sell at their ask (or offer) price • Invest their own capital (risky) but may earn a return • Execute orders for others (broker) • Earn the bid-ask spread on every transaction Chapter 6: The Global Stock Market

  33. Decimalization • A tick represents the minimum amount by which a price can change • Prior to 1997 the tick was 1/8 but then became 1/16 • However the tick size is now 1¢ since the exchanges instituted decimalization • Expected to reduce the bid-ask spread and trading costs Chapter 6: The Global Stock Market

  34. NYSE Listing Requirements • To be listed on the NYSE must have • A minimum taxable annual income of $2.5 million • A minimum net tangible assets of $18 million • A minimum of 1.1 million shares of publicly held stock with a minimum market value of $18 million • A minimum number of 2,000 investors owning round-lots (100 shares) • One specialist Chapter 6: The Global Stock Market

  35. NYSE Operations • Approximately 460 specialists with about 8 stocks assigned to each specialist’s trading post • About 1,500 trading booths with telephones surround the perimeter of the trading floor • Allows for order transmission and confirmation between brokers’ offices and exchange floor • NYSE has 1,366 members who must own a seat on the exchange • Almost all members are either specialists or floor brokers Chapter 6: The Global Stock Market

  36. Floor Brokers • Buy and sell securities for the clients of brokerage houses or for their own accounts • Order process • Broker receives order via phone from the brokerage • Walks to trading floor and executes transaction at the specialist’s post • Phones brokerage and provides confirmation Chapter 6: The Global Stock Market

  37. Specialists • Accepts obligation to make a fair and orderly market by • 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) • Buying shares for their own inventory if there are more sell orders than buy orders (or by lowering the price of the stock) • Keeps a limit order book (LOB) for each stock in which they make a market Chapter 6: The Global Stock Market

  38. Limit Order Book • Today is kept on a computer • Records buy and sell orders from potential traders • Outlines the supply and demand curves that determine market price of security • Helps specialists earn trading profits Chapter 6: The Global Stock Market

  39. NYSE • NYSE has lagged behind other organizations in terms of technology • Uses Super Designated Order Turnaround (SuperDOT) system • Routes small market orders and limit orders directly from member firms to specialists • Bypasses floor brokers • Specialists usually let PCs execute SuperDOT transactions automatically Chapter 6: The Global Stock Market

  40. Block Trades • A single transaction involving 10,000 or more shares • Increased steadily throughout the 1960s-1980s but leveled off in the 1990s • Specialists are not involved in block trades that occur outside the NYSE by block positioners • Special brokers/dealers that line up multiple buyers for a large block • Some large investment banks have a block positioning department • Have the capital to carry a large block for a few days and the connections to distribute it • The upstairs market • Economies of scale lead to small commissions per share Chapter 6: The Global Stock Market

  41. Nasdaq Market • Electronic, over-the-counter (OTC) market • Lists over 15% of the world’s stock market capitalization • Over 6,400 common and preferred stocks • About 320 foreign stocks • About 140 ADRs Chapter 6: The Global Stock Market

  42. Nasdaq Market • National Association of Securities Dealers Automated Quotations (Nasdaq) is the communications network that services the OTC market • About 61,000 computer terminals are connected to Nasdaq’s mainframe via phone lines • Can obtain current bid and ask prices for all Nasdaq stocks • Updated continuously by about 540 competing Nasdaq market-makers (dealers) • Investor’s broker can access the system to find the best bid/ask price for a security • Broker then calls dealer to execute transaction as trades cannot be executed via Nasdaq computer Chapter 6: The Global Stock Market

  43. Nasdaq Market • Centralizes a geographically dispersed market into a mainframe computer • 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 • Designed to handle up to 20,000 stocks • Currently lists about 6,500 actively traded stocks • In 1999 Nasdaq merged with AMEX • Nasdaq plans to cross-list stocks with various international exchanges • Positioning itself to more effectively compete with NYSE Chapter 6: The Global Stock Market

  44. CQS, ITS and Law of One Price • SEC requires that the Consolidated Quotation System (CQS) report current transactions for NYSE, OTC, AMEX, regional U.S. stock exchanges and the third market • Helps investors find the best prices • CQS cannot perform executions • SEC urged NYSE to create the Intermarket Trading System (ITS) • Electronic trading network linking various U.S. markets • Nasdaq supplemented ITS with an electronic communications network called Primex • Gives faster access to NYSE-listed stocks • Combining CQS with ITS and Primex allows arbitrageurs to enforce the law of one price Chapter 6: The Global Stock Market

  45. Non-Nasdaq National Quotation Bureau (NQB) • To be included in Nasdaq’s national daily list, a stock must have • At least two market makers • A minimum of 1,500 stockholders • Significant investor interest • A stock not meeting these requirements are listed with the National Quotation Bureau (NQB) • NQB lists 3,600 stocks, some of which are not actively traded • Includes • Domestic U.S. micro-cap stocks • Shares in foreign corporations that cannot be listed on an organized exchange • ADRS and GDRs for stocks that do not meet the accounting standards for listing on an organized exchange Chapter 6: The Global Stock Market

  46. Third U.S. Market • Third market—subset of OTC market where exchange-listed stocks are traded • Competes with organized exchanges • Offers cost savings in the form of better bid-ask prices • Nasdaq and regional stock exchanges are the core of the third market • For instance, in 1999 Chicago Stock Exchange (CHX) traded over 90% of the NYSE-listed stocks • Majority of CHX’s trading volume is from dual listings • CHX pays for order flow • 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 Chapter 6: The Global Stock Market

  47. Fourth U.S. Market • Fourth market—a network of market-makers, block traders and institutions • Bypass normal dealer services and negotiate directly with each other • Instinet (short for Institutional Network) has operated in the fourth market since 1970 • Has computer terminals in over 5,000 subscribers’ offices • Millions of shares are traded in secrecy daily via Instinet • Commissions range from 2¢ to 8¢ a share Chapter 6: The Global Stock Market

  48. Order Crossing Networks • An electronic communication network that tries to match buy and sell orders • The price may be • The last reported price from an organized exchange • Midway between the current bid-ask prices on an organized exchange • Traders may pay a fixed annual fee to use alternative market systems • Variable trading costs are zero • Rapid executions are possible if the other half of the transaction is already present in network • Offers anonymity • Sometimes the network is not operating when it is needed • Or the other halfof the transaction is unavailable Chapter 6: The Global Stock Market

  49. Order Crossing Networks • Instinet operates the Crossing Network and competes with Investment Technology Group’s (ITG) Portfolio System for Institutiional Trading (POSIT) • Bloomberg runs Tradebook—a continuous matching system mainly for Nasdaq stocks • In 1999 Bloomberg & ITG created SuperECN • Offers a crossing network with a larger order flow • Other crossing networks include • Investor’s Liquidity Network by Fidelity Investors • E-Crossnet is for European stocks Chapter 6: The Global Stock Market

  50. Electronic Order Working Systems • Electronic order working systems • Screen telecommunication networks, capture current market information and use it to make ongoing transactions • Needs the following information • Securities that are to be traded • Limit order prices • Quantities available at different prices • Binding time limits • Markets where the securities are traded • Any additional information Chapter 6: The Global Stock Market

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