Chapter 1Web Extension 1B A Closer Look at the Stock Markets
Topics in Web Extension • Stock indexes • Regulation • Overview of investment banking • Stock trading
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 . .)
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 . .)
Composition by Exchange • NYSE Composite • Nasdaq Composite (More . .)
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
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
Composition by International Region • Morgan Stanley Capital International (MSCI) • EAFE (Europe, Asia, Far East) Index • Emerging Markets Index • Pacific Index
Stock Weighting in Indexes • Price weighted • DJIA • Market-value weighted • S&P500 • Nasdaq Composite • Equally weighted • Value Line Index
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.
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.
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).
Initial Public Offerings • Initial Public Offerings (IPOs) • Underpricing—Average increase is 14% on first day. • Performance– Underperforms similar stock during three years after IPO.
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.
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
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
Margin Trading • Investor uses only a portion of own capital for an investment. • Borrows remaining component. • Margin arrangements differ for stocks and futures.
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
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.
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