The Global Stock Market

The Global Stock Market Chapter 6 Chapter 6: The Global Stock Market

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

The Global Stock Market

The Global Stock Market

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