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Organization and Organization and Functioning of Functioning of

Securities Markets + Securities Markets + Market IndexesMarket IndexesChapter 4 & 5 of Reilly & BrownChapter 4 & 5 of Reilly & Brown

Copyright © 2000 by Harcourt, Inc. All rights reserved.

What is a market?What is a market?• Brings buyers and sellers together to aid in

the transfer of goods and services

• Does not require a physical location

• Does not have to own the goods and services involved

• Buyers and sellers both benefit from the existence of the market


Characteristics of a Good Characteristics of a Good MarketMarket

• Transparency– Availability of timely and accurate information about past

transaction – Info on Price, volume, supply and demand, etc.

• Liquidity– marketability– price continuity– depth

• Internal efficiency– Lower transaction cost

• External efficiency – prices quickly reflect new information


Organization of the Securities MarketOrganization of the Securities Market

• Primary markets– Initial Public Offerings (IPOs) and other

New issues are sold

• Secondary markets– Trading of already issued securities

takes place.


Investment Banks Make Primary Investment Banks Make Primary MarketsMarkets

• 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


Investment Bankers’ Investment Bankers’ FunctionsFunctions

• Each public offering has four steps– Consulting with the issuer– Carrying out administrative duties– Underwriting the issue– Distributing the securities to investors


Secondary MarketSecondary 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


Why Secondary Markets Are Why Secondary Markets Are ImportantImportant

• Provides liquidity to investors who acquire securities in the primary market

• Helps determine market pricing for new issues


NYSENYSE• 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


NYSENYSE• 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


DecimalizationDecimalization• A tick represents the minimum

amount by which a price can change

– The tick size is now 1¢ since the exchanges instituted decimalization

– Expected to reduce the bid-ask spread and trading costs


NYSE Listing RequirementsNYSE 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


NYSE OperationsNYSE Operations• NYSE has 1,366 members who must own a

seat on the exchange– Almost all members are either specialists or

floor brokers


Floor BrokersFloor 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


SpecialistsSpecialists• 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


NYSENYSE• 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


Nasdaq MarketNasdaq 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


Third U.S. MarketThird 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


Fourth U.S. MarketFourth 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


Exchange MembershipExchange Membership• Specialist• Commission brokers

– Employees of a member firm who buy or sell for the customers of brokerage firms

• Floor brokers– Independent members of an exchange who

act as broker for other members• Registered traders

– Use their membership to buy and sell for their own accounts


Trading on MarginTrading 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


Trading on MarginTrading 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


Margin TransactionsMargin TransactionsBuy 200 shares of Widget at $50/share = $10,000 Borrow 50% (initial margin) of investment ($5,000)If price increases to $60/share, position

– Value is $12,000– Less - $5,000 borrowed – Leaves $7,000 equity for a– Margin=$7,000/$12,000 = 58%

What is your rate of return with and without margin?


Margin TransactionsMargin TransactionsIf price decreases to $40/share, position

– Value is $8,000– Less - $5,000 borrowed – Leaves $3,000 equity for a– $3,000/$8,000 = 37.5% equity position

What is your rate of return with and without margin?


If maintenance margin =25%, then, at what per share price of Widget (P*) would you receive a margin call?

Margin CallMargin Call


Short salesShort sales

• Sell overpriced stock that you don’t own and purchase it back later (at a lower price)

• Borrow the stock from another investor (through your broker)

• Three technical points of short sales– Short sale can only be made on an uptick

trade;– The short sellers must pay any dividends

due to investors who lent the stock;– Short sellers must post the same margin

as buyers of the stock


Types of Trading OrdersTypes 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


Types of Trading OrdersTypes of Trading Orders• Stop orders

– To buy (sell) 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

– Variation on stop order• Stop limit orders

– When stop order is activated it becomes a limit order rather than a market order


Why construct Market Why construct Market Indexes?Indexes?

1. Judge the performance of investment managers.

2. Form indexed portfolios.3. Perform research on the macroeconomic factors

that affect security prices.4. Analyze relationship between investment

returns across borders.5. Perform technical and fundamental analysis of

the entire equity class of assets.6. Serve as the “market portfolio” for measuring

beta and systematic risk.


Differentiating Factors in Differentiating Factors in Constructing Market IndexesConstructing Market Indexes

What does the index represent?1.Source2.Size3.Breadth

Computational procedure1.Simple average2.Geometric average

Weighting sample members1.price-weighted series2.value-weighted series3.unweighted (equally weighted) series


Dow Jones Industrial Average Dow Jones Industrial Average (DJIA)(DJIA)

• Begun in 1884 with 11 stocks• Price-weighted average of thirty (since

1928) large well-known industrial stocks, leaders in their industry.

• Total the current price of the 30 stocks and divide by a divisor (adjusted for stock splits and changes in the sample)


Example of Change in DJIA Divisor Example of Change in DJIA Divisor When a Sample Stock SplitsWhen a Sample Stock Splits

After Three-for One

Before Split Split by Stock A Prices PricesA 30 10B 20 20C 10 10 60 3 = 20 40 X = 20

X = 2 (New Divisor)


Impact of Differently Priced Shares on a Price-Impact of Differently Priced Shares on a Price-Weighted Indicator SeriesWeighted Indicator Series

PERIOD T+ 1

Period T Case A Case B A 100 110 100B 50 50 50C 30 30 33Sum 180 190 183Divisor 3 3 3Average 60 63.3 61% Change 5.5% 1.7%


Criticism of the DJIACriticism of the DJIA• Sample used is limited• Introduces a downward bias in DJIA by

reducing weighting of fastest growing companies whose stocks split

• Biased toward the behavior of the highest priced securities

• It represents the performance of a portfolio of an equal number of shares in each of the stocks in DJIA.


Value-Weighted SeriesValue-Weighted Series

• The Standard & Poor’s (S&P), New York Stock Exchange (NYSE), American Stock Exchange (AMEX), NASDAQ, Financial Times Actuaries (London) and Tokyo Exchange Price Index (Japan)


Value-Weighted SeriesValue-Weighted Series

where:

Indext = index value on day t

Pt = ending prices for stocks on day t

Nt = number of outstanding shares on day t

P0 = ending price for stocks on base day 0

N0 = number of outstanding shares on base day 0

000

t IIndex ndexNP

NP tt


ExampleExample

Stock Shares Price 1Mkt V1 Price 2

Mkt V2

A 100000 10 11

B 20000 35 33

C 10000 100 105

Total


ExampleExample

Stock Shares O Price 1 Mkt V1 Price 2 Mkt V2

A 100000 10 1000000 11 1100000

B 20000 35 700000 33 660000

C 10000 100 1000000 105 1050000

Total 2700000 2810000


ExampleExample

• Index2=

• %Index=


Unweighted Price Indicator Unweighted Price Indicator SeriesSeries

• All stocks carry equal weight regardless of price or market value

• May be used by individuals who invest the same dollar amount in each stock in the sample

• Some use arithmetic average of the percent price changes for the stocks in the index


Unweighted Price Indicator Unweighted Price Indicator SeriesSeries

• Value Line and the Financial Times Ordinary Share Index (London) compute a geometric mean of the holding period returns and derive the holding period yield from this calculation


ExampleExample

StockPrice 1 Price 2

A 10 11

B 35 33

C 100 105

Total


ExampleExample• If the index on Day 1 is 200, index on

day 2 would be:

• %Index=


Additional ExampleAdditional Example

P0 Q0 P1 Q1 P2 Q2

A 90 100 95 100 95 100

B 50 200 45 200 45 200

C 100 200 110 200 55 400

Stock C split 2 for 1 between T=1 and T=2.


Price-Weighted AveragePrice-Weighted AverageIndex0=(90+50+100)/3=80

Index1=(95+45+110)/3=83.3

R1=(83.3/80)-1=4.17%

ND=(95+45+55)/83.3=2.34Index2=(95+45+55)/2.34=83.3


Value-Weighted IndexValue-Weighted IndexMV0=(90x100+50x200+100x200)=39000

MV1=(95x100+45x200+110x200)=40500

R1=(40500/39000)-1=3.85%

MV2=(95x100+45x200+55x400)=40500


Equal Weighted IndexEqual Weighted IndexRA=(95/90)-1=5.56%

RB=(45/50)-1=-10%

RC=(110/100)-1=10%

R1=(5.56%-10%+10%)/3=1.85%

R1=3 (1 5.56%)*(1 10%)*(1 10%) 1 1.48%

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