11Ch2&3 – MBA 567

Capital Market Overview

Capital MarketsDebt

Common stock

Preferred stock

Derivative securities

Security TradingTrading

Trading Costs

Buy on margin versus short sell

22Ch2&3 – MBA 567

Major Types of Securities

Debt Money market instruments

Bonds

Common stock

Preferred stock

Derivative securities

33Ch2&3 – MBA 567

Markets and Instruments

Money MarketDebt Instruments

Derivatives

Capital MarketBonds

Equity

Derivatives

44Ch2&3 – MBA 567

Money Market Instruments

Treasury bills

Certificates of deposit

Commercial Paper

Bankers Acceptances

Eurodollars

Repurchase Agreements

Federal Funds

LIBOR Market

55Ch2&3 – MBA 567

Bond Markets

US Treasury Bonds and Notes

Agency Issues (Fed Gov)

International Bonds

Municipal Bonds

Corporate Bonds

Mortgage-Backed Securities

66Ch2&3 – MBA 567

Municipal Bond Yields

Interest income on most municipals is not subject to tax

To compare the yields on municipals to other bonds use equivalent taxable yield

(municipal return) / (1 – tax rate)

Or solve for the tax rate that equates the two yields

Tax rate = 1 – (municipal rate/taxable rate)

77Ch2&3 – MBA 567

Capital Market - Equity

Common stockResidual claimLimited liability

Analyzing stocks – finance.yahoo.comPreferred stock

Fixed dividends - limitedPriority over commonTax treatment

88Ch2&3 – MBA 567

Stock Market Indexes

UsesTrack average returns

Comparing performance of managers

Base of derivatives

Factors in constructing or using an Index Representative?

Broad or narrow?

How is it constructed?

99Ch2&3 – MBA 567

Examples of Indexes - Domestic

Dow Jones Industrial Average (30 Stocks)

Standard & Poor’s 500 Composite

NASDAQ Composite

NYSE Composite

1010Ch2&3 – MBA 567

Examples of Indexes - International

Nikkei 225 & Nikkei 300FTSE (Financial Times of London)DaxRegion and Country Indexes

EAFEFar EastUnited Kingdom

1111Ch2&3 – MBA 567

Bond Indexes

Lehman Brothers

Merrill Lynch

Salomon Brothers

Specialized IndexesMerrill Lynch Mortgage

1212Ch2&3 – MBA 567

Construction of Indexes

How are stocks weighted?Price weighted (DJIA)

Market-value weighted (S&P500, NASDAQ)

Equally weighted (Value Line Index)

How returns are averaged?Arithmetic (DJIA and S&P500)

Geometric (Value Line Index)

1313Ch2&3 – MBA 567

Derivatives Securities

Options

Basic PositionsCall (Buy)

Put (Sell)

TermsExercise Price

Expiration Date

Assets

Futures

Basic PositionsLong (Buy)

Short (Sell)

TermsDelivery Date

Assets

1414Ch2&3 – MBA 567

Tips on Investment

Buy under-valued stocks

Buy recent-past winners

Don’t over trade – investing in stocks is costly

You can buy bonds

Invest in real estates

1515Ch2&3 – MBA 567

Security Trading

Primary Market versus Secondary Market

Types of Orders

Trading Mechanisms

Buy on margin and short selling

1616Ch2&3 – MBA 567

Primary vs. Secondary Security Sales

PrimaryNew issueKey factor: issuer receives the proceeds from the sale

SecondaryExisting owner sells to another partyIssuing firm doesn’t receive proceeds and is not directly involved

1717Ch2&3 – MBA 567

How Firms Issue Securities

Investment Banking

Shelf Registration

Private Placements

Initial Public Offerings (IPOs)

1818Ch2&3 – MBA 567

1919Ch2&3 – MBA 567

2020Ch2&3 – MBA 567

Shelf Registrations

SEC Rule 415

Introduced in 1982

Ready to be issued – on the shelf

2121Ch2&3 – MBA 567

Initial Public Offerings

Process Road shows

Bookbuilding

Underpricing Post sale returns

Cost to the issuing firm

See page 60-61

2222Ch2&3 – MBA 567

Figure 3.3 Average Initial Returns for IPOs in Various Countries

2323Ch2&3 – MBA 567

Figure 3.4 Long-term Relative Performance of Initial Public Offerings

2424Ch2&3 – MBA 567

Types of Orders

Instructions to the brokers on how tocomplete the order

Market

Limit

Stop orders

Page 64-65

2525Ch2&3 – MBA 567

Figure 3.6 Price-Contingent Orders

2626Ch2&3 – MBA 567

Trading Mechanisms

Dealer marketsElectronic communication networks (ECNs)

Specialists markets

Page 66

2727Ch2&3 – MBA 567

U.S. Security Markets

Nasdaq

Small stock OTCPink sheets

Organized Exchanges New York Stock Exchange

American Stock Exchange

Regionals

Electronic Communication Networks (ECNs)

National Market System

2828Ch2&3 – MBA 567

Nasdaq

National Market System

Nasdaq SmallCap Market

Levels of subscribersLevel 1 – inside quotes (investors)

Level 2 – receives all quotes but they can’t enter quotes

Level 3 – dealers making markets

SuperMontage

2929Ch2&3 – MBA 567

Table 3.1 Requirements for Listing on Nasdaq Markets

3030Ch2&3 – MBA 567

New York Stock Exchange

Member functions Commission brokers

Floor brokers

Specialists

Block houses

SuperDot (70% of NYSE trading volume)

3131Ch2&3 – MBA 567

Table 3.3 NYSE Listing Requirements

3232Ch2&3 – MBA 567

Costs of Trading

Commission: fee paid to broker for making the transaction

Spread: cost of trading with dealerBid: price dealer will buy from you

Ask: price dealer will sell to you

Spread: ask - bid

Combination: on some trades both are paid

3333Ch2&3 – MBA 567

Margin Trading

Using only a portion of the proceeds for an investmentBorrow remaining componentMaximum margin is currently 50%; you can borrow up to 50% of the stock valueSet by the FedMaintenance margin: minimum amount equity in trading can be before additional funds must be put into the accountMargin call: notification from broker you must put up additional funds

3434Ch2&3 – MBA 567

Margin Trading - Initial Conditions Example 3.1

X Corp $100

60% Initial Margin

30% Maintenance Margin

100 Shares Purchased

Initial Position

Stock $10,000 Borrowed $4,000

Equity $6,000

3535Ch2&3 – MBA 567

Margin Trading - Maintenance Margin Ex. 3.1

Stock price falls to $70 per share

New Position

Stock $7,000 Borrowed $4,000

Equity $3,000

Margin% = $3,000/$7,000 = 43%

3636Ch2&3 – MBA 567

Margin Trading - Margin Call Example 3.2

How far can the stock price fall before amargin call? The maintenance margin is 30%.

3737Ch2&3 – MBA 567

Short Sales

Purpose: to profit from a decline in the price of a stock or security

Mechanics

Borrow stock through a dealer

Sell it and deposit proceeds and margin in an account

Closing out the position: buy the stock and return to the party from which is was borrowed

3838Ch2&3 – MBA 567

Short Sale - Initial Conditions

Dot Bomb 1,000 Shares50% Initial Margin30% Maintenance Margin$100 Initial Price

Sale Proceeds $100,000Margin & Equity 50,000Stock Owed 100,000What if price increases to 110?How much can the stock price rise before a margin call?

3939Ch2&3 – MBA 567

Short Sale - Margin Call

How much can the stock price rise before a margin call?