Chapter 2

McGraw-Hill/Irwin Copyright © 2008 by The McGraw-Hill Companies, Inc. All rights reserved.

Chapter 2Chapter 2

Security Markets: Security Markets:

Present and Present and FutureFuture

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Learning ObjectivesLearning Objectives

The functions of financial marketsThe functions of financial markets The role of investment bankersThe role of investment bankers Organized exchanges versusOrganized exchanges versus

over-the-counter marketsover-the-counter markets The future outlook for capital marketsThe future outlook for capital markets Legislation affecting capital marketsLegislation affecting capital markets

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Security Markets: Present and Security Markets: Present and FutureFuture

The Market EnvironmentThe Market Environment Market FunctionsMarket Functions Organization of The Primary MarketsOrganization of The Primary Markets: :

• The Investment BankerThe Investment Banker Organization of the Secondary MarketsOrganization of the Secondary Markets The Organization of the NYSEThe Organization of the NYSE

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Security Markets: Present and Security Markets: Present and Future (continued)Future (continued)

The Nasdaq Stock MarketThe Nasdaq Stock Market Electronic Communication Networks (ECN’s)Electronic Communication Networks (ECN’s) Other Organized ExchangesOther Organized Exchanges Over-The-Counter Markets Over-The-Counter Markets Institutional TradingInstitutional Trading Regulation of the Security MarketsRegulation of the Security Markets

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The Market EnvironmentThe Market Environment

Dramatic Changes:Dramatic Changes:• Deregulation and other legal changesDeregulation and other legal changes

• Global consolidation and competitionGlobal consolidation and competition

• Internet online brokerage and Electronic Internet online brokerage and Electronic communication networks (ECNs)communication networks (ECNs)

• Real-time quotesReal-time quotes

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DramaticDramatic Changes (continued): Changes (continued):

• 24 hour trading and record trading volume24 hour trading and record trading volume

• DecimalizationDecimalization

• TerrorismTerrorism

• Public ownership of securities exchangesPublic ownership of securities exchanges

• Sarbanes-Oxley ActSarbanes-Oxley Act

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WhatWhat

areare

marketsmarkets

supposed to do?supposed to do?

WhatWhat

areare

marketsmarkets

supposed to do?supposed to do?

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Markets:Markets:

Possible Characteristics of MarketsPossible Characteristics of Markets Possible Characteristics of MarketsPossible Characteristics of Markets

A way of exchanging assetsA way of exchanging assetsA way of exchanging assetsA way of exchanging assets

EfficientEfficient Primary or SecondaryPrimary or Secondary

LiquidLiquidOrganized orOrganized or

Over-The-CounterOver-The-Counter

CompetitiveCompetitive Spot or FutureSpot or Future

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Market Efficiency and LiquidityMarket Efficiency and Liquidity

Efficient MarketsEfficient Markets::• Prices respond quickly to new informationPrices respond quickly to new information

• Prices fluctuate little with successive tradesPrices fluctuate little with successive trades

• High volumes absorbed with little price changeHigh volumes absorbed with little price change

LiquidityLiquidity

• Speed of converting an asset to cash at or close to its fair Speed of converting an asset to cash at or close to its fair market valuemarket value

• Greater with more participants and continuous tradingGreater with more participants and continuous trading

• Greater with low transaction costsGreater with low transaction costs

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Competition and Allocation Competition and Allocation of Capitalof Capital

All assets compete for investor fundsAll assets compete for investor funds

Investors choose assets to achieve Investors choose assets to achieve desired risk-return trade-offdesired risk-return trade-off

In In efficientefficient and and liquid liquid markets, investors markets, investors quickly move capital to alternative quickly move capital to alternative investments in response to fresh investments in response to fresh information information

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Secondary MarketsSecondary Markets

Markets for existing assets currently Markets for existing assets currently traded between investorstraded between investors

Provide increased liquidity and a place to Provide increased liquidity and a place to convert existing assets to cashconvert existing assets to cash

Provide ability to adjust capital allocation Provide ability to adjust capital allocation to new informationto new information

Provides valuation for existing assets Provides valuation for existing assets

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Primary MarketsPrimary Markets

Market for buying assets directly from their Market for buying assets directly from their sources; the first market where an asset is sources; the first market where an asset is

originally bought and soldoriginally bought and sold

Raises funds for issuer to expand capital base Raises funds for issuer to expand capital base Once sold, assets begin trading on secondary Once sold, assets begin trading on secondary

marketsmarkets Price competition on secondary markets enables Price competition on secondary markets enables

primary markets to price new issues fairlyprimary markets to price new issues fairly

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Organization of the Primary Organization of the Primary Markets: The Investment BankerMarkets: The Investment Banker

Investment BankerInvestment Banker• Middleman involved in the distribution of Middleman involved in the distribution of

securities from issuing corporation to securities from issuing corporation to investorsinvestors

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Underwriting FunctionUnderwriting Function

UnderwritingUnderwriting• Guarantee by investment banker to purchase Guarantee by investment banker to purchase

issuer’s securities at a fixed price issuer’s securities at a fixed price Eliminates risk of not selling whole issueEliminates risk of not selling whole issue Investment banker usually “makes a market” to Investment banker usually “makes a market” to

ensure a liquid market and wider distributionensure a liquid market and wider distribution

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Alternatives to UnderwritingAlternatives to Underwriting

Investment banker makes “Investment banker makes “best effortsbest efforts” to ” to sell security but issuer assumes risk of sell security but issuer assumes risk of unsold securitiesunsold securities

Securities may be Securities may be sold directlysold directly to investors to investors by the issuer in a public offering or in a by the issuer in a public offering or in a private placementprivate placement

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DistributionDistribution

On large issues, investment bankers may On large issues, investment bankers may share the risk and burden of distribution by share the risk and burden of distribution by forming a “forming a “syndicatesyndicate””

A “A “TombstoneTombstone” advertising a stock or bond ” advertising a stock or bond issue may list many underwriters distributing issue may list many underwriters distributing a securitya security

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Investment Banking CompetitionInvestment Banking CompetitionTop 10 Underwriters of Global Stocks and Bonds

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Initial Public Offering (IPO)Initial Public Offering (IPO)

The process of bringing private The process of bringing private companies to the public market companies to the public market for the first timefor the first time

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Investment Banking CompetitionInvestment Banking CompetitionTop 10 Underwriters of Initial Public Offerings (IPOs)

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Investment Banking CompetitionInvestment Banking CompetitionTop Investment Bankers by Category

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Investment Banking CompetitionInvestment Banking CompetitionBiggest Corporate Financings of 2006

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Organization of the Secondary MarketsOrganization of the Secondary Markets

Organized ExchangesOrganized Exchanges Consolidated TapeConsolidated Tape Listing Requirements for FirmsListing Requirements for Firms Listing FeesListing Fees

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Organized ExchangesOrganized Exchanges• NationalNational

New York Stock Exchange (NYSE)New York Stock Exchange (NYSE) American Stock Exchange (AMEX)American Stock Exchange (AMEX) Nasdaq Stock MarketNasdaq Stock Market

• RegionalRegional ChicagoChicago CincinnatiCincinnati PhiladelphiaPhiladelphia BostonBoston

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Organized Exchanges (continued)Organized Exchanges (continued)• Central trading location Central trading location

• Securities are bought and sold in an Securities are bought and sold in an auction marketauction market

• Brokers act as agents for buyers and Brokers act as agents for buyers and sellerssellers

• ““Open outcry” auction system is being Open outcry” auction system is being replaced by electronic tradingreplaced by electronic trading

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Consolidated TapeConsolidated Tape Allows brokers on any exchange to see Allows brokers on any exchange to see

prices of transactions on other exchanges in prices of transactions on other exchanges in dually listed NYSE stocksdually listed NYSE stocks

Such composite price data increases market Such composite price data increases market efficiency and keeps prices competitiveefficiency and keeps prices competitive

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Listing Requirements for FirmsListing Requirements for Firms

To be traded, a stock must meet minimum To be traded, a stock must meet minimum listing requirements of an exchangelisting requirements of an exchange

New York Stock Exchange (NYSE)New York Stock Exchange (NYSE)

has the most restrictive listing requirementshas the most restrictive listing requirements

Stocks may be delisted for failing to meet Stocks may be delisted for failing to meet criteria such as total market valuationcriteria such as total market valuation

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The Organization of the NYSEThe Organization of the NYSE

NYSE Euronext is world’s largest NYSE Euronext is world’s largest exchangeexchange

Recently transformed into a for-profit Recently transformed into a for-profit corporationcorporation• Ticker symbol – NYXTicker symbol – NYX

Hybrid market consisting of Hybrid market consisting of traditional floor trading and traditional floor trading and electronic tradingelectronic trading

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Trading on the NYSETrading on the NYSE Floor BrokersFloor Brokers

• Act as agents for clients and execute buy and sell orders on Act as agents for clients and execute buy and sell orders on the floor of the exchangethe floor of the exchange

House BrokersHouse Brokers• Execute orders for customers of NYSE member firms such as Merrill Execute orders for customers of NYSE member firms such as Merrill

Lynch, or for the firm’s direct accountLynch, or for the firm’s direct account Independent BrokersIndependent Brokers

• Individuals or employees of small “boutique” firms that execute orders for Individuals or employees of small “boutique” firms that execute orders for member or nonmember firms, and help house brokers with overflowmember or nonmember firms, and help house brokers with overflow

SpecialistsSpecialists About ¼ of exchange membershipAbout ¼ of exchange membership Each stock has a specialist assigned to itEach stock has a specialist assigned to it Most specialists are responsible for more than one stockMost specialists are responsible for more than one stock Handle special orders such as “limit” bids or offersHandle special orders such as “limit” bids or offers Maintain a continuous, liquid, and orderly market in assigned stocksMaintain a continuous, liquid, and orderly market in assigned stocks

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The Nasdaq Stock MarketThe Nasdaq Stock Market

August 1, 2006: recognized as a August 1, 2006: recognized as a national securities exchange by the national securities exchange by the Securities and Exchange Commission Securities and Exchange Commission (SEC)(SEC)

22ndnd largest exchange in U.S. by dollar largest exchange in U.S. by dollar trading volumetrading volume

For-profit companyFor-profit company• Ticker symbol – NDAQTicker symbol – NDAQ

Electronic stock exchangeElectronic stock exchange

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The Nasdaq Stock MarketThe Nasdaq Stock Market No central locationNo central location Trades executed electronically or by Trades executed electronically or by

telephonetelephone DealersDealers

• Buy and sell securities for their own account Buy and sell securities for their own account rather than just act as agents processing rather than just act as agents processing ordersorders

• Belong to The National Association of Belong to The National Association of Security Dealers (NASD)Security Dealers (NASD)

Self-policing organizationSelf-policing organization Requires at least two market makers (dealers) for Requires at least two market makers (dealers) for

each securityeach security Often 5 – 10 market makers for a security, even 20 Often 5 – 10 market makers for a security, even 20

market makers for government securitiesmarket makers for government securities

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Electronic Communication Electronic Communication Networks (ECNs)Networks (ECNs)

Also called alternative trading systems Also called alternative trading systems (ATSs)(ATSs)

Act as broker-dealer or as exchangeAct as broker-dealer or as exchange Retail and institutional investors, market Retail and institutional investors, market

makers, and broker-dealersmakers, and broker-dealers NYSE Arca (acquired by NYSE)NYSE Arca (acquired by NYSE) INET and BRUT (acquired by NASDAQ)INET and BRUT (acquired by NASDAQ)

Electronic trading systems that automatically Electronic trading systems that automatically match buy and sell orders at specified pricesmatch buy and sell orders at specified prices

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Advantages of Advantages of Electronic Communication Electronic Communication

Networks (ECNs)Networks (ECNs) Integrate marketsIntegrate markets Allow anonymity in tradingAllow anonymity in trading Lower the cost of tradingLower the cost of trading

Institutions can trade among themselves and Institutions can trade among themselves and bypass broker and trading feesbypass broker and trading fees

Permit “after-hours” trading, longer trading hoursPermit “after-hours” trading, longer trading hours Facilitate more competitionFacilitate more competition Facilitate smaller spreadsFacilitate smaller spreads

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The American Stock Exchange The American Stock Exchange (AMEX)(AMEX)

Securities of smaller firms than NYSESecurities of smaller firms than NYSE Primarily for individual investors Primarily for individual investors

• Many listed firms do not meet liquidity needs of Many listed firms do not meet liquidity needs of large institutional investorslarge institutional investors

One of largest markets for options on stocks One of largest markets for options on stocks and indexesand indexes

Central market for Exchange Traded Funds Central market for Exchange Traded Funds (EFTs) – approximately 100 listed(EFTs) – approximately 100 listed• S&P 500 (SPDRS)S&P 500 (SPDRS)• Dow Jones Industrial Average (DIAMONDS)Dow Jones Industrial Average (DIAMONDS)

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The Chicago Board Options The Chicago Board Options ExchangeExchange

Competes with AMEX in trading optionsCompetes with AMEX in trading options

Options on stocks Options on stocks

Options on stock market indexesOptions on stock market indexes

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Futures MarketsFutures Markets

Trade the right to buy or sell a certain amount Trade the right to buy or sell a certain amount of a commodity or financial instrument at a of a commodity or financial instrument at a

set price for a specified periodset price for a specified period

Contracts are normally reversed (closed out) prior Contracts are normally reversed (closed out) prior to expirationto expiration

The two largest futures exchanges:The two largest futures exchanges:• The Chicago Mercantile Exchange (CME)The Chicago Mercantile Exchange (CME)• The Chicago Board of Trade (CBOT) The Chicago Board of Trade (CBOT)

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Over-the-Counter MarketsOver-the-Counter Markets

Over-the-counter bulletin board Over-the-counter bulletin board market (OTC.BB)market (OTC.BB)• Small companiesSmall companies• No listing requirementsNo listing requirements• Companies must file regulatory reports Companies must file regulatory reports

with SECwith SEC

Pink SheetsPink Sheets• Companies choosing not to file with SECCompanies choosing not to file with SEC• Little public information availableLittle public information available

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Over-the-Counter MarketsOver-the-Counter Markets

OTC markets exist for:OTC markets exist for:• StocksStocks• Corporate BondsCorporate Bonds• Mutual FundsMutual Funds• Federal Government SecuritiesFederal Government Securities• State and Local BondsState and Local Bonds• Commercial PaperCommercial Paper• Negotiable Certificates of DepositsNegotiable Certificates of Deposits• Various other securitiesVarious other securities

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Over-The-Counter MarketsOver-The-Counter Markets

The “spread”The “spread”• Difference between bid and asked price Difference between bid and asked price • Dealer profit earned by making a marketDealer profit earned by making a market

Example:

XYZ common stock is bid 10 and asked 10.50

Dealer will buy at least 100 shares at $10 per share or Dealer will sell 100 shares at $10.50 per share

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Debt Securities Traded Debt Securities Traded Over-the-CounterOver-the-Counter

Government securities Government securities • Largest dollar volume on the OTCLargest dollar volume on the OTC

• Billions of dollars in trades each weekBillions of dollars in trades each week

• Government security dealers trade securities inGovernment security dealers trade securities in Treasury billsTreasury bills Treasury bondsTreasury bonds Federal agency securitiesFederal agency securities

• Federal National Mortgage Association issues (FNMA)Federal National Mortgage Association issues (FNMA)• Government National Mortgage Association (GNMA)Government National Mortgage Association (GNMA)

• Student Loan Marketing Association (Sallie Mae)Student Loan Marketing Association (Sallie Mae)

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Regulation of Security MarketsRegulation of Security Markets Organized exchangesOrganized exchanges

• Regulated by the Securities and Exchange Commission Regulated by the Securities and Exchange Commission (SEC)(SEC)

• Self-regulatedSelf-regulated

The OTC marketThe OTC market• Regulated by the National Association of Security Regulated by the National Association of Security

Dealers (NASD)Dealers (NASD)

Securities Act of 1933Securities Act of 1933 Securities Exchange Act of 1934Securities Exchange Act of 1934 Securities Acts Amendments of 1975Securities Acts Amendments of 1975

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Pertains to new issues of securitiesPertains to new issues of securities Registration with SEC required for new Registration with SEC required for new

issues of securities sold in more than one issues of securities sold in more than one statestate

20 day filing requirement in advance of 20 day filing requirement in advance of date of new issuedate of new issue

Prospectus required for new issueProspectus required for new issue Officers and others can be sued for losses Officers and others can be sued for losses

resulting from fraudulent or incomplete resulting from fraudulent or incomplete information in the prospectusinformation in the prospectus

Securities Act of 1933Securities Act of 1933The “Truth in Securities” Act

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Securities Exchange Act of 1934Securities Exchange Act of 1934

Established guidelines for insider tradingEstablished guidelines for insider trading Board of Governors of the Federal Reserve Board of Governors of the Federal Reserve

responsible for setting margin requirementsresponsible for setting margin requirements Manipulation of securities by conspiracies Manipulation of securities by conspiracies

between investors prohibitedbetween investors prohibited SEC given control of proxy proceduresSEC given control of proxy procedures Required periodical reports from companies Required periodical reports from companies

traded on exchangestraded on exchanges Required all exchanges to register with the SECRequired all exchanges to register with the SEC

Created the Securities and Exchange Commission to enforce the securities laws

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Securities Exchange Act of 1975Securities Exchange Act of 1975

Assumed extensive use of computers and Assumed extensive use of computers and electronic communication deviceselectronic communication devices

Prohibited fixed commissions on public transactionsProhibited fixed commissions on public transactions

Prohibited banks, insurance companies, and other Prohibited banks, insurance companies, and other financial institutions from buying stock exchange financial institutions from buying stock exchange memberships to save commission costs for their memberships to save commission costs for their own institutional transactionsown institutional transactions

Directed SEC to supervise development of a national securities market

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Investment Advisor Act of 1940Investment Advisor Act of 1940

Any adviser with more than 15 public Any adviser with more than 15 public clients (excluding tax accountants and clients (excluding tax accountants and lawyers) must register with the SEClawyers) must register with the SEC

Registered advisers must file semi-annual Registered advisers must file semi-annual reportsreports

Created to protect the public from unethical investment advisors

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Investment Company Act of 1940Investment Company Act of 1940

Gives NASD authority to supervise and Gives NASD authority to supervise and limit commissions and investment advisory limit commissions and investment advisory fees on certain types of mutual fundsfees on certain types of mutual funds

Provides oversight for mutual funds and investment companies dealing with small investors

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Securities Investor Protection Act of 1970Securities Investor Protection Act of 1970

Securities Investor Protection Securities Investor Protection Corporation (SIPC)Corporation (SIPC)

Insures investors’ accounts up to Insures investors’ accounts up to $500,000 in case of bankruptcy of $500,000 in case of bankruptcy of brokerage firmbrokerage firm

Does not insure market value losses while Does not insure market value losses while waiting for securities from bankrupt waiting for securities from bankrupt brokerage firmsbrokerage firms

Established to oversee liquidation of brokerage firms

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Insider TradingInsider Trading

Definition of “insider” includes anyone with Definition of “insider” includes anyone with special non-public informationspecial non-public information

Punitive measures discourage illegal use Punitive measures discourage illegal use of insider information for profitsof insider information for profits

Insiders may make proper long-term Insiders may make proper long-term investments in corporationsinvestments in corporations

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Program Trading and Market Price LimitsProgram Trading and Market Price Limits

Program trading Program trading • Computer-based trigger points are established in which Computer-based trigger points are established in which

large volumes of trades are initiated by institutional large volumes of trades are initiated by institutional investorsinvestors

• may increase market volatility may increase market volatility blamed for the 508-point market crash on October 19, 1987blamed for the 508-point market crash on October 19, 1987

““Circuit breakers” shut down the market briefly when Circuit breakers” shut down the market briefly when there are specified dramatic drops in stock pricesthere are specified dramatic drops in stock prices

Nasdaq, the American Stock Exchange, and the Nasdaq, the American Stock Exchange, and the Chicago Board of Trade also discontinue trading if Chicago Board of Trade also discontinue trading if there is a halt on the NYSEthere is a halt on the NYSE

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Exploring the WebExploring the Web

Website AddressWebsite Address CommentsComments

www.nyse.comwww.nyse.comProvides information on Provides information on regulations and market regulations and market operationsoperations

www.nasdaq.comwww.nasdaq.com Provides information about Provides information about the Nasdaq marketthe Nasdaq market

www.cboe.comwww.cboe.comProvides information about Provides information about options traded on the Chicago options traded on the Chicago Board Options ExchangeBoard Options Exchange

http://www.marketwatch.comhttp://www.marketwatch.comMarketwatch IPO newsMarketwatch IPO news

http://biz.yahoo.com/reports/ipo.htmlhttp://biz.yahoo.com/reports/ipo.html Recent IPO newsRecent IPO news

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Chapter 2