Trading Locations

Stock Exchanges trading floors auction system central auction specialist system

Over-The-Counter Market no trading floor negotiated system multiple market maker system

Independent Electronic Trading Systems

Stock Exchanges in The US

Major National Stock Exchanges NYSE or Big Board AMEX or ASE or Curb

Regional Stock Exchanges Boston, Chicago,

Cincinnati, San Francisco, Philadelphia

OTC Market NASDAQ NASD

Types of Markets

First Market trading on exchanges of stocks listed on an exchange

Second Market trading in OTC market of stocks not listed on an

exchange

Third Market trading in OTC market of stocks listed on an

exchange

Fourth Market private transactions between institutional investors

International Stock Exchanges

Japan – Tokyo plus 7 othersUnited Kingdom – LondonGermany – FrankfurtFrance – ParisHong KongCanada – Toronto

Functions of Brokers

Receive and track ordersFind other partiesNegotiate pricesServer as focal point tradingExecute orders

Functions of Dealers (Market Makers)

Smooth out temporary supply/demand imbalances Supplies “immediacy”

Provide better price information Privileged access to order flow and limit

order informationAct as auctioneer

Short Selling

A way to “bet” that a security will fall in value Borrow the security and sell it

Economic value of short selling Limit upward bias

Limits on short selling “Tick” rules

Margin Transactions

Borrow funds using securities as collateral

Margin Requirements Initial margin Maintenance margin Margin call

Transactions Costs

Commissions Other Fees

Custodial fees Transfer fees

Execution Costs market impact market timing

Opportunity Costs

Trading Arrangements for Institutional Investors

Block TradingTrades of 10,000 shares or more of a given stock or trades with a market value of $200,000 or more.

Program TradingSimultaneous purchase or sale of shares in a large number of different stocks, which is computer-assisted.

Price Limits and Collars

Put in Place after the Stock Market

Crash of 1987

Trading or Price Limits

Rule 80B or Circuit Breakers

Rule 80A or Trading Collar

US Stock Market Indices

Dow Jones Industrial AverageS&P 500NYSE CompositeAMEXNASDAQ CompositeValue Line Composite Average

Major International Indices

World Morgan Stanley (EAFE)

Country Japan – Nikkei 225, Nikkei 300, Topix UK – FTSE 100, FTSE 250 Germany – DAX France – CAC Hong Kong – Hang Seng Canada – Toronto 300 Composite

Stock Market Indices

Issues in Construction Universe of stocks in index Relative weights

Price weightedEqually-weightedMarket value weighted

Averaging methodArithmeticGeometric

Efficient Market Hypothesis: Summary

Three forms of market efficiency• Weak form (random walk)

• Current prices reflect past prices and volume

• Technical analysis is useless

• Semi-strong form• Prices reflect all public information

• Most financial analysis is useless

• Strong form• Prices reflect all that is knowable

• Nobody consistently makes superior profits

Relationship among Three Different Information Sets

Informationset of

past prices

Information setof publicly available

information

All informationrelevant to a stock

Market Efficiency “Nuclear Weapons”

Argument for Efficiency: Performance of mutual funds – actively

managed mutual funds don’t beat the market

Argument against Efficiency Asset bubbles – Prices depart from

fundamental value on the high side for an extended period

Efficient Market Hypothesis: Summary

Does Not Say:• Prices are uncaused• Investors are foolish and too stupid to be in the

market• All shares of stock have the same expected returns• Investors should throw darts to select stocks• There is no upward trend in stock prices

Does Say• Prices reflect underlying value• Financial managers cannot time stock and bond sales• Sales of stock and bonds will not depress prices• You cannot cook the books

Market Anomalies

Small firmPrice to book (earnings)Neglected firmCalendar effects

January Turn of the month Weekend

Weather

Efficient Market Hypothesis: Summary

Why Doesn’t Everyone Believe It?• There are optical illusions, mirages and

apparent patterns in charts of stock and market returns

• The truth is less interesting• There is some evidence against efficiency

• Seasonality• Small vs large stocks• Value vs growth stocks

• Tests of market efficiency are weak

Pricing Efficiency of the Stock Market

Forms of Efficiency Weak form Semistrong form Strong form

Implications for Investing in Common Stock Active strategies Passive strategies