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The Trading Process and The Trading Process and Mutual FundsMutual Funds
B, K & M Chapters 3 & 4B, K & M Chapters 3 & 4
End of chapter problems: (3) 2,3,7; (4) 1,2,10,17
Primary Markets: How Firms Issue Primary Markets: How Firms Issue SecuritiesSecurities
The primary market is used to issue new securities The primary market is used to issue new securities (IPO’s) or seasoned new issues(IPO’s) or seasoned new issues
There is strong evidence of underpricing of new equity There is strong evidence of underpricing of new equity issues both here and abroadissues both here and abroad
The secondary market is used to trade outstanding The secondary market is used to trade outstanding securitiessecurities
How Firms Issue Securities
Investment BankingShelf RegistrationPrivate Placements Initial Public Offerings (IPOs)
Shelf Registrations
Introduced in 1982
SEC Rule 415 Opposed by Investment Banks
Ready to be issued – on the shelf
Private placement: sale to a limitednumber of sophisticated investors notrequiring the protection of registration
Allowed under Rule 144A
Dominated by institutions
Very active market for debt securities
Not active for stock offerings
Private Placements
Initial Public Offerings
Process Road showsBookbuilding
Underpricing Post sale returnsCost to the issuing firm
Relationship Among a Firm Issuing Securities, the Underwriters and the Public
Figure 3.3 Average Initial Returns for IPOs in Various Countries
Long-term Relative Performance of Initial Public Offerings
Secondary Market Trading Mechanisms
Dealer markets (OTC markets)
Electronic communication networks (ECNs)
Specialist markets Auction Markets
Types of Retail OrdersTypes of Retail Orders
Market Orders: buy or sell orders that are executed Market Orders: buy or sell orders that are executed immediately at current market pricesimmediately at current market prices
Limit Orders: specify prices at which an investor is willing to Limit Orders: specify prices at which an investor is willing to transact. Example: IBM last sold for $50. A limit may be transact. Example: IBM last sold for $50. A limit may be placed at a price of $45. If the price falls to $45, this order will placed at a price of $45. If the price falls to $45, this order will then be executed.then be executed.
Stop-Loss Orders: similar to limit orders but they specify the Stop-Loss Orders: similar to limit orders but they specify the trade is not to be executed unless the price hits a limit. (In the trade is not to be executed unless the price hits a limit. (In the previous example, a stop buy order might be placed at a price previous example, a stop buy order might be placed at a price of $55.)of $55.)
Limit Order Book for Intel on ArcaEx Exchange
U.S. Security Markets
Nasdaq Stock Market Nasdaq National Market System (min shareholder equity = $15mil) Nasdaq SmallCap Market (min shareholder equity = $5mil)
Pink Sheets (www.pinksheets.com) Even smaller firms or those that want to avoid listing disclosure
requirements
Organized Exchanges New York Stock Exchange American Stock Exchange Regionals
Electronic Communication Networks (ECNs)
Table 3.1 Partial Requirements for Listing on Nasdaq Markets
Nasdaq Market Center
Nasdaq Market CenterConsolidates electronic markets into an
integrated systemAllows for automatic execution
Levels of subscribersLevel 1 – inside quotesLevel 2 – receives all quotes but they can’t
enter quotesLevel 3 – dealers making markets
Trading on the Nasdaq MarketTrading on the Nasdaq Market Competing dealers establish bids and asksCompeting dealers establish bids and asks
It is increasingly a computerized market with no centralized It is increasingly a computerized market with no centralized locationlocation
The Department of Justice settled a suit against NASD that The Department of Justice settled a suit against NASD that alleged price fixing by dealers in the establishment of quotesalleged price fixing by dealers in the establishment of quotes
Academic studies (Christie and Schultz, 1995) detailed Academic studies (Christie and Schultz, 1995) detailed apparent apparent tacit collusion, and lead to the Department of Justice tacit collusion, and lead to the Department of Justice and SEC’s actionsand SEC’s actions
New York Stock Exchange
The Major Players Commission brokers
Bring a brokerage firm’s orders to the floor for execution
Specialists
Block houses
SuperDot NYSE members send orders directly to the specialist
over computer lines
Some Initial Listing Requirements for the NYSE
NYSENYSE
On the NYSE, each stock traded has a “specialist” who On the NYSE, each stock traded has a “specialist” who is charged with maintaining a “fair and orderly” marketis charged with maintaining a “fair and orderly” market
Block Transactions on the New York Stock Exchange
Electronic Computer Networks (ECNs)
Market Structures in Other Countries
London - predominately electronic trading
Euronext – market formed by combination of the Paris, Amsterdam and Brussels exchanges
Tokyo Stock Exchange
Dollar Volume of Trading in Major World Markets, 2004
Trading CostsTrading Costs
Explicit Costs: Explicit Costs:
Commission costs which are paid to Commission costs which are paid to brokers are explicit (full service vs brokers are explicit (full service vs discount discount brokers)brokers)
Bid-Ask SpreadsBid-Ask Spreads
Bid is the highest limit order to buyBid is the highest limit order to buy
Ask is the lowest limit order to sellAsk is the lowest limit order to sell
Dollar Spread = Ask – BidDollar Spread = Ask – Bid
Proportional Spread = (Ask – Bid) / (Mid-Point of Spread)Proportional Spread = (Ask – Bid) / (Mid-Point of Spread)
Proportional spreads range from well less than 1% to over Proportional spreads range from well less than 1% to over 5% (over 10% for penny stocks)5% (over 10% for penny stocks)
Equally weighted average proportional spread on NYSE Equally weighted average proportional spread on NYSE stocks is = .6%stocks is = .6%
Nasdaq spreads are higher Nasdaq spreads are higher
Determinants of the spreadDeterminants of the spread
Spreads depend on: Spreads depend on:
-the amount of competition between -the amount of competition between providers of liquidityproviders of liquidity
-the need to cover the costs of being a dealer -the need to cover the costs of being a dealer including including
-inventory costs-inventory costs
-and the possibility that the dealer -and the possibility that the dealer (specialist) will trade with a better (specialist) will trade with a better informed informed tradertrader
Buying on MarginBuying on Margin The investor borrows part of the purchase price from The investor borrows part of the purchase price from the broker the broker
The Fed dictates the maximum margin (currently 50%) The Fed dictates the maximum margin (currently 50%) meaning that at most 50% of the purchase price may be meaning that at most 50% of the purchase price may be borrowedborrowed
By buying on margin, investors gain leverage and By buying on margin, investors gain leverage and greater upside potential, but also expose themselves to greater upside potential, but also expose themselves to greater riskgreater risk
If the stock price falls, the investor may receive a If the stock price falls, the investor may receive a margin callmargin call
Short SalesShort Sales First borrow certificates for sale (from broker), then repay First borrow certificates for sale (from broker), then repay the loan with certificates obtained in a later purchasethe loan with certificates obtained in a later purchase
Must be identified as a short sale (may not be made in a Must be identified as a short sale (may not be made in a falling market – tick test on NYSEfalling market – tick test on NYSE
Borrower must deposit cash equal to the initial value of the Borrower must deposit cash equal to the initial value of the securities, and post additional marginsecurities, and post additional margin
Borrower must pay the lender the equivalent of all dividends Borrower must pay the lender the equivalent of all dividends or interest received between the short sale and the subsequent or interest received between the short sale and the subsequent repurchaserepurchase
Potential Potential lossloss of short sale is of short sale is unlimitedunlimited
Short Sales (cont.)Short Sales (cont.)
In 2003 short sales accounted for approx. 10% of total In 2003 short sales accounted for approx. 10% of total sales (NYSE specialists and hedge funds are frequent sales (NYSE specialists and hedge funds are frequent short-sellers)short-sellers)
Short interest is the total of all shares sold short that Short interest is the total of all shares sold short that remain uncovered (reported in the WSJ)remain uncovered (reported in the WSJ)
Mutual FundsMutual Funds Benefits to individual investors include:Benefits to individual investors include:
- Efficient record keeping- Efficient record keeping
- Low-cost diversificationLow-cost diversification
- Professional ManagementProfessional Management
- Lowered transaction costsLowered transaction costs
Open-end fundsOpen-end funds stand ready to redeem or issue shares at their net asset stand ready to redeem or issue shares at their net asset value (NAV) which is the market value of all securities held divided by the value (NAV) which is the market value of all securities held divided by the number of shares outstanding. The number of shares will change dailynumber of shares outstanding. The number of shares will change daily
Closed-end fundsClosed-end funds are traded much like shares of common stock. They do are traded much like shares of common stock. They do not issue or redeem shares at NAV, and often trade at a discount or surplus not issue or redeem shares at NAV, and often trade at a discount or surplus NAV (have lost much market share to ETFs)NAV (have lost much market share to ETFs)
Often sell at a premium or discount from NAV Often sell at a premium or discount from NAV
Mutual Funds (cont.)Mutual Funds (cont.)
Real Estate Investment Trusts (REIT’s)Real Estate Investment Trusts (REIT’s): Similar to a : Similar to a closed-end fund invested in real estateclosed-end fund invested in real estate
Hedge FundsHedge Funds: Structured as private partnerships and : Structured as private partnerships and subject to little SEC regulationsubject to little SEC regulation
Exchange Trades Funds: Exchange Trades Funds: Typically replicate an index Typically replicate an index but trade like individual stocksbut trade like individual stocks
Unit Investment TrustsUnit Investment Trusts: Pools of money invested in a portfolio : Pools of money invested in a portfolio that is fixed for the life of the fundthat is fixed for the life of the fund
---Have declined in importance---Have declined in importance
U.S. Mutual Funds by Investment Classification, December 2004
Mutual Fund CostsMutual Fund Costs Front-end loadFront-end load: A commission paid when you purchase shares. : A commission paid when you purchase shares. Range from 0% to as much as 10%Range from 0% to as much as 10%
Back-end loadBack-end load: A redemption fee paid when you sell shares. : A redemption fee paid when you sell shares. Often declines as a function of how long the shares have been Often declines as a function of how long the shares have been heldheld
Operating ExpensesOperating Expenses: The costs of operating the portfolio, : The costs of operating the portfolio, including fee paid to investment advisors and administrative including fee paid to investment advisors and administrative expenses. Low for index funds (< .5%) and sometimes expenses. Low for index funds (< .5%) and sometimes approaching 5% for specialized fundsapproaching 5% for specialized funds
- Are periodically deducted from the fund’s assetsAre periodically deducted from the fund’s assets
- Operating expenses are an important determinant of fund Operating expenses are an important determinant of fund performance!!performance!!
Mutual Fund Costs (cont.)Mutual Fund Costs (cont.)
12b-1 Charges12b-1 Charges: These fees are named after the SEC rule : These fees are named after the SEC rule that permits funds to pay for distribution costs such as that permits funds to pay for distribution costs such as advertising, promotional literature and, most importantly, advertising, promotional literature and, most importantly, commissions to brokers out of fund assetscommissions to brokers out of fund assets
- Are deducted from the fund’s assetsAre deducted from the fund’s assets
- Fees can have an important impact on fund Fees can have an important impact on fund performanceperformance
Mutual Fund Costs (cont)
Many Fund Families Offer Different Classes of Shares (Dreyfus Premier Growth Fund as of 2003)
Class A Class B Class C Class T
Front-end Load 0-5.75% 0 0 0-4.5%
Back-end Load 0 0-4% 0-1% 0
12b-1 fees .25% 1% 1% .50%
Expense Ratio 1.25% 1.25% 1.25% 1.25%
Very Important Advice
Never buy a fund with a front-end load, 12b-1 fees, or an expense ratio above .5% (1% for an international fund)
If there is a back-end load, it should go away with time
Mutual Fund PerformanceMutual Fund PerformanceDo mutual fund managers, on average, beat the Do mutual fund managers, on average, beat the
market? This is an important question we will take market? This is an important question we will take up in detail when we discuss market efficiency.up in detail when we discuss market efficiency.
ETFs (Exchange Traded Funds)
Trade like individual stocks, but typically replicate an indexLow expenses and tax efficientCan be bought on margin and sold shortPurchasing (and selling involves incurring
the same transactions costs associated with transacting individual stocks)