Organized exchanges

Colombo Stock Exchange, NSE

The listing of securities

Over-the-counter markets

Nasdaq stock market

“Third” and “fourth” markets

OTC for listed securities (block trades off the exchange)

Trade via computerized systems on subscription basis

Offer to buy (the bid) and sell (the ask) for their own accounts

Spread

Difference between the bid and ask prices

Market makers

Do not set the level of prices

Market forces set the prices

Facilitate securities transactions

Financial analysis Construct earnings estimates

Buy side Analysts who provide recommendations for institutional

clients (non brokerage) such as mutual funds

Sell side Analysts who provide recommendations for the use by

brokers These recommendations will be used to “generate sales”

for the broker Potential conflict of interest

Broker – An agent who handles buy and sell order for an investor.

Dealer/Market Makers – Buys and sell for the own account

Broker dealers – Two separate divisions

Registered representative – A person who trades for a client/investor (should maintain trust and confidence and understand the client)

The long (bullish) position

Anticipating prices to rise

Investor will purchase the security

The short (bearish) position

Anticipating prices to fall

Investor will sell the security

Sell Short (discussed later)

Market orders

– Buy or sell certain quantity at current market price

– Execution is ensured but not the price

Limit orders

– Buy or sell certain quantity at a specified price or better

– Execution not assured but price is assured if executed

Good till cancelled order

– Order that remains until executed or cancelled by the investor

Stop (loss) orders

Sell when market hits specified lower price

Buy when market hits specified higher price

When market hits specified price, stop order becomes a market order

No assurance of the price

Execution may not occur

Not to confuse limit order and stop order

Once the specified price is reached stop order ensures execution not the price where as limit order ensures the price not execution

Confirmation statements

T+3: settlement date (three business days after the trade date)

Cash account

No borrowing

Margin account

Can borrow/leverage

Regulation and broker may limit borrowing

Increases the risk

Magnifies the potential profit or loss

ROE will increase so long as the cost of borrowing is less than the return on investment

Initial margin requirement

The minimum percentage of the cost of an investment the individual must put to buy securities

Maintenance margin

Minimum equity required in a margin account at all times

Margin call

A call by the broker to deposit additional cash when maintenance margin is breached

Regulatory Fees to CSE, CDS and SEC

Commissions

Fees charge by brokers for execution of trades

Large deals on negotiated commissions

The spread

Impact on price

Applicable for large orders and illiquid securities

Sale of borrowed securities in anticipation of a price decline Bearish strategy Process Broker to borrow the stock on behalf of the investor and sell

Sales proceeds to be kept with the broker

Investor to keep a margin with the broker

Investor must subsequently buy the stock and return to the lender (covering the short sale)

Short seller has to make a payment to the lender equal to the dividends received

Gain = Selling Price – Purchase Price – Interest Paid

Companies Act No 7 of 2007

Securities and Exchange Commission Laws

SEC Act

Takeover and Mergers Code

Directives

Listing Rules of the CSE and circulars

Corporate Code of Best Practices

Purpose – Protect the investors by ensuring honest and fair

practices

Annual reports

Quarterly financials

Periodic announcements - Change in the firm that

may affect the value

Immediate disclosure

An investor who buys 10% and 30% of a company

Inside Information – Material corporate information which is likely to impact the share price which has not been made public

The directors and employees are prohibited from trading using inside information

Criminal offence

Directors and officers are required to report their holdings and changes in their holdings

Private Placement

Public Offer

Direct sale of securities to institutional/private investors

Eliminates selling costs Less disclosure requirement Terms of the issue and features can be tailor made

for both parties More appropriate for smaller and emerging firms

who are not yet ready to tap the public market

IPO - First sale of common stock to the public Increase public interest towards the company By pass restrictive covenants of financial intermediaries Securities are sold to the public via an investment banker Extensive disclosures in the prospectus Needs to have higher level of corporate governance Investment Banker – A firm that manages the public issue SEC approval is not for the worth of the firm but to confirm

that information has been provided and the prospectus is complete in the format and content

Prices change quickly to new information

Current price embodies all known information

By the time most investors know the information, the price change has already occurred

New information must be random

Successive price changes are independent

Today’s price does not forecast tomorrow’s price

A large number of competing participants

Information is readily available virtually costless

Transaction costs are small May not hold for individual investors

Cannot expect to beat the market consistently on a risk-adjusted basis Future earnings and dividends are correctly reflected in the prices

Earning a higher return is not necessarily outperforming the market Could at a higher level of risk

Considering risk is also important Risk adjusted returns

The forms of the efficient market hypothesis:

The weak form

The semi-strong form

The strong form

Studying past price and volume data will not lead to superior investment results.

All historical information is reflected in the price

While the weak form suggests that using price data will not produce superior results, using financial analysis may produce superior return.

Prices reflect all public information (past and present)

Studying economic and accounting data and historical prices will not lead to superior investment returns.

Studying inside information may lead to superior returns.

Illegal

Prices reflect all public and inside information.

Even having access to inside information will not lead to superior investment returns.

Empirical results generally support:

The weak form

The semi-strong form

Possible exceptions to the efficient market hypothesis, called anomalies, appear to exist.

Low P/E stocks The small firm effect The January effect The neglected firm effect The day-of-the-week effect The overreaction effect

Empirical evidence of the existence of an anomaly does not mean the individual can take advantage of the anomaly.

The anomaly can still exist and the market be effectively efficient from the individual investor’s perspective.

Securities prices embody known information.

The playing field is level.

Specifying financial goals may be more important than seeking undervalued stocks.