Securities Markets
Economics 71a
Spring 2007
Mayo, Chapter 3
Lecture notes 2.3
Outline
MarketsOrdersPositions Information
Markets
Primary markets New issues (IPO’s, corporate and public
debt)Secondary markets
Trading old stuff In many cases most activity in secondary
Money and Capital Markets
Money markets Short term securities (1 year or less)
Capital markets Longer term
Money Market Securities
Treasury bills U.S. government debt Short term (less than 1 year)
Commercial paper Short term corporate borrowing
Discount pricing Buy for $10, get paid $11 in future No interest payments
Capital Market Securities
Bonds (longer term borrowing) U.S. Treasury Municipal (tax free) Corporate More later
Capital Market Securities
Stocks Common stock Preferred stock International More later
Trading and Secondary Markets
Stock marketsBond marketsDerivativesForeign Exchange
U.S. Stock Markets
New York Stock Exchange (NYSE)National Association of Securities
Dealers Automated Quotation (Nasdaq) American Stock Exchange (AMEX)
Continuous Trading
Market types Specialist Electronic dealer Open outcry Over the counter
NASDAQ Upstairs (negotiated) ECN (electronic crossing network)
ECN’s: Electronic Crossing Networks
Internet based trade networks Customers can meet directly (no broker) Used mostly by professional money
managers Advantage: fewer intermediaries Disadvantage: less liquidity
(Fewer people to trade with)
Fastest growing markets
Other Markets
Futures/OptionsForeign Exchange
Spot versus forwardBond
International Markets
Many major international stock markets London Tokyo China many more
US accounts for only 36% of the companies listed on stock markets around the world
International Investments
Purchase stocks or bonds in foreign countries Purchase shares in foreign firms in U.S.
(American Depository Receipts) ($/English) Bonds can be issued in different currencies
Eurobond: Intel issues $ denominated bond in Japan
Trading Hours
Most U.S. stock markets 9:30-4:00
Extended hours on electronic trading networks
“After hours trading” International markets (local times) Foreign exchange markets (24 hours) Hours increasing : toward a 24 hour market
Outline
MarketsOrdersPositions Information
Types of Orders
Market orderLimit order
Market Order
Buy or sell at the current market priceNo restrictions“Buy 50 shares at market”
Limit Orders
Buy when price drops below a limit Sell when price moves above a limit Example
Limit buy at 50 (price at 60) Stock moves to 55 (nothing happens) Stock moves to 49 (order executed)
Advantage Might end up with a better price
Disadvantage Order might end up unfilled
Brokers
Enable trading of financial services Dealer function Access
Mail Phone Internet
Types of Brokers
Full service Extensive research Merrill Lynch
Premium discount Limited research Charles Schwab
Basic discount No research E*trade
Classification is difficult
Transaction Costs
CommissionsBid/ask spreads
Costs of Trading
Commissions Fixed Negotiated Varying structures (fixed + varying)
$20 + shares * C
Bid/ask spread Buy at the ask Sell at the bid
Bid/ask Spread
Example: Ask = 88.5 (buy) Bid = 88 (sell)
Spreads may change Over time Over stocks
Reveal the ease of trading a stock “Liquidity” again
Order Books
Order book List of current limit buy and sell orders
If you want to buy Can “hit” limit sell orders Walk up the book Higher price for more stock
If you want to sell Can “hit” limit buy orders Walk down the book
ECN’s and visible order books
Settlement and Delivery
Settlement dates Usually trade date + 3 days
Take delivery or leave shares with broker (street name)
Outline
MarketsOrdersPositions Information
Long Purchase
Straight purchase of a securitySpeculate that price will increase
Buy at 100 Sell at 110 10% return
Margin Purchase
“Buying on margin”Borrow money to buy stockBuy at 75% margin
75% of money in investment is yours 25% is borrowed from broker or bank
Purchase $100 of stock at 75% margin You put in $75, and you borrow $25
Basic Margin Formula
€
Margin =Total value −Borrowed funds
Total value
Margins and Magnification
Example stock: Price = $100 Up: Price = $150 Down: Price = $75
If you purchased with your own money $100 total investment Up: + $50 Down: - $25
Margins and Magnification
Buy on 50% margin (zero interest charges)
$100 own, and $100 borrowed (needs to be paid back)
Purchase $200/$100 shares = 2 shares $100 total investment Up: 2*150 - 100 - 100 = $100 (50) Down: 2*75 - 100 - 100 = $-50 (-25)
Margin Buying
Borrowing money to buy stocks Magnifies gains and losses Can lose more than you put in
Buy $200 of stock $100 your own $100 borrowed
Stock goes to zero Lose $100 of own investment, and Owe $100 of borrowed money too
Maintenance Margins
Margin required for investor to maintain If margin falls below this level investors
must add more of their own money“Margin call”Common margin call
Prices fall Margin rises Investor needs to come up with more funds
Margin Requirements
Common stock: 50%Bonds: 50%Options: 20% stock valueFutures: 2-10% of the contract value
Short Sales
Holding negative stock Sell stock you don’t have (borrow) Buy it back later Pay dividends yourself in between
Key issue Make money on a price fall Lose money on a rise
Betting against a stock
The Mechanics of a Short
Tell broker you want to sell 100 shares of IBM short (price = $50)
Broker “borrows” shares of 100 shares of IBM owned by another client
Sells it to someone for 50*100=5000, and pays this to you
You must keep this amount on account with broker
When dividends are to be paid, you pay broker, and broker pays the other client
The Mechanics of a Short
IBM goes down to $40 per share You “buy” your 100 shares to take you back to zero,
pay broker 40*100=4000. Broker buys at market, and puts the shares back in
the other person’s account You make 5000-4000 = 1000 (less dividends) Make money when price falls Lose money when price rises
The Mechanics of a Short
IBM goes up to $60 per share You “buy” your 100 shares to take you back to zero,
pay broker 60*100=6000. Broker buys at market, and puts the shares back in
the other person’s account You lose 5000-6000 = -1000 (less dividends)
Margins and Shorts
Broker requires additional funds to cover possible losses
Fraction of additional sale amount Example
Sell $5000 worth of stock at 50% margin Need to keep 1.5*5000 = 7500 on account with
the broker When the price goes up, need to increase this “Margin call”
Oddities About Shorts
Can lose unbounded amounts of money Normally only lose what you put in With short price can go up forever, and your losses keep
increasing
Also, broker can get in trouble if you default Other customer could lose original shares Often insured for this
Short Interest
Fraction of shares sold shortMeasure of market pessimism in a
stockCommon market indicatorMeasures market pessimism
Squeeze Play
Assume Microsoft has a large number of short sellers
Price starts to rise Short sellers losing money Get nervous Buy stock to close out their short positions Prices rise more, more buying .. (etc. etc)
Outline
MarketsOrdersPositions Information
Information Sources
Private Quicken and Yahoo finance Wall St. Journal (fee) Value line and Standard and Poors (fee) Brokerage firms Corporations
Government Federal Reserve SEC
Information Sources
Key publications Economic information
Federal reserve bulletins (economic info) Firm/investment data
Value Line Survey Standard and Poor’s Handbook Security firm reports Firm annual reports
The Internet and Investing
Cheap and accessible information Investor tools
Charts Screening Calculators
Online trading
Investment Information on the Web
News articles NY times CBS Market watch CNN financial
More Investment Information
Stock information Yahoo Google Quicken
Historical information Yahoo Datastream (fee) Bloomberg (fee)
Warnings on Internet Information
Don’t use information to trade to frequently
Don’t believe everything you see on the web
More (biased) Information
Firm annual reports and accounting infoAnalyst information
Analysts recommend (buy, sell, hold) Problems:
Firms often are biased in what they tell analysts Analysts are biased since stocks they analyze
can be their own clients
Internet Tools
Education www.investorguide.com www.fool.com www.smartmoney.com
Calculators www.financenter.com
Internet Tools
Stock screening Quicken Yahoo Google
Plotting/graphics bigcharts.com smartmoney.com
Market Indices
Summarize market movements Examples
Dow Jones Industrial (30 stocks) NYSE Composite S&P 500 Composite (500 stocks) NASDAQ Composite Nikkei (Japan) Wilshire 5000 Sector indices
Index Construction
Weighted sum
Weighting options Equal w = (1/N) Relative value of the firm (S&P, NASDAQ)
Value weighting Odd (Dow Jones)
€
Pt,I = w jPt , jj=1
N
∑
1= w jj=1
N
∑
Index Uses
Summary of the market Investor benchmark (performance
check) Compare own result to index
Investment target Index mutual fund
Index Problems
Index is not constant Additions and removals Changing weights
As stock increases in value, share in index increases
Index can drift towards growing sectors in the market