Understanding Markets

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Jan. 2, 2012

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Donald W. Reynolds National Center For Business Journalism

At Arizona State University

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James K. Gentry, Ph.D. Clyde M. Reed Teaching Professor School of Journalism and Mass

Communications University of Kansas jgentry@ku.edu

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Risk-Return Relationship

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Basic Types of Risk Systematic or market Unsystematic or nonmarket. Also

called “business risk.” Can be diversified away.

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Specific Types of Risk Financial risk, credit risk, default risk Market risk Interest rate risk Purchasing power or inflation risk Event risk Exchange-rate or foreign exchange risk Liquidity risk Political or sovereign risk Tax risk

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Types of Businesses Sole proprietorship Partnership Corporation

Limited liability Greater access to capital Permanency Flexibility Double taxation

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Types of Structures Private corporations Public corporations Non-profits

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Types of Investments Stocks Bonds Other

Options, futures, commodities, real estate, collectibles, currencies

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Types of Markets Equity: Stocks Credit: Bonds, debt or fixed income Others

Derivatives (such as options and futures), commodities, real estate, collectibles, currencies

Historically, the amount of long-term debt financing issued in the U.S. greatly exceeds the volume of equity financing

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Stock

Stockholders want: Stock price to increase Dependable dividend stream Increase in size of dividend

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Types of Stock

Common stock Preferred stock

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Common Stock

Risk: Lose your money if company falters

Reward: Owners share in success when company does well Appreciation Dividends

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Dividends Represent a return on capital invested

by shareholders. Board must declare dividend for it to be

paid. Dividend payment is not a business

expense. It is an after-tax expense. Usually relationship between company’s

age and size, and the dividends it pays.

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Preferred Stock Reduced risk but reward may be limited Dividend amount is stated and is paid

before dividends on common If company is liquidated, holders are

preferred over common holders. Dividends don’t necessarily increase if

company prospers.

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Bond Bond is debt a company owes Individual or company “loans” money to

the company by buying a bond Bond pays interest over a fixed period of

time Principal is repaid to the lender or holder of

the bond at end of the term Interest rate is typically fixed when the

bond is sold (i.e., fixed income security) Interest rate is comparable to what other

bonds, with that rating, are payingStrictly Financials

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Bond Terminology Interest rate: Fixed percentage of the bond’s

purchase price that is paid annually to the bond holder

Yield: Return on investment if bond is held to maturity. Equals interest rate. If bond is traded before maturity date, yield could change although interest rate stays the same.

Par value: Dollar amount paid for bond at time of issue

Maturity date: When bond comes due

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Issuers Prefer Bonds When companies need to raise money,

they can issue stock or sell bonds They often prefer bonds, in part because

issuing more stock can dilute the value of shares investors already own

Bonds also may have income tax advantages

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A Quasi-Bond? Is preferred stock debt (i.e., a bond) in

disguise? Preferred holders have a “guaranteed”

dividend. Is that like the fixed interest rate of a bond?

Why do investors pick common, preferred or bonds?

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Risk and Reward

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Yield CurveYield

Maturity

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Equity or Securities Markets

Primary market Go public Private placement

Secondary market

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Going Public Entrepreneurs have an idea. Company

grows with an investment from the private equity market (venture capital).

Owners decide to “go public.” Register with SEC to make an initial

public offering (IPO). Investment bankers typically

underwrite the offering through a syndicate.

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Going Public (cont.)

Company prepares a prospectus, which is a detailed analysis of the company’s financial history, its products and services, as well as management’s background and experience.

Prospectus should identify and assess risk factors the company faces.

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IPO Terms

Prospectus Road show Quiet period Lockup period

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Shelf Registration

Firm can file one registration statement for a relatively large block of stock and sell parts over a two-year period

This can reduce red tape and costs, and because stock can be sold directly to institutional investors, can eliminate the underwriting fee

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Private Placement New issues can be sold in large lots to a

small group of buyers. Allows start-up firms to show appeal by raising capital on their own.

Additional shares later can be offered through an underwriter.

Many debt issues are placed privately, usually to large buyers such as insurance companies.

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Secondary Offering

If company already is public, it can sell more stock through a secondary offering. Causes dilution

Major owners sell their shares. They get the funds so no dilution.

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Wall Street

Got its name from a wall of brush and mud built by early settlers to protect the city of New York from attacks (1609)

Site of New York’s first organized stock trading

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New York Stock Exchange In March 1792, Wall Street leaders

met to establish an improved auction market

In May 1792, 24 men signed an agreement to trade securities only among themselves, maintain fixed commission rates and avoid other auctions

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NYSE (cont.)

Until March 2006, was owned by 1,366 seat-holding members

Highest price ever paid for a seat was $4 million

Price was determined by auction.

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NYSE Members Floor brokers

House brokers Independent brokers

Specialists Manage auction process Execute orders for brokers Serve as catalysts Provide capital Stabilize prices

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In The Day, Buy or Sell Order Tell your broker or “registered

representative” to buy or sell a stock at the current price, or market price. Called a market order.

If you name the price to buy or sell, you’re making a limit order.

Tell your broker to buy or sell once the price hits a specific price, you’re placing a stop order at a stop price.

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Trading on the NYSE Floor

Trading occurs in the “Big Room” Numerous stations, each with a

roughly figure-eight shape, with counters and screens above. Called “trading posts.”

Each counter is a “specialist’s” post

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NYSE Floor (cont.) Order comes to the booth that is rented

by a brokerage house Floor broker takes order to appropriate

specialist’s post Specialist keeps a list of unfilled orders.

Processes orders as prices move. Specialist’s job is to maintain an orderly

market in the stock (match buyers/sellers)

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NYSE Floor (cont.) Stocks or groups of stocks are traded at

trading posts near the specialists’ positions. Floor brokers can use a specialist or trade

between themselves, called trading in the “crowd”

Terminals display the stock’s activity. After every trade, a reporter records the

stock symbol, price and initiating broker. Successful trades are confirmed.

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NYSE Floor (Then & Now)

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Round or Odd Lots

Round lots: Buying or selling stock in multiples of 100 shares

Odd lots: Buying or selling stock in other quantities

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Who Holds Your Stock?

Virtually all investors leave shares in their brokerage account in what’s called the street name. Investor retains beneficial ownership, though.

This offers safe storage. You can get tangible certificates if

you want them. Typically, you must pay for them.

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Super DOT System

Designated Order Turnaround Allows orders to be transmitted

electronically to specialist. Now makes up a substantial

percentage of NYSE trading, particularly smaller orders

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American Stock Exchange Non-members of NYSE couldn’t

afford office space so traded in the street

1842: New York Curb Exchange By late 1870s known as “curbstone

brokers” and their market was known as the Curb.

Merged with NASDAQ in 1998 Acquired by NYSE Euronext in 2009

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NASDAQ

National Association of Securities Dealers Automated Quotations system

NASDAQ is a computer network with no physical location for trading

Uses a multiple market maker system, not the specialist system

About 4,000-plus companies

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Trading on the NASDAQ

Trading is through an open market, multiple dealer system, with many market makers competing to handle each transaction.

The computer network checks for matches, which can be handled instantly.

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In Which Market?

In general, but with exceptions: NYSE: Oldest, largest, best known AMEX: Smaller, younger NASDAQ: Youngest, least experienced Some of NYSE’s most actively traded

stocks are also quoted on the NASDAQ

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ECNs

Electronic Communications Networks

Are basically Web sites that allow investors to trade directly with one another

Archipelago and Instinet were best known

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NYSE - Archipelago Marriage Merged in March 2006 to create NYSE

Group, Inc., a publicly-held company. Largest merger ever between

securities exchanges. Combined leading equities market

with most successful electronic exchange.

Archipelago: low fees, user-friendly technology

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NYSE Euronext

Merged April 2007 Operates world’s largest, most

liquid exchange with diverse products and services

Six equities exchanges in five countries and six derivatives exchanges

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Deutsche Borse Seeks To Buy NYSE Euronext

Been working on a deal since early 2011.

Would create world’s largest trading entity.

European regulators are forcing the companies to sell assets because of competitive concerns.

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NYSE ‘Hybrid Market’

Floor trading and automated trading

Specialists or Archipelago strengths

Why? Customers’ desire for faster access to liquidity and greater anonymity

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NASDAQ Response

NASDAQ acquired Instinet Group Inc., another ECN

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Exchanges v. OTC Market

Stocks in almost 10,000 companies aren’t listed on any exchanges.

They are traded “over the counter” (OTC)

Typically handled by phone or computer

Generally, comparatively inexpensive and infrequently, or “thinly,” traded

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BATS Global Markets

Newer exchange, founded in 2005 Located in Kansas City Competes on technology and cost Developed its own software platform Also offers an options trading

platform An ECN

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U.S Equities Market Share

NYSE 27.5% Arca, 14% Floor, 13.5%

NASDAQ, 21.5% BATS, 12%

September 2011

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Stock Market Participants and the Role of an Exchange

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Direct Edge Another ECN Has exchange status

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Dark Pools Also “Dark Liquidity” or “Dark Pool Liquidity” Lightly regulated trading not open to the public. Mostly involves block trades by institutions away

from public exchanges so trades are anonymous. Main advantage to institutional investors: Can buy or

sell in large blocks without other investors knowing since neither size of trade or trader’s identity are revealed. Prices are reported after trades completed.

Also means some market participants are disadvantaged since they can’t see trades executed and prices paid so this market is not transparent.

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High-Frequency Trading Also known as “high-speed trading.’ Electronic trading strategies driven by

statistics and algorithms. WSJ reported in October that by some

measures, such firms make up 5 of every 10 stock trades in the U.S. each day.

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High-Frequency Trading Research has shown that algorithmic

trading broadly makes prices less volatile and reduces the overall cost of trading.

These firms’ ability to buy and sell large blocks of securities in fractions of a second has raised fears that ordinary investors are being left behind.

Is drawing criticism.

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Cyclical, Income, Growth Cyclical: Highly dependent on the state

of the economy. When things slow, earnings and stock price fall. When economy recovers, earnings and stock prices rise.

Income: Stocks that pay dividends regularly.

Growth: Pay little or no dividend while profits are reinvested.

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Stock Ownership

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Stock Ownership

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Institutional Investors Organizations that invest their own assets or

pool those it holds in trust for others. Examples: Investment companies (including

mutual funds), pension systems, insurance companies, universities and banks.

Trade regularly and in tremendous volume. Must buy or sell at least 10,000 shares for a

transaction to be an “institutional trade.”

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Changing Attitudes

Institutional investors who own large blocks of stock are increasingly demanding a say in corporate management.

Socially or environmentally conscious individual shareholders also are becoming more involved.

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Stock Market Averages Dow Jones Industrial Average: Best known

and most widely reported market indicator Made up of 30 industrial companies Dow Jones Transportation Average: 20

airlines, railroads and trucking companies Dow Jones Utility Average: 15 gas, electric

and power companies Dow Jones 65 Composite Average: all 65

companies in the other three averages

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Stock Market Indexes NYSE Composite Index: All stocks traded

on the NYSE. Standard & Poor’s 500 Index: Broad

base of 500 stocks. Considered benchmark for large-stock investors.

NASDAQ Stock Market Composite Index: Stocks traded through its electronic system. Often more volatile because of types of companies it covers.

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Market Indexes (cont.) AMEX Composite: Companies on the

AMEX. Russell 2000: Follows smallest two-

thirds of the 3,000 largest U.S. companies. Includes many IPOs of past few years. Benchmark for small-company stocks.

Value-Line: 1,700 common stocks. Wilshire 5000: Broadest index, including

nearly all stocks traded in U.S. markets.

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Reg FD, Disclosure and Guidance Regulation Fair Disclosure, October

2000 Bars public issuers from selectively

revealing material nonpublic information to securities analysts, broker-dealers, investment advisers, and institutional investors, before disclosing it to the public.

Tension: Guidance vs. disclosure

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Blue-Chip Stock

Company with national reputation for quality, reliability and ability to be profitable in good or bad times

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Bulls and Bears

Bulls: Persons who think prices or values will rise. In general, being optimistic.

Bears: Persons with a pessimistic market outlook.

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Selling Short

Selling a security not owned by seller Investor borrows stock and sells it for

later delivery. Seller hopes to buy the stock later at

a lower price, thereby making a profit, which comes from difference between price at sale and price at later purchase.

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Margin

Buying on margin: Borrowing money from broker to buy securities.

Federal Reserve regulates margin. Today investor can borrow up to 50 percent of the price of the stock.

Broker requires a minimum balance and can issue a “margin call” if stock’s value declines.

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Classes of Stock

Some firms have more than one class Primarily done to assure control of the

firm by one group, such as Ford Motor Company’s Class B, which isn’t publicly traded (held by family) but has 40 percent of voting power, although it represents less than 10 percent of total shares outstanding.

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Stock Split If stock price increases significantly, a

company might do a split to lower the price, which it expects to stimulate trading.

In a split, more shares are available but total market value is still the same.

Price may move up after split, therefore increasing the value of your stock.

Reverse split: Exchange more shares for fewer, say 10 for five. To boost share price.

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Arbitrage

Simultaneous purchase and sale of an asset to profit from a differential in the price. Usually takes place on different exchanges or marketplaces.

Ex: Buy stock in company on one exchange at one price and sell stock in the same company on another exchange at a different price.

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Insider Trading

Buying and selling of company stock by officers, directors, employees, family members, etc. Person or trust owning 10 percent or more of a company's stock also considered an "insider."

SEC calls them "insiders" because of access to early and potentially key company events.

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Option

On an organized exchange, the right to buy or sell securities, commodities, etc. at some point for an agreed upon amount.

In a company, stock options are granted to corporate executives and others as part of their compensation packages.

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Warrant

Type of security, usually issued with a bond or preferred stock, that entitles holder to buy a proportionate amount of common stock at a specified price, usually higher than the market price at time of issuance, for a period of time.

Also called a Subscription Warrant

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Global Marketplace

Stocks are traded around the clock, around the world. There’s a market open somewhere, 24 hours a day, Monday through Friday.

Growing number of multinational companies on several exchanges.

Tendency of investors to buy in many markets, not just their own.

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American Depositary Receipts A bank buys and deposits actual foreign

securities with another bank (called a depositary), which then issues certificates in the U.S. that represent (and are backed) by the deposited securities.

Depositary handles day-to-day interactions with ADR holders.

Advantages: As U.S. securities, ADRs are subject to U.S. regulations and protections.

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ADRs (cont.) Priced in dollars and dividends paid

in U.S. dollars. ADR prices follow closely (but not

necessarily 1:1) the underlying foreign security, based on supply and demand.

Very few U.S. banks are depositaries. Bank of New York is largest with more than 50 percent of all ADR issues.

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Tracking Global Markets

Wall Street Journal tracks 24 national stock markets outside the U.S. with 32 indexes.

Worldwide market performance is compared by looking at percentage change.

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Why International

Rewards Diversification, capital gains, dividends,

country’s currency rises against dollar Risks

Tax treatments differ by country, accounting and trading rules can be different, converting dividends can add expenses, distance and language barriers

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Credit or Debt Markets

Historically, the amount of long-term debt financing issued in the U.S. greatly exceeds the volume of equity financing

Short-term or “money market” Bond market

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Money Market

Commercial paper Bankers’ acceptance Repurchase agreements Certificates of deposit Municipal notes Treasury bills Money market mutual funds

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Terminology

Bills – Maturity dates up to one year

Notes – Maturity dates of two to 10 years

Bonds – 10 years or longer

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Who Issues Bonds

Issued by U.S. companies Issued by the U.S. Treasury Issued by federal, state and local

government agencies Issued by overseas companies and

governments. When sold in dollars, are sometimes called Yankee Bonds.

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Issuers Prefer Bonds

When companies need to raise money, they can issue stock or sell bonds

They often prefer bonds, in part because issuing more stock tends to dilute the value of shares investors already own

Bonds also may have income tax advantages

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Treasury Issues

Life, or term, is fixed at time of issue

Treasury bill: One year or less Treasury note: One to 10 years Treasury bond: 10 years or more Generally, the longer the term the

higher the interest rate

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Uses of Bonds

Corporations use bonds: To raise capital to pay for expansion

or modernization To cover operating expenses To finance corporate takeovers or

other changes in management structure

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Uses of Bonds (cont.)

U.S. Treasury uses bonds: To finance a wide range of

government activities To pay off (actually refinance) the

national debt

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Uses of Bonds (cont.)

States, cities, counties and towns issue bonds: To pay for a wide variety of public

projects To supplement their operating

budgets

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How Bonds Are Sold Issuing bonds has similarities to an IPO Bonds are sold at par, or face value, in

units of $1,000 After issue, bonds trade in secondary

market and are bought and sold through brokers

Government bonds are directly available through a Federal Reserve Bank program called Treasury Direct or through a broker

Most municipals are sold through a broker

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How Bonds Are Traded

Most already-issued bonds are traded over the counter

Bonds also can be purchased from the inventory of a brokerage firm that might make a market in the bonds

Commissions and markups

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Bonds Then and Today Until 1983, all bondholders received

certificates Some of these Bearer Bonds had coupons

attached to the certificate To collect interest, investor detached the

coupon and exchanged it for cash. Hence, the bond interest rate is called the Coupon Rate.

Today most new bonds are called Book Entry bonds and are registered electronically

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Rating Bonds Standard & Poor’s, Moody’s Investors

Services and Fitch are best known Corporate, international and municipal

bonds are rated Credit ratings influence interest rates If a company’s rating is downgraded,

investors demand a higher yield

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Bond Rating Code Aaa/AAA: Best quality Aa/AA: High quality A/A: High-medium quality Baa/BBB: Medium quality Ba/BB: Some speculative element B/B: Future default risk Caa/CCC: Poor quality, default danger Ca/CC: Highly speculative C/C: Lowest rated, poor prospects

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