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Capital Market Overview Capital Markets Debt Common stock Preferred stock Derivative securities Security Trading Trading Trading Costs Buy on margin versus short sell Major Types of Securities Debt Money market instruments Bonds Common stock Preferred stock Derivative securities

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Capital Market Overview

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Capital Market Overview

  • Capital Markets

    • Debt

    • Common stock

    • Preferred stock

    • Derivative securities

  • Security Trading

    • Trading

    • Trading Costs

    • Buy on margin versus short sell


Major Types of Securities

  • Debt

    • Money market instruments

    • Bonds

  • Common stock

  • Preferred stock

  • Derivative securities


Markets and Instruments

  • Money Market

    • Debt Instruments

    • Derivatives

  • Capital Market

    • Bonds

    • Equity

    • Derivatives


Money Market Instruments

  • Treasury bills

  • Certificates of deposit

  • Commercial Paper

  • Bankers Acceptances

  • Eurodollars

  • Repurchase Agreements

  • Federal Funds

  • LIBOR Market


Bond Markets

  • US Treasury Bonds and Notes

  • Agency Issues (Fed Gov)

  • International Bonds

  • Municipal Bonds

  • Corporate Bonds

  • Mortgage-Backed Securities


Municipal Bond Yields

  • Interest income on most municipals is not subject to tax

  • To compare the yields on municipals to other bonds use equivalent taxable yield

    (municipal return) / (1 – tax rate)

  • Or solve for the tax rate that equates the two yields

    Tax rate = 1 – (municipal rate/taxable rate)


Capital Market - Equity

  • Common stock

    • Residual claim

    • Limited liability

  • Analyzing stocks – finance.yahoo.com

  • Preferred stock

    • Fixed dividends - limited

    • Priority over common

    • Tax treatment


Stock Market Indexes

  • Uses

    • Track average returns

    • Comparing performance of managers

    • Base of derivatives

  • Factors in constructing or using an Index

    • Representative?

    • Broad or narrow?

    • How is it constructed?


Examples of Indexes - Domestic

  • Dow Jones Industrial Average (30 Stocks)

  • Standard & Poor’s 500 Composite

  • NASDAQ Composite

  • NYSE Composite


Examples of Indexes - International

  • Nikkei 225 & Nikkei 300

  • FTSE (Financial Times of London)

  • Dax

  • Region and Country Indexes

    • EAFE

    • Far East

    • United Kingdom


Bond Indexes

  • Lehman Brothers

  • Merrill Lynch

  • Salomon Brothers

  • Specialized Indexes

    • Merrill Lynch Mortgage


Construction of Indexes

  • How are stocks weighted?

    • Price weighted (DJIA)

    • Market-value weighted (S&P500, NASDAQ)

    • Equally weighted (Value Line Index)

  • How returns are averaged?

    • Arithmetic (DJIA and S&P500)

    • Geometric (Value Line Index)


Derivatives Securities

Options

Basic Positions

Call (Buy)

Put (Sell)

Terms

Exercise Price

Expiration Date

Assets

Futures

Basic Positions

Long (Buy)

Short (Sell)

Terms

Delivery Date

Assets


Tips on Investment

  • Buy under-valued stocks

  • Buy recent-past winners

  • Don’t over trade – investing in stocks is costly

  • You can buy bonds

  • Invest in real estates


Security Trading

  • Primary Market versus Secondary Market

  • Types of Orders

  • Trading Mechanisms

  • Buy on margin and short selling


Primary vs. Secondary Security Sales

  • Primary

    • New issue

    • Key factor: issuer receives the proceeds from the sale

  • Secondary

    • Existing owner sells to another party

    • Issuing firm doesn’t receive proceeds and is not directly involved


How Firms Issue Securities

  • Investment Banking

  • Shelf Registration

  • Private Placements

  • Initial Public Offerings (IPOs)


Shelf Registrations

  • SEC Rule 415

  • Introduced in 1982

  • Ready to be issued – on the shelf


Initial Public Offerings

  • Process

    • Road shows

    • Bookbuilding

  • Underpricing

    • Post sale returns

    • Cost to the issuing firm

    • See page 60-61


Figure 3.3 Average Initial Returns for IPOs in Various Countries


Figure 3.4 Long-term Relative Performance of Initial Public Offerings


Types of Orders

Instructions to the brokers on how to

complete the order

  • Market

  • Limit

  • Stop orders

  • Page 64-65


Figure 3.6 Price-Contingent Orders


Trading Mechanisms

  • Dealer markets

    • Electronic communication networks (ECNs)

  • Specialists markets

  • Page 66


U.S. Security Markets

  • Nasdaq

  • Small stock OTC

    • Pink sheets

  • Organized Exchanges

    • New York Stock Exchange

    • American Stock Exchange

    • Regionals

  • Electronic Communication Networks (ECNs)

  • National Market System


Nasdaq

  • National Market System

  • Nasdaq SmallCap Market

  • Levels of subscribers

    • Level 1 – inside quotes (investors)

    • Level 2 – receives all quotes but they can’t enter quotes

    • Level 3 – dealers making markets

    • SuperMontage


Table 3.1 Requirements for Listing on Nasdaq Markets


New York Stock Exchange

  • Member functions

    • Commission brokers

    • Floor brokers

    • Specialists

  • Block houses

  • SuperDot (70% of NYSE trading volume)


Table 3.3 NYSE Listing Requirements


Costs of Trading

  • Commission: fee paid to broker for making the transaction

  • Spread: cost of trading with dealer

    • Bid: price dealer will buy from you

    • Ask: price dealer will sell to you

    • Spread: ask - bid

  • Combination: on some trades both are paid


Margin Trading

  • Using only a portion of the proceeds for an investment

  • Borrow remaining component

  • Maximum margin is currently 50%; you can borrow up to 50% of the stock value

  • Set by the Fed

  • Maintenance margin: minimum amount equity in trading can be before additional funds must be put into the account

  • Margin call: notification from broker you must put up additional funds


Margin Trading - Initial Conditions Example 3.1

X Corp$100

60%Initial Margin

30%Maintenance Margin

100Shares Purchased

Initial Position

Stock $10,000 Borrowed $4,000

Equity $6,000


Margin Trading - Maintenance Margin Ex. 3.1

Stock price falls to $70 per share

New Position

Stock $7,000 Borrowed $4,000

Equity $3,000

Margin% = $3,000/$7,000 = 43%


Margin Trading - Margin Call Example 3.2

How far can the stock price fall before amargin call? The maintenance margin is 30%.


Short Sales

Purpose: to profit from a decline in the price of a stock or security

Mechanics

  • Borrow stock through a dealer

  • Sell it and deposit proceeds and margin in an account

  • Closing out the position: buy the stock and return to the party from which is was borrowed


Short Sale - Initial Conditions

Dot Bomb1,000 Shares

50%Initial Margin

30%Maintenance Margin

$100Initial Price

Sale Proceeds$100,000

Margin & Equity 50,000

Stock Owed 100,000

What if price increases to 110?

How much can the stock price rise before a margin call?


Short Sale - Margin Call

How much can the stock price rise before a margin call?


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