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Lecture Note 1 Introduction to Capital Markets; How Securities are Traded in the Markets Capital Markets Primary markets: for new issues. Firms raise funds in primary markets. Secondary markets: for existing securities. Secondary markets provide liquidity .

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Lecture Note 1

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Lecture Note 1

Introduction to Capital Markets;

How Securities are Traded in the Markets


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Capital Markets

  • Primary markets: for new issues.

    • Firms raise funds in primary markets.

  • Secondary markets: for existing securities.

    • Secondary markets provide liquidity.

  • Liquidity measures how easy it is to buy or sell securities.

    • Stocks vs. real estate assets

    • Large stocks vs. small stocks


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The Role of the Stock Exchange

  • A stock exchange

    • Provides a (secondary) market place for the trading of securities;

    • Administers the listing requirements for firms listed;

    • Ensures the market is informed (disclosure requirements).

  • ASX is the national stock exchange in Australia.


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ASX Listing Requirements

  • A minimum of $1m issued capital and at least 500 shareholders, each with a parcel of at least $2000 each;

  • An aggregate profit before tax for the past 3 years of at least $1m, or $0.4m in the last year before listing; Or should have net tangible assets of at least $2m.


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US Stock Markets

  • There are seven stock exchanges in the US. The most influential one is the New York Stock Exchange (NYSE). Stocks traded on an exchange are called listed.

  • NASDAQ -- The automatic quotation system for the over-the-counter market. Most technology firms are traded here.

  • Partial requirements for listing in the NYSE and the Nasdaq can be found in Table 3.2 & Table 3.4.


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Market Indexes

  • All Ordinaries Indexes (All-Ords): Share Price Index, Accumulation Index (or Total Return index).

    • Total return index includes both dividend income and capital appreciation

  • Dow Jones Industrial Average.

  • S & P 500.

  • NASDAQ Index.

  • MSCI (Morgan Stanley Capital International) indexes.

  • Bond Market Indicators.


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Price-weighted vs. Market-value-weighted

  • Example:

  • Price-weighted: from 5.5 to 6, ==> 9.09%.

  • Mkt-value-weighted: from 350 to 440, ==> 25.71%.


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How to Handle Stock Split?

  • It won’t affect the market-value-weighted indexes.

  • If ABC were to split two for one, then P1’= $4, but the total shares = 200.

  • To keep the price-weighted average increase at 9.09%, the new divisor should be (4+4)/d = 6.

    d = 1.3333, down from 2.


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Brokering vs Dealing

  • A dealer maintains inventory. She earns her living from the difference between her buying price (bid price) and her selling price (ask price). A dealer exposes herself to price risk.

    • The difference between the bid and ask prices is called the bid-ask spread, which is a measure of liquidity.

  • A broker does not maintain inventory: gains commission on each transaction he makes.

    • Some brokerage houses are full service shops, others are discounters.

    • Internet trading offers deep discount in commissions.


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Orders of Trades

  • Market Order (quantity alone): an order to buy or sell at a price which will complete the transaction promptly.

  • Limited Order (quantity and price): an order to buy or sell at a specified price or better.

    • Good-for-day

    • Good-till-cancelled


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Stop Loss Order

  • Stop-loss order: an order not to be executed unless the stock hits a price limit.

  • It is similar to a limit order except the execution is in the opposite direction.

  • It is often used as a portfolio insurance strategy.


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How are Shares Traded?

  • In the Australian Stock Exchange (ASX), the market is order driven.

  • All share trading is conducted through stockbrokers’ computer terminals using a system called SEATS (Stock Exchange Automated Trading System).

  • The SEATS matches buy orders with sell orders. Large trades by institutions (block transactions) can be done off the market at mutually agreed prices.


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An Example of the Limit-Order Book

  • Suppose the following orders have been recorded:

  • Note: the bid-ask spread is said to be at $3.05-$3.06 in the order driven market such as the ASX.


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How are Orders Filled?

  • If there is a market order to buy 3000 shares, then the order is filled at $3.06.

  • Seconds later, another market buy order for 3000 shares is in, then this buyer will get the first 1000 shares at $3.06, and the remaining shares at $3.08 per share.

  • Note: the order book changes constantly as new orders come in.


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NYSE and Specialist

  • The NYSE is a specialist system. A specialist is a broker as well as a dealer.

    • There are only seven specialist firms now in the NYSE.

  • The specialist has to set the bid-ask spread and to prepare to trade from his own account at any time to maintain market liquidity.


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Specialist’s Role

  • A specialist has to put his own bid-ask spread. His duty is to give investors the best price available.

  • In our example, suppose he quotes the spread $3.05-$3.07. Then when the second market buy order comes in, the order will be filled at $3.06 for the first 1000 shares, and $3.07 for the remaining shares.

  • Only a small percentage of trades is actually going through the specialist.

    • The role of floor traders and the value of “seats”

    • Block trades


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NASDAQ

  • The NASDAQ is an automated quotation system for over-the-counter stocks in the U.S.

  • Dealers compete business with their own bid-ask quotes. The NASDAQ market is heavily represented by technology firms.

  • Many Australian firms are listed either in the NYSE or the NASDAQ markets (i.e. American Depository Receipts or ADRs) for the ease of raising capital in the U.S.

    • For example, NAB, Telstra, Orbital Engine are traded on the NYSE, while Amcor, Santos are traded on the NASDAQ, see http://www.ssga.com/library/resh/vtalaganaradrsaustralianstocks20040827/page.html for a partial list.


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How are Bonds Traded?

  • In the U.S., some corporate bonds from large companies are traded on stock exchanges. Government bonds and other corporate bonds are traded on over-the-counter markets.

  • In Australia, although the ASX lists a number of corporate bonds, trades in these interest rate securities are usually thin.


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Buying on Margin

  • You can borrow money from your brokers to invest in the share market. Buying on margin increases the expected returns as well as risk in your portfolio.

  • Initial margin: the percentage of your own money in the initial portfolio.

  • Maintenance margin: below which you will get the margin call from your broker, requiring you to put more money into the margin account.


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An Example of Margin Call

  • An investor pays $6,000 toward the purchase of 100 shares of XYZ at $100 per share, borrowing the rest from the broker.

  • Suppose the maintenance margin is 30%, when will the investor get a margin call if the price drops?


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Short Sales

  • A short sale allows investors to borrow shares of stock from a broker and sells it.

  • Short sellers must return the shares and pay the lender of the security any dividends paid during the short sale.

  • If you speculate that the stock price will fall, then you may short. “Sell high and then buy low.”

  • There is also a margin requirement for short sellers.


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An Example of Short Sale

  • Suppose you want to short sell 1000 shares of XYZ at a price of $100/share. Suppose the broker has a 50% margin requirement. Then you have to deposit $50,000 in your account with the broker.

  • Assume the maintenance margin is 30%, when will you get a margin call if the price rises?


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Trading Costs

  • Explicit costs:

    • commissions paid to brokers

    • capital gains tax

  • Implicit costs:

    • bid-ask spread

    • market impact

    • opportunity cost such as missed opportunity for limit orders, which is difficult to measure


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