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Chapter 18. The Common Stock Market Types of markets Trading mechanics Stock market indexes Pricing efficiency Common stock equity security ownership entitled to distributed earnings entitled to share of assets I. Type of Markets exchanges OTC trading of

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chapter 18 the common stock market
Chapter 18. The Common Stock Market
  • Types of markets
  • Trading mechanics
  • Stock market indexes
  • Pricing efficiency
common stock
Common stock
  • equity security
    • ownership
    • entitled to distributed earnings
    • entitled to share of assets
i type of markets
I. Type of Markets
  • exchanges
  • OTC trading of
    • unlisted stocks & listed stocks
  • direct trading
exchanges
Exchanges
  • physical location for trading
  • trading by members
    • own a seat on the exchange
  • stock traded on exchange are listed stocks
slide5
NYSE
  • the “Big Board”
  • about 2800 listed U.S. companies
    • & 450 non-U.S. companies
  • $18 trillion market value (2/04)
  • 1366 seats (fixed)
    • seat price $2 million 2002
    • 10/2003 $1.35 million
slide6
stocks trade at post on the trading floor
    • 20 posts, trading about 100 stocks
  • each stock has one specialist
    • 10 specialist firms, 470 specialists
    • each specialist has 5-10 stocks
    • process trades from floor brokers (5%) and electronically (95%)
role of the specialist
role of the specialist
  • MUST maintain a fair and orderly market for stock
  • act as buyer or seller as needed (10% of trades)
  • match buyers and sellers
  • maintain order priority
the future of the specialist
the future of the specialist
  • may be phased on with next 5-10 years
  • recent SEC fines for improper trading for several major firms
slide9
AMEX
  • merged w/ Nasdaq 1998
  • specializes in equity derivative securities and closed-end funds
regional exchanges
Regional exchanges
  • stocks may be listed on both NYSE and regional exchange
  • 5 regional exchanges
  • cheaper seat prices
otc markets
OTC markets
  • electronic network of dealers all over the world
  • ECNs
    • electronic communication networks
  • more than one dealer per stock
    • not obligated to make a market
nasdaq
Nasdaq
  • not the only OTC system, but the largest
  • over 4000 companies listed
    • mkt. value $2 trillion (2/28/03)
  • leader in daily share volume
  • over 500 dealers
  • listing requirements
ii trading mechanics
II. Trading Mechanics
  • types of orders
  • short selling
  • buying on the margin
  • institutional trading
types of orders
Types of orders
  • instructions from investors to brokers
  • market order
    • buy/sell order to be executed at best price

-- get lowest price for buy order

-- get highest price for sell order

slide16
market order (cont.)
    • market orders given priority in trading
    • no guarantee of execution price

-- price could rise/fall from time order is placed to time it is executed

slide17
limit order
    • buy/sell order where investor specifies price range
    • “buy at $50 or less”
    • “sell at $52 or more”
    • specialist records orders in

limit order book

slide18
investor sets reservation price

BUT

  • no guarantee that limit order will be executed
slide19
stop order
    • order lies dormant
    • turns into market order when certain price (“the stop”) is reached
    • “buy if price rises to $60”
    • “sell if price falls to $58”

-- stop loss order

slide20
investor does not have to watch market
    • but in a volatile market stop could be triggered prematurely

-- end up trading unnecessarily

slide21
stop limit order
    • turns into limit order when stop is reached
    • “buy if price rises to $60, but only is executed at $65 or less”
slide22
market if touched order
    • turns into market order if certain price is reached
    • “buy if price falls to $55”
    • “sell if price rises to $62”
how long is an order good
how long is an order good?
  • fill or kill order
    • executed when reaches trading floor, or canceled
  • good until canceled/open order
    • is good indefinitely
order size
order size
  • round lots
    • lots of 100 shares
  • odd lots
    • less than 100 shares
    • more difficult to trade
  • block trades
    • 10,000 shares or $200,000 value
short selling
short selling
  • sale of borrowed stock
  • profit from belief that stock price is too high will fall soon
  • how?
    • borrow stock through broker
    • sell stock
    • buy and return later
slide26
short selling could further destabilize falling prices
    • tick test rules on exchange
  • short sales allowed if
    • uptick or zero uptick in price for previous trades:
    • $20.75, $21 (uptick)
    • $20.75, $20.75 (zero upick)
    • $20.75, $20 (downtick)
slide27
so short sellers
    • believe price will fall and SOON
    • but price not currently falling
    • face unlimited losses if price rises
buying on the margin
Buying on the margin
  • buyer borrows part of purchase price of stock, using stock as collateral
    • borrow at call money rate
  • Fed sets initial margin requirement
    • minimum cash payment
    • 50% since 1975
slide29
if stock price falls
    • collateral worth less
    • if collateral worth only 125% of loan (maintenance margin)

-- margin call

-- owner must put up more cash or sell stock

    • margin calls can worsen stock crash
example
example
  • 1000 shares, $20 per share
    • $20,000 cost
    • $10,000 cash, borrow $10,000
  • leverage
    • gains/losses on $20,000 capital
    • but tied up only $10,000 capital
slide31
if prices falls to $12,
    • value of stock $12,000
    • below 125% of $10,000 loan
    • get a margin call
institutional trading
Institutional trading
  • vs. retail trades
    • institutional trades are larger
    • special execution
    • over 50% of NYSE share volume
block trades
block trades
  • large # shares in one stock
  • executed in “upstairs” market
    • other firms directly take other side of trade
  • remainder executed on trading floor or Nasdaq (downstairs)
program trades
program trades
  • large # shares, different stocks
  • used by mutual funds for asset allocation
  • want
    • low commissions
    • prevent frontrunning
what is frontrunning
what is frontrunning?
  • brokers trade ahead of program trade
    • to benefit from anticipated price movements
    • due to large trade
example36
example
  • broker buys ahead of large buy order
    • broker buys first
    • large buy order pushes up price
    • broker’s holdings increase in value
  • result
    • frontrunning starts to push up price, so firm does not get best price
agency basis
agency basis
  • brokers bid for trade by commission
  • low commission, but
  • frontrunning likely
agency incentive agreement
agency incentive agreement
  • set benchmark value for trade
    • based on last day’s prices
  • if broker does better
    • gets commission + bonus
  • higher commission, but
  • frontrunning less likely
iii stock market indicators
III. Stock market indicators
  • measure average performance of a group of stocks
  • different indexes are highly correlated:
    • DJIA & S&P 500 .991 (1990s)
    • DJIA & NYSE .95
indexes differ due to
indexes differ due to
  • stocks included in the index
  • weighting of stocks
    • equal, price, value
  • average
    • arithmetic
    • geometric
stock exchange index
stock exchange index
  • includes all stocks listed on exchange
  • NYSE Composite
  • Nasdaq Composite
  • (both value weighted)
subjectively selected index
subjectively selected index
  • organization picks group of stocks to measure
  • Dow Jones Industrial average
  • S&P 500
slide43
DJIA
  • price weighted
  • 30 large blue chip companies
    • cross section of industries
    • leaders
  • large movements in DJIA may halt trading on NYSE
s p 500
S&P 500
  • 500 large blue chip companies
  • value weighted
  • most popular benchmark for index funds
objectively selected index
objectively selected index
  • inclusion of stock based on objective criteria
    • market value
  • Wilshire 5000
    • all publicly traded stocks
  • Russell 2000
    • largest 3000 companies, then take

smallest 2000 of those

iv pricing efficiency of the stock market
IV. Pricing Efficiency of the Stock Market
  • what information is reflected in current stock prices?
    • what implications does this have for active vs. passive investment strategies?
3 levels of price efficiency
3 levels of price efficiency
  • what are they?
  • implication?
  • evidence for U.S. stock markets?
weak form efficiency
Weak form efficiency
  • current stock prices reflect
    • information about past prices
    • and trading history
implication
implication
  • if markets are weak-form efficient
    • using past price/trading pattern to predict future stock prices will not work
    • so, technical analysis will fail to beat the market
evidence
evidence
  • U.S. stock market is weak-form efficient
  • technical analysts do not beat the market
    • especially after trading costs
semi strong form efficiency
Semi strong form efficiency
  • current stock prices reflect
    • all publicly available information

relevant to stock

-- economic data

-- financial statements

implication52
implication
  • using public info to predict future stock prices will not work
    • fundamental analysis will fail to beat market
evidence53
evidence
  • mixed
  • Yes
    • most actively managed portfolios do not outperform randomly selected portfolios
slide54
No.
    • certain pricing anomalies persist for long periods of time
    • January effect
    • size effect
strong form efficiency
Strong form efficiency
  • current stock prices reflect all information
    • public and private
implication56
implication
  • impossible to predict future stock prices
    • stock prices are a random walk
evidence57
evidence
  • U.S. stock market is not strong form efficient
  • why?
    • corporate insiders consistently outperform market
    • & they have access to private info
active strategy
active strategy
  • using fundamental or technical analysis to select stocks to buy/sell
  • growth, sector, value funds
  • trading on this info increases
    • trading costs
    • tax consequences
  • odds of working are low
passive strategy
passive strategy
  • believe market is efficient, just capture long-run returns of market
  • buy-and-hold diversified portfolio
    • index funds
  • lower expenses, defer taxes
  • index funds outperform most actively managed funds