Chapter 18. The Common Stock Market - PowerPoint PPT Presentation

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Chapter 18. The Common Stock Market

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  1. Chapter 18. The Common Stock Market • Types of markets • Trading mechanics • Stock market indexes • Pricing efficiency

  2. Common stock • equity security • ownership • entitled to distributed earnings • entitled to share of assets

  3. I. Type of Markets • exchanges • OTC trading of • unlisted stocks & listed stocks • direct trading

  4. Exchanges • physical location for trading • trading by members • own a seat on the exchange • stock traded on exchange are listed stocks

  5. 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

  6. 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%)

  7. 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

  8. the future of the specialist • may be phased on with next 5-10 years • recent SEC fines for improper trading for several major firms

  9. AMEX • merged w/ Nasdaq 1998 • specializes in equity derivative securities and closed-end funds

  10. Regional exchanges • stocks may be listed on both NYSE and regional exchange • 5 regional exchanges • cheaper seat prices

  11. 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

  12. 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

  13. II. Trading Mechanics • types of orders • short selling • buying on the margin • institutional trading

  14. 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

  15. 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

  16. 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

  17. investor sets reservation price BUT • no guarantee that limit order will be executed

  18. 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

  19. investor does not have to watch market • but in a volatile market stop could be triggered prematurely -- end up trading unnecessarily

  20. 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”

  21. 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”

  22. 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

  23. 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

  24. 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

  25. 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)

  26. so short sellers • believe price will fall and SOON • but price not currently falling • face unlimited losses if price rises

  27. 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

  28. 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

  29. 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

  30. if prices falls to $12, • value of stock $12,000 • below 125% of $10,000 loan • get a margin call

  31. Institutional trading • vs. retail trades • institutional trades are larger • special execution • over 50% of NYSE share volume

  32. 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)

  33. program trades • large # shares, different stocks • used by mutual funds for asset allocation • want • low commissions • prevent frontrunning

  34. what is frontrunning? • brokers trade ahead of program trade • to benefit from anticipated price movements • due to large trade

  35. 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

  36. agency basis • brokers bid for trade by commission • low commission, but • frontrunning likely

  37. 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

  38. 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

  39. indexes differ due to • stocks included in the index • weighting of stocks • equal, price, value • average • arithmetic • geometric

  40. stock exchange index • includes all stocks listed on exchange • NYSE Composite • Nasdaq Composite • (both value weighted)

  41. subjectively selected index • organization picks group of stocks to measure • Dow Jones Industrial average • S&P 500

  42. DJIA • price weighted • 30 large blue chip companies • cross section of industries • leaders • large movements in DJIA may halt trading on NYSE

  43. S&P 500 • 500 large blue chip companies • value weighted • most popular benchmark for index funds

  44. 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

  45. 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?

  46. 3 levels of price efficiency • what are they? • implication? • evidence for U.S. stock markets?

  47. Weak form efficiency • current stock prices reflect • information about past prices • and trading history

  48. 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

  49. evidence • U.S. stock market is weak-form efficient • technical analysts do not beat the market • especially after trading costs