Financial Markets FIN 3600: Chapter 5Timothy R. Mayes, Ph.D.
What is a Market? • A market is a public place where products or services are sold, either directly or through intermediaries. • Markets are important for a number of reasons: • They provide a place (either physical or virtual) for the trading of goods or services. • They provide for competition so that the best price may be found (this is called price discovery). • They provide liquidity.
Money vs. Capital Markets • Money Market – Short-term, high quality debt securities are traded here. These securities carry little or no default risk and have very little price risk due to their short maturities. • Capital Market – Long-term securities trade in the capital markets. These securities are subject to significant price risk, default risk, purchasing power risk, etc. due to their longer maturities.
Primary vs. Secondary Markets • Primary markets are where securities are initially sold. In this market the issuer receives the proceeds from the sale. • Once securities have been sold into the primary market, they begin trading in the secondary markets. In the secondary markets the seller of the securities receives the proceeds, not the issuer. • Primary markets would barely exist were it not for well functioning, efficient secondary markets. At the least, prices of securities would be far lower due to much higher required returns. How much would you pay for a security that you could never sell? • There are also third and fourth markets. The third market is comprised of trades in listed securities away from the exchange where they are listed. This is an institutional market. The fourth market refers to trades directly between buyers and sellers.
Organized vs. OTC Markets • Organized markets are those which have a physical location where all trading takes place. For example, the NYSE, Amex, and regional exchanges are organized markets. • Over the Counter (OTC) markets do not have physical locations. Instead, they are characterized by networks of dealers who are connected by telephone or computer networks. The Nasdaq is an example of an OTC market.
Investment Bankers • When securities are sold into the primary market, firms enlist the services of investment bankers. • Investment bankers provide three basic services to companies: • Advice and counsel (before and after the sale) • Underwriting • Distribution
Investment Banking Functions: Advice and Counsel • Investment bankers provide important advice on security issues, such as: • Pricing • Size of the offering • Timing of the offering • Type of security (debt or equity) • Special features (callability, convertibility, coupon rate, etc) • Additionally, investment bankers often consult on issues of corporate governance, such as mergers.
Investment Banking Functions: Underwriting • Once the company and investment banker agree as to the type of security, pricing, etc. the issue is ready to market. • The investment banker may either: • Underwrite the issue – here the investment banker purchases the issue and hopes to sell it at a higher price to the public (assumes price risk). This is also known as a “firm commitment.” • Act as an agent – Also known as a “best efforts” offering, the investment banker does not purchase the securities and merely markets them to the public. • Typically only small, relatively unknown firms agree to a best efforts offering.
Investment Banking Functions:Distribution • The final role of the investment banker is to actually sell the securities. • Typically, the originating investment banking firm will form an underwriting group (syndicate) to spread the price risk. • Next, a selling group consisting of the underwriting group and, perhaps, other brokerage firms is formed to sell the security. Each member of the selling group is given an allocation for which it is responsible. • The selling group then allocates its share of the securities among interested customers.
Investment Banking Functions:Distribution (cont.) • Before a new issue may actually be sold to investors, the originating underwriter must file a registration statement (Form S-1, or other Form S-x) with the Securities and Exchange Commission (SEC). • This preliminary prospectus (“red herring”) contains information about the firm, the type of security being offered, and the proposed use of the proceeds. • While it is being reviewed by the SEC, the preliminary prospectus is distributed to interested investors. • The exact pricing, and often quantity, of the issue is determined the night before the actual offering. • It is important to note that the SEC does not judge the quality of the issue and does not give investment advice. Its approval simply means that the prospectus meets all requirements concerning disclosure. • For some time after the securities are sold, the investment banker will often participate in price-stabilizing trades (if the market tries to drive the price down, the IB will often step in to buy, thereby propping up the price).
Largest Investment Bankers (2001) Source: Thomson Financial Securities Data Corp. in Business Week, July 30, 2001.
Domestic Stock Markets • In the U.S. we have three major stock exchanges: • The New York Stock Exchange (NYSE) • Nasdaq • The American Stock Exchange (Amex) • We also have several regional stock exchanges: • The Pacific Exchange (known mostly for options trading) • The Boston Stock Exchange • The Cincinnati Stock Exchange (all electronic, located in Chicago) • The Chicago Stock Exchange (formerly the Midwest Stock Exchange) • The Philadelphia Stock Exchange (known mostly for options trading) • Small companies, or those which do not meet listing requirements may be traded on the OTC Bulletin Board or in the Pink Sheets.
Domestic Stock Markets (cont.) • Additionally, in the past several years (mostly since 1997) many electronic communications networks (ECNs) have begun trading stocks, and some are seeking “exchange” status: • The Island • Archipelago (run by the Pacific Exchange) • Instinet • B-Trade (Bloomberg) • NexTrade • RediBook • ECNs offer such advantages as lower costs, anonymity, open limit order books, and after-hours trading.
The NYSE History • The New York Stock and Exchange Board began on 17 May 1792 under a buttonwood tree. Originally, 24 brokers signed the Buttonwood Agreement in which they agreed to trade only among themselves and at a fixed commission rate (fixed commissions were the rule until 1975). • In 1817 the exchange was moved into rented rooms at 40 Wall Street. They also wrote and approved a formal constitution. • In 1863, the name was changed to The New York Stock Exchange. • In 1903 the NYSE moved to its current home. • Today, the NYSE Group is a publicly traded company (NYSE: NYX).
Nasdaq History and Operation • The Nasdaq stock market began operations on 8 February 1971. Prior to that, the NASD had regulatory authority over a very fragmented OTC market. • Nasdaq originally, but no longer, stood for National Association of Securities Dealers Automated Quotation system. • Unlike the NYSE and AMEX, Nasdaq is not an open outcry auction market, and does not use specialists. Instead, it uses a system of market makers. • A market maker is a dealer who competes with others to get customer orders. The market maker posts his bid/ask quote on the system for all to see. • Today, the Nasdaq is a publicly traded company (Nasdaq: NDAQ).
Differences Between Market Makers and Specialists • The major difference between a specialist and a market maker is that a specialist is charged with maintaining an orderly market and is required to step in and buy when there are no buyers and sell when there are no sellers. Market makers may withdraw from the market at any time, though there are rules. • There is only one specialist for an NYSE stock, but there are usually multiple market makers for Nasdaq stocks.
AMEX History and Operation • The American Stock Exchange (Amex) was originally known as the New York Curb Market because it was based outside the NYSE and traded stocks that were not traded on the NYSE. • In 1921, the Curb was moved indoors. It was renamed in 1953. • The Amex is something of a poor stepchild to the NYSE and has struggled somewhat to survive. It has turned to technology and new products (options, ETFs, etc) to survive. • In 1998 the Amex was merged with the NASD, and today operates as an independent entity within the NASD.
Stock Market Indices and Averages • For more than 110 years, people have tracked the market’s daily ups and downs using various “indexes” of overall market performance • There are currently thousands of indices calculated by various information providers. Best known are: • Dow Jones & Co • Standard & Poor’s • Morgan Stanley Capital Markets (MSCI) • Lehman Brothers (bond indices) • Dow Jones alone currently publishes more than 3,000 indices
Stock Market Indices and Averages (cont.) • A short list of the major indices: • Dow Jones Industrial Average (DJIA) • Dow Jones Transportation Average (DJTA) • Dow Jones Utility Average (DJUA) • Standard & Poor’s 500 Index (S&P 500) • Standard & Poor’s 100 Index (S&P 100, or OEX) • Nasdaq Composite • Nasdaq 100 • Value Line Arithmetic Index • Value Line Geometric Index • Wilshire Total Market Index (formerly Wilshire 5000 index)
Types of Indices and Averages • There are essentially four methods of index or average construction: • Price Weighted • Capitalization Weighted • Equal Weighted Arithmetic • Equal Weighted Geometric • There are also some variations of these techniques. We will cover the basics.
Index Types: Price-weighted Average • A price-weighted average is calculated by adding up the prices of the index constituents and dividing by a divisor. • The divisor begins as the number of constituents, but will change over time (to maintain price continuity) as: • Constituents change • Stocks are split or pay a big stock dividend • Divisions are spun off
Index Types: Price-weighted Average (cont.) • The DJIA is the best-known price-weighted average. • It was created by Charles Dow on 17 May 1896, and originally contained only 12 stocks (industrial stocks were less important at the time than the railroads). • Today, General Electric is the only company left that was in the original average. • Today, the DJIA contains 30 stocks and the divisor is about 0.14418073. (17 September 2002) • Each 1 point change in a component therefore adds about 6.94 points to the value of the average.
Index Types: Price-weighted Average (cont.) • As an example of calculating a price-weighted average, consider our sample data. • On day 1, we start our average by adding up the prices and dividing by 3, to get a value of 42.67. • For day 2, we calculate the average the same way, and get a value of 43. • For day 3, ABC has split 2-for-1 necessitating a change in the divisor. The new divisor is calculated (using day 2 closing prices adjusted for the split) such that the average begins day 3 unchanged from day 2.
Index Types: Price-weighted Average (cont.) • To calculate the divisor: • Now, to calculate the average on day 3: • From now on, until another adjustment is required, the divisor will be 2.279.
Index Types:Capitalization-weighted • A capitalization-weighted index is weighted by the total value of the outstanding shares (price x shares) rather than stock price. • The best known cap-weighted index is the S&P 500 which contains 500 of the leading stocks in the U.S. markets (not necessarily the largest, though the S&P 500 is considered a large-cap index). • Currently, the total market value of the 500 stocks is over $8.23 trillion. The divisor is 9,237,672,206 (on 9/16/2002).
Index Types:Capitalization-weighted (cont.) • The current (9/25/2006) composition of the S&P 500 is shown below: Source: Standard & Poor’s
Index Types:Capitalization-weighted (cont.) • A capitalization-weighted index is calculated by dividing the total market cap of the stocks in the index by the index divisor. • The divisor is determined at inception by dividing the total market cap by the desired beginning level of the index. • The divisor will occasionally be adjusted for splits, changing constituents, spin-offs, etc.
Index Types:Capitalization-weighted (cont.) • As an example of calculating a capitalization-weighted average, consider our sample data. • Suppose that we want to set the initial index value at 100. First calculate the divisor, note that it is 239. • Now, calculate the index for each day. • Note that the split has no impact on the divisor.
Index Types:Equal-weighted • Both price-weighted and capitalization-weighted indices are affected most by certain stocks (either the highest priced, or the most valuable). • An equally-weighted index gives each stock equal weight, it is most affected by those that have the biggest percentage changes. • Value Line calculates two indices using equal weightings: • Value Line Geometric • Value Line Arithmetic • These indices both include about 1600 to 1700 stocks, and vary only in the type of averaging they use.
Index Types:Equal-weighted: Geometric Average • On June 30, 1961 Value Line introduced its Value Line Composite Index, which is an index of the geometric average of the percentage changes in its 1600 to 1700 stocks. • An equally-weighted geometric index is calculated with the following equation: • Where Indext-1 is the previous day’s index value, and Pj,t and Pj,t-1 are today’s price and yesterday’s price for stock j.
Index Types:Equal-weighted: Geometric Average • As an example, again consider our sample data. • First, we arbitrarily set the beginning index value to 100 or whatever value seems appropriate. • Next, calculate the percentage changes from the previous day, and calculate the geometric mean of these. • Finally, multiply by the previous day’s index value.
Index Types:Equal-weighted: Arithmetic Average • After complaints that the geometric index underestimated market performance relative to competing indices, on February 1, 1988 Value Line began calculating an arithmetic version of their index. • This index is calculated using the same data as the geometric index, but the method of averaging is different. • To calculate an equally-weighted arithmetic index use the following formula:
Index Types:Equal-weighted: Arithmetic Average • Once again, using the our sample data, and a day 1 index value of 100, the index on days 2 and 3 is: • Note that we have adjusted for the split within the calculation of the average return.
Summary of Index Calculations (cont.) • Notice that the total returns for each index are different, despite the fact that they are all measuring the “average” returns of the same group of stocks. • This is not a contrived situation. The different weighting schemes will always lead to different returns. • Note that the average price change of the three stocks is 1.88%, so it would seem that the equally-weighted arithmetic average is closest to what really happened. • However, one could easily argue that stocks with larger market caps are “more important” in the market, and therefore the cap-weighted index is better. • The least defensible of the indices is the price-weighted average. There is no reason to believe that higher priced stocks are any more important than lower priced stocks (especially because when they split, they are automatically “less important” even though there is no economic change). Price weighting was only chosen by Dow simply because it was very easy to calculate in the days before computers and calculators.