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Chapter Three

Chapter Three. PARTICIPATING IN THE MARKET. © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. McGraw-Hill/Irwin. Measures of Price Performance: Market Indexes Indexes and Averages. Dow Jones Averages Standard & Poor Indexes Value Line Average Other Market Indexes.

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Chapter Three

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  1. Chapter Three PARTICIPATING IN THE MARKET © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. McGraw-Hill/Irwin

  2. Measures of Price Performance: Market IndexesIndexes and Averages • Dow Jones Averages • Standard & Poor Indexes • Value Line Average • Other Market Indexes

  3. Buying and Selling in the Market • Cash or Margin Account • Long or Short?–That Is The Question Types of Orders Cost of Trading Taxes and the 2003 Tax Act • Capital Gains and Dividends

  4. MEASURES OF PRICE PERFORMANCE COMPARE WITH MARKET INDEXESPlease click on the icon for more information on the indexes www.standardandpoors.com www.nasdaq.com www.russell.com

  5. Index • Statistical indicator providing a representation of the value of the securities which constitute it. Indexes often serve as barometers for a given market or industry and benchmarks against which financial or economic performance is measured.

  6. INDEXES AND AVERAGES • Dow Jones Averages • www.dj.com • Standard & Poor’s Indexes • www.standardpoors.com • Value Line Average • www.valueline.com • Other Market Indexes • www.nasdaq.com • National Association of Securities

  7. Dow Jones Averages • Industrial (DJIA) • Transportation (DJTA) • Utilities (DJUA) Averages are maintained and reviewed by editors of The Wall Street Journal. For the sake of continuity, composition changes are rare, and generally occur only after corporate acquisitions or other dramatic shifts in a component's core business. When such an event necessitates that one component be replaced, the entire index is reviewed. As a result, multiple component changes are often implemented simultaneously

  8. Dow Jones Averages - continued • There are no rules for component selection, a stock typically is added only if it has • an excellent reputation • demonstrates sustained growth • is of interest to a large number of investors • accurately represents the sector(s) covered by the average

  9. DJIA continued • DJTA include only transportation stocks • DJUA include only utilities stocks • DJIA not limited to traditionally defined industrial stocks • Serves as a measure of the entire U.S. market, covering such diverse industries as • financial services • technology • retail • entertainment • consumer goods

  10. Calculation of DJIA • Unique • price weighted • NOT market capitalization weighted • Component weightings affected only by changes in the stocks' prices • NOT (in contrast with other indexes‘) weightings that are affected by both price changes and changes in the number of shares outstanding • Initially, their values were calculated by simply adding up the component stocks' prices and dividing by the number of components • Later, adjusting the divisor was initiated to smooth out the effects of stock splits and other corporate actions • The current divisor values are as follows: DJIA 0.13561241, DJTA 0.22477839, and DJUA 1.5940823

  11. DOW JONES INDUSTRIAL AVERAGE - DJIA • The most popular index • 30 large industrial companies • “blue-chip” index i.e. stocks of very high quality • Price-weighted average • Follow the general trend of the market • Comprise more than 25% of market value of the 3,000 firms listed on the NYSE • Bias toward high priced stocks www.djindexes.com

  12. Standard & Poor’s Indexes • S&P 500 – a measure of broad stock market activity (about 75% of the total value of the 3,000 firms listed on the NYSE • Used by: • professional money managers • Security market researchers

  13. S&P 400 MidCap Index • Composed of • 400 middle-sized firms • Firms with market values between $1.2 billion and $9 billion versus S&P 500 which shows the performance of large firms like Microsoft – stock symbol MSFT, market value $300 billion in January 2004

  14. Other S&P Indexes • S&P 600 SmallCap Index • Companies smaller that MidCap • S&P 1500 combines • S&P 500 • S&P 600 & • S&P 400 • S&P 100 • 100 blue-chip stocks • For which CBOE has individual option contracts

  15. The Complete List 100 Stocks in NAZDAQ-100 Please click on the following Hyperlink for the complete list NASDAQ-100 (the index itself) • The Index reflects Nasdaq's largest growth companies across major industry groups. All index components have a minimum market capitalization of $500 million, and an average daily trading volume of at least 100,000 shares

  16. The shadow of the Index • The Nasdaq 100 Index Tracking Stock (symbol) QQQQ is an Exchange Traded Fund which allows investors to essentially invest in all of the stocks that make up the Nasdaq 100 in a single security

  17. This graph shows how closely the shadow QQQ follows the Nasdaq

  18. Application Example • Standard & Poor’s Indexes • value-weighted indexes • each company weighted by its total market value as a percentage of the total market value for all firms Example – a value-weighted index comprising of three firms A, B, and C the weighting is shown on the next slide

  19. Application ExampleValue-weighted Indexes

  20. Value Line Average • 1,700 companies from NYSE, AMEX, and NASDAQ • Equal-weighted index • Weighted equally • Regardless of market price or total market value • Equal-weighting more closely conforms to the portfolio of individual investors

  21. Other Market Indexes

  22. Other Countries Every major country has an index that represents its stock exchange. Here are some of the more important indexes around the world: • FTSE 100 - United Kingdom • Hang Seng - Hong Kong • Nikkei - Japan • DAX – Germany (Frankfurt DAX) • TSX - Canada • CAC 40 France

  23. Important Consideration of looking at an INDEX • How much the index has changed over a given period of time • Hours (intraday) • Day • Week • Month • Quarter • Semi-annual • Year(s)

  24. Bond Market Indicators • Not widely followed by • Index or • Average • Gauged by • Interest-rate movements Rising interest rates falling bond prices Falling interest rates rising bond prices

  25. Other Categories of Bonds • Treasury Securities • Treasury notes • Treasury Bills • Treasury Bonds • Corporate debt • Mortgaged-backed securities • Municipal Bonds • Eurobonds

  26. Mutual Fund Averages • Mutual funds • Preferred choice of investment for many investors in the U.S. & worldwide • Commitment to mutual funds • Necessity of understanding the underlying • Stocks • Bonds

  27. Buying and Selling in the Market • Using full service brokers, e.g. • Merrill Lynch • Salmon Smith Barney • UBS Paine Webber • Broker must determine investors’ objective • Conservative – preservation of capital • Income • Growth plus income • Growth • Risk versus (expected) return

  28. Buying and Selling in the Market -continued • Using discount brokers • Using online brokers • Charge very low commissions • Give stripped-down service • No investment advice • Communications usually by emails

  29. Cash or Margin Account • Cash account Full payment • Margin account Pay a percentage • Settlement in three (3) business days for both type of account • Margin percentage set by the Federal Reserve Bank • Used to control speculation • 10% in 1920s • 80% in 1968 • 50% since 1974

  30. Long or Short? – That is the Question

  31. Types of Orders • Market order – usually trade close to the last price • Limit orders • When buying – pay NO more than the limit price • When selling – receive no less than the limit price • Stop order -an order to buy or sell a stock once the price of the stock reaches a specified price, known as the stop price. When the specified price is reached, the stop order becomes a market order

  32. Length of Time for Executing Orders to Buy/Sell Securities • Day orders – expire at the end of the day • Good till canceled (GTC) - order to buy or sell a security that is good until the investor decides to cancel it • Most brokerage firms let GTC orders automatically expire after 30 - 60 days

  33. Cost of Trading • Full-service brokerage • Merrill Lynch • UBS PaineWebber • Morgan Stanley Dean Witter • Discount brokers • Charles Schwab • Quick &Reilly • Olde • Online brokers • Ameritrade • E-trade

  34. Effects of Pricing Differential Example: 100 shares traded at $40/share i.e. total of $4,000

  35. Other Factors to Consider before Choosing the Type of Brokerage Service • Degree of sophistication of the investor • Degree of complexity of the investment • Capital gains tax implications • Potential merger offers • Retirement planning • Estate planning • ALL the above may outweigh savings in commissions

  36. The Merits and Drawbacks of Internet & Online Trading

  37. Taxes and the 2003 Tax Act • Legal tax advice provided only by a CPA or CFP (Certified Financial Planner) • Tax considerations could outweigh savings on brokerage commissions Please click on the following icon for a summary of the 2003 Tax Act www.turbotax.com

  38. Calculating the Marginal Tax RatesExample: Single - taxable income of $34,000

  39. Calculating the Average TaxExample: Single - taxable income of $34,000 • Amount of taxes paid • Divided by taxable income Taxes paid $5,310.10 Taxable income $34,000.00 Average Tax Rate = 15.62% =

  40. Capital Gains and Dividends • Capital gain or loss • Asset held for investment purposes • Sold Asset held for more than one year Long-term capital gain Max tax rate on dividends 15%

  41. Comparing Taxes Long-term Capital Gains versus Short-term Capital Gains

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