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Securities Markets

Securities Markets. The Role of Financial Markets. Money markets: debt type securities with maturity up to one year Capital Markets: everything else Stock Markets Bonds (Fixed Income Markets): bonds, loans, notes, securitizations Financial Derivatives: Futures, Options, Swaps

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Securities Markets

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  1. Securities Markets

  2. The Role of Financial Markets • Money markets: debt type securities with maturity up to one year • Capital Markets: everything else • Stock Markets • Bonds (Fixed Income Markets): bonds, loans, notes, securitizations • Financial Derivatives: Futures, Options, Swaps • Foreign Exchange markets

  3. Primary vs Secondary Markets • New securities are issued with the help of investment banks (or underwriter) • New issues are sold on the primary market first, and subsequently sell on the secondary market. • The secondary markets are the security exchanges. • The selling of shares for the first time in a new company is called a initial public offering (IPO) • A private placement means new securities are sold directly to investors, bypassing the open market • Registration not required

  4. Underwriting • Investment banks: advise or underwrite new issues; distribute shares to institutional investors through road shows • For Large Issues, a Syndicate is Used • Hot Issue Market • During some periods, over 50 news firms go public every month. • Many investors want these shares • Initial returns are high • Who gets shares? • Those who want shares ask their broker. • When more shares are sought, than are being issued, priority tends to go to the large shareholders and the broker’s best clients. • If you are a small-money investor and receive shares of an IPO, look out, it may be a lemon!

  5. Secondary Markets • Markets where investors trade previously issued securities • Auction markets involve bidding in a specific physical location (example NYSE) • Brokers represent investors for a fee • Others trade for their own account • Negotiated markets consist of decentralized dealer network (example NASDAQ, Bond markets, FX markets)

  6. Equity Markets • New York Stock Exchange • An Agency Auction Market • Market in which brokers represent buyers and sellers and prices are determined by supply and demand. • Trading • All trading in a specific stock is done at the post where that stock is assigned on the NYSE floor. • Trading is managed by the specialist.

  7. Nasdaq • Electronic market • NASDAQ National Market • NASDAQ SmallCap Market • Negotiated market • Market makers are dealers • They quote bid-ask prices (ask is greater than bid) • Bid: price dealer/market maker buys • Ask: price dealer/market maker sells

  8. Over-the-Counter Markets • Network of dealers standing ready to either buy or sell securities at specified prices • Dealers profit from spread between buy and sell prices • Handle unlisted securities • NasdaqSmallCap Market • 800 small firms seeking Nasdaq market maker sponsorship • No penny stocks (price < $1) • Over-the-Counter Bulletin Board • 3,000+ securities offered by 300+ market makers • Penny stocks traded here • Electronic Communication Networks (ECNs) • Electronic market for institutional investors to trade with each other • ECNs handle the after hours trading too

  9. Equity Market Indicators/Indices • Provide a composite report of market behavior on a given day • Price Weighted: Dow Jones Industrial Average • Value Weighted: S&P500

  10. Brokerage Operations • Brokerage firms earn commissions on executed trades, sales loads on mutual funds, profits from securities sold from inventory, underwriting fees and administrative account fees • Full-service brokers offer order execution, information on markets and firms, and investment advice • Discount brokers offer order execution

  11. Account Types • Cash account: Investor pays 100% of purchase price for securities • Margin account: Investor borrows part of the purchase price from the broker • Cash management account • Checks can be written against account’s assets • Wrap account: Brokers match investors with outside money managers • All costs, fees wrapped into one

  12. Orders in OTC Markets • Dealers ready to either buy or sell • Bid price is highest offer price to buy • Ask price is lowest price willing to sell • Ask price - Bid price >0 (dealer spread) • “Makes a market” in the security • More than one dealer for each security in over-the-counter markets

  13. Types of Orders • Market orders: Authorizes immediate transaction at best available price “Buy 50 shares of Home Depot at market” • Limit orders: Specifies a particular market price before a transaction is authorized • How long to wait? • Fill or kill • Day order • Good ‘til canceled • “Sell 100 shares of IBM at $82.70 or better, today” • “Buy 200 shares of Dell at $30.72 or better, fill or kill”

  14. Types of Orders • Stop orders: Specifies a particular market price at which a market order is authorized - Stop Loss order: Placing an order to sell when a stock falls to a specific price. • Most settlement dates are three business days after the trade date

  15. Impact on Return • A study of 1,607 investors which moved from discount broker to online broker. • Before going online: • average turnover was 70% • beat the market by 2.4% per year • After going online: • turnover jumped to 120% • under performed the market by 3.5% per year Brad Barber and Terrance Odean, 2002, “Online Investors: Do the Slow Die First?” Review of Financial Studies, 15, 455-487.

  16. Margin Accounts • To open margin account, exchanges set minimum required deposit of cash or securities • Investor then pays part of investment cost, borrows remainder from broker • Margin is percent of total value that cannot be borrowed from broker • Federal Reserve sets the minimum initial margin on securities • Unchanged since 1974 at 50% • Actual margin at any time cannot go below the maintenance margin level set by exchanges, brokers • Investor’s equity changes with price • Margin call when equity below maintenance level

  17. Margin Accounts • Margin is percent of total value that cannot be borrowed from broker • Initial Margin: Amount investor put up/ Value of the account • Ex: if the initial margin is 60%, and an investor wants to buy (transact) $10,000 of stock he needs to post $6,000 his money and borrow from broker $4,000 • Maintenance margin: percentage of investor’s equity on hand at all times

  18. Margin account • Consider that you borrowed $10,000 to buy $20,000 of stock. • If the value of the stock increases to $25,000, what is your margin? • If the value of the stock declines to $15,000, what is your margin?

  19. Leverage, the reason to use margin • Using margin magnifies the realized return. • Example: • buy 200 shares at $40 per share ($8,000 total) • Use $4,000 or your own money and borrow $4,000. • What is your return if the stock rises to $44? (a 10% increase) • Solution: • Profit is ($44 - $40) × 200 = $800 • Return is $800 / $4,000 = 20% • A 20% return from a stock that increased 10%!

  20. Leverage, the reason NOT to use margin • Using margin magnifies the realized return. • Example: • buy 200 shares at $40 per share ($8,000 total) • Use $4,000 or your own money and borrow $4,000. • What is your return if the stock falls to $34? (a 15% decline) • Solution: • Loss is ($34 - $40) × 200 = -$1,200 • Return is -$1,200 / $4,000 = -30% • A -30% return from a stock that declined -15%!

  21. Short selling: Profiting from falling stock prices • The simple rule of “buy low, sell high” works well when prices are increasing. • When prices are falling, can you “sell high, buy low?” • Selling short (or short selling) • By executing a short sale, the investor sell stock that they do not own (by borrowing it from the brokerage). • Later, after the price falls (hopefully!) the stock is repurchased (called covering the short) and given back to the broker.

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