Lecture Note 1 Introduction to Capital Markets; How Securities are Traded in the Markets
Capital Markets • Primary markets: for new issues. • Firms raise funds in primary markets. • Secondary markets: for existing securities. • Secondary markets provide liquidity. • Liquidity measures how easy it is to buy or sell securities. • Stocks vs. real estate assets • Large stocks vs. small stocks
The Role of the Stock Exchange • A stock exchange • Provides a (secondary) market place for the trading of securities; • Administers the listing requirements for firms listed; • Ensures the market is informed (disclosure requirements). • ASX is the national stock exchange in Australia.
ASX Listing Requirements • A minimum of $1m issued capital and at least 500 shareholders, each with a parcel of at least $2000 each; • An aggregate profit before tax for the past 3 years of at least $1m, or $0.4m in the last year before listing; Or should have net tangible assets of at least $2m.
US Stock Markets • There are seven stock exchanges in the US. The most influential one is the New York Stock Exchange (NYSE). Stocks traded on an exchange are called listed. • NASDAQ -- The automatic quotation system for the over-the-counter market. Most technology firms are traded here. • Partial requirements for listing in the NYSE and the Nasdaq can be found in Table 3.2 & Table 3.4.
Market Indexes • All Ordinaries Indexes (All-Ords): Share Price Index, Accumulation Index (or Total Return index). • Total return index includes both dividend income and capital appreciation • Dow Jones Industrial Average. • S & P 500. • NASDAQ Index. • MSCI (Morgan Stanley Capital International) indexes. • Bond Market Indicators.
Price-weighted vs. Market-value-weighted • Example: • Price-weighted: from 5.5 to 6, ==> 9.09%. • Mkt-value-weighted: from 350 to 440, ==> 25.71%.
How to Handle Stock Split? • It won’t affect the market-value-weighted indexes. • If ABC were to split two for one, then P1’= $4, but the total shares = 200. • To keep the price-weighted average increase at 9.09%, the new divisor should be (4+4)/d = 6. d = 1.3333, down from 2.
Brokering vs Dealing • A dealer maintains inventory. She earns her living from the difference between her buying price (bid price) and her selling price (ask price). A dealer exposes herself to price risk. • The difference between the bid and ask prices is called the bid-ask spread, which is a measure of liquidity. • A broker does not maintain inventory: gains commission on each transaction he makes. • Some brokerage houses are full service shops, others are discounters. • Internet trading offers deep discount in commissions.
Orders of Trades • Market Order (quantity alone): an order to buy or sell at a price which will complete the transaction promptly. • Limited Order (quantity and price): an order to buy or sell at a specified price or better. • Good-for-day • Good-till-cancelled
Stop Loss Order • Stop-loss order: an order not to be executed unless the stock hits a price limit. • It is similar to a limit order except the execution is in the opposite direction. • It is often used as a portfolio insurance strategy.
How are Shares Traded? • In the Australian Stock Exchange (ASX), the market is order driven. • All share trading is conducted through stockbrokers’ computer terminals using a system called SEATS (Stock Exchange Automated Trading System). • The SEATS matches buy orders with sell orders. Large trades by institutions (block transactions) can be done off the market at mutually agreed prices.
An Example of the Limit-Order Book • Suppose the following orders have been recorded: • Note: the bid-ask spread is said to be at $3.05-$3.06 in the order driven market such as the ASX.
How are Orders Filled? • If there is a market order to buy 3000 shares, then the order is filled at $3.06. • Seconds later, another market buy order for 3000 shares is in, then this buyer will get the first 1000 shares at $3.06, and the remaining shares at $3.08 per share. • Note: the order book changes constantly as new orders come in.
NYSE and Specialist • The NYSE is a specialist system. A specialist is a broker as well as a dealer. • There are only seven specialist firms now in the NYSE. • The specialist has to set the bid-ask spread and to prepare to trade from his own account at any time to maintain market liquidity.
Specialist’s Role • A specialist has to put his own bid-ask spread. His duty is to give investors the best price available. • In our example, suppose he quotes the spread $3.05-$3.07. Then when the second market buy order comes in, the order will be filled at $3.06 for the first 1000 shares, and $3.07 for the remaining shares. • Only a small percentage of trades is actually going through the specialist. • The role of floor traders and the value of “seats” • Block trades
NASDAQ • The NASDAQ is an automated quotation system for over-the-counter stocks in the U.S. • Dealers compete business with their own bid-ask quotes. The NASDAQ market is heavily represented by technology firms. • Many Australian firms are listed either in the NYSE or the NASDAQ markets (i.e. American Depository Receipts or ADRs) for the ease of raising capital in the U.S. • For example, NAB, Telstra, Orbital Engine are traded on the NYSE, while Amcor, Santos are traded on the NASDAQ, see http://www.ssga.com/library/resh/vtalaganaradrsaustralianstocks20040827/page.html for a partial list.
How are Bonds Traded? • In the U.S., some corporate bonds from large companies are traded on stock exchanges. Government bonds and other corporate bonds are traded on over-the-counter markets. • In Australia, although the ASX lists a number of corporate bonds, trades in these interest rate securities are usually thin.
Buying on Margin • You can borrow money from your brokers to invest in the share market. Buying on margin increases the expected returns as well as risk in your portfolio. • Initial margin: the percentage of your own money in the initial portfolio. • Maintenance margin: below which you will get the margin call from your broker, requiring you to put more money into the margin account.
An Example of Margin Call • An investor pays $6,000 toward the purchase of 100 shares of XYZ at $100 per share, borrowing the rest from the broker. • Suppose the maintenance margin is 30%, when will the investor get a margin call if the price drops?
Short Sales • A short sale allows investors to borrow shares of stock from a broker and sells it. • Short sellers must return the shares and pay the lender of the security any dividends paid during the short sale. • If you speculate that the stock price will fall, then you may short. “Sell high and then buy low.” • There is also a margin requirement for short sellers.
An Example of Short Sale • Suppose you want to short sell 1000 shares of XYZ at a price of $100/share. Suppose the broker has a 50% margin requirement. Then you have to deposit $50,000 in your account with the broker. • Assume the maintenance margin is 30%, when will you get a margin call if the price rises?
Trading Costs • Explicit costs: • commissions paid to brokers • capital gains tax • Implicit costs: • bid-ask spread • market impact • opportunity cost such as missed opportunity for limit orders, which is difficult to measure