people.brandeis.edu

Securities Markets

Economics 71a

Spring 2007

Mayo, Chapter 3

Lecture notes 2.3

Outline

MarketsOrdersPositions Information

Markets

Primary markets New issues (IPO’s, corporate and public

debt)Secondary markets

Trading old stuff In many cases most activity in secondary

Money and Capital Markets

Money markets Short term securities (1 year or less)

Capital markets Longer term

Money Market Securities

Treasury bills U.S. government debt Short term (less than 1 year)

Commercial paper Short term corporate borrowing

Discount pricing Buy for $10, get paid $11 in future No interest payments

Capital Market Securities

Bonds (longer term borrowing) U.S. Treasury Municipal (tax free) Corporate More later

Capital Market Securities

Stocks Common stock Preferred stock International More later

Trading and Secondary Markets

Stock marketsBond marketsDerivativesForeign Exchange

U.S. Stock Markets

New York Stock Exchange (NYSE)National Association of Securities

Dealers Automated Quotation (Nasdaq) American Stock Exchange (AMEX)

Continuous Trading

Market types Specialist Electronic dealer Open outcry Over the counter

NASDAQ Upstairs (negotiated) ECN (electronic crossing network)

ECN’s: Electronic Crossing Networks

Internet based trade networks Customers can meet directly (no broker) Used mostly by professional money

managers Advantage: fewer intermediaries Disadvantage: less liquidity

(Fewer people to trade with)

Fastest growing markets

Other Markets

Futures/OptionsForeign Exchange

Spot versus forwardBond

International Markets

Many major international stock markets London Tokyo China many more

US accounts for only 36% of the companies listed on stock markets around the world

International Investments

Purchase stocks or bonds in foreign countries Purchase shares in foreign firms in U.S.

(American Depository Receipts) ($/English) Bonds can be issued in different currencies

Eurobond: Intel issues $ denominated bond in Japan

Trading Hours

Most U.S. stock markets 9:30-4:00

Extended hours on electronic trading networks

“After hours trading” International markets (local times) Foreign exchange markets (24 hours) Hours increasing : toward a 24 hour market

Outline

MarketsOrdersPositions Information

Types of Orders

Market orderLimit order

Market Order

Buy or sell at the current market priceNo restrictions“Buy 50 shares at market”

Limit Orders

Buy when price drops below a limit Sell when price moves above a limit Example

Limit buy at 50 (price at 60) Stock moves to 55 (nothing happens) Stock moves to 49 (order executed)

Advantage Might end up with a better price

Disadvantage Order might end up unfilled

Brokers

Enable trading of financial services Dealer function Access

Mail Phone Internet

Types of Brokers

Full service Extensive research Merrill Lynch

Premium discount Limited research Charles Schwab

Basic discount No research E*trade

Classification is difficult

Transaction Costs

CommissionsBid/ask spreads

Costs of Trading

Commissions Fixed Negotiated Varying structures (fixed + varying)

$20 + shares * C

Bid/ask spread Buy at the ask Sell at the bid

Bid/ask Spread

Example: Ask = 88.5 (buy) Bid = 88 (sell)

Spreads may change Over time Over stocks

Reveal the ease of trading a stock “Liquidity” again

Order Books

Order book List of current limit buy and sell orders

If you want to buy Can “hit” limit sell orders Walk up the book Higher price for more stock

If you want to sell Can “hit” limit buy orders Walk down the book

ECN’s and visible order books

Settlement and Delivery

Settlement dates Usually trade date + 3 days

Take delivery or leave shares with broker (street name)

Outline

MarketsOrdersPositions Information

Long Purchase

Straight purchase of a securitySpeculate that price will increase

Buy at 100 Sell at 110 10% return

Margin Purchase

“Buying on margin”Borrow money to buy stockBuy at 75% margin

75% of money in investment is yours 25% is borrowed from broker or bank

Purchase $100 of stock at 75% margin You put in $75, and you borrow $25

Basic Margin Formula

€

Margin =Total value −Borrowed funds

Total value

Margins and Magnification

Example stock: Price = $100 Up: Price = $150 Down: Price = $75

If you purchased with your own money $100 total investment Up: + $50 Down: - $25

Margins and Magnification

Buy on 50% margin (zero interest charges)

$100 own, and $100 borrowed (needs to be paid back)

Purchase $200/$100 shares = 2 shares $100 total investment Up: 2*150 - 100 - 100 = $100 (50) Down: 2*75 - 100 - 100 = $-50 (-25)

Margin Buying

Borrowing money to buy stocks Magnifies gains and losses Can lose more than you put in

Buy $200 of stock $100 your own $100 borrowed

Stock goes to zero Lose $100 of own investment, and Owe $100 of borrowed money too

Maintenance Margins

Margin required for investor to maintain If margin falls below this level investors

must add more of their own money“Margin call”Common margin call

Prices fall Margin rises Investor needs to come up with more funds

Margin Requirements

Common stock: 50%Bonds: 50%Options: 20% stock valueFutures: 2-10% of the contract value

Short Sales

Holding negative stock Sell stock you don’t have (borrow) Buy it back later Pay dividends yourself in between

Key issue Make money on a price fall Lose money on a rise

Betting against a stock

The Mechanics of a Short

Tell broker you want to sell 100 shares of IBM short (price = $50)

Broker “borrows” shares of 100 shares of IBM owned by another client

Sells it to someone for 50*100=5000, and pays this to you

You must keep this amount on account with broker

When dividends are to be paid, you pay broker, and broker pays the other client

The Mechanics of a Short

IBM goes down to $40 per share You “buy” your 100 shares to take you back to zero,

pay broker 40*100=4000. Broker buys at market, and puts the shares back in

the other person’s account You make 5000-4000 = 1000 (less dividends) Make money when price falls Lose money when price rises

The Mechanics of a Short

IBM goes up to $60 per share You “buy” your 100 shares to take you back to zero,

pay broker 60*100=6000. Broker buys at market, and puts the shares back in

the other person’s account You lose 5000-6000 = -1000 (less dividends)

Margins and Shorts

Broker requires additional funds to cover possible losses

Fraction of additional sale amount Example

Sell $5000 worth of stock at 50% margin Need to keep 1.5*5000 = 7500 on account with

the broker When the price goes up, need to increase this “Margin call”

Oddities About Shorts

Can lose unbounded amounts of money Normally only lose what you put in With short price can go up forever, and your losses keep

increasing

Also, broker can get in trouble if you default Other customer could lose original shares Often insured for this

Short Interest

Fraction of shares sold shortMeasure of market pessimism in a

stockCommon market indicatorMeasures market pessimism

Squeeze Play

Assume Microsoft has a large number of short sellers

Price starts to rise Short sellers losing money Get nervous Buy stock to close out their short positions Prices rise more, more buying .. (etc. etc)

Outline

MarketsOrdersPositions Information

Information Sources

Private Quicken and Yahoo finance Wall St. Journal (fee) Value line and Standard and Poors (fee) Brokerage firms Corporations

Government Federal Reserve SEC

Information Sources

Key publications Economic information

Federal reserve bulletins (economic info) Firm/investment data

Value Line Survey Standard and Poor’s Handbook Security firm reports Firm annual reports

The Internet and Investing

Cheap and accessible information Investor tools

Charts Screening Calculators

Online trading

Investment Information on the Web

News articles NY times CBS Market watch CNN financial

More Investment Information

Stock information Yahoo Google Quicken

Historical information Yahoo Datastream (fee) Bloomberg (fee)

Warnings on Internet Information

Don’t use information to trade to frequently

Don’t believe everything you see on the web

More (biased) Information

Firm annual reports and accounting infoAnalyst information

Analysts recommend (buy, sell, hold) Problems:

Firms often are biased in what they tell analysts Analysts are biased since stocks they analyze

can be their own clients

Internet Tools

Education www.investorguide.com www.fool.com www.smartmoney.com

Calculators www.financenter.com

Internet Tools

Stock screening Quicken Yahoo Google

Plotting/graphics bigcharts.com smartmoney.com

Market Indices

Summarize market movements Examples

Dow Jones Industrial (30 stocks) NYSE Composite S&P 500 Composite (500 stocks) NASDAQ Composite Nikkei (Japan) Wilshire 5000 Sector indices

Index Construction

Weighted sum

Weighting options Equal w = (1/N) Relative value of the firm (S&P, NASDAQ)

Value weighting Odd (Dow Jones)

€

Pt,I = w jPt , jj=1

N

∑

1= w jj=1

N

∑

Index Uses

Summary of the market Investor benchmark (performance

check) Compare own result to index

Investment target Index mutual fund

Index Problems

Index is not constant Additions and removals Changing weights

As stock increases in value, share in index increases

Index can drift towards growing sectors in the market