The common stock market ppt @ mba finance

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The Common Stock Market

Types of markets Trading mechanics Stock market indexes Pricing efficiency

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Common stock

equity security ownership entitled to distributed earnings entitled to share of assets

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I. Type of Markets

exchanges OTC trading of

unlisted stocks & listed stocks direct trading

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Exchanges

physical location for trading trading by members

own a seat on the exchange

stock traded on exchange are listed stocks

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NYSE

the “Big Board” about 2800 listed U.S. companies

& 450 non-U.S. companies

$18 trillion market value (2/04) 1366 seats (fixed)

seat price $2 million 2002 10/2003 $1.35 million

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stocks trade at post on the trading floor 20 posts, trading about 100 stocks

each stock has one specialist 10 specialist firms, 470 specialists each specialist has 5-10 stocks process trades from floor brokers (5%) and

electronically (95%)

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role of the specialist

MUST maintain a fair and orderly market for stock

act as buyer or seller as needed (10% of trades) match buyers and sellers maintain order priority

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the future of the specialist

may be phased on with next 5-10 years recent SEC fines for improper trading for

several major firms

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AMEX

merged w/ Nasdaq 1998 specializes in equity derivative securities and

closed-end funds

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Regional exchanges

stocks may be listed on both NYSE and regional exchange

5 regional exchanges cheaper seat prices

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OTC markets

electronic network of dealers all over the world

ECNs electronic communication networks

more than one dealer per stock not obligated to make a market

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Nasdaq

not the only OTC system, but the largest over 4000 companies listed

mkt. value $2 trillion (2/28/03)

leader in daily share volume over 500 dealers listing requirements

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II. Trading Mechanics

types of orders short selling buying on the margin institutional trading

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Types of orders

instructions from investors to brokers market order

buy/sell order to be executed at best price

-- get lowest price for buy order

-- get highest price for sell order

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market order (cont.) market orders given priority in trading no guarantee of execution price

-- price could rise/fall from time order is placed to time it is executed

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limit order buy/sell order where investor specifies price range “buy at $50 or less” “sell at $52 or more” specialist records orders in

limit order book

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investor sets reservation price

BUT no guarantee that limit order will be executed

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stop order order lies dormant turns into market order when certain price (“the

stop”) is reached “buy if price rises to $60” “sell if price falls to $58”

-- stop loss order

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investor does not have to watch market but in a volatile market stop could be triggered

prematurely

-- end up trading unnecessarily

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stop limit order turns into limit order when stop is reached “buy if price rises to $60, but only is executed at

$65 or less”

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market if touched order turns into market order if certain price is reached “buy if price falls to $55” “sell if price rises to $62”

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how long is an order good?

fill or kill order executed when reaches trading floor, or canceled

good until canceled/open order is good indefinitely

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order size

round lots lots of 100 shares

odd lots less than 100 shares more difficult to trade

block trades 10,000 shares or $200,000 value

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short selling

sale of borrowed stock profit from belief that stock price is too high

will fall soon how?

borrow stock through broker sell stock buy and return later

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short selling could further destabilize falling prices tick test rules on exchange

short sales allowed if uptick or zero uptick in price for previous trades: $20.75, $21 (uptick) $20.75, $20.75 (zero upick) $20.75, $20 (downtick)

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so short sellers believe price will fall and SOON but price not currently falling face unlimited losses if price rises

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Buying on the margin

buyer borrows part of purchase price of stock, using stock as collateral borrow at call money rate

Fed sets initial margin requirement minimum cash payment 50% since 1975

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if stock price falls collateral worth less if collateral worth only 125% of loan

(maintenance margin)

-- margin call

-- owner must put up more cash or sell stock margin calls can worsen stock crash

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example

1000 shares, $20 per share $20,000 cost $10,000 cash, borrow $10,000

leverage gains/losses on $20,000 capital but tied up only $10,000 capital

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if prices falls to $12, value of stock $12,000 below 125% of $10,000 loan get a margin call

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Institutional trading

vs. retail trades institutional trades are larger special execution over 50% of NYSE share volume

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block trades

large # shares in one stock executed in “upstairs” market

other firms directly take other side of trade

remainder executed on trading floor or Nasdaq (downstairs)

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program trades

large # shares, different stocks used by mutual funds for asset allocation want

low commissions prevent frontrunning

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what is frontrunning?

brokers trade ahead of program trade to benefit from anticipated price movements due to large trade

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example

broker buys ahead of large buy order broker buys first large buy order pushes up price broker’s holdings increase in value

result frontrunning starts to push up price, so firm does

not get best price

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agency basis

brokers bid for trade by commission low commission, but frontrunning likely

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agency incentive agreement

set benchmark value for trade based on last day’s prices

if broker does better gets commission + bonus

higher commission, but frontrunning less likely

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III. Stock market indicators

measure average performance of a group of stocks

different indexes are highly correlated: DJIA & S&P 500 .991 (1990s) DJIA & NYSE .95

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indexes differ due to

stocks included in the index weighting of stocks

equal, price, value

average arithmetic geometric

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stock exchange index

includes all stocks listed on exchange NYSE Composite Nasdaq Composite (both value weighted)

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subjectively selected index

organization picks group of stocks to measure Dow Jones Industrial average S&P 500

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DJIA

price weighted 30 large blue chip companies

cross section of industries leaders

large movements in DJIA may halt trading on NYSE

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S&P 500

500 large blue chip companies value weighted most popular benchmark for index funds

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objectively selected index

inclusion of stock based on objective criteria market value

Wilshire 5000 all publicly traded stocks

Russell 2000 largest 3000 companies, then take

smallest 2000 of those

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IV. Pricing Efficiency of the Stock Market

what information is reflected in current stock prices? what implications does this have for active vs.

passive investment strategies?

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3 levels of price efficiency

what are they? implication? evidence for U.S. stock markets?

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Weak form efficiency

current stock prices reflect information about past prices and trading history

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implication

if markets are weak-form efficient using past price/trading pattern to predict future

stock prices will not work so, technical analysis will fail to beat the market

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evidence

U.S. stock market is weak-form efficient technical analysts do not beat the market

especially after trading costs

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Semi strong form efficiency

current stock prices reflect all publicly available information

relevant to stock

-- economic data

-- financial statements

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implication

using public info to predict future stock prices will not work fundamental analysis will fail to beat market

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evidence

mixed Yes

most actively managed portfolios do not outperform randomly selected portfolios

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No. certain pricing anomalies persist for long periods

of time January effect size effect

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Strong form efficiency

current stock prices reflect all information public and private

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implication

impossible to predict future stock prices stock prices are a random walk

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evidence

U.S. stock market is not strong form efficient why?

corporate insiders consistently outperform market & they have access to private info

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active strategy

using fundamental or technical analysis to select stocks to buy/sell

growth, sector, value funds trading on this info increases

trading costs tax consequences

odds of working are low

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passive strategy

believe market is efficient, just capture long-run returns of market

buy-and-hold diversified portfolio index funds

lower expenses, defer taxes index funds outperform most actively

managed funds