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Chapter 18. The Common Stock Chapter 18. The Common Stock MarketMarketChapter 18. The Common Stock Chapter 18. The Common Stock MarketMarket

• Types of markets

• Trading mechanics

• Stock market indexes

• Pricing efficiency

• Types of markets

• Trading mechanics

• Stock market indexes

• Pricing efficiency

Common stockCommon stockCommon stockCommon stock

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

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

I. Type of MarketsI. Type of MarketsI. Type of MarketsI. Type of Markets

• exchanges

• OTC trading of

• unlisted stocks & listed stocks

• direct trading

• exchanges

• OTC trading of

• unlisted stocks & listed stocks

• direct trading

ExchangesExchangesExchangesExchanges

• physical location for trading

• trading by members• own a seat on the exchange

• stock traded on exchange are listed stocks

• physical location for trading

• trading by members• own a seat on the exchange

• stock traded on exchange are listed stocks

NYSENYSENYSENYSE

• 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

• 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

• 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%)

• 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%)

role of the specialistrole of the specialistrole of the specialistrole 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

• 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

the future of the specialistthe future of the specialistthe future of the specialistthe future of the specialist

• may be phased on with next 5-10 years

• recent SEC fines for improper trading for several major firms

• may be phased on with next 5-10 years

• recent SEC fines for improper trading for several major firms

AMEXAMEXAMEXAMEX

• merged w/ Nasdaq 1998

• specializes in equity derivative securities and closed-end funds

• merged w/ Nasdaq 1998

• specializes in equity derivative securities and closed-end funds

Regional exchangesRegional exchangesRegional exchangesRegional exchanges

• stocks may be listed on both NYSE and regional exchange

• 5 regional exchanges

• cheaper seat prices

• stocks may be listed on both NYSE and regional exchange

• 5 regional exchanges

• cheaper seat prices

OTC marketsOTC marketsOTC marketsOTC 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

• electronic network of dealers all over the world

• ECNs• electronic communication

networks

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

NasdaqNasdaqNasdaqNasdaq

• 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

• 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

II. Trading MechanicsII. Trading MechanicsII. Trading MechanicsII. Trading Mechanics

• types of orders

• short selling

• buying on the margin

• institutional trading

• types of orders

• short selling

• buying on the margin

• institutional trading

Types of ordersTypes of ordersTypes of ordersTypes 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

• 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

• 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

• 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

• 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

• 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

• investor sets reservation price

BUT• no guarantee that limit order will

be executed

• investor sets reservation price

BUT• no guarantee that limit order will

be executed

• 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

• 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

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

triggered prematurely

-- end up trading unnecessarily

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

triggered prematurely

-- end up trading unnecessarily

• 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”

• 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”

• 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”

• 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”

how long is an order good?how long is an order good?how long is an order good?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

• fill or kill order• executed when reaches trading

floor, or canceled

• good until canceled/open order• is good indefinitely

order sizeorder sizeorder sizeorder 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

• 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

short sellingshort sellingshort sellingshort 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

• 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

• 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)

• 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)

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

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

Buying on the marginBuying on the marginBuying on the marginBuying 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

• 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

• 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

• 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

exampleexampleexampleexample

• 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

• 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

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

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

Institutional tradingInstitutional tradingInstitutional tradingInstitutional trading

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

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

block tradesblock tradesblock tradesblock 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)

• 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)

program tradesprogram tradesprogram tradesprogram trades

• large # shares, different stocks

• used by mutual funds for asset allocation

• want• low commissions• prevent frontrunning

• large # shares, different stocks

• used by mutual funds for asset allocation

• want• low commissions• prevent frontrunning

what is frontrunning?what is frontrunning?what is frontrunning?what is frontrunning?

• brokers trade ahead of program trade• to benefit from anticipated price

movements• due to large trade

• brokers trade ahead of program trade• to benefit from anticipated price

movements• due to large trade

exampleexampleexampleexample

• 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

• 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

agency basisagency basisagency basisagency basis

• brokers bid for trade by commission

• low commission, but

• frontrunning likely

• brokers bid for trade by commission

• low commission, but

• frontrunning likely

agency incentive agreementagency incentive agreementagency incentive agreementagency 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

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

• if broker does better• gets commission + bonus

• higher commission, but

• frontrunning less likely

III. Stock market indicatorsIII. Stock market indicatorsIII. Stock market indicatorsIII. 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

• measure average performance of a group of stocks

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

indexes differ due toindexes differ due toindexes differ due toindexes differ due to

• stocks included in the index

• weighting of stocks• equal, price, value

• average• arithmetic• geometric

• stocks included in the index

• weighting of stocks• equal, price, value

• average• arithmetic• geometric

stock exchange indexstock exchange indexstock exchange indexstock exchange index

• includes all stocks listed on exchange

• NYSE Composite

• Nasdaq Composite

• (both value weighted)

• includes all stocks listed on exchange

• NYSE Composite

• Nasdaq Composite

• (both value weighted)

subjectively selected indexsubjectively selected indexsubjectively selected indexsubjectively selected index

• organization picks group of stocks to measure

• Dow Jones Industrial average

• S&P 500

• organization picks group of stocks to measure

• Dow Jones Industrial average

• S&P 500

DJIADJIADJIADJIA

• price weighted

• 30 large blue chip companies• cross section of industries• leaders

• large movements in DJIA may halt trading on NYSE

• price weighted

• 30 large blue chip companies• cross section of industries• leaders

• large movements in DJIA may halt trading on NYSE

S&P 500S&P 500S&P 500S&P 500

• 500 large blue chip companies

• value weighted

• most popular benchmark for index funds

• 500 large blue chip companies

• value weighted

• most popular benchmark for index funds

objectively selected indexobjectively selected indexobjectively selected indexobjectively 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

• 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

IV. Pricing Efficiency of theIV. Pricing Efficiency of the Stock Market Stock Market

IV. Pricing Efficiency of theIV. Pricing Efficiency of the Stock Market Stock Market

• what information is reflected in current stock prices?• what implications does this have

for active vs. passive investment strategies?

• what information is reflected in current stock prices?• what implications does this have

for active vs. passive investment strategies?

3 levels of price efficiency3 levels of price efficiency3 levels of price efficiency3 levels of price efficiency

• what are they?

• implication?

• evidence for U.S. stock markets?

• what are they?

• implication?

• evidence for U.S. stock markets?

Weak form efficiencyWeak form efficiencyWeak form efficiencyWeak form efficiency

• current stock prices reflect • information about past prices • and trading history

• current stock prices reflect • information about past prices • and trading history

implicationimplicationimplicationimplication

• 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

• 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

evidenceevidenceevidenceevidence

• U.S. stock market is weak-form efficient

• technical analysts do not beat the market• especially after trading costs

• U.S. stock market is weak-form efficient

• technical analysts do not beat the market• especially after trading costs

Semi strong form efficiencySemi strong form efficiencySemi strong form efficiencySemi strong form efficiency

• current stock prices reflect• all publicly available information

relevant to stock

-- economic data

-- financial statements

• current stock prices reflect• all publicly available information

relevant to stock

-- economic data

-- financial statements


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

beat market

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

beat market


• mixed

• Yes• most actively managed portfolios

do not outperform randomly selected portfolios

• mixed

• Yes• most actively managed portfolios

do not outperform randomly selected portfolios

• No.• certain pricing anomalies persist

for long periods of time• January effect• size effect

• No.• certain pricing anomalies persist

for long periods of time• January effect• size effect

Strong form efficiencyStrong form efficiencyStrong form efficiencyStrong form efficiency

• current stock prices reflect all information• public and private

• current stock prices reflect all information• public and private


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

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


• U.S. stock market is not strong form efficient

• why?• corporate insiders consistently

outperform market• & they have access to private info

• U.S. stock market is not strong form efficient

• why?• corporate insiders consistently

outperform market• & they have access to private info

active strategyactive strategyactive strategyactive 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

• 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

passive strategypassive strategypassive strategypassive 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

• 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

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