MODULE 1

INTRODUCTION

The views expressed in this paper are the views of the authors and do not necessarily reflect the views or policies of the Asian Development Bank (ADB), or its Board of Directors or the governments they represent. ADB makes no representation concerning and does not guarantee the source, originality, accuracy, completeness or reliability of any statement, information, data, finding, interpretation, advice, opinion, or view presented.

MODULE ONE

INTRODUCTION

Learning Objective

The objective of this module is to provide the learner with an overall introduction to the basic principals, functions and terms behind securities regulation.

CONTENTS I II III Purpose of Securities Laws General Focus of Securities Laws Types of Regulation Merit-based Regulation Disclosure-based Regulation IV V VI Functions of Securities Markets Efficiency of Securities Markets Definition of a Security Stocks Bonds Yield Curve Rating Agencies VII VIII Risks Participants in Securities Markets Issuers Investors Intermediaries IX X XI Capital and Money Markets Primary and Secondary Markets Exchanges and Over The Counter Markets Liquidity 1

Page 3 3 4 4 4 6 7 7 8 8 9 10 12 13 13 13 13 13 13 14 15

Fair Price Determination XII Indexes and Averages Stocks Bonds XIII Foreign Exchanges European Exchanges London Frankfurt Paris Russia Switzerland Latin American Exchanges Tokyo Exchange United States Exchanges

15 16 16 16 17 18

20 20 20

PURPOSE OF SECURITIES LAWS

The purpose of securities laws and regulations is to protect the investor by ensuring that the system is fair, efficient and transparent. Transactions involving securities are subject to special registration, mandatory disclosure and antifraud rules. Securities law are designed to regulate the information, the markets, the market participants, the securities and the process of buying and selling (collectively known as trading) so that each individual investor has access to the same information at the same time and the same opportunity to trade. When all potential investors have access to the same information and the same opportunities at the same time, the situation is known as a level playing field. This level playing field produces a market in which investors can have confidence. This level playing field is achieved by requiring full disclosure of all material facts from the issuer and affording equal access to that information to any and all potential investors. The laws and regulations also define and monitor the behavior of the market participants and provide penalties for breaches of this behavior as well as set standards for the registration of the issuers, intermediaries and the securities.

II

GENERAL FOCUS OF SECURITIES LAWS

Since securities are created, rather than produced, they can be issued in unlimited amounts, virtually without cost since they are nothing in themselves but only represent an interest in something else. One important focus of securities laws, therefore, is assuring that when securities are created and offered to the public, investors have an accurate idea of what that something else is and how much of an interest in it the security represents. Securities are also not used or consumed by their purchasers. They become a kind of currency traded in the secondary market at fluctuating prices. These secondary transactions far outweigh in number and volume the offerings of newly created securities. A second important focus of securities law, therefore, is to assure that there is a continuous flow of information about the corporation, or other entity, whose securities are being traded. Additional disclosure is required whenever security holders are being asked to vote or make some other decision with respect to the securities they hold. It is the issuers responsibility in a disclosure based regulatory system to keep all relevant information updated and to release any new information that would be a part of any investors decision to trade. Since a large industry has grown up to buy and sell securities for investors and traders, securities laws are concerned with the regulation of people and firms engaged in that business, as well as the regulation of the securities themselves.

A third important focus of securities laws, therefore, is to assure that these professionals do not take advantage of their superior experience and access to information and overreach their non-professional customers. Because the trading markets for securities are uniquely susceptible to manipulation and deceptive practices, A forth important focus of securities laws is the general antifraud provisions. These provisions have been interpreted to apply not only to manipulation of securities prices, but also to trading by insiders on the basis of material, nonpublic information and to various kinds of misstatements by corporate management and others. Securities laws provide for a variety of governmental sanctions against those who violate their prohibitions as well as civil liability to persons injured by such violation. In addition, the courts may imply the existence of civil liabilities in situations where they are not expressly provided by statute.

III

TYPES OF REGULATION MERIT-BASED REGULATION

In merit-based regulation, the regulator has the discretion to approve or disapprove the applications for registration and require such revisions and impose such terms and conditions as the regulator deems necessary. The regulator has the power to reject issues that it reasonably believes are not in the best interest of the company or the investing public. This usually includes the regulators ability to determine whether or not the proposed issue is fairly priced. The regulator may even comment on the likelihood of the proposed return. DISCLOSURE-BASED REGULATION Disclosure-based regulation makes no determination of the value of the application for registration. The regulator is only concerned with whether or not the application fulfills all the necessary requirements of disclosing the proper information. The philosophy behind mandatory disclosure, is that when combined with antifraud liability, full and accurate disclosure will equip securities investors and securities markets with the information necessary to make an informed investment decision and stimulate the capital markets. The guiding principal behind disclosure-based regulation is that the issuer is responsible for proving full and accurate information regarding the issuer, its business, finances, future prospects and the terms of the offering so that every investor has the same and sufficient information at the same time to make an informed decision. Of particular 4

importance in disclosure regulation is the responsibility to disclose any adverse information and risks regarding the issuer or the offering. And to provide on-going relevant information as it becomes available or changes information already disclosed. Disclosure regulation, therefore, focuses not on whether the issue is in the best interests of the issuer and the public as in merit-based regulation, but rather whether or not the applicable standards of disclosure have been met. The regulator does not pass on the merits of the investment, only on whether or not it has met the disclosure requirements of the law. Under a disclosure system, it is the investor who determines whether or not the issue is a good investment based upon his or her own evaluation of the potential risks and rewards given the information disclosed by the issuer. It is the investor, therefore, who assumes the burden of determining the merits of an issue under the disclosure-based regulation system and not the regulator as under the merit-based regulation system. EXAMPLE The issuer is a corporation owned by three men, each aged 35 who are interested in raising US$150,000, in US$10,000 units for the purpose of going to Macau and gambling for a period of one week during the Chinese new year in the next calendar year. The men have 13, 15, and 16 years of experience in gambling, respectively, and each has made a net profit of more than US$20,000 in each of the last five years through gambling. The prospectus lists in detail the background of each man and his gambling experiences. It also lists the games that each man believes are his particular expertise and the fact that each of them will only play the games within that expertise. The prospectus includes a detailed list of all anticipated expenses. The prospectus then states that after all applicable expenses have been deducted, any profits obtained will be divided equally between the shareholders in proportion to the percent of ownership in the corporation, with each of the three men having a 5% ownership. Would you approve this application for registration? In this example, the role of the regulator in merit-based regulation would focus on whether or not this investment was in the best interests of the company and the public at large. The regulator would follow a set of standard guidelines for all investments designed to protect the investing public. The regulator would determine whether the shares were fairly priced and the probable return on the investment. The role of the disclosure-based regulator, in this example, would focus on the protection of potential investors by ensuring that all of the necessary information was disclosed for the potential investor to make an informed decision. Assuming that gambling is not an illegal activity in the country in which this offering is being made, this would most likely be approved under disclosure-based regulations and mostly likely not be approved under merit-based regulations. In disclosure-based regulation, it doesnt matter what the merits of the investment are, only that full and accurate disclosure has been made about the investment. It is up to the potential investor, not the regulator, to determine the merits of the investment.

Few countries operate a full merit based regulation system anymore and those that did are currently in the process of changing over to a more disclosure based system and therefore may be using elements of each. While a merit based disclosure system may offer more protection to the individual shareholder, in such a system the government assumes a great deal of responsibility by tacidly, if not actually legally, approving the issue. While most countries have immunity laws for the commission and its employees to prevent legal liability, China , for example, at this writing, does not yet provide such immunity and therefore the individuals and the commission may theoretically be sued if an investment turns bad. Even with legal immunity, in merit based disclosure, the investor often assumes the government has given its tascid approval of each offering. A merit system also requires an extensive of amount of resources and as a consequence, the review process is slow to bring new companies and issues to market. A disclosure system of regulation shifts a great deal of the burden in deciding the merits of any particular offering to the shareholder and thus requires a more sophisticated and educated investor. The benefits, however, are that issues may be brought to market faster, there is less of a demand on the resources of the government and the government is not perceived as having tascidly approved the issue. This course will assume a disclosure-based regulatory system because that is the system that the developed markets of the world use and has become the international example. In such a system, there are generally three duties imposed upon the registrant (the entity registering securities for sale to the public): 1) 2) the duty to disclose any and all material information in such a manner as to present the facts in a way that is not misleading to a potential investor; the duty to correct any information that was materially inaccurate or misleading when first disclosed if it is later determined that such information was inaccurate; and discloser was inaccurate or misleading when initially disclosed; and the duty to update any information that new facts or events make a material change to information previously disclosed.

3)

In a disclosure environment, it the responsibility of the registrant to keep all information currently available to the public as accurate as the registrant can make it. Any failure to do so is usually punishable by law. The definition of what is material information, what is inaccurate material information and all other particulars of these requirements will be delineated by law and regulations in each country and may differ between countries.

IV

FUNCTIONS OF SECURITIES MARKETS

The term stock market or securities market is used to describe the activity of trading stocks or shares and related securities either on a formal exchange or in an over the 6

counter market. Depending upon the size and sophistication of the market, there may be separate markets for stocks, bonds, futures, commodities or other specific securities. Or all these instruments may be traded as one market. Securities markets serve two basic functions: 1. Capital formation. Securities markets bring together investors who have capital to invest and issuers that are looking to raise capital. 2. Liquidity. Liquidity is the ability to readily sell an investment instrument. The securities markets provide liquidity by providing a place (either physically or electronically) where sellers and buyers can meet to establish prices and do business. It is this immediate ability to buy and sell that provides liquidity to securities and securities markets.

EFFICIENCY OF SECURITIES MARKETS

It is often said that the securities markets are efficient markets. By this it is meant that the markets are complete and transparent in providing information and that at any one time the price of a security fully reflects all information that is available to the public. In an efficient market, information affects the market price of a security as though everyone had the same information at the same time. New information is reflected by a new price for the security as though all information was learned by all investors at the same time and those investors, armed with the new information, reached a consensus on a new price. In an efficient market, no one person or group of persons has more or different information than any other person or group of persons. It is the purpose of the securities regulators to administer and enforce the laws and regulations that will provide the circumstances where information is not only fully disclosed, but is disclosed to all investors at the same time.

VI

DEFINITION OF SECURITY

Securities differ from most other commodities with which people deal. Securities have no intrinsic value in themselves, they represent rights in something else. The value of a bond, note or other promise to pay depends on the financial condition of the issuer and its ability to repay the debt. The value of a share of stock depends on the profitability or future earnings prospects of the corporation or other entity that issued it. Its market price depends upon how much someone else is willing to pay for it based upon their evaluation of those future prospects. What constitutes a security is specifically defined by the laws of each country. Because of the elusive and difficult nature of defining what exactly is a security, most securities laws list general categories and specific instruments and then also include open-ended 7

authority for the government regulator of securities to add other instruments as needed. Once an instrument is deemed to be a security, it comes under the regulation of the securities laws. You should study the definition of security in the law of your country because each will define it differently. Any attempt at a general definition across different countries and different regions is bound to fail. Understanding that, however, it is fair to say that very generally, a security is typically any document that evidences either ownership or debt and is exchangeable in a marketplace. A share, or stock, is evidence of ownership whereas a debenture, or bond, is evidence of a loan or debt. Some countries find that while an instrument is definitely a security, it does not need regulating. These securities are called exempt securities and while they may be exempt from the registration and disclosure requirements of the law, they are usually still subject to the antifraud and civil liability provisions. In some countries, government bonds are exempt from registration or are subject to less stringent registration than equities or corporate bonds. In Indonesia money market instruments are not considered securities. STOCKS /SHARES The word stock usually means ownership or equity in a corporation. Stock is typically issued in the form of shares. This share of ownership is what is meant by the words stock or share. BONDS There are numerous securities that are not stocks. The generic term for such securities is bonds. These generally represent debt or loans and may be issued by governments, government agencies or corporations. In some cases, this broad distinction between stocks and bonds, equity and debt, may not be completely clear. The growth of derivatives has lead to the existence of securities that have elements of both debt and equity. Interest Bonds, or debt, are measured by the interest that they pay. Interest is the price paid for having the money now rather than later, a concept known as the time value of money. Generally speaking, short-term interest rates are lower than long-term interest rates because the risk that conditions will change, and be adverse to the investor, increases over time. Investors, therefore, look for increasingly higher returns increasingly longer time frames. Other and more profitable investment opportunities may also arise over a longer period of time. Having invested money earlier and not having it available now is called an opportunity cost and is part of the costs that an investor expects to be rewarded for when determining the cost of an investment and the return on that investment.

Yields Yield is the return on an investment and frequently is used to describe the interest rate of a bond. The yield curve is a graph indicating the relationship between the yield to maturity (the date when the debt is to be paid) and the term to maturity (the amount of time between issue and payment) of an investment. Current yield is the annual income from a bond divided by the current market price of the bond. Yield to maturity is the average percentage yield of a bond earned annually from the purchase date to the maturity date and includes both capital gains and losses. Bond value tables list the market price and yield to maturity of bonds. They are therefore useful if the investor has one piece of information and wishes to know the other. Thus, a known market price can be used to determine a yield to maturity and vice versa. Yield curves are used by bond investors to predict the value of debt instruments. Positive Yield Curve. When plotted on a graph, the circumstances of short-term interest rates being lower than long-term interest rates is known as a normal, or positive, yield curve.

Negative Yield Curve. However, it is possible that short-term interest rates can be higher than long-term interest rates. This occurs particularly in time of high inflation when it is believed that in the long term, the high rates will be reduced. Under these conditions, the graph would produce an inverse or negative yield curve.

Figure 2: Inverse Yield Curve

(Figure)

Flat Yield Curve If interest rates and inflation are steady and are thought to remain so for some period of time, the graph would show a flat yield curve. Figure 3: Flat Yield Curve

Interest rate % per annum

Term to Maturity

Rating Agencies Bonds are usually rated by independent ratings agencies that are private companies and not part of any government or government agency. These companies publish a ratings chart that lists their rankings from the highest grade to the lowest grade. While these

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charts may differ somewhat between agencies, they follow a general pattern of starting with triple A as the highest rating (AAA for Standard and Poors, Aaa for Moodys) and going down to single C (Standard and Poors also has a D rating for defaulted bonds). Moodys Aaa Aa1 Aa2 Aa3 A1 A2 A3 Baa1 Baa2 Baa3 Ba1 Ba2 Ba3 B1 B2 B3 Caa Ca C Standard & Poors AAA AA+ AA AAA+ A ABBB+ BBB BBBBB+ BB BBB+ B BCCC+ CCC CCCCC C Interpretation Highest grade High grade Upper medium; sound Medium; some uncertainty Fair; uncertainty Speculative

Speculative; high default risk Speculative; Default imminent Speculative; Default imminent In default; no apparent value

The services make every effort to be impartial because any hint of prejudice would destroy their reputations and their usefulness, which means their business. Bonds, when issued, are given one of these alphabetical ratings. Bond ratings from all the services are derived from the same publicly available information that is released to the securities regulator and sometimes the press. While the interpretation of that information and the conclusions drawn may differ from service to service, the ratings tend to be similar, if not exactly the same. A bonds rating is critical because it is one of the chief determinants of the interest rate that will be applied. For example, say the difference between the highest rating and the next highest rating of an agency is 0.15% (reported as 15 basis points-a basis point is 1/100th of a percent). That means that if a corporations bond issue receives the lower rating, it will have to pay an additional 15 basis points in interest payments. If we use US dollars in our example, the additional 15 basis points amounts to US$1.50 per each US$I,000 of principal per year. The principal is the amount the bondholder paid for the

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bond. On a corporate offering of US$500million, the difference would be an additional US$1million each year. Bonds rated in the A categories and the first level of the B listings are usually said to be investment grade securities. Some institutional investors are not allowed, either by law, internal rules or practice, to invest in less than investment grade securities. Stocks are also rated by the agencies, but investors and the market pay little attention to them. The most important rating of a stock is done by the markets themselves and is reflected in the price. VII RISKS

Risk is the possibility of loss. With every investment there is a risk. Some risks are higher than others. The higher the risk, usually, the higher the return that must be promised in order to induce an investor to take that risk and purchase the security. Risk is the deviation from an expected return on a security or some other investment. Risk is measured by the deviation from an expected value with a formula known as the standard deviation. (The mathematics of the standard deviation are beyond the scope of this course and the learner is directed to any number of statistics books for a full explanation.). Total risk is the sum of the systemic (or systematic) and Non-systemic risks. Nonsystemic risk is also called residual risk. Systemic risk is the risk that is of, relating to, or common to the system itself. Every system has systemic risks. Systemic risks for the market would be risks due to common factors that would affect returns on all securities. Systemic risks cannot be protected against by diversification of the portfolio. Market confidence, or lack of it, is a systemic risk. Systemic risk is measured by Beta. Beta therefore is the measurement of the extent to which returns on a security may be expected to differ from the return of the market as a whole. The Beta for the market as a whole is arbitrarily set at 1. A beta for a particular stock that is less than 1 would mean that the stock will not go up as fast as the market, but it will also not go down as fast as the market. Stocks with Betas less than one are good defensive stocks in a down (bear) market. Stocks with Betas greater than one will more faster than the market, both up and down and therefore are good aggressive stocks in a rising (bull) market. Non-systemic risks are caused by unique factors. They affect only a certain industry, sector or stock. Non-systemic risks can be protected against by diversification. A strike at a company is an non-systemic risk. Markets are said to be liquid or illiquid. A liquid market is one in which an investor may buy and sell a security immediately at the market price. An illiquid market does not offer these benefits. Liquidity risk, therefore, is the possibility that investors may not be able to convert an investment into cash immediately or without a loss in value. Liquidity is a systemic risk for a market. 12

Time value risk refers to the length of time before an investment matures and whether the investment will be worth its anticipated price at that time. While this usually refers to bonds, it may be used for other securities. There is a time value risk for options, for example. Time value is an non-systemic risk. Risks can be both systemic and non-systemic. Purchasing power risk, for example, usually refers to fixed income securities and the risk that the rate of inflation will erode the future purchasing power of the rate of return. Purchasing power is an non-systemic risk for a security, but a systemic risk for the economy as a whole,

VIII

PARTICIPANTS IN SECURITIES MARKETS

There are three essential categories of participants in securities markets: Issuers: the organizations that issue (sell) a security that represents either a percentage share in the organization (stocks/shares) or a promise to pay back a loan with interest (bonds). the buyers and sellers (traders) of securities who are seeking a profit (called a return) on their investment the organizations or persons who bring investors together and introduce issuers to the market.

Investors:

Intermediaries;

IX

CAPITAL AND MONEY MARKETS

A capital market is a financial market that includes both equity securities and long-term debt instruments. Long-term is usually defined as instruments that mature in one year or more. Money markets, on the other hand, are financial markets that include only short-term debt instruments and loans. Short-term is usually defined as instruments that mature in less than one year.

PRIMARY AND SECONDARY MARKETS PRIMARY MARKET

The initial sale of securities from the issuer to the investor is called a primary distribution. The primary market is the facility through which the security is first sold to the public and is bought directly from the issuer, i.e. the corporation or government entity that is issuing 13

the security. The money paid for the security goes to the issuer. The purchasers of these shares become the initial owners. They may either hold those shares or sell them to someone else. The process of selling stock to the public for the first time is known as taking the company public. This means that the company will no longer be owned only by the original investors or founders. The company will sell shares of itself to the general public, which is how the term going public came into existence. This is not true in countries that were part of the former Soviet Union. In those countries, the process of selling shares in a company to individuals is called taking the company private. The difference in terminology comes from the fact that, in the former Soviet Union and other communist states, the government owns all of the assets of the country including the companies and by extension therefore, the people of the country own the assets of the state including the companies. To take the company out of the hands of the government, and therefore the collective public, and sell the company to shareholders means that the company is now held by private individuals rather than the collective public through the government. The concept is the same, only the terminology is different (and sometimes confusing). The process by which a company sells stock for the first time is called an Initial Public Offering or IPO. SECONDARY MARKET Because few investors could be convinced to tie up their funds indefinitely, most securities are negotiable. This means that the shares may be freely transferred from a seller to a buyer by determining a price that is satisfactory to both and by delivering the shares to the buyer. Legal title of ownership will pass to the buyer upon delivery. This determination of price and delivery takes place in what is known as the secondary market. The secondary market is where the ongoing trading of the securities occurs between buyers and sellers. The money from this trading activity goes to the owners of the security and not to the original issuer. Issuers do not benefit financially from the trading in the secondary market between traders. Most trading occurs in the secondary markets and the securities traded in the secondary market may be traded either on an established exchange or over-the-counter. It is the function of the securities exchanges and over the counter markets to provide a place where such prices may be determined and delivery may take place.

XI

EXCHANGES AND OVER THE COUNTER MARKETS

The secondary market for securities is conducted either on an exchange, known as an auction market, or over the counter (OTC), known as a dealer, or negotiated, market.

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The major difference between an exchange and an OTC used to be that an exchange had a physical floor where the broker/dealers met face to face to trade while on the OTC brokers and dealers traded securities by computer hook-up or telephone rather than through the facilities of a securities exchange floor. Increasingly the difference between an OTC and the floor exchanges is becoming less clear as floor exchanges rely more and more on computer networks and less and less on trading floors. The Toronto Stock Exchange has, for example, eliminated their exchange floor. In the most general of terms, a trade either occurs on an exchange floor or it does not. Any trade that does not trade on a floor is loosely referred to as over-the-counter. The over-the-counter market has traditionally been completely unstructured without any physical facility and with any qualified firm being free to engage in any types of activities with respect to any securities. In the traditional OTC market, traders act as dealers and make a market in various stocks. For this reason, these traders are also known as market makers. They make a two-sided (bid-offer) market by quoting a price at which they would pay a seller (bid) or a price at which they would sell to a buyer (offer or asking price). The difference between the bid and the ask is called the spread. If a dealer has an order for a stock in which it does not make a market, it simply goes to other dealers who do make markets for that security and compares quotes. Dealers charge no commission because the price quoted includes a markup on the buy side and a markdown on the sell side. These markups and markdowns are the dealers profit. Market makers do not usually deal directly with the public, they either deal with other traders or with brokers who are buying on behalf of a customer. This is more like a wholesale market while the broker deals with the retail market. The principal function of an exchange or OTC is to provide a marketplace in which member firms, acting as brokers, can purchase and sell securities for the accounts of their customers. LIQUIDTY Securities are exchanged for cash. Buyers and sellers continually bargain over what a stock is worth at any given time. This creation of a continuous, or liquid, market is one of the most important functions of an exchange and OTC. It is the liquidity of the market, the easy and immediate opportunity to sell or buy, that makes securities trading on exchanges or OTCs so effective. Four conditions indicate liquidity in a market for any given stock: 1. 2. 3. 4. Frequency of sales; Narrow spread between bids and offers; Prompt execution of orders; and Minimum price changes between transactions.

FAIR PRICE DETERMINATION Neither the exchange nor the OTC markets determine the price of securities traded there. Rather, it is the buyers and sellers that determine the price. This is known as fair 15

price determination, or price discovery. The continuous interaction between buyers and sellers is what determines what a buyer is willing to pay and a seller is willing to accept. This system may be subject to manipulation if one party has more or different information than the other. It is the purpose of the laws an regulations and the responsibility of the regulator to prevent that from happening. In most well developed markets, there is a computerized system that monitors the trading patterns of each stock and signals unusual deviations that are then turned over for investigation. An exchange market, such as the Philippine Stock Exchange, the Kuala Lumpur Stock Exchange, the Shanghai Stock Exchange, the Honk Kong Stock Exchange, the Korean Stock Exchange, or the Jakarta Stock Exchange operates in a physical facility with a trading floor to which all transactions in a particular security or type of security are directed. The exchanges are traditionally operated in a very structured manner with strict rules regarding the number and qualifications of members, the functions that they perform and the types of instruments that may be traded. In larger markets, there may be separate exchanges for equities, commodities, futures contracts, etc., such as The Singapore Futures Exchange that trades only futures contracts.

XII

INDEXES AND AVERAGES STOCKS

Frequently the terms index and average are used interchangeably. Technically, however, indexes are more refined measures than averages, especially over the long term. An index is a measure based upon comparison with a base year, which is normally designated as 100. All indexes use a base period, but the base period varies from index to index. Indexes typically contain more issues than most stock averages and sometimes comprise all of the issues traded in a given market. Averages, on the other hand, are weighted or un-weighted arithmetic means of the prices of a group of stocks on a given market. This group may be a sample of the stocks traded on the exchange or it may be all of the stocks traded. Most major averages are weighted according to market capitalization where the market price of a share is multiplied by the number of shares outstanding. This gives more importance to companies with large market capitalization rather than just those with high share prices. If an average is not weighted, then it is computed simply by averaging all of the closing prices of the stocks in the index. Hence the name. There is an index or average for practically every market and this is the benchmark by which portfolio performance is judged. Each portfolio is compared to an index or average based upon the kind of investments the portfolio holds. Portfolios that hold large companies are compared to the index for the exchange that trades large capitalized stocks, portfolios that hold high technology stocks or commodities are compared with the indexes of those exchanges or over the counter markets. 16

BONDS One of the problems with constructing bond indexes or averages is the limited life of the securities. Unlike stocks, which are likely to last for a very long time, the ages of debt securities are known at the time of their issue. In addition, the typical corporate bond issue does not usually reach maturity. These issues are typically called or redeemed before the actual maturity date. To complicate matters even further, bond indexes or averages can also be quoted on either a price basis or a yield basis. The former being based upon the cost of the security while the later is based upon the return the security will offer. Bond indexes are typically used only by professional investors and then only by those who specialize in fixed-income instruments.

XIII

FOREIGN EXCHANGES

The 1990s have been witness to a remarkable acceleration in the mobilization of capital. Money moves around the world with astonishing speed. Time zone changes and after hours trading have made it possible to trade virtually around the clock of each business day. Capital now moves in hours or days rather than in weeks or months. This movement allows developing countries to expand much more rapidly than otherwise would have been possible if these countries had to rely only on their own economies to raise capital. It offers investment opportunities that would not have been possible previously. The negative side of this growth comes from several causes. This instant communication has made the countries of the world more integrated and interdependent. During the 1990 Asian market crisis, it was said that Asia sneezed and the world caught a cold. What happens in one country is no longer confined to that country alone. Prosperity and recessions spread from one part of the world to another with increasing speed. The world is becoming one economy. And this causes unique problems. Global money has no loyalty. A massive outflow or influx of money into any one market can cause great disruption to that market. Large inflows to a small market may cause hyper-inflation of stock prices. Large outflows can cause down turns in large markets or worse, the collapse of a smaller market. Flight capital now moves around the world by those with wealth in politically unstable countries, or in countries where the integrity of the currency comes into question. Banking centers in the Cayman Island, Panama, Luxemburg and Switzerland are favorite parking places for this kind of moneyMoney laundering has become a worldwide problem, not only within each country but also between the markets of different countries. The anti-money laundering laws are different for each country and you should study those of your country. The Financial Action Task Force on Money Laundering (FATF) has established 40 recommendations and identified 25 criteria on which they evaluate compliance of anti-money laundering activities of the worlds countries. A country that failures to comply may be the subject of sanctions which include, among 17

other things, the publication of the name of the country and the reasons for the failing evaluation with a published warning to other member countries that financial dealings with the offending country could result in money laundering. Thereby raising the possibility that the offending country could be boycotted from international financial operations. The learner is directed to the website of FATF at <http://www.faif-gafi.org> for a fuller explanation of the organization and its operations. EUROPEAN STOCK EXCHANGES European stock markets are frequently referred to a bourses from the Latin word bursa meaning purse. THE LONDON STOCK EXCHANGE London has long had an influential role in the markets of Europe and recently has increased that dominance. After World War II, a market for US dollars held abroad began to develop in London and created the Eurodollar market. The lack of registration requirements and looser securities regulations outside the United States made for cheaper financing. As Europe began to rebuild and local currencies strengthened, and what was once a Eurodollar bond market became the Eurobond market that exists today. The term Eurobond refers to a debt security payable in a currency resident outside its home country. Trading is done on over the counter markets. What affect the new common currency, the Euro, will have on this market is still to be determined. The London Stock Exchange is located in the financial heart of London called the city. This market has truly become an international market as the large and prestigious London brokerage houses and banks have either merged with or been bought by larger European and U.S. firms. The most recent and probably the most highly visible of these deals was the take over of the British investment bank called Barings by ING, a Dutch banking and insurance firm, after a crippling scandal involving derivatives trading by Barings in its Singapore office. The index is the FTSE 100 (pronounced foot see and stands for Financial Times Stock Exchange). The Financial Times is the leading international business newspaper. The trading floor is mostly all automated. THE FRANKFURT STOCK EXCHANGE tThe major German banks and the business community have developed a strong foothold in Frankfurt. As the European Union gathers strength and organization, there may likely be the development of a central financial market. While London may have a lead over Frankfurt at the moment for this title, the United Kingdom has yet to become a full member of the EU or convert its currency. In addition, Frankfurt is connected electronically with the small capitalized company market exchanges of Paris, Brussels and Amsterdam. The German market is dominated by very large, established companies and banks. The average German does not participate in the stock market to any significant degree.

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The index is the DAX 30 (Deutsche Aktien Index) and is an index of blue chip stocks. THE PARIS STOCK EXCHANGE The Paris stock exchange is entirely electronic and there is no trading floor. This market is dominated by large, established, companies and banks. Only about 10% of individuals in France own stock. The index is the CAC 40 (Compagnie des Agents de Change) and is an index of blue chip stocks. THE SWISS STOCK EXCHANGE The Zurich Stock Exchange contains some of the worlds largest companies. Switzerland is home to the worlds second largest bank. Zurich Insurance has acquired a large U.S. money management firm, Scudder, Stevens and Kemper. The exchange lists some of the worlds most successful Swiss pharmaceutical companies. This exchange customarily trades very large companies that tend to have high prices per share. Per share prices of over US$1,000 are not uncommon. The top 10 companies constitute over 50% of the total market capitalization. It comprises roughly 3% of the worlds total market. The index is the Zurich SMI. THE RUSSIAN STOCK EXCHANGE The Russian Trading System (RTS) is electronic. This exchange encounters many of the problems of developing countries. Valuing Russian shares is even more difficult than in other emerging markets because of the lack of reliable financial information. Clearance of trades can take weeks. This is complicated by the sheer size of this market. It is difficult to get accurate figures because of the lack of proper record keeping but estimates of trading run as high as 100 million shares per day. The size of this market is due to the fact that millions of workers became shareholders, or were given share vouchers, as the country transitioned from communism to capitalism and workers became owners of the companies as the companies went private. THE LATIN AMERICAN STOCK EXCHANGES Although growing rapidly, Latin American economies, and hence the markets, are very volatile. In addition, the Mexican peso crisis of the mid1990s caused investors to rethink their positions. Then there is the Argentina bank crises of 2002. Chile has become a major market for investors despite the fact that it is much smaller than either Argentina or Brazil. A principal reason for this is the Chilean privatized mandatory pension retirement system. The funds derived from this source have created very mature capital markets rather quickly.

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THE TOKYO STOCK EXCHANGE The Tokyo Stock Exchange is Japans largest and best-known stock exchange. Japan represents approximately 20% or the worlds market. The market is mostly automated and is divided into two tiers. The first tier trades the larger and more established firms and has about 1,000 listings. The second tier trades smaller and newer companies and has about 500 listings. The largest companies on this exchange are the Japanese banks The index is called the NIKKEI (pronounced nee kay) average. THE UNITED STATES STOCK EXCHANGES In the late 1990s the United States share of the world market stood at roughly 40%. That was down from roughly 70% in the early 1970s. The rising European, Pacific and the emerging market economies are increasingly becoming more important in the new global economy. The largest and most famous stock exchange in the U.S. is the New York Stock Exchange (NYSE). Recently, however, with the explosive growth of the technology stock market and possible merger plans, the Nasdaq stock market has also come into prominence. The NYSE is a formal exchange with a trading floor and trades mostly the larger and well-established companies. The index for the NYSE is called the Dow Jones Industrial Average (usually referred to as the Dow or the Dow Jones). Dow Jones & Company is the publisher of The Wall Street Journal, including the European and Asian editions. Nasdaq (pronounced nas dack) is an electronic over the counter market and has recently surpassed the NYSE in volume of trades, but not in value of trades. Nasdaq was created in 1971. The index is known as the Nasdaq index. There are also specific exchanges or OTCs that only trade a certain securities. The best known of these are the Chicago Board of Trade, that only trades commodities, and the Chicago Board Options Exchange that only trades options and is the largest options exchange in the world.

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