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Part II: Security Markets

Topic 8 - Stock Markets

Copyright © 2006 Scott Bauguess


Equity Claims in Capital Markets
Residual Claimants: Shareholders or equity owners
1. Are the legal owners of the firm
2. Have limited liability (losses are limited to the amount of the investment)
3. Have voting rights – elect the directors who hire/fire management
4. Otherwise are have little control and are passive in their participation of
management

Dividends: equivalent to the coupon payment of a bond, except…


1. There is no promise of the amount of frequency
2. Are taxed twice (at the corporate level and at the personal level)

Maturity: Equity claims are infinitely lived


1. Unless a firm repurchases shares, investors never do not get their initial return
back
2. Most investors anticipate a “capital” return which is untaxed until sold, which is
often prefferred to dividends
3. Secondary markets allow investors to “cashout”

Copyright © 2006 Scott Bauguess


Stock Markets - Primary & Secondary

Copyright © 2006 Scott Bauguess


World Wide Market Capitalization

3.88 1.77
2.65
United State

15.03
Europe

Japan

Canada/Australia/New
54.97 Zealand
Pacific Basin

21.71 Emerging Markets

reprinted from Saunders Cornett “Financial markets and institutions,” 3rd edition, McGraw-Hill Irwin 2006
Copyright © 2006 Scott Bauguess
Market Value of Common Stock
Outstanding
(billions of dollars)
14000
12000
10000
8000
6000
4000
2000
0
1994 1997 2000 2004

Nonfinancial corp. bus Financial corp Rest of world

reprinted from Saunders Cornett “Financial markets and institutions,” 3rd edition, McGraw-Hill Irwin 2006
Copyright © 2006 Scott Bauguess
Role of Primary Markets
Serve to reduces the adverse selection process in raising capital
1. Underwriters (investment banks) certify firm type by taking firms public (IPO)
2. Rating agencies certify debt issues
3. Government provides strict framework for the registration process

Reduces search costs – intermediaries (underwriters) find investors


1. Large institutions
2. Wealthy clients
3. Active household investors

How does this relate to perfect capital markets (PCM)?


1. Rational expectations  a well-defined registration process with government
supervision allows investors to have more homogenous beliefs
2. Transactions costs  Lower search costs reduces market frictions, and
reputable underwriters communicate information efficiently

Copyright © 2006 Scott Bauguess


Role of Secondary Markets
Liquidity: Investors trade time and risk, buying and selling financial instruments
prior to maturity

Search costs: Central trading locations reduce search costs

Information production
1. Continuous trading – assets are priced daily
2. Low cost - look for stock price online

Market discipline: addresses moral hazard issue of a firm changing type


1. Financial markets (FM) – react to “bad” news with lower stock prices
2. Market for corporate control (MCC)– lower stock prices make firms “good” targets for
takeover

Copyright © 2006 Scott Bauguess


Types of secondary markets
Exchanges: (NYSE, AMEX, Regional, CBOE, London Gold Exchange)

1. A central location (trading floor) where the exchange of financial securities takes
place
2. Central agents match buyers and sellers (one point of contact)

Over-the-counter (OTC): eg. Nasdaq

– A geographically dispersed trading forum where traders are linked through


telecommunications (computer) systems
– Infinite number of communications pathways (no single point of contact)

Copyright © 2006 Scott Bauguess


Secondary Market structures
Call Market (Walrasian auction): Orders are batched together for simultaneous execution

1. Auctioneer determines the market clearing price prior to trading in the following manner:
2. Auctioneer proposes a price
3. Representatives (buyers and sellers) privately indicate whether or not they are a buyer or
seller at that price.
4. If equilibrium (net buys = net sells) is not reached, then auctioneer proposes adjusted price.
5. Process continues until auctioneer finds the market clearing price.
6. Once this price is determined, then all trades occur simultaneously

• Free rider problem: All private information is revealed prior to trading since trading
does not occur until a market clearing price is revealed. The price moves to
equilibrium prior to the first trade, so even uninformed investors benefit (free-ride) off
the private information of informed investors.
• London Gold Bullion market is a call market – prices set twice daily.

Continuous (Auction) Market:


1. Most common market in the electronic age.
2. Prices are determined continuously throughout the trading hours as buyers submit their buy
and sell orders.

Copyright © 2006 Scott Bauguess


Secondary Market Participants
Investors: buyers and sellers of securities (households and financial institutions)

Brokers: Earn commissions by serving as an agent on behalf of the buyer or seller


(real estate agent, mortgage broker, stock broker)

Dealers: Take inventory on their own account in a traded asset to facilitate trading (car
dealer, investment or commercial bank)

Broker-dealers: act as agents in addition to holding inventory and trading on their own
account

Market-Makers: A dealer that is tasked with keeping the market running smoothly,
and may be a privileged/regulatory activity (NYSE specialist)

Copyright © 2006 Scott Bauguess


Stock Market Participants
Common Stock Markets: Stock markets that trade the securities of public firms are perhaps
the most easily recognizable financial secondary markets.

1. Investors: buyers and sellers of common stock

2. Brokers: transmit investor orders (E*Trade, Schwab, Fidelity, Merrill Lynch, Ameritrade etc.)

3. Dealers: trade on their own account (Goldman Sachs, Morgan Stanley, JP Morgan, Merrill Lynch
& other investment banks)

4. Market Makers: Dealer-brokers who are required to trade to keep market moving smoothly
(NASD member firms and NYSE specialists). Market makers profit through two avenue streams:

• Order matching – earns commission by acting as an agent to the investor

• Taking a position – earns the bid-ask spread by acting as a dealer (principal/owner)

• In an idealized market, Market makers would need only match orders and charge a small
fee. However, if trade imbalances occur (more buys than sells or vice-versa), then the
market-maker is required to take a position to smooth trading.

Copyright © 2006 Scott Bauguess


Stock Market Investors
(in
(inbillions
billionsof
ofdollars)
dollars)
%
%ofof
1994
1994 1997
1997 2004
2004 Total
Total

Household
Householdsector
sector $3,070.9
$3,070.9 $5,689.6
$5,689.6 $6,132.7
$6,132.7 39.2
39.2
State
Stateand
andlocal
localgov.
gov. 10.6
10.6 79.0
79.0 87.6
87.6 0.6
0.6
Rest
Restofofworld
world 397.7
397.7 919.5
919.5 1,670.3
1,670.3 10.7
10.7
Depository
Depositoryinst.
inst. 180.6
180.6 331.4
331.4 260.1
260.1 1.7
1.7
Life
Lifeins.
ins.co.
co. 246.1
246.1 558.6
558.6 962.4
962.4 6.2
6.2
Other
Otherins.
ins.co.
co. 112.1
112.1 186.0
186.0 187.5
187.5 1.2
1.2
Private
Privatepension
pensionfunds
funds 996.3
996.3 1,863.9
1,863.9 1,536.3
1,536.3 9.8
9.8
Public
Publicpension
pensionfunds
funds 557.4
557.4 1,431.7
1,431.7 1,180.3
1,180.3 7.5
7.5
Mutual
Mutualfunds
funds 709.6
709.6 2,018.7
2,018.7 3,431.7
3,431.7 22.0
22.0
Closed-end
Closed-endfundsfunds 31.9
31.9 50.2
50.2 70.8
70.8 0.4
0.4
Brokers
Brokersand anddealers
dealers 20.1
20.1 51.9
51.9 107.5
107.5 0.7
0.7
reprinted from Saunders Cornett “Financial markets and institutions,” 3rd edition, McGraw-Hill Irwin 2006
Copyright © 2006 Scott Bauguess
Brokers, Dealers and Market Makers
Brokers, dealers, broker-dealers and market makers enter the market to reduce the
trading costs incurred by investors

1. Easier to buy a new car from a dealer with a car-lot of 1,000 cars than visiting the same
number of cars at the individual residences of private sellers

2. Dealers can stand ready to buy on a moments notice, enhances liquidity.

3. Brokers match buyers and sellers that might not otherwise find each other (real estate
agents can pull up listing on the MLS and quickly show a buyer available properties)

Copyright © 2006 Scott Bauguess


Bid-Ask spreads
Bid-Ask Spread: Is the difference in price between what the market maker is willing to
buy and sell a security, and is compensation for the market-maker assuming the risks
associated with holding inventory in the security.

1. Bid Price: Price dealer pays investors or price investors receive from dealers.
2. Ask Price: Price dealer receives from investors or price investor pays dealer.
3. Spread = Ask - Bid

The size of the spread is indicative of the amount of risk associated with ownership in the
security, including:

1. Liquidity risk (time required to unwind a position)


2. Security price uncertainty (highly volatile firms)
3. Trading against informed investors

Bid-Ask spreads increase with risk, particularly when a security is illiquid, volatile or there
is a threat that insiders (informed investors) are trading on private information

Copyright © 2006 Scott Bauguess


Security A Security B
27.30 28.25
27.25 28.00
27.20 27.75
27.15 27.50
27.05 27.25
Ask = 27.05 Ask = 27.05
Bid = 27.00 Bid = 27.00
27.00 27.00
26.95 26.75
26.90 26.50
26.85 26.25
26.80 26.00

Spread = $0.05 Spread = $0.25

Security B has a larger spread: Relative to Security A, B likely has (1) more risk,
(2) more informed traders, or is less liquid.

Copyright © 2006 Scott Bauguess


Common Stock Exchanges
Market Structure: e.g. NYSE, AMEX
1. Operate using the auction system with a single market maker (in most cases) for
each traded security

Membership:
1. Market makers must be member of the exchange. Members pay for the right to
trade in a security (buy a seat on the exchange).
2. Not all seats are created equal – The right to trade IBM shares may be more
profitable than the right to trade 7-Eleven

Regulation & listing rules:


1. Exchanges are regulated by the SEC according to the Securities Exchange Act of
1934. Exchanges like the NYSE are also self-regulating organizations (SRO),
performing many of the monitoring activities to ensure credible markets. This does
not prohibit the NYSE from profiting (NYSE is not a non-profit organization)
2. Exchanges have minimum listing requirements such as minimum stock price,
market value and trading volume. These are imposed mainly to ensure that
sufficient revenue can be earned by the market-maker.
3. Firms need not be exclusive with their listing, and can list shares on a regional
and/or foreign exchange in addition to listing nationally. In each case, the firm must
meet the listing requirements of the exchange.

Copyright © 2006 Scott Bauguess


New York Stock Exchange (NYSE)
(a.k.a. the “Big Board”)

Is the biggest and most prestigious national exchange with 2,800 listed companies
and a market value of $13.3 Trillion (13/30/05).

The NYSE has 1366 exchange members (seats) which themselves trade at prices
upwards of 2 million dollars. These firms collectively own the exchange; however,
they do not run the exchange

Seat holders are allowed to buy and sell securities on the exchange floor without
paying commissions

Copyright © 2006 Scott Bauguess


New York Stock Exchange (NYSE)
NYSE Characteristics:
1. Average trading volume is about 1 billion shares per day
2. About half of the NYSE members are commission brokers, while the other half is
specialists/market makers
3. The market opens each day as a call market (specialist sets market clearing
price), and then operates as a continuous auction throughout the rest of the
trading day
4. Each firm traded on the exchange is assigned only one specialist, but a
specialist can be assigned more than one security/firm
5. Each specialist has a private limit order book in which they have the demand
schedule for all buyers and sellers (price & quantity). Their first obligation is to
match orders, and only if necessary, trade on their own inventory
6. 80% of all trades done by a specialist or order matches, 20% are trades on their
own inventory.
7. If trade imbalances get too large, beyond the capacity of the market maker to
facilitate smooth trading, then trade suspension may occur. This occurs more
often than you think, particularly around merger announcement or large private
information events. If the Specialist observes unusual activity, then trading can
be suspended.

Copyright © 2006 Scott Bauguess


NYSE Delisting
NYSE delisting can occur if:
1. There are fewer than 400 total security holders
2. There are less than 1,200 total holders and average month-end volume
is 100,000 shares
3. Fewer than 600,000 shares in public hands
4. Market cap less than $8 Million
5. Market cap or tangible assets less than $12 Million and NI less than
600,000

Comment: Reverse stock splits are often performed to meet exchange


requirements.

Copyright © 2006 Scott Bauguess


Over the Counter (OTC) markets
Over-the-counter stock markets: NASDAQ (National Association of Securities Dealers
Automated Quotations system) was established in 1971 as a subsidiary of the NASD
(National Association of Securities Dealers)

Trades over 3,800 stocks (Market cap of $3.6 Trillion – 12/31/05) on a virtual trading floor
– a network of computer systems – and over 500 market makers.

Market characteristics
1. Negotiated system with Multiple Market Makers – as many as 20 market makers may list quotes
on Microsoft (MSFT).
2. Although smaller aggregate market cap, share volume on the Nasdaq larger than NYSE, with
almost 500 billions shares traded annually.
3. There are listing requirement for NASDAQ firms, but even so, this is referred to as the “unlisted”
firm market, because initially the NASDAQ served those firms that could not list on an
exchange. Historically, firms would switch to the NYSE from NASDAQ when they were
sufficiently mature, but since the late 1980’s, many firms remained, particularly in the high-tech
sectors (Microsoft, Oracle, Cisco etc.). Now the NASDAQ is on par with the NYSE.
4. Market makers post bid-ask spreads, but are only required to fill those quotes up to 1,000
shares, so doing so in not costly relative to the risks of a specialist.
5. Nasdaq is actually two separate markets: Nasdaq National Market (NNM) and Nasdaq small
cap market.

Copyright © 2006 Scott Bauguess


Electronic Communication Networks (ECNs)
ECNs electronic communications exchanges (Island, Instinet, Archipelago,
MarketXT etc.) are a relatively recent financial innovation

1. ECNs were initially formed as a private network to execute trades, but have
since been popularized with competitive pricing

2. NASDAQ was opened to ECN’s in late 1990’s which spurred their growth. ECN
orders are transmitted to NASDAQ and are displayed along side market makers

3. ECNs are not market makers, do not act as a dealer holding inventory, but
simply broker order matching. Investors can trade directly with one another
through an ECN, by passing the regular market structure

4. ECN’s now have 30% of NASDAQ trading volume, 5% of NYSE

5. Execute after hour trades (past 4PM Eastern time) – greater than 70 million
shares a day

Copyright © 2006 Scott Bauguess


Institutional Trading
Block Trades: Trades greater than 10,000 shares and a Market Value of
$200,000
1. 1961: 9 block trades per day (3% of NYSE volume)
2. 1999: 16,600 block trades per day (50% of NYSE volume, 24.6% of NASDAQ)

Program Trades: When a buyer wants to purchase a number of different


stocks at the same time
1. NYSE definition is at least 15 stocks at a market value of $1 million
2. Institutions with diverse portfolios often care about firm characteristics, and not
specific firm, hence “baskets” of stocks trading with lower transactions costs are
attractive

Upstairs market: Trading desks at major securities firms are linked


electronically to make trades among themselves, off of the exchange floor,
and not through a market maker or specialist.

Copyright © 2006 Scott Bauguess


Trading Mechanics
Market Order: An order to be executed at the best price available in the market
1. The order with the best price is always executed first for buying and selling
2. When orders are submitted to the market at the same price, the rule is first-in first-
executed. However, public orders always supercede dealer orders at the same price
when dealers are trading on their own account (public orders executed first).
3. Risk of a market order is that the price is unknown at the time of submission. The
investor specifies the number of shares to buy or sell, and then accepts the best
price available.
Conditional Orders: Designates a price threshold for the execution of a trade.
1. Limit orders:
• Buy limit order – the stock may be purchased only at a designated price or
lower
• Sell limit order – the stock may be sold only at a designated price or higher
1. Stop orders:
• Buy stop order – the stock is purchased only after the price rises to a
designated price.
• Sell stop order – the stock is sold only if the price falls to a designated price.
a) Protects investors from adverse price changes at the time of order
b) Does not guarantee that the order will take place.

Copyright © 2006 Scott Bauguess


Limit order examples
Acme Lubbock Inc is currently trading at $92.

The following are possible limit orders:

1. buy limit order at $85 – Investor will buy only if the share price drops to $85 or
lower

2. sell limit order at $99 – Investor will sell if the share price rises to $99

3. buy stop order at $99 – Investor will buy once the price rises to $99

4. sell stop order at $85 – Investor will sell if the share price drops to $85

Copyright © 2006 Scott Bauguess


Trading Mechanics
Fill or Kill: Order must be executed when it reaches the market (usually within
a day, but usually shorter)

Open Order: This order is good until the investor cancels it, but no more than 3
months.

Odd Lot: < 100 shares. Firms often try to buy-out owners of odd lots since
shareholders impose significant expense to the firm. Firm must send out
annual reports and proxy statements to each owners of the firm. And these
costs might be more than the aggregate investment value of an odd lot.

Round Lot: 100 share multiple

Copyright © 2006 Scott Bauguess


Short Selling
Selling borrowed shares (securities not owned by the investor at the time of sale).
1. short selling is a vital component to maintaining market efficiency. It allows downward
price pressure to over-valued securities that might not otherwise incorporate new
information if left only to the discretion of current shareholder.
2. Borrowing shares is effectively taking out a loan. The short seller pays interest on
borrowed shares until they are eventually returned (position covered).

Example: Investor sells short 100 shares of IBM at $90/share


1. Investor borrows shares from an IBM shareholder (could be a brokerage that is holding
shares on behalf of an IBM shareholder)
2. Investor pays interest on shares borrowed, worth $9,000 at the time of borrowing. This
accumulates daily.
3. Investor sells the shares at the market price of $90 and now has $9,000 in cash.

----- The shares must eventually be returned to the original IBM shareholder ----
• Investor returns to the market and buys 100 shares at the new prevailing price, and
returns the shares.

Copyright © 2006 Scott Bauguess


Short Selling
If the price falls (drops) during the time the shares were sold short, then the
investor buys them back at a reduced price and pockets the difference.
1. sold short 100 shares at $90 = collects $9,000
2. covered short position by buying back shares at $80 one week later = pays $8,000
3. Investor is left with $1,000 profit after returning the shares

Short selling constraints:


1. Short selling constraints occur when there is so much short interest (short sellers
taking positions), that it is hard to find shares to borrow
2. The short selling transaction, borrowing interest, is settled daily
3. The original shareholder of stock (or intermediary holding the stock) can demand
the shares back at any point in time, requiring the short seller to cover the position
4. There is no centralized market for selling short, so the process may be inefficient

Short selling constraints are believed by many to be one contributing factor for
over valued share prices like we saw in the dot.com era.

Copyright © 2006 Scott Bauguess


Margin Trading
Trading on Margin: When an investor borrows money to buy securities.
– By levering an investment (financial leverage), and investor can earn greater than the
market rate of return. This is done by borrowing money and investing into the market
as depicted in the diagram above

Example: Investor places $10,000 into a brokerage account to by shares of Acme Lubbock
Inc at $100/share
1. No leverage: Investor A purchases 100 shares worth $10,000.
2. Leverage: Investor B purchases 200 shares, borrowing $10,000 for the extra shares

If price increases by $10 then investor B receives a higher return


• RA = $10/share*100 shares = $1,000, $1,000/$10,000 = 10%
• RB = $10/share*200 shares = $2,000, $1,000/$10,000 = 20%

The opposite is true for a $10 decline


• If the price drops $50/share, then investor B loses 100% of his initial equity
while investor A loses 50%.

Copyright © 2006 Scott Bauguess


Margin Trading and the Efficient Frontier

Return
100%
in market
portfolio

Rm M

Rf

100% risk free


(lending $)

margin trading, standard deviation


borrowing to
trade > 100%
in market

Margin trading can facilitate efficient markets by creating investment opportunities that
might not otherwise be available.

Copyright © 2006 Scott Bauguess


Margin Maintenance
Margin Maintenance: The FED controls how much equity must be maintained
by margin traders. During the bubble years, it was 35%, but now it is 50%.
1. Equity = (total value of investment – amount borrowed) / total value of
investment.
2. In the previous example, investor B has (20,000–10,000)/20,000 = 50% (the
current limit)

Margin Call: When an investor drops below, the current margin limit, the
brokerage requires:
1. additional cash put into the account
2. liquidation of securities to the extent that margin requirements are met
3. If the investor fails to put up additional cash, then the broker has the authority to
sell securities for the investors account
4. Some brokerages set different margin limits by restricting which stocks can be
margined
• High volatility stocks like xoom.com or etoys (both now bankrupt) may not
be marginable

Copyright © 2006 Scott Bauguess


Market Indicies
An index is based on a statistical aggregation of share prices in a number of
representative securities. The index is a single price representation for a basket
of stocks that can be tracked by investors how wish to understand aggregate
market movement

Popular examples
1. Dow Jones 30
2. Nasdaq composite
3. NYSE Composite
4. Russell 1000
5. S&P 500
6. Wilshire 5000
7. Value line composite

Indices are fictitious constructs defined by whomever created the index


1. Standard & Poors created the S&P500
2. Dow Jones created the DJ30 or DJIA

Copyright © 2006 Scott Bauguess


Index pricing methods
Indicies are priced by weighting
1. Value weighting – companies with higher market capitalization (Microsoft & IBM)
are weighted more heavily
2. Price weighting: Each stock is weighted by the price, or in other words, equal
number of shares are invested in each security (buy 100 shares of each firm).
3. Equal weighting: Each stock is equally weighted regardless of market value of
price. Assumes that equal dollar amounts are invested in each security (buy
$100 in each firm).

Most indices, like the SP500 are value weighted, but the DJIA is price weighted. Price
weighting is problematic when stock splits occur, and because of this, the DJIA has to
use an index divisor.

1. DJIA – (1/divisor) * (the sum of all 30 share prices)


2. the divisor is adjusted for stock splits.
3. as of 11/15/2004, the divisor was a nice round 0.13532775
4. criticism of DJIA is that higher priced stock has a higher impact on the average.

Copyright © 2006 Scott Bauguess


Price weighted index
Example: How does a price weighted index treat a stock split?
Consider a two stock index:

Pre split Post Split


Price Shares Market Price Shares Market
outstanding Value outstanding Value

Stock A $40 60 $2,400 $40 60 $2,400


Stock B $100 20 $2,000 $50 40 $2,000

If divisor is 2, then price weighted index (PWI) is:


1. Index = (40 + 100) / 2 = $70
After Split divisor becomes
1. $70 = (40 + 50)/divisor
2. divisor = 90/70 = 1.285
3. Index = (40 + 50)/ 1.285 = $70
With the new divisor, the index remains unchanged with the split.

Copyright © 2006 Scott Bauguess


Market Value weighted Index
Market Value weighting is weights each index component in proportion to its market
capitalization. Consider the S&P500 composition, and in particular, the top 10 holdings
(2001 data)
1. GE = 3.4%
2. Exxon Mobil = 2.9%
3. Microsoft = 2.6%
4. Citigroup = 2.2%
5. Wal-mart=2.0%
6. Pfizer = 1.8%
7. B of A = 1.7%
8. Johnson & Johnson = 1.7%
9. AIG = 1.5%
10. IBM = 1.5%

The top 10 holdings represent 21% of the entire market capitalization of the index, but
represents only 2% of the total firms – would be 2% if equal weighted.

Copyright © 2006 Scott Bauguess


Index correlation
Indices are highly correlated – portfolios remove idiosyncratic risk, therefore different
indices are simply comparing different measure of systematic risk in the market
1. DJIA is systematic risk in industrial firms
2. NASDAQ 100 measure the systematic risk in high tech
3. SP500 measures the systematic risk as a broader market measure.

Dow Jones 30 correlation with other indices:


74% with Nasdaq composite
95% with NYSE composite
93% with Russell 1000
95% with SP500
87% with value line
92% with Wilshire

Copyright © 2006 Scott Bauguess