Learning Objectives part 1 of 2

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Chapter 16
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Learning Objectives (part 1 of 3)

• Discuss why financial markets exist and the
  benefit they provide to society
• Explain the difference between the primary and
  secondary market
• Describe the IPO process and the role of DPOs
• Describe the different places where securities
  are traded, the different listing standards, and
  the different methods of trading
• Name the more common of the stock market indices

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Learning Objectives (part 2 of 3)

• Distinguish between the types of brokers and
  brokerage firms
• Decide whether to order out stock or leave it in
  street name
• Analyze the benefits of DPPs and DRIPs
• Define the most common types of orders used in
  trading securities and explain the advantages and
  disadvantages of each
• Describe how buying on margin works.

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Learning Objectives (part 3 of 3)

• Explain the process of selling short
• Describe how dollar cost averaging works
• Describe how to experiment in the market without
  actually investing cash
• Discuss the protections available to an investor
• Describe pyramid schemes and Ponzi schemes

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Financial Markets

• They exist to facilitate the transfer of money
  from people with more cash than they currently
  need to people with less cash than they currently
  need
• The more efficient they are, the more
  opportunities for economic growth in a society

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Primary vs. Secondary Markets

• Primary Markets
• Newly issued securities sold by the issuer (e.g.,
  a company sells bonds to pay for a manufacturing
  plant)
• Usually no commission to buyer (seller pays full
  commission)
• Secondary Markets
• Issuer not involved, all trades between investors

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IPOs and DPOs

• Initial Public Offering
• Firm sells stock to public for the first time
• Firm assisted by an investment banker
• Transaction covered by Security Act of 33
• Seller usually under prices slightly
• Direct Public Offering
• Firms attempt to bypass investment banker and
  sell stock directly to the public

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Where are stocks traded?

• National Exchanges
• New York Stock Exchange (NYSE)
• American Stock Exchange (AMEX)
• Regional Stock Exchanges
• Midwest Stock Exchange
• Pacific Coast Stock Exchange
• Over the counter market (OTC)
• NASDAQ

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Listing Standards

• Toughest for national exhanges
• For NYSE
• At least 2,000 round-lot holders in the U.S., or
• At least 2,200 shareholders and a six-month
  average monthly volume of 100,000 shares, or
• At least 500 total shareholders and an average
  twelve-month volume of 1,000,000 shares.

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Methods of Trading

• Specialist (e.g., used on NYSE)
• Assigned specific stocks
• Required to make markets move smoothly and to
  make continuous quotes available
• Dealers (e.g., used in the OTC)
• Can have multiple dealers per stock
• Both specialists and dealers use bid-asked spreads

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Stock Market Indexes

• Dow Jones Industrial Average (DJIA)
• Dollar-weighted index
• Contains only 30 stocks
• Standard Poor 500 (SP 500)
• Value weighted index
• NYSE Composite Index
• NASDAQ Composite
• Wilshire 5000

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Types of brokerage firms (1 of 2)

• Distinction becoming blurred over time
• Full-service brokers
• Customer deals with one specific broker
• Substantial services offered
• Highest commission rates
• Brokers income based on annual commission volume
  generated
• Emphasis on office location

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Types of brokerage firms (2 of 2)

• Discount brokers
• All brokers respond to all accounts
• Fewer services offered
• Brokers are salaried
• Few actual offices

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Ordering out vs. street name

• Ordering out (taking possession)
• Direct communications from company (including
  dividends)
• Occasional direct benefits
• Street Name (leave at brokerage)
• No worry if lost or destroyed
• Immediacy of selling
• Simplification of tax information

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Direct Purchase Plan

• Similar to IPO, buy stock directly from company
  but stock has active market
• Must leave stock in account with company
• Great for dollar averaging programs
• Ideal for new (young) investors

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Dividend Reinvestment Program

• Like a dollar averaging program
• Shares must be on deposit with the company
• Still must declare dividends as taxable income
• Causes loss of portfolio diversification over
  time
• Great for new (young) investors

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Types of Orders for Trading (1 of 2)

• Market Order
• Will be immediately executed
• No certainty as to price
• If a trade is a good idea, then just do it

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Types of Orders for Trading (2 of 2)

• Limit order
• Specify price lower than market for buy
• Specify price higher than market for sell
• Execution NOT guaranteed
• Price guaranteed IF trade occurs
• Penny wise, pound foolish

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Buying on margin (1 of 3)

• Computing the initial margin
•  Buy 100 shares of stock at 10 per share
•  100 shrs x 10 price 1,000 total purchase
• 1,000 total purchase x 60 initial margin rate
  
• 600 minimum initial cash provided
• 1,000 total cash
• - 600 minimum initial cash
• 400 maximum initial loan

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Buying on margin (2 of 3)

• The Effect of Buying on Margin
• ROE ROA / m
• where
• ROE investors return on equity,
• ROA the return on the investment itself, and m
  initial margin rate

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Buying on margin (3 of 3)

• Buy 100 shares at 10 per share stock goes to
  15 per share
•  ROA (1500 - 1000) / 1000 50
• If buy stock on 60 margin ( ignore interest
  charges)
• Initial investment 600
• Profit 500 (1,500 - 1,000)
• ROE 500 / 600 83.33
• Note 83.33 50 / .60

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Mechanics for selling a stock short (1 of 2))

• TODAY
•  
• Investor places an order to sell (short) stock
  that is not owned
•  
• Broker borrows the stock from someone else
•  
• Broker sells the stock to someone who has no clue
  that the stock being acquired is a short sale
  (i.e., being shorted)

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Mechanics for selling a stock short (2 of 2)

• IN THE FUTURE
• Investor decides to close out the position and
  places an order to buy the stock
• Broker buys the stock from someone who has no
  clue the stock is being bought to cover a short
  sale
• Broker returns the stock to whoever loaned it for
  the short sale

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Dollar Averaging (1 of 2)

• Commit to a program of buying a fixed dollar
  amount of an investment at predefined intervals
  (e.g., first of each month)
• This forces one to buy MORE shares when price low
  (and stock unattractive), and to buy LESS shares
  when price high (and stock looks great)

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Dollar Averaging (2 of 2)

• This has the effect of reducing the average
  purchase price over time (as compared to buying a
  fixed number of shares on the same intervals)
• Ideal if purchases made out of income
• Poor strategy if have all of cash today, unless
  it is the only strategy that one would follow to
  invest

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Playing the Market for Fun

• Can always do it on paper
• Time consuming and most people lose interest in a
  few days
• More interesting if done as a class game with
  extra credit points to the winners
• Several Internet sites allow one to construct and
  update a portfolio

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Protections for Investors

• If brokerage firm fails Securities Investor
  Protection Corporation (SIPC)
• If investor the victim of deception, fraud, etc.
  
• Arbitration (if signed a binding agreement when
  opened account)
• National Association of Security Dealers
• Securities and Exchange Commission

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Pyramid Schemes

• Partnerships or distributorships are sold (along
  with a product)
• Each seller of a partnership gets a percentage of
  the buyers revenues
• Great for the initial partners, not so good for
  the later partners

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Ponzi Schemes

• Principal of initial investors is used to pay
  incredible returns to these investors
• Word-of-mouth by early investors brings in new
  investors
• Money from later investors used to pay returns to
  the early investors.
• All Ponzi schemes eventually collapse