Securities Markets

1
Securities Markets

• Economics 71a
• Spring 2007
• Mayo, Chapter 3
• Lecture notes 2.3

2
Outline

• Markets
• Orders
• Positions
• Information

3
Markets

• Primary markets
• New issues (IPOs, corporate and public debt)
• Secondary markets
• Trading old stuff
• In many cases most activity in secondary

4
Money and Capital Markets

• Money markets
• Short term securities (1 year or less)
• Capital markets
• Longer term

5
Money Market Securities

• Treasury bills
• U.S. government debt
• Short term (less than 1 year)
• Commercial paper
• Short term corporate borrowing
• Discount pricing
• Buy for 10, get paid 11 in future
• No interest payments

6
Capital Market Securities

• Bonds (longer term borrowing)
• U.S. Treasury
• Municipal (tax free)
• Corporate
• More later

7
Capital Market Securities

• Stocks
• Common stock
• Preferred stock
• International
• More later

8
Trading and Secondary Markets

• Stock markets
• Bond markets
• Derivatives
• Foreign Exchange

9
U.S. Stock Markets

• New York Stock Exchange (NYSE)
• National Association of Securities Dealers
  Automated Quotation (Nasdaq)
  
• American Stock Exchange (AMEX)

10
Continuous Trading

• Market types
• Specialist
• Electronic dealer
• Open outcry
• Over the counter
• NASDAQ
• Upstairs (negotiated)
• ECN (electronic crossing network)

11
ECNs Electronic Crossing Networks

• Internet based trade networks
• Customers can meet directly (no broker)
• Used mostly by professional money managers
• Advantage fewer intermediaries
• Disadvantage less liquidity
• (Fewer people to trade with)
• Fastest growing markets

12
Other Markets

• Futures/Options
• Foreign Exchange
• Spot versus forward
• Bond

13
International Markets

• Many major international stock markets
• London
• Tokyo
• China
• many more
• US accounts for only 36 of the companies listed
  on stock markets around the world

14
International Investments

• Purchase stocks or bonds in foreign countries
• Purchase shares in foreign firms in U.S.
  (American Depository Receipts) (/English)
  
• Bonds can be issued in different currencies
• Eurobond Intel issues denominated bond in Japan

15
Trading Hours

• Most U.S. stock markets
• 930-400
• Extended hours on electronic trading networks
• After hours trading
• International markets (local times)
• Foreign exchange markets (24 hours)
• Hours increasing toward a 24 hour market

16
Outline

• Markets
• Orders
• Positions
• Information

17
Types of Orders

• Market order
• Limit order

18
Market Order

• Buy or sell at the current market price
• No restrictions
• Buy 50 shares at market

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Limit Orders

• Buy when price drops below a limit
• Sell when price moves above a limit
• Example
• Limit buy at 50 (price at 60)
• Stock moves to 55 (nothing happens)
• Stock moves to 49 (order executed)
• Advantage
• Might end up with a better price
• Disadvantage
• Order might end up unfilled

20
Brokers

• Enable trading of financial services
• Dealer function
• Access
• Mail
• Phone
• Internet

21
Types of Brokers

• Full service
• Extensive research
• Merrill Lynch
• Premium discount
• Limited research
• Charles Schwab
• Basic discount
• No research
• Etrade
• Classification is difficult

22
Transaction Costs

• Commissions
• Bid/ask spreads

23
Costs of Trading

• Commissions
• Fixed
• Negotiated
• Varying structures (fixed varying)
• 20 shares C
• Bid/ask spread
• Buy at the ask
• Sell at the bid

24
Bid/ask Spread

• Example
• Ask 88.5 (buy)
• Bid 88 (sell)
• Spreads may change
• Over time
• Over stocks
• Reveal the ease of trading a stock
• Liquidity again

25
Order Books

• Order book
• List of current limit buy and sell orders
• If you want to buy
• Can hit limit sell orders
• Walk up the book
• Higher price for more stock
• If you want to sell
• Can hit limit buy orders
• Walk down the book
• ECNs and visible order books

26
Settlement and Delivery

• Settlement dates
• Usually trade date 3 days
• Take delivery or leave shares with broker (street
  name)

27
Outline

• Markets
• Orders
• Positions
• Information

28
Long Purchase

• Straight purchase of a security
• Speculate that price will increase
• Buy at 100
• Sell at 110
• 10 return

29
Margin Purchase

• Buying on margin
• Borrow money to buy stock
• Buy at 75 margin
• 75 of money in investment is yours
• 25 is borrowed from broker or bank
• Purchase 100 of stock at 75 margin
• You put in 75, and you borrow 25

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Basic Margin Formula
31
Margins and Magnification

• Example stock Price 100
• Up Price 150
• Down Price 75
• If you purchased with your own money
• 100 total investment
• Up 50
• Down - 25

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Margins and Magnification

• Buy on 50 margin (zero interest charges)
• 100 own, and 100 borrowed (needs to be paid
  back)
  
• Purchase 200/100 shares 2 shares
• 100 total investment
• Up 2150 - 100 - 100 100 (50)
• Down 275 - 100 - 100 -50 (-25)

33
Margin Buying

• Borrowing money to buy stocks
• Magnifies gains and losses
• Can lose more than you put in
• Buy 200 of stock
• 100 your own
• 100 borrowed
• Stock goes to zero
• Lose 100 of own investment, and
• Owe 100 of borrowed money too

34
Maintenance Margins

• Margin required for investor to maintain
• If margin falls below this level investors must
  add more of their own money
  
• Margin call
• Common margin call
• Prices fall
• Margin rises
• Investor needs to come up with more funds

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Margin Requirements

• Common stock 50
• Bonds 50
• Options 20 stock value
• Futures 2-10 of the contract value

36
Short Sales

• Holding negative stock
• Sell stock you dont have (borrow)
• Buy it back later
• Pay dividends yourself in between
• Key issue
• Make money on a price fall
• Lose money on a rise
• Betting against a stock

37
The Mechanics of a Short

• Tell broker you want to sell 100 shares of IBM
  short (price 50)
  
• Broker borrows shares of 100 shares of IBM
  owned by another client
  
• Sells it to someone for 501005000, and pays
  this to you
  
• You must keep this amount on account with broker
• When dividends are to be paid, you pay broker,
  and broker pays the other client
  

38
The Mechanics of a Short

• IBM goes down to 40 per share
• You buy your 100 shares to take you back to
  zero, pay broker 401004000.
  
• Broker buys at market, and puts the shares back
  in the other persons account
  
• You make 5000-4000 1000 (less dividends)
• Make money when price falls
• Lose money when price rises

39
The Mechanics of a Short

• IBM goes up to 60 per share
• You buy your 100 shares to take you back to
  zero, pay broker 601006000.
  
• Broker buys at market, and puts the shares back
  in the other persons account
  
• You lose 5000-6000 -1000 (less dividends)

40
Margins and Shorts

• Broker requires additional funds to cover
  possible losses
  
• Fraction of additional sale amount
• Example
• Sell 5000 worth of stock at 50 margin
• Need to keep 1.55000 7500 on account with the
  broker
  
• When the price goes up, need to increase this
• Margin call

41
Oddities About Shorts

• Can lose unbounded amounts of money
• Normally only lose what you put in
• With short price can go up forever, and your
  losses keep increasing
  
• Also, broker can get in trouble if you default
• Other customer could lose original shares
• Often insured for this

42
Short Interest

• Fraction of shares sold short
• Measure of market pessimism in a stock
• Common market indicator
• Measures market pessimism

43
Squeeze Play

• Assume Microsoft has a large number of short
  sellers
  
• Price starts to rise
• Short sellers losing money
• Get nervous
• Buy stock to close out their short positions
• Prices rise more, more buying .. (etc. etc)

44
Outline

• Markets
• Orders
• Positions
• Information

45
Information Sources

• Private
• Quicken and Yahoo finance
• Wall St. Journal (fee)
• Value line and Standard and Poors (fee)
• Brokerage firms
• Corporations
• Government
• Federal Reserve
• SEC

46
Information Sources

• Key publications
• Economic information
• Federal reserve bulletins (economic info)
• Firm/investment data
• Value Line Survey
• Standard and Poors Handbook
• Security firm reports
• Firm annual reports

47
The Internet and Investing

• Cheap and accessible information
• Investor tools
• Charts
• Screening
• Calculators
• Online trading

48
Investment Information on the Web

• News articles
• NY times
• CBS Market watch
• CNN financial

49
More Investment Information

• Stock information
• Yahoo
• Google
• Quicken
• Historical information
• Yahoo
• Datastream (fee)
• Bloomberg (fee)

50
Warnings on Internet Information

• Dont use information to trade to frequently
• Dont believe everything you see on the web

51
More (biased) Information

• Firm annual reports and accounting info
• Analyst information
• Analysts recommend (buy, sell, hold)
• Problems
• Firms often are biased in what they tell
  analysts
  
• Analysts are biased since stocks they analyze can
  be their own clients
  

52
Internet Tools

• Education
• www.investorguide.com
• www.fool.com
• www.smartmoney.com
• Calculators
• www.financenter.com

53
Internet Tools

• Stock screening
• Quicken
• Yahoo
• Google
• Plotting/graphics
• bigcharts.com
• smartmoney.com

54
Market Indices

• Summarize market movements
• Examples
• Dow Jones Industrial (30 stocks)
• NYSE Composite
• SP 500 Composite (500 stocks)
• NASDAQ Composite
• Nikkei (Japan)
• Wilshire 5000
• Sector indices

55
Index Construction

• Weighted sum
• Weighting options
• Equal w (1/N)
• Relative value of the firm (SP, NASDAQ)
• Value weighting
• Odd (Dow Jones)

56
Index Uses

• Summary of the market
• Investor benchmark (performance check)
• Compare own result to index
• Investment target
• Index mutual fund

57
Index Problems

• Index is not constant
• Additions and removals
• Changing weights
• As stock increases in value, share in index
  increases
  
• Index can drift towards growing sectors in the
  market