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Chapter 18. The Common Stock Market Types of markets Trading mechanics Stock market indexes Pricing efficiency Types of markets Trading mechanics Stock.

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Presentation on theme: "Chapter 18. The Common Stock Market Types of markets Trading mechanics Stock market indexes Pricing efficiency Types of markets Trading mechanics Stock."— Presentation transcript:

1 Chapter 18. The Common Stock Market Types of markets Trading mechanics Stock market indexes Pricing efficiency Types of markets Trading mechanics Stock market indexes Pricing efficiency

2 Common 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

3 I. Type of Markets exchanges OTC trading of unlisted stocks & listed stocks direct trading exchanges OTC trading of unlisted stocks & listed stocks direct trading

4 ExchangesExchanges 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

5 NYSENYSE 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 /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 /2003 $1.35 million

6 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%)

7 role 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

8 the 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

9 AMEXAMEX 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

10 Regional 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

11 OTC 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

12 NasdaqNasdaq 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

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14 II. Trading Mechanics types of orders short selling buying on the margin institutional trading types of orders short selling buying on the margin institutional trading

15 Types 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

16 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

17 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

18 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

19 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

20 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

21 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

22 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

23 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

24 order 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

25 short 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

26 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)

27 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

28 Buying 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

29 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

30 exampleexample 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

31 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

32 Institutional 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

33 block 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)

34 program 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

35 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

36 exampleexample broker buys ahead of large buy order broker buys first large buy order pushes up price brokers 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 brokers holdings increase in value result frontrunning starts to push up price, so firm does not get best price

37 agency basis brokers bid for trade by commission low commission, but frontrunning likely brokers bid for trade by commission low commission, but frontrunning likely

38 agency incentive agreement set benchmark value for trade based on last days prices if broker does better gets commission + bonus higher commission, but frontrunning less likely set benchmark value for trade based on last days prices if broker does better gets commission + bonus higher commission, but frontrunning less likely

39 III. Stock market indicators measure average performance of a group of stocks different indexes are highly correlated: DJIA & S&P (1990s) DJIA & NYSE.95 measure average performance of a group of stocks different indexes are highly correlated: DJIA & S&P (1990s) DJIA & NYSE.95

40 indexes 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

41 stock 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)

42 subjectively 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

43 DJIADJIA 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

44 S&P 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

45 objectively 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

46 IV. Pricing Efficiency of the 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?

47 3 levels of price efficiency what are they? implication? evidence for U.S. stock markets? what are they? implication? evidence for U.S. stock markets?

48 Weak form efficiency current stock prices reflect information about past prices and trading history current stock prices reflect information about past prices and trading history

49 implicationimplication 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

50 evidenceevidence 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

51 Semi 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

52 implicationimplication 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

53 evidenceevidence mixed Yes most actively managed portfolios do not outperform randomly selected portfolios mixed Yes most actively managed portfolios do not outperform randomly selected portfolios

54 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

55 Strong form efficiency current stock prices reflect all information public and private current stock prices reflect all information public and private

56 implicationimplication impossible to predict future stock prices stock prices are a random walk impossible to predict future stock prices stock prices are a random walk

57 evidenceevidence 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

58 active 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

59 passive 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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