Presentation on theme: "Vicentiu Covrig 1 Securities Markets. Vicentiu Covrig 2 The Role of Financial Markets Money markets: debt type securities with maturity up to one year."— Presentation transcript:
Vicentiu Covrig 2 The Role of Financial Markets Money markets: debt type securities with maturity up to one year Capital Markets: everything else Stock Markets Bonds (Fixed Income Markets): bonds, loans, notes, securitizations Financial Derivatives: Futures, Options, Swaps Foreign Exchange markets
Vicentiu Covrig 3 Primary vs Secondary Markets New securities are issued with the help of investment banks (or underwriter) New issues are sold on the primary market first, and subsequently sell on the secondary market. - The secondary markets are the security exchanges. The selling of shares for the first time in a new company is called a initial public offering (IPO) A private placement means new securities are sold directly to investors, bypassing the open market Registration not required
Vicentiu Covrig 4 Underwriting Investment banks: advise or underwrite new issues; distribute shares to institutional investors through road shows For Large Issues, a Syndicate is Used Hot Issue Market - During some periods, over 50 news firms go public every month. - Many investors want these shares - Initial returns are high Who gets shares? - Those who want shares ask their broker. - When more shares are sought, than are being issued, priority tends to go to the large shareholders and the broker’s best clients. - If you are a small-money investor and receive shares of an IPO, look out, it may be a lemon!
Vicentiu Covrig 5 Markets where investors trade previously issued securities Auction markets involve bidding in a specific physical location (example NYSE) - Brokers represent investors for a fee - Others trade for their own account Negotiated markets consist of decentralized dealer network (example NASDAQ, Bond markets, FX markets) Secondary Markets
Vicentiu Covrig 6 Equity Markets New York Stock Exchange - An Agency Auction Market Market in which brokers represent buyers and sellers and prices are determined by supply and demand. - Trading All trading in a specific stock is done at the post where that stock is assigned on the NYSE floor. Trading is managed by the specialist.
Vicentiu Covrig 7 Electronic market NASDAQ National Market NASDAQ SmallCap Market Negotiated market - Market makers are dealers - They quote bid-ask prices (ask is greater than bid) - Bid: price dealer/market maker buys - Ask: price dealer/market maker sells Nasdaq
Vicentiu Covrig 8 Network of dealers standing ready to either buy or sell securities at specified prices - Dealers profit from spread between buy and sell prices - Handle unlisted securities Nasdaq SmallCap Market - 800 small firms seeking Nasdaq market maker sponsorship - No penny stocks (price < $1) Over-the-Counter Bulletin Board - 3,000+ securities offered by 300+ market makers - Penny stocks traded here Electronic Communication Networks (ECNs) - Electronic market for institutional investors to trade with each other - ECNs handle the after hours trading too Over-the-Counter Markets
Vicentiu Covrig 9 Provide a composite report of market behavior on a given day Price Weighted: Dow Jones Industrial Average Value Weighted: S&P500 Equity Market Indicators/Indices
Vicentiu Covrig 10 Brokerage firms earn commissions on executed trades, sales loads on mutual funds, profits from securities sold from inventory, underwriting fees and administrative account fees - Full-service brokers offer order execution, information on markets and firms, and investment advice - Discount brokers offer order execution Brokerage Operations
Vicentiu Covrig 11 Cash account: Investor pays 100% of purchase price for securities Margin account: Investor borrows part of the purchase price from the broker Cash management account - Checks can be written against account’s assets Wrap account: Brokers match investors with outside money managers - All costs, fees wrapped into one Account Types
Vicentiu Covrig 12 Dealers ready to either buy or sell - Bid price is highest offer price to buy - Ask price is lowest price willing to sell Ask price - Bid price >0 (dealer spread) - “Makes a market” in the security - More than one dealer for each security in over-the- counter markets Orders in OTC Markets
Vicentiu Covrig 13 Market orders: Authorizes immediate transaction at best available price “Buy 50 shares of Home Depot at market” Limit orders: Specifies a particular market price before a transaction is authorized - How long to wait? Fill or kill Day order Good ‘til canceled - “Sell 100 shares of IBM at $82.70 or better, today” - “Buy 200 shares of Dell at $30.72 or better, fill or kill” Types of Orders
Vicentiu Covrig 14 Types of Orders Stop orders: Specifies a particular market price at which a market order is authorized - Stop Loss order: Placing an order to sell when a stock falls to a specific price. Most settlement dates are three business days after the trade date
Vicentiu Covrig 15 Impact on Return Before going online: - average turnover was 70% - beat the market by 2.4% per year After going online: - turnover jumped to 120% - under performed the market by 3.5% per year Brad Barber and Terrance Odean, 2002, “Online Investors: Do the Slow Die First?” Review of Financial Studies, 15, 455-487. A study of 1,607 investors which moved from discount broker to online broker.
Vicentiu Covrig 16 To open margin account, exchanges set minimum required deposit of cash or securities Investor then pays part of investment cost, borrows remainder from broker - Margin is percent of total value that cannot be borrowed from broker Federal Reserve sets the minimum initial margin on securities - Unchanged since 1974 at 50% Actual margin at any time cannot go below the maintenance margin level set by exchanges, brokers - Investor’s equity changes with price - Margin call when equity below maintenance level Margin Accounts
Vicentiu Covrig 17 Margin Accounts Margin is percent of total value that cannot be borrowed from broker Initial Margin: Amount investor put up/ Value of the account Ex: if the initial margin is 60%, and an investor wants to buy (transact) $10,000 of stock he needs to post $6,000 his money and borrow from broker $4,000 Maintenance margin: percentage of investor’s equity on hand at all times
Vicentiu Covrig 18 Margin account Consider that you borrowed $10,000 to buy $20,000 of stock. - If the value of the stock increases to $25,000, what is your margin? - If the value of the stock declines to $15,000, what is your margin?
Vicentiu Covrig 19 Leverage, the reason to use margin Using margin magnifies the realized return. Example: - buy 200 shares at $40 per share ($8,000 total) - Use $4,000 or your own money and borrow $4,000. - What is your return if the stock rises to $44? (a 10% increase) Solution: - Profit is ($44 - $40) × 200 = $800 - Return is $800 / $4,000 = 20% - A 20% return from a stock that increased 10%!
Vicentiu Covrig 20 Leverage, the reason NOT to use margin Using margin magnifies the realized return. Example: - buy 200 shares at $40 per share ($8,000 total) - Use $4,000 or your own money and borrow $4,000. - What is your return if the stock falls to $34? (a 15% decline) Solution: - Loss is ($34 - $40) × 200 = -$1,200 - Return is -$1,200 / $4,000 = -30% - A -30% return from a stock that declined -15%!
Vicentiu Covrig 21 Short selling: Profiting from falling stock prices Selling short (or short selling) - By executing a short sale, the investor sell stock that they do not own (by borrowing it from the brokerage). - Later, after the price falls (hopefully!) the stock is repurchased (called covering the short) and given back to the broker. The simple rule of “buy low, sell high” works well when prices are increasing. When prices are falling, can you “sell high, buy low?”