1 Chapter 1 Web Extension 1B A Closer Look at the Stock Markets

2 Topics in Web Extension Stock indexes Regulation Overview of investment banking Stock trading

3 Stock Indexes Stock indexes try to measure some aspect of the market The differ with respect to: Composition (types of stock in the index) Weighting (how the individual stocks are aggregated into an index) (More..)

4 Index Composition Replicate a particular exchange Measure a country’s most important stocks Measure a particular business sector Measure a particular investment “style” Measure an international region (More..)

5 Composition by Exchange NYSE Composite Nasdaq Composite (More..)

6 Composition by Business Sector Many different index providers, such as: Dow Jones Amex Morgan Stanley Many different sectors, such as: Airlines Biotechnology Chemicals Consumer retailers Technology

7 Composition by “Style” Two important investment styles are by the size of the firm and by its growth prospects. Growth is measure by high-expected sales growth and high price-book ratios (value stocks have lower growth and lower price- book ratios) Examples: Russell 1000 Growth Russell Midcap Value

8 Composition by International Region Morgan Stanley Capital International (MSCI) EAFE (Europe, Asia, Far East) Index Emerging Markets Index Pacific Index

9 Stock Weighting in Indexes Price weighted DJIA Market-value weighted S&P500 Nasdaq Composite Equally weighted Value Line Index

10 Regulation of Securities Markets Government Regulation– such as SEC. Insider trading oversight (SEC) Margin oversight (Federal Reserve) Self-regulation– such as NASD. Circuit Breakers– automatic halt in trading if stock prices have exceptional changes.

11 Public vs. Private Offerings Public offerings: registered with the SEC and sale is made to the investing public. Shelf registration (Rule 415, since 1982) allows firms to register an offering and sell parts of the offering over time. Private offering: Sale to a limited number of sophisticated investors not requiring the protection of registration. - Dominated by institutions. - Very active market for debt securities. - Not as active for stock offerings.

12 Investment Banking and Security Offerings Underwritten vs. “Best Efforts” Underwritten: firm commitment on proceeds to the issuing firm. Best Efforts: no firm commitment. Negotiated vs. Competitive Bid Negotiated: issuing firm negotiates terms with investment banker. Usually a 7% spread. Competitive bid: issuer structures the offering and secures bids (more common in bonds than stocks).

13 Initial Public Offerings Initial Public Offerings (IPOs) Underpricing—Average increase is 14% on first day. Performance– Underperforms similar stock during three years after IPO.

14 Costs of Trading Commission: fee paid to broker for making the transaction Spread: cost of trading with dealer Bid: price dealer will buy from you Ask: price dealer will sell to you Spread: ask - bid “Price Impact”– Large sales or purchase might cause prices to change. “Payment for Order Flow”– Exchange will pay brokers to direct orders to them.

15 The Specialist at the NYSE Handles around stocks (one per specialist) Stocks trade at the “specialist’s post” “Makes a market” by matching buyers/seller and by buying/selling from own inventory Goal is to “maintain a fair and orderly market” so that price changes are smooth Specialist loses money when smoothing the market, but makes it back during normal conditions

16 Trading Away from Exchanges Third Market– trading listed stocks but not through exchange Institutional market: to facilitate trades of larger blocks of securities. Involves services of dealers and brokers Fourth Market– institutions trading with institutions No middleman involved in the transaction

17 Margin Trading Investor uses only a portion of own capital for an investment. Borrows remaining component. Margin arrangements differ for stocks and futures.

18 Stock Margin Trading Maximum initial margin Currently 50% Set by the Fed Maintenance margin Minimum level of equity margin if prices change Margin call Call for more equity funds

19 Short Sales Mechanics Opening a short position: Borrow stock through a dealer. Sell it Deposit proceeds and margin in account. Closing out the position: Buy the stock Return to the party from which it was borrowed.

20 Short Sales Purposes and Features Purpose: to profit from a decline in the price of a stock or security. Must pay the broker the equivalent of any dividends paid by the stock “Uptick” restrictions– can only sell short when the ask price of a stock is higher than the last transaction Unlimited loss potential