Finance 300 Financial Markets Lecture 6 Fall, 2001© Professor J. Petry

2 Housekeeping First Mid-term Exam (Next class meeting) –24% of grade (one mid-term can be dropped) –Exam will last the entire hour –3 parts to the exam matching, True/False (combined for about 50%) problems (about 50%) –There have been many definitions & terminologies developed, you should read over the book a few times clarifying each of the terms we have developed. We need not have gone over the definitions in class to have them on the exam. Definitions/terminology will represent a good chunk of the matching/true false component of the exam. –Problems to resemble “Things to Do” in flavor. You should think of variations on the theme to truly understand these problems, and be properly prepared for the exam.

3 Chapter III-Equity & Equity Markets Extra Credit Solutions

4 Chapter III-Equity & Equity Markets

5 Institutional Features of Equity Markets Trade Orders An instruction conveyed to a broker who then executes or fills the order Execution Priority Orders execution is prioritized by price and time. Preferential Trading Rules also prioritize client trading in front of non-client orders (someone who works for the brokerage firm is a non-client) At-the-Market Order An instruction to buy or sell a security immediately at the best available prices. (Sell 500 shares of GM at the market). Limit Order An instruction to buy or sell at a specific price or better. (Buy 1000 shares of GM at $65 or less; Sell 2000 shares of GM at $70 or more). Limit Order Book The list of outstanding limit orders. These orders will be executed when and if markets allow.

6 Chapter III-Equity & Equity Markets Institutional Features of Equity Markets Stop (Loss) Order An instruction to buy or sell a security to limit further damage. If you own the security (are long the security), a stop loss order will be an order to sell (Sell GM Stop Loss at $55). If you have borrowed the security and sold it to someone else (short the security) expecting the price to decline but it goes up instead, a stop loss order would be an order to buy (Buy GM Stop Loss at $70). A Stop Loss Order becomes a market order once the specified price is reached. Stop Loss Limit Order Same as a Stop Loss Order, but instead of becoming a market order, it becomes a limit order. You specify the limit order price, such that if/when your trade is actually ready to be completed, the price must be this level or better (higher if a Stop Loss Order to Sell securities you are long; lower if a Stop Loss Order to Buy securities you are short).

7 Chapter III-Equity & Equity Markets Institutional Features of Equity Markets Market-if-touched Order The opposite of a Stop Loss Order. Designed to get someone into a stock that they believe will go up (Buy GM if the price declines to $55 Market If Touched Order), or to sell a stock that they own which has already gone up in order to lock in profits (Sell GM at $85 Market If Touched Order). Good through Order An order which is good for a specified number of days, and cancelled if not filled. Open Order An order which remains active until executed or cancelled by client. All-or-None Order Specifies a minimum number of shares that must be bought/sold before the client will accept the fill. Any-part-order The opposite of an All-or-None order. The order can be filled piece-meal.

8 Chapter III-Equity & Equity Markets Institutional Features of Equity Markets Switch Order An instruction to sell one security and use the proceeds to buy another. Things to Do III-6 John Q. Investor calls his broker at 6:00am and submits the following orders: A market buy order for 2000 shares of IBM A limit sell order for 2000 shares of IBM at $90 A stop loss order for 2000 shares of IBM at $80 During the day IBM opens at $88 and rises to $102. What has happened to each of JQ’s orders?

9 Chapter III-Equity & Equity Markets Institutional Features of Equity Markets Determinants of the Bid-Ask Spread –Bid is the highest price per share the potential buyer is willing to pay –Ask is the lowest price per share the potential seller is willing to take –Bid-Ask Spread is the difference between the lowest ask price and the highest bid price quoted. The Bid is always lower than the Ask. Things to Do III-7 The limit order book for Discovery Café is displayed on the following page: The Specialist posts a bid of , and an ask of 1000 A. What is the bid-ask spread? B. The first order received is a market sell for 300 shares. It is executed at what price? Who is the buyer? C. The next order received is a market Buy for 100 shares. It executes at what price? Who is the Seller? D. The next order is a limit sell for It is executed at what price? Who is the buyer?

10 Chapter III-Equity & Equity Markets

11 Chapter III-Equity & Equity Markets Institutional Features of Equity Markets Circuit Breakers Rules that limit equity trading automatically when the “breaker” is triggered. Although only officially related to the NYSE, other exchanges have agreed to halt trading as well. First adopted in 1988 and amended in November 1997 are based on the change in the DJIA (Dow Jones Industrial Average) from previous day’s close. +/- 2%. Automatic computer generated trading is halted. +/- 10%. Halts trading for 60 minutes if before 2:00pm, and 30 minutes if betweeb 2:00 - 2:30. No impact if triggered after 2:30. +/- 20%. Halts trading for 120 minutes if before 1:00pm; 60 minutes if triggered between 1:00pm and 2:00pm; the remainder of the day if triggered between 2:30-4:00. +/- 30%. Halts trading for the remainder of the day. Margin Transactions The investor pays part of the cost of his investment in cash and borrows the remainder from his broker, using the investment itself as collateral. Leverage increases the risk of the investment. Minimum margin requirements are set by the Federal Reserve and by the exchange on which the security is traded.

12 Chapter III-Equity & Equity Markets Institutional Features of Equity Markets Margin The percentage of the value of the stock you must deposit money for. If you buy stock on 75% margin, you put down 75% of the value of the stock you purchase, and borrow 25%. Leverage The amplification in the return on equity when the investment is financed, wholly or partially through debt. Leverage = 1/margin Things to Do III-8 You decide to buy 1000 shares of Proctor & Gamble (PG) on 60% margin. PG is trading at $78 per share. How much must you pay to your broker? (Do not include commission). What is your leverage?

13 Chapter III-Equity & Equity Markets Institutional Features of Equity Markets Margin The percentage of the value of the stock you must deposit money for. If you buy stock on 75% margin, you put down 75% of the value of the stock you purchase, and borrow 25%. Leverage The amplification in the return on equity when the investment is financed, wholly or partially through debt. Leverage = 1/margin Things to Do III-8 You decide to buy 1000 shares of Proctor & Gamble (PG) on 60% margin. PG is trading at $78 per share. How much must you pay to your broker? (Do not include commission). What is your leverage?