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Chapter 18. The Common Stock Market

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1 Chapter 18. The Common Stock Market
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

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

4 Exchanges physical location for trading trading by members
own a seat on the exchange stock traded on exchange are listed stocks

5 NYSE 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 2002 10/2003 $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%)

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

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

9 AMEX 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

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

12 Nasdaq 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


14 II. Trading Mechanics 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

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

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

18 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

20 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”

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”

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

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

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

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)

27 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

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

30 example 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

32 Institutional trading
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)

34 program trades 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

36 example broker buys ahead of large buy order broker buys first
large buy order pushes up price broker’s 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

38 agency incentive agreement
set benchmark value for trade based on last day’s 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

40 indexes differ due to 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)

42 subjectively selected index
organization picks group of stocks to measure Dow Jones Industrial average S&P 500

43 DJIA price weighted 30 large blue chip companies
cross section of industries leaders large movements in DJIA may halt trading on NYSE

44 S&P 500 500 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

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?

47 3 levels of price efficiency
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

49 implication 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 evidence 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

52 implication using public info to predict future stock prices will not work fundamental analysis will fail to beat market

53 evidence 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

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

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

57 evidence 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

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

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