1. McGraw-Hill/Irwin Copyright © 2008 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 3 Participating in the Market

2. 3-2 Learning Objectives  Describe the process of buying and selling securities  Explain the difference between cash and margin accounts  Describe the types of trading orders that can be executed  Explain the tax implications of various investing strategies  Understand how to measure the performance of securities in various markets through the use of market indexes

3. 3-3 Participating in the Market Buying and Selling in the Market Buying and Selling in the Market Types of Orders Types of Orders Cost of Trading Cost of Trading Taxes and the 2003 Tax Act Taxes and the 2003 Tax Act Measures of Price Performance: Measures of Price Performance: Market IndexesMarket Indexes Indexes and Averages Indexes and Averages

4. 3-4 Buying and Selling in the Market Full service brokers Full service brokers ExamplesExamples Merrill Lynch Merrill Lynch Salmon Smith Barney Salmon Smith Barney UBS UBS Broker determines investors’ objectiveBroker determines investors’ objective Conservative Conservative Preservation of capitalPreservation of capital Income Income Growth plus income Growth plus income Growth Growth Risk versus (expected) returnRisk versus (expected) return

5. 3-5 Buying and Selling in the Market - (continued) Discount brokers and Online brokers Discount brokers and Online brokers Low commissionsLow commissions Stripped-down serviceStripped-down service No investment adviceNo investment advice Communications usually by emailsCommunications usually by emails

6. 3-6 Cash or Margin Account Cash account Full payment Cash account Full payment Margin account Pay a percentage Margin account Pay a percentage Settlement in three (3) business days for either account Settlement in three (3) business days for either account Margin percentage set by the Federal Reserve Bank Margin percentage set by the Federal Reserve Bank Used to control speculationUsed to control speculation 10% in 1920s10% in 1920s 80% in 196880% in 1968 50% since 197450% since 1974

7. 3-7 Margin Account Example You purchase 100 shares at $60 per share and margin = 50%

8. 3-8 Margin Account Example (continued) Assume the stock rises to $80 per share.

9. 3-9 Margin Account Example (continued) What is the return on the initial investment?

10. 3-10 Margin Account Example (continued) Assume, instead, the stock drops to $40 per share.

11. 3-11 Margin Account Example (continued) What is the return on the initial investment?

12. 3-12 Long or Short? – That is the Question ACTIONOBJECTIVEPOSITION Buy stocks Profit from expected increase in price Long Sell stocks (not owned) Profit from expected decline in price Short

13. 3-13 Short Sales Example You sold short 100 shares at $70 per share and margin is 50% If the price of the stock increases to $80, what will be the new value of your equity position?

14. 3-14 Types of Orders Market order – usually trades close to the current market price Market order – usually trades close to the current market price Limit orders Limit orders When buying – pay NO more than the limit priceWhen buying – pay NO more than the limit price When selling – receive no less than the limit priceWhen selling – receive no less than the limit price Stop order – becomes market order when price is hit Stop order – becomes market order when price is hit When buying – placed above current priceWhen buying – placed above current price When selling (“sell stop”) – placed below current priceWhen selling (“sell stop”) – placed below current price

15. 3-15 Length of Time for Executing Orders to Buy/Sell Securities Day orders – expire at the end of the day Day orders – expire at the end of the day Good till canceled (GTC) – expire when investor decides to cancel it Good till canceled (GTC) – expire when investor decides to cancel it investor Most brokerage firms let GTC orders automatically expire after 30 - 60 daysMost brokerage firms let GTC orders automatically expire after 30 - 60 daysbrokerage

16. 3-16 Cost of Trading Full-service brokerage Full-service brokerage Merrill LynchMerrill Lynch UBSUBS Morgan StanleyMorgan Stanley Discount brokers Discount brokers Charles SchwabCharles Schwab Quick &ReillyQuick &Reilly OldeOlde Online brokers Online brokers AmeritradeAmeritrade E-tradeE-trade

17. 3-17 Effects of Pricing Differential Example: 100 shares traded at $40/share i.e. total of $4,000 Broker type Commission/Total trade % commission Online$7/$4,0000.17% Discount$42/$4,0001.05% Full-service$100/$4,0002.50%

18. 3-18 Other Factors to Consider before Choosing the Type of Brokerage Service Degree of sophistication of the investor Degree of sophistication of the investor Degree of complexity of the investment Degree of complexity of the investment Capital gains tax implicationsCapital gains tax implications Potential merger offersPotential merger offers Retirement planningRetirement planning Estate planningEstate planning ALL the above may outweigh savings in commissions ALL the above may outweigh savings in commissions

19. 3-19 The Merits and Drawbacks of Internet & Online Trading ProsCons Availability of instant information How to interpret the information Downloading  Balance sheets  Income statement  Up-to-the-minute press releases (Hint: Google search for Free Edgar, requires free registration) The requirement to know The requirement to know  Accounting  Finance  Investment  Economics  Tax  Legal issues

20. 3-20 Taxes and the 2003 Tax Act Legal tax advice provided only by a CPA or CFP (Certified Financial Planner) Legal tax advice provided only by a CPA or CFP (Certified Financial Planner) Tax considerations could outweigh savings on brokerage commissions Tax considerations could outweigh savings on brokerage commissions

21. 3-21 Calculating the Marginal Tax Rates Example: Single - taxable income is $36,000 How much is your tax obligation?

22. 3-22 Calculating the Average Tax Example (continued) Single - taxable income of $36,000

23. 3-23 Capital Gains and Dividends Capital gain or loss occurs when an asset held for investment purposes is sold Capital gain or loss occurs when an asset held for investment purposes is sold Assets held for more than one year Assets held for more than one year Long-term capital gainLong-term capital gain Max tax rate: 15%Max tax rate: 15% Includes dividendsIncludes dividends Assets held for less than one year Assets held for less than one year Short-term capital gainShort-term capital gain Taxed as ordinary incomeTaxed as ordinary income

24. 3-24 Comparing Taxes Long-term Capital Gains versus Short-term Capital Gains Holding Period Profit Tax Rate Taxes 6 months $10,00035%$3,500 Over 12 months $10,00015%$1,500

25. 3-25 Measures of Price Performance: Market Indexes Dow Jones Averages Dow Jones Averages Standard & Poor Indexes Standard & Poor Indexes Value Line Average Value Line Average Other Market Indexes Other Market Indexes

26. 3-26 MEASURES OF PRICE PERFORMANCE COMPARE WITH MARKET INDEXES Please click on the icon for more information on the indexes TYPE OF PORTFOLIO RELEVANT INDEX Professional pension fund manager’s portfolio S&P 500 Stock Index Mutual fund specializing in small OTC stocks Nasdaq Portfolio of a small investor (in small cap stocks) Value Line Average or Russell 2000 www.nasdaq.com www.standardandpoors.com www.russell.com

27. 3-27

28. 3-28 Dow Jones Averages  Dow Jones Industrial Average (DJIA)  30 large “industrial” companies Serves as measure of entire U.S. market, covering:Serves as measure of entire U.S. market, covering: financial services financial services technology technology retail retail entertainment entertainment consumer goods consumer goods  Dow Jones Transportation Average (DJTA)  20 transportation stocks  Dow Jones Utilities Average (DJUA)  15 utility stocks www.djindexes.com

29. 3-29 DOW JONES INDUSTRIAL AVERAGE - DJIA The most popular index The most popular index “Blue-chip” index (i.e. stocks of very high quality) “Blue-chip” index (i.e. stocks of very high quality) Follows the general trend of the market Follows the general trend of the market Comprised of more than 25% of market value of the 3,000 firms listed on NYSE Comprised of more than 25% of market value of the 3,000 firms listed on NYSE Price-weighted average Price-weighted average

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31. 3-31 Calculation of DJIA Price Weighted Average Price Weighted Average Bias toward high priced stocks Bias toward high priced stocks Initially calculated by adding up the component stocks' prices and dividing by the number of components Initially calculated by adding up the component stocks' prices and dividing by the number of components Later, divisor was adjusted to smooth out effects of stock splits Later, divisor was adjusted to smooth out effects of stock splits

32. 3-32 Standard & Poor’s Indexes S&P 500 – S&P 500 – Widely followed by professional money managers and security market researchersWidely followed by professional money managers and security market researchers Comprised of more than 75% of market value of the 3,000 firms listed on NYSEComprised of more than 75% of market value of the 3,000 firms listed on NYSE In 2007, consisted of:In 2007, consisted of: 369 Industrial firms 369 Industrial firms 16 Transportation firms 16 Transportation firms 48 Utilities 48 Utilities 67 Financial firms 67 Financial firms Value-weighted indexValue-weighted index

33. 3-33 Other Standard & Poor's Indexes S&P 400 MidCap Index S&P 400 MidCap Index Composed of 400 middle-sized firms with market values between $1.2 billion and $9 billionComposed of 400 middle-sized firms with market values between $1.2 billion and $9 billion S&P 600 SmallCap Index S&P 600 SmallCap Index Companies smaller that MidCapCompanies smaller that MidCap S&P 1500 Index S&P 1500 Index CombinesCombines S&P 500 S&P 500 S&P 600 & S&P 600 & S&P 400 S&P 400 S&P 100 S&P 100 100 blue-chip stocks100 blue-chip stocks CBOE has individual option contracts on this index CBOE has individual option contracts on this index Closely mirrors performance of S&P 500 index Closely mirrors performance of S&P 500 index

34. 3-34 Application Example Standard & Poor’s Indexes Standard & Poor’s Indexes Value-weighted indexesValue-weighted indexes Each company weighted by its market value as a percentage of total market value for all firms Each company weighted by its market value as a percentage of total market value for all firms Example – a value-weighted index comprising of three firms A, B, and C the weighting is shown on the next slide

35. 3-35 Application Example Value-weighted Indexes StockSharesPrice Total Market Value WeightingA150$10$1,50012.0% B200$20$4,00032.0% C500$14$7,00056.0% $12,500100.0%

36. 3-36 Value Line Average 1,700 companies from NYSE, AMEX, and NASDAQ 1,700 companies from NYSE, AMEX, and NASDAQ Equal-weighted index Equal-weighted index Weighted equallyWeighted equally Regardless of market price or total market valueRegardless of market price or total market value Equal-weighting more closely conforms to the portfolio of individual investors Equal-weighting more closely conforms to the portfolio of individual investors

37. 3-37 The Complete List 100 Stocks in NAZDAQ-100 Please click on the following Hyperlink for the complete list NASDAQ-100NASDAQ-100 (the index itself) NASDAQ-100 Reflects Nasdaq's largest growth companies across major industry groups Reflects Nasdaq's largest growth companies across major industry groups All index components have a minimum market capitalization of $500 million, and an average daily trading volume of at least 100,000 shares All index components have a minimum market capitalization of $500 million, and an average daily trading volume of at least 100,000 shares

38. 3-38 The shadow of the Index The Nasdaq 100 Index Tracking Stock (symbol) QQQQ is an Exchange Traded Fund which allows investors to essentially invest in all of the stocks that make up the Nasdaq 100 in a single security The Nasdaq 100 Index Tracking Stock (symbol) QQQQ is an Exchange Traded Fund which allows investors to essentially invest in all of the stocks that make up the Nasdaq 100 in a single securityQQQQExchange Traded FundQQQQExchange Traded Fund

39. 3-39 This graph shows how closely the shadow QQQ follows the Nasdaq

40. 3-40 Nasdaq Composite Index Has become a particularly popular index since the 1990s Has become a particularly popular index since the 1990s http://www.nasdaq.com/

41. 3-41 Wilshire 5000 Equity Index The most comprehensive index The most comprehensive index Represents the total dollar volume of all U.S. equity issues with readily available price data from NYSE, AMEX and NASDAQ stock markets Represents the total dollar volume of all U.S. equity issues with readily available price data from NYSE, AMEX and NASDAQ stock markets Contains more than 5,000 stocks Contains more than 5,000 stocks

42. 3-42 Other Market Indexes New York Stock Exchange http://money.cnn.com/markets/nyse/ The American Stock Exchange http://www.amex.com/ Wilshire 5000 Equity Index http://www.neatideas.com/w5000.htm Russell 3000 Index symbol: $RAZ.X Index symbol: $RAZ.X $RAZ.X Russell 2000 http://www.neatideas.com/r2000.htm Russell 1000 Index symbol: $RUXY or $RUI.X Index symbol: $RUXY or $RUI.X $RUXY$RUI.X$RUXY$RUI.X

43. 3-43 International Stock Averages Dow Jones World Index Dow Jones World Index FTSE 100 - United Kingdom FTSE 100 - United Kingdom FTSE 100 FTSE 100 Hang Seng - Hong Kong Hang Seng - Hong Kong Hang Seng Hang Seng Nikkei - Japan Nikkei - Japan Nikkei DAX – Germany (Frankfurt DAX) DAX – Germany (Frankfurt DAX) DAX TSX - Canada TSX - Canada TSX CAC 40 France CAC 40 France CAC 40 CAC 40

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45. 3-45 Bond Market Indicators Not widely followed by Not widely followed by Index orIndex or AverageAverage Gauged by Gauged by Interest-rate movementsInterest-rate movements Rising interest rates falling bond prices Falling interest rates rising bond prices

46. 3-46 Other Categories of Bonds Other Categories of Bonds Treasury Securities Treasury Securities Treasury notesTreasury notes Treasury BillsTreasury Bills Treasury BondsTreasury Bonds Corporate debt Corporate debt Mortgaged-backed securities Mortgaged-backed securities Municipal Bonds Municipal Bonds Eurobonds Eurobonds

47. 3-47 Mutual Fund Averages Mutual funds Mutual funds Preferred choice of investment for many investors in the U.S. & worldwidePreferred choice of investment for many investors in the U.S. & worldwide Broken into various categories to compute measures of performance Broken into various categories to compute measures of performance Starting point of the measurement period is very important in determining relative performance Starting point of the measurement period is very important in determining relative performance

48. 3-48 Important Consideration of looking at an INDEX How much the index has changed over a given period of time How much the index has changed over a given period of time Hours (intraday)Hours (intraday) DayDay WeekWeek MonthMonth QuarterQuarter Semi-annualSemi-annual Year(s)Year(s)

49. 3-49 Direction of Indexes Direction of indexes are closely related Direction of indexes are closely related They do not necessarily move together They do not necessarily move together Use the appropriate index that represents the risk characteristics of the portfolio being measured Use the appropriate index that represents the risk characteristics of the portfolio being measured

50. 3-50 WebsiteComment http://www.mscibarra.com/ Provides information on bond and stock indexes and on various modified indexes www.standardandpoors.com Contains information about S&P indexes and the markets www.sec.gov US Security and Exchange Commission’s website Provides access to SEC filings www.dowjones.com Provides information about the Dow Jones indexes finance.yahoo.com/ Profile pages on stock quotes provide access to company SEC filings

51. 3-51 WebsiteComment www.ashkon.com/nasdaq-100.html Components of NASDAQ-100 (QQQ) http://www.investorwords.com Investing glossary http://finance.yahoo.com/etf/education/04 Exchange Traded Funds http://finance.yahoo.com/q?s=QQQQ PowerShares QQQQ NASDAQ-100 Index Tracking ETF www.bloomberg.com Market data: rates & bonds