Chapter 18.

The Common Stock Market

• Types of markets • Trading mechanics • Stock market indexes • Pricing efficiency

Common stock

• equity security
• ownership • entitled to distributed earnings • entitled to share of assets

I. Type of Markets

• • •

exchanges OTC trading of • unlisted stocks & listed stocks direct trading

Exchanges

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

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

• 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%)

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

the future of the specialist

• may be phased on with next 5-10 •
years recent SEC fines for improper trading for several major firms

AMEX

• merged w/ Nasdaq 1998 • specializes in equity derivative
securities and closed-end funds

Regional exchanges

• stocks may be listed on both NYSE • •
and regional exchange 5 regional exchanges cheaper seat prices

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

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

• • •

II. Trading Mechanics

• types of orders • short selling • buying on the margin • institutional trading

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

• 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

• 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

• investor sets reservation price BUT • no guarantee that limit order will be executed

• 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

• investor does not have to watch
market • but in a volatile market stop could be triggered prematurely -- end up trading unnecessarily

• 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”

• 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”

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

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

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

• 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)

• so short sellers
• believe price will fall and SOON • but price not currently falling • face unlimited losses if price rises

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

• 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

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

• if prices falls to $12,
• value of stock $12,000 • below 125% of $10,000 loan • get a margin call

Institutional trading

• vs. retail trades
• institutional trades are larger • special execution • over 50% of NYSE share volume

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)

program trades

• large # shares, different stocks • used by mutual funds for asset •
allocation want • low commissions • prevent frontrunning

what is frontrunning?

• brokers trade ahead of program
trade • to benefit from anticipated price movements • due to large trade

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

agency basis

• brokers bid for trade by commission • low commission, but • frontrunning likely

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

III. Stock market indicators

• measure average performance of a •
group of stocks different indexes are highly correlated: • DJIA & S&P 500 .991 (1990s) • DJIA & NYSE .95

indexes differ due to

• stocks included in the index • weighting of stocks •
• equal, price, value average • arithmetic • geometric

stock exchange index

• includes all stocks listed on • • •
exchange NYSE Composite Nasdaq Composite (both value weighted)

subjectively selected index

• organization picks group of stocks • •
to measure Dow Jones Industrial average S&P 500

DJIA

• price weighted • 30 large blue chip companies

• cross section of industries • leaders large movements in DJIA may halt trading on NYSE

S&P 500

• 500 large blue chip companies • value weighted • most popular benchmark for index
funds

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

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?

3 levels of price efficiency

• what are they? • implication? • evidence for U.S. stock markets?

Weak form efficiency

• current stock prices reflect
• information about past prices • and trading history

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

evidence

• U.S. stock market is weak-form •
efficient technical analysts do not beat the market • especially after trading costs

Semi strong form efficiency

• current stock prices reflect
• all publicly available information relevant to stock -- economic data -- financial statements

implication

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

evidence

• mixed • Yes
• most actively managed portfolios do not outperform randomly selected portfolios

• No.
• certain pricing anomalies persist for long periods of time • January effect • size effect

Strong form efficiency

• current stock prices reflect all
information • public and private

implication

• impossible to predict future stock
prices • stock prices are a random walk

evidence

• U.S. stock market is not strong form •
efficient why? • corporate insiders consistently outperform market • & they have access to private info

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

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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