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The Common Stock Market
Types of markets Trading mechanics Stock market indexes Pricing efficiency
ownership entitled to distributed earnings entitled to share of assets
I. Type of Markets
exchanges OTC trading of unlisted stocks & listed stocks direct trading
physical location for trading trading by members
own a seat on the exchange stock traded on exchange are listed stocks
the ³Big 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
470 specialists each specialist has 5-10 stocks process trades from floor brokers (5%) and electronically (95%) . stocks trade at post on the trading floor 20 posts. trading about 100 stocks each stock has one specialist 10 specialist firms.
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. value $2 trillion (2/28/03) leader in daily share volume over 500 dealers listing requirements . but the largest over 4000 companies listed mkt.
II. Trading Mechanics types of orders short selling buying on the margin institutional trading .
get lowest price for buy order -.Types of orders instructions from investors to brokers market order buy/sell order to be executed at best price -.get highest price for sell order .
price could rise/fall from time order is placed to time it is executed .) market orders given priority in trading no guarantee of execution price -. market order (cont.
limit order buy/sell order where investor specifies price range ³buy at $50 or less´ ³sell 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 loss order . stop order order lies dormant turns into market order when certain price (³the stop´) is reached ³buy if price rises to $60´ ³sell if price falls to $58´ -.
investor does not have to watch market but in a volatile market stop could be triggered prematurely -.end up trading unnecessarily .
but only is executed at $65 or less´ . stop limit order turns into limit order when stop is reached ³buy if price rises to $60.
market if touched order turns into market order if certain price is reached ³buy if price falls to $55´ ³sell if price rises to $62´ .
or canceled good until canceled/open order is good indefinitely .how long is an order good? fill or kill order executed when reaches trading floor.
000 shares or $200.order size round lots lots of 100 shares odd lots less than 100 shares more difficult to trade block trades 10.000 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 .
75.75 (zero upick) $20. $20.75.75. $20 (downtick) . $21 (uptick) $20. 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.
so short sellers believe price will fall and SOON but price not currently falling face unlimited losses if price rises .
using stock as collateral borrow at call money rate Fed sets initial margin requirement minimum cash payment 50% since 1975 .Buying on the margin buyer borrows part of purchase price of stock.
margin call -. if stock price falls collateral worth less if collateral worth only 125% of loan (maintenance margin) -.owner must put up more cash or sell stock margin calls can worsen stock crash .
000 capital but tied up only $10. $20 per share $20.example 1000 shares.000 cash.000 leverage gains/losses on $20.000 capital . borrow $10.000 cost $10.
000 loan get a margin call . value of stock $12. if prices falls to $12.000 below 125% of $10.
retail trades institutional trades are larger special execution over 50% of NYSE share volume .Institutional trading vs.
block trades large # shares in one stock executed in ³upstairs´ market other firms directly take other side of trade remainder executed on trading floor or Nasdaq (downstairs) .
different stocks used by mutual funds for asset allocation want low commissions prevent frontrunning .program trades large # shares.
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 .95 .991 (1990s) DJIA & NYSE .
price.indexes differ due to stocks included in the index weighting of stocks equal. 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 .
then take smallest 2000 of those .objectively selected index inclusion of stock based on objective criteria market value Wilshire 5000 all publicly traded stocks Russell 2000 largest 3000 companies.
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? .
stock markets? .S.3 levels of price efficiency what are they? implication? evidence for U.
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 .
stock market is weak-form efficient technical analysts do not beat the market especially after trading costs .evidence U.S.
Semi strong form efficiency current stock prices reflect all publicly available information relevant to stock -.financial statements .economic data -.
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 .
certain pricing anomalies persist for long periods of time January effect size effect . No.
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. stock market is not strong form efficient why? corporate insiders consistently outperform market & they have access to private info .S.
sector.active strategy using fundamental or technical analysis to select stocks to buy/sell growth. value funds trading on this info increases trading costs tax consequences odds of working are low .
passive strategy believe market is efficient. defer taxes index funds outperform most actively managed funds . just capture long-run returns of market buy-and-hold diversified portfolio index funds lower expenses.