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 brokers 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 days 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