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Chapter 1

Web Extension 1C
A Closer Look at the Stock
Markets

Topics in Web Extension

Stock indexes
Regulation
Overview of investment banking
Stock trading

Stock Indexes

Stock indexes try to measure some


aspect of the market
The differ with respect to:

Composition (types of stock in the index)


Weighting (how the individual stocks are
aggregated into an index)

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Index Composition

Replicate a particular exchange


Measure a countrys most important
stocks
Measure a particular business sector
Measure a particular investment style
Measure an international region
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Composition by Exchange

NYSE Composite
Nasdaq Composite

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Composition by Business
Sector

Many different index providers, such as:

Dow Jones
Amex
Morgan Stanley

Many different sectors, such as:

Airlines
Biotechnology
Chemicals
Consumer retailers
Technology

Composition by Style

Two important investment styles are by the


size of the firm and by its growth prospects.
Growth is measure by high-expected sales
growth and high price-book ratios (value
stocks have lower growth and lower pricebook ratios)
Examples:

Russell 1000 Growth


Russell Midcap Value
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Composition by International
Region

Morgan Stanley Capital International


(MSCI)

EAFE (Europe, Asia, Far East) Index


Emerging Markets Index
Pacific Index

Stock Weighting in Indexes

Price weighted

DJIA

Market-value weighted
S&P500
Nasdaq Composite

Equally weighted

Value Line Index


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Regulation of Securities
Markets

Government Regulation such as SEC.


Insider trading oversight (SEC)
Margin oversight (Federal Reserve)
Self-regulation such as NASD.

Circuit Breakers automatic halt in trading


if stock prices have exceptional changes.

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Public vs. Private Offerings

Public offerings: registered with the SEC and


sale is made to the investing public.

Shelf registration (Rule 415, since 1982) allows firms to


register an offering and sell parts of the offering over time.

Private offering: Sale to a limited number of


sophisticated investors not requiring the protection of
registration.
- Dominated by institutions.
- Very active market for debt securities.
- Not as active for stock offerings.

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Investment Banking and


Security Offerings

Underwritten vs. Best Efforts

Underwritten: firm commitment on proceeds to


the issuing firm.
Best Efforts: no firm commitment.

Negotiated vs. Competitive Bid

Negotiated: issuing firm negotiates terms with


investment banker. Usually a 7% spread.
Competitive bid: issuer structures the offering
and secures bids (more common in bonds than
stocks).
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Initial Public Offerings

Initial Public Offerings (IPOs)

UnderpricingAverage increase is 14% on


first day.
Performance Underperforms similar stock
during three years after IPO.

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Costs of Trading

Commission: fee paid to broker for making


the transaction
Spread: cost of trading with dealer

Bid: price dealer will buy from you


Ask: price dealer will sell to you
Spread: ask - bid

Price Impact Large sales or purchase


might cause prices to change.
Payment for Order Flow Exchange will pay
brokers to direct orders to them.
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The Specialist at the NYSE

Handles around 10-20 stocks (one per


specialist)
Stocks trade at the specialists post
Makes a market by matching buyers/seller
and by buying/selling from own inventory
Goal is to maintain a fair and orderly
market so that price changes are smooth
Specialist loses money when smoothing the
market, but makes it back during normal
conditions
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Trading Away from Exchanges

Third Market trading listed stocks but


not through exchange

Institutional market: to facilitate trades of


larger blocks of securities.
Involves services of dealers and brokers

Fourth Market institutions trading with


institutions

No middleman involved in the transaction


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Margin Trading

Investor uses only a portion of own


capital for an investment.
Borrows remaining component.
Margin arrangements differ for stocks
and futures.

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Stock Margin Trading

Maximum initial margin

Maintenance margin

Currently 50%
Set by the Fed
Minimum level of equity margin if prices
change

Margin call

Call for more equity funds


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Short Sales Mechanics

Opening a short position:

Borrow stock through a dealer.


Sell it
Deposit proceeds and margin in account.

Closing out the position:

Buy the stock


Return to the party from which it was
borrowed.
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Short Sales Purposes and


Features

Purpose: to profit from a decline in the


price of a stock or security.
Must pay the broker the equivalent of
any dividends paid by the stock
Uptick restrictions can only sell short
when the ask price of a stock is higher
than the last transaction
Unlimited loss potential
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