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Financial Securities: Equity Markets

Financial Securities: Equity Markets. Introduction. A company’s stock represents a unit of ownership Shares are sold to generate money to achieve a company objective (ex. expansion, reduce debt, etc.)

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Financial Securities: Equity Markets

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  1. Financial Securities:Equity Markets

  2. Introduction • A company’s stock represents a unit of ownership • Shares are sold to generate money to achieve a company objective (ex. expansion, reduce debt, etc.) • A company’s shares trade initially on a primary market and subsequently on one or more secondary markets • A market is defined as a place where buyers and sellers come together for the purpose of exchange

  3. Primary Markets • New shares are issued in a primary market • An IPO (initial public offering) is when shares of a company are sold for the first time • IPO’s facilitated by investment dealers • Specialists in advice, design, and sales • Intermediaries between issuer and investor

  4. Secondary Markets – Stock Exchanges • A stock exchange brings together buyers and sellers of stock • Historically, stock exchanges had a physical location known as a trading floor • Most exchanges are now completely electronic (NYSE maintains a trading floor) • Investors are represented by brokers who engage in a bidding process in an attempt to obtain the best price possible for their clients

  5. Stock Market Indexes • A market index is a sample of stocks whose group activity is monitored to assess overall stock exchange performance

  6. Toronto Stock Exchange • Largest stock exchange in Canada • Listed companies include a broad range of Canadian and international businesses • Market capitalization of over $2 trillion (market cap = # of shares * price) INDEX: TSX Composite Index • widely quoted index of just over 200 companies that is designed to measure the performance of the Toronto Stock Exchange • Link • market-value weighted index • index is reviewed quarterly to ensure companies satisfy the inclusion criteria

  7. TSX Venture Exchange • Smaller Canadian exchange for usually smaller, domestic firms • Market capitalization of over $48 billion • INDEX:TSX Venture Composite Index • Measures the performance of the Venture Exchange • Market-value weighted index TSX Website

  8. New York Stock Exchange • Largest stock exchange in the world (“The Big Board”) • Owned by NYSE Euronext • Annual seat licenses are sold providing direct market access • Includes the stock of more than 2800 companies with a combined market value of over $20 trillion • S&P 500, NYSE Composite Index, etc. measure the performance of the NYSE • www.nyse.com

  9. Alcoa - AA American Express - AXP AT&T - T Boeing - BA Caterpillar - CAT Coca-Cola - KO Citigroup - C Disney - DIS DuPont - DD Eastman Kodak - EK Exxon Mobil - XOM General Electric - GE General Motors - GM Hewlett-Packard - HWP Home Depot - HD Honeywell - HON IBM - IBM Intel - INTC International Paper - IP Johnson & Johnson - JNJ McDonald's - MCD Merck - MRK Microsoft - MSFT 3M - MMM JP Morgan - JPM Philip Morris - MO Proctor & Gamble - PG SBC Communications - SBC United Tech - UTX Wal-Mart - WMT Dow Jones Industrial Index • Measures the performance of the broad market • Tracks the price changes of 30 significant industrial stocks • Price weighted index • Combined market value is equal to roughly 20% of the market value of all stocks

  10. NASDAQ • National Association of Securities Dealers Automated Quotations Systems • Computerized exchange that specializes in high-tech stocks • Market capitalization of over $4 trillion • Performance is measured by the Nasdaq Composite Index • www.nasdaq.com

  11. Global Stock Exchanges • There are approximately 200 stock exchanges in over 60 nations in the world • Global Stock Exchanges

  12. Over-The-Counter Market • A network of securities dealers linked together by phone and computer • Involves the trading of stocks that are not traded on a stock exchange • Often are small companies that have low trading volume

  13. After-Hours Trading • Most North American exchanges allow trading between 9:30-4pm • In 1999, individuals were given access to after-hours trading • Trading is supported by Electronic Communication Networks (ECN) which allow buyers and sellers to interact and trade (ex. Instinet, SelectNet)

  14. How to Make a Stock Trade • Investors can gain access to the stock market by using a full service or discount broker • Full Service Brokers provide access to the market as well as research and advice • Discount Brokers provide access to the market at a reduced commission but do not provide research/advice • Broker commissions can be a flat rate per trade or based on the number of shares traded • Broker Commissions

  15. Stock Market Transactions • Most investors confine their activity to simple buying and selling of stock • When you have performed a simple buy, you are said to be in a long position • There are a variety of different types of transactions that an investor can use

  16. BID & ASK Prices • Stocks trade based on bid and ask prices • BID = the highest price anyone is willing to pay for a stock • ASK = the lowest price anyone is willing to sell the stock • In order for a trade to occur, there must be a match between the BID and the ASK

  17. Calculating Profit • Investing expenses may include: commission, interest, or option premiums • To express profit as a percent, divide the profit in dollars by the original investment and multiply by 100 Profit ($) = Number of Shares * (Selling Price – Buying Price)‏ Less: Investing Expenses

  18. Selling Short • Opposite of a normal buy transaction • Short selling is done if you think the stock price will decrease Step #1: To sell short, a broker must lend you the shares in question. (sometimes stocks are scarce and cannot be borrowed for short sales)‏ Step #2: Sell the shares on the market in hopes that the price will decrease in the future. Step #3: Once the shares reach the desired level, buy the shares on the market and return them to the lender.

  19. Risks of Short Selling • If the share price increases, you lose money (no limit to losses!!!)‏ 2) If the broker asks you to cover your short position (buy back the stock on the market) before you are ready • If dividends are declared, you are responsible for compensating the lender

  20. Short Selling – 9/11 • In the month before the attacks, short sales on American and United Airlines jumped by 20 and 40 percent, respectively • Similar patterns were not replicated in the stocks of any other airlines • Unusual patterns of trading also occurred with investment firms Merrill Lynch stock, Morgan Stanley Dean Witter stock, and stock in Munich Re and the AXA Group (two of the insurers of the World Trade Center)

  21. Investopedia

  22. Short Selling - Example • You believe that shares in GM will decrease so you instruct your broker to sell short 100 shares. The shares are currently trading at $50. Assume the broker charges $20 commission on all trades. Calculate the profit/loss under the following circumstances: a) Assume the shares decrease to $40. b) Assume the shares increase to $75.

  23. Broker Orders • Market Orders • indicates that you want to buy/sell a stock immediately at the best price available • Limit Orders • An order to buy or sell at a specified price or better • No guarantee the trade will go through • Stop Orders • An order to buy or sell when the price surpasses a particular point • Once the price surpasses the stop price, the stop order becomes a market order

  24. LIMIT ORDER TO BUY Example: Bell Canada shares are trading for $35 and you are willing to buy but the most you are willing to pay is $33. Broker Order: Limit Order to Buy @ $33 Once the price reaches $33, the shares will be purchased as long as they can be acquired at or below the limit price. LIMIT ORDER TO SELL Example: Ford shares are trading for $25 and you are willing to sell but the lowest you are willing to sell for is $28. Broker Order: Limit Order to Sell @ $28 Once the price reaches $28, the shares will be sold as long as they can be sold at or above the limit price. Limit Order Examples

  25. Limit Orders • The duration of a limit order can be until the end of the day OR until cancelled Investopedia

  26. Stop Loss Order • An order to sell shares when the price of the stock drops to the stated limit (stop price)‏ • Reduces the amount of loss incurred when prices drop • Once the stop price is reached, the broker will sell for the best price available (market order)

  27. Stop Loss Order - Example • Example • B. Smith purchased shares of Ford for $4. He would like to limit his losses to $.50 per share. Broker Order: Stop Loss Order @ $3.50 If the share price drops to $3.50, the sale will be executed at the best possible price.

  28. Stop Buy Order • Used to limit your losses or protect your gains after selling short • If the price increases to a stated level, the shares will be automatically purchased to cover your position • Similar to the stop loss order

  29. Stop Buy Order - Example • Example: • B. Smith sold short shares of Ford when they were trading for $4. He would like to limit his losses to $.50 per share. Broker Order: Stop Buy Order @ $4.50 If the share price increases to $4.50, the broker will buy the shares for the best possible price available.

  30. Stop Limit Order • Combination of the stop and limit orders • Similar to a stop order that becomes a limit order rather than a market order when the order is triggered • There is no guarantee the order will be filled

  31. Stop Limit Order – Example • Example: You bought Disney at $80 and it has increased to $89. You think the stock might decrease in value and you would like to protect $8/share of profit and you are not willing to accept a lower price than $87. • Broker Order: Stop Limit Order (Stop - $88; Limit - $87) • If the stock price hits $88, the order becomes a limit order and the stock will be sold above $87 or not at all

  32. Buying on Margin • Very risky method of investing • Involves borrowing money for a portion of the investment • Interest is charged on the borrowed amount • Minimum amount the investor is required to contribute is referred to as the minimum margin requirement (%)‏ • Each stock exchange and broker have different requirements as to the minimum percentage • Example: If you wish to buy $10,000 worth of a stock and the margin requirement is 60%, you must put up $6000.

  33. Minimum Margin Requirements - Canada • The Investment Dealers Association (IDA) sets the margin requirements • Individual brokers may increase the requirements if deemed necessary

  34. Buying on Margin (cont’d)‏ • If the stock price increases, the excess can be withdrawn or used to purchase more stock • If the stock price decreases, the investor absorbs all the losses and may receive a margin call

  35. Margin Call • A margin call is theamount required to be paid by the investor to re-establish the minimum margin requirement Calculating the amount of the margin call… (Market Value – Broker Loan) + x = Minimum Margin Requirement (%) Market Value Let x be the amount of the margin call.

  36. BENEFITS Increases your buying power Increases the size of your profit RISKS Increases size of losses (more shares purchased; interest must be paid) Even if the stock rises, the break-even point is higher by the amount of the interest charges Buy on margin?

  37. Margin - Example • You are confident that shares in PepsiCo Inc. will increase in the near future. You would like to leverage your position by buying the shares on margin. The shares are currently trading at $75. You have $21,000 to invest. The minimum margin requirement is 70%. Assume the broker charges 10% on all borrowed funds. Answer the following questions: a) Determine the total value of the initial investment if you take advantage of the full amount available from your broker (borrow as much as possible)? How many shares can be purchased? b) If the stock price decreases to $70, calculate the amount of the margin call that will follow.

  38. Margin – Example (cont’d)‏ c) In three months if the share price increases to $80, calculate the profit if you sell your shares (assume a commission of $20 per trade).‏

  39. Mutual Funds • Defined: Investments that allow people with similar investment goals to pool their money in a diversified portfolio • A fund manager uses this pooled money to buy securities (stocks, bonds, etc.) • The price of mutual funds will increase or decrease with the value of the underlying securities • Bought/Sold at the end of the day for their Net Asset Value (NAV)

  40. Mutual Funds (Cont’d) • The main advantages of mutual funds include diversification and professional money management • The main disadvantages include fees and minimum investments

  41. Mutual Fund Fees • Mutual funds charge fees to cover the cost of managing your money • Management Expense Ratio (MER) is the percentage of the fund’s net asset value that is paid out annually to cover expenses • Costs include fees for the fund managers, marketing, accounting, record keeping, and legal advice • MER’s usually range from 1-3% • Fees are paid whether the fund makes money or not • How much do my mutual funds really cost?

  42. Mutual Fund Fees – (Cont’d) • In addition to the MER, some funds include “loads” which are fees you pay when you sell your units • Before investing in a mutual fund, you should read the fund prospectus • Front-End Loads – pay fee when you buy • Back-End Loads – pay fee when you sell • No Load – no fees for buying or selling • AIC Dividend Income

  43. Types of Mutual Funds • Money Market Funds • Objectives of income and liquidity • Investments include short-term money market instruments • Attractive to investors seeking low risk and high liquidity • (a) Mortgage Funds • Investment terms may be  5 years • Riskier than money market (more interest rate risk), but less risky than bond funds (shorter maturities) (b) Bond Funds • Objectives of income and safety • Subject to capital gains/losses due to interest rate risk

  44. Types of Mutual Funds (cont’d) • (a) Balanced Funds • Objectives of safety, income and capital appreciation • Min./max. rules apply for percentage invested in each asset class. (b) Asset Allocation Funds • Similar objectives as balanced funds, but typically not restricted by asset class percentage rules • Equity/Common Stock Funds • Objective of capital gains • Bulk of assets are in equity, but other assets held for liquidity, income and diversification purposes • May vary greatly in degree of risk and growth objectives

  45. Types of Mutual Funds (cont’d) • Growth Funds • Tend to invest in small-cap stocks, i.e. small companies with growth potential • Riskier than equity funds (small firms pay no dividends) • Specialty Funds • Objective of superior capital gains (through minimal diversification) • Tend to focus on one industry, market, or segment • International/Global Funds, for example, invest in foreign securities (and carry the risk of foreign exchange exposure)

  46. Types of Mutual Funds (cont’d) • (a) Real Estate Funds • Invest in income-generating properties for long-term growth and capital gains • Portfolio valuation is based on infrequent external appraisal • Less liquid than other funds – investors may need to give advance notice when selling (b) Ethical Funds • Relatively new type of fund • Investments are guided by moral criteria (e.g., not investing in tobacco-related firms)

  47. Types of Mutual Funds (cont’d) • Index Funds • Objective is to mirror the performance of a market index (e.g., S&P/TSX 60) • Generally lower management fees than other funds. • Dividend Funds • Objective of tax reduction through favourable treatment of dividend • Inappropriate for RRSPs or RRIFs • Price changes are driven by interest rates and market trends

  48. Types of Mutual Funds (cont’d) • Each type of fund has different risk-return characteristics. In general, they can be ranked from lowest risk/return to highest risk/return as follows: • Money market • Mortgage • Bond • Balanced • Dividend • Equity • Real estate • Specialty

  49. Other Funds • Segregated funds • Provide death benefits • Must guarantee a minimum percentage (75% is required, 100% is usually offered) of investor’s payments will be returned at fund maturity (or at death of owner) • Structured to prevent fund assets from being seized by creditors if investor declares bankruptcy • Upon owner’s death, assets may be transferred to beneficiaries without being subject to probate fees

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