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Investment Markets and Transactions

Investment Markets and Transactions. Gitman-Joehnk Chapter 2. Three Functions of Investment Markets. Economic Function Continuous Pricing Function Fair Pricing Function. Trading on the Capital Market.

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Investment Markets and Transactions

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  1. Investment Markets and Transactions Gitman-Joehnk Chapter 2

  2. Three Functions of Investment Markets • Economic Function • Continuous Pricing Function • Fair Pricing Function

  3. Trading on the Capital Market Economic Function- this mechanism facilitates the transfer of money from savers to borrowers * matches up would be borrowers with available savers

  4. Trading on the Capital Market Continuous Pricing Function - prices are available moment by moment * investors can discover the prices of various financial assets instantaneously during the business day

  5. Trading on the Capital Market Fair Pricing Function - when you buy or sell your stock at the going market price, you are assured of getting a fair price * many people are competing for this business - the greater the number of people and the moral formal the market place the greater the assurance of a fair price

  6. Trading on the capital market initially takes place on the primary market. Primary market transactions generally take the form of: IPOs SEOs Rights Offerings Private Placements Generally make use of Investment Banks to provide administrative and underwriting services

  7. Secondary market transactions (also called after-market transactions) are carried out using: Organized Securities Exchanges Over-the-Counter Markets ECNs - electronic communication networks

  8. Trading Systems • Securities are traded through 3 different mechanisms: • specialist system • market-makers system • Super DOT ( electronically)

  9. Specialist System Unique to the NYSE and AMEX exchanges trades at these two exchanges are subject to the oversight of an exchange member called a “specialist” the Specialist is expected to maintain a fair and orderly market in one or more assigned securities.

  10. Specialist System Specialists own > 1/3 of the 1,366 NYSE memberships Consider the following example of a transaction on the specialist system: • an investor with a brokerage acct. at Paine Webber places an order to buy 100 shares of IBM common stock

  11. Specialist System • Broker for Paine Webber wires order to floor of exchange where PW employee receives it and takes it to the Specialist’s post • the post is the specific location where IBM is traded on the exchange floor. • The specialist’s job is to keep the difference or “spread” between the buy and sell prices small and to see that the seller or buyer will always have a counterparty to their trade.

  12. Market-Maker System • Relies on a Group of competing individuals (rather than a specialist) to maintain a fair and orderly market • market maker system uses trading pits • at these sunken areas on the trading floor, groups of market makers trade by the open outcry, that is by calling out their offers to buy and sell

  13. Market-Maker System • The open outcry market maker system eliminates any stand in line or computerized order entry • The group of market makers in the pit is called the “crowd”

  14. Super DOT • Super DOT - an electronic system enabling the NYSE member firms to send certain orders directly to the specialists’ posts on the floor of the exchange without using a human runner to deliver the order • Specialists use Super DOT to confirm trades back to member firms • NYSE: on any given day >75% of trading volume is done via Super DOT

  15. Super DOT • Prior to the opening of the trading day, investors may place orders for “immediate execution” of up to 30,000 shares • once trading starts, maximum order size falls to 2,100 shares

  16. National Exchanges • Two National exchange markets in US. • NYSE • AMEX • NYSE first opened in 1817 but trading in non-listed securities continued near the buttonwood tree, outside in an area called the “curb exchange”

  17. National Exchanges • This curb exchange moved inside in 1921 and became known as AMEX • During an Avg. day, $9 billion worth of stock trades at the NYSE

  18. Regional Exchanges • NYSE is NOT the oldest exchange • the Philadelphia Exch. Was founded 2 years earlier • there are now 14 regional exchanges in the US • Many securities are dual listed - that is they are traded on both a national and a regional exchange • there are now approximately 150 stock exchanges throughout 50 countries

  19. NYSE Most organized exchanges are modeled after NYSE Membership on NYSE requires purchase of seat currently 1,366 seats past prices have ranged from $17K to $1.15 M Most members of NYSE are brokerage firms owning more than one seat

  20. NYSE Currently comprised of over 2300 firms with listings of over 2900 stocks (common and preferred) listings of over 2100 bonds

  21. NYSE Members are assigned particular roles: Commission brokers - partners in a brokerage firm and execute orders for their firm’s clients on the floor of the exchange Large brokerage house will have several to enable the quick execution of client orders Floor brokers - freelance commission brokers. No direct contact with the public. Handle order overflows the commission brokers are unable to handle. Receive a % of commission brokers fee

  22. NYSE Registered Traders - buy and sell solely for their own account. No public orders. Often referred to as floor traders engage in speculating Specialists - role discussed below

  23. NYSE Listing Requirements on NYSE include: at least 2,000 stockholders owning at least 100 shares at least 1.1 m. shares of publicly held stock demonstrated earnings power of : $2.5 m. earnings before tax at time of listing $2.0 m. earnings after tax for each of previous two years at least $18 m. of net tangible assets $18 m. in market value for publicly traded shares pay listing fee once listed, must comply with SEC and NYSE requirements or risk delisting

  24. Trading Activity at the NYSE Trading takes place on the NYSE exchange floor 18 trading posts specific stocks traded at each post Bonds & less frequently traded stocks are traded in an annex All trades made on the floor by members Perimeter contains telecommunications equipment used to transmit buy and sell orders from brokers’ offices to exchange floor and back

  25. Trading at the NYSE NYSE uses an auction process for trading goal: fill all sell orders at highest possible price fill all buy orders at lowest possible price NYSE employs a “specialist” to facilitate negotiation between buyers and sellers with the purpose of maintaining a continuous and orderly market any lack of continuity requires the specialist to buy or sell at specified prices from their own positions

  26. NYSE Those brokerage firm members designated as seat holders are the only individuals allowed to make transactions on the floor of NYSE.

  27. Other Exchanges AMEX second largest organized exchange in the US operates like the NYSE but with lower listing requirements 660 seats > 1,000 listed stocks approximately 125 listed corporate bonds

  28. OTC Market The OTC market is NOT an institution such as NYSE. Rather, it is a way of trading securities OTC markets account for 38% of the total dollar volume of domestic shares traded prices on OTC markets are determined using a quote system that involves: negotiation and dealer quotes

  29. OTC Market 35,000 issues are traded OTC approximately 5,400 have an active market in which frequent trades take place

  30. NASDAQ OTC dealers that “make” the markets for securities traded are linked to brokers and buyers and sellers through NASDAQ NASDAQ is an automated system that provides up-to-date bid & ask prices on the 5,400 selected, highly active, OTCsecurities

  31. NASDAQ Approximately 3,400 of the NASDAQ stocks are included in the NASDAQ/NMS system These stocks meet specific qualification standards for financial size performance trading activity Transactions involving stocks on NASDAQ/NMS are reported more quickly and in more detail than are transactions for non-NMS securities

  32. Investors are increasing including foreign investments in their investment portfolios This is an avenue through which they can enhance the diversification of their portfolio Offers wider range of industries and securities securities are traded in a larger number of markets securities are denominated in different currencies

  33. Securities exchanges now operate in over 100 countries and thus provide opportunities for trading nearly 24 hours a day. US investors can invest in foreign securities either directly converting US$ into appropriate foreign currencies and purchasing foreign securities on foreign exchanges purchasing shares of mutual funds that invest in foreign securities purchasing ADR on US exchanges purchasing shares in multinational firms that trade on US mkts.

  34. Foreign security investments will often out-perform domestic security investment. However investors must be aware of the additional risks associated with foreign investment. Risks may be associated with any number of uncertainties including: changes in trade policy changes in regulation, laws and taxation unstable governments and foreign exchange risk

  35. General Market Conditions Bull Markets - favorable markets, normally associated with: rising stock prices investor optimism economic expansion government stimulus Bear Markets - unfavorable markets, normally associated with: falling stock prices investor pessimism economic slowdown government restraint

  36. General Market Conditions In general, investors experience higher returns on common stock during bull markets since most securities are bullish in bullish markets most securities are bearish in bearish markets Market Conditions are hard to predict and can generally be identified only after the fact.

  37. Basic Types of Transactions Long Purchase - transaction in which an investor buys securities hoping to sell them at a later date at a higher price. This is the most common type of securities transaction The investor’s return from a long purchase will come from any dividends received plus any appreciation in share price (or minus any depreciation in share price), minus transactions costs.

  38. Basic Types of Transactions Margin Trading - securities purchases that are made at least in part with borrowed funds is known as Margin Trading. Margins are generally expressed as the percentage of the transaction financed with the investor’s own capital, the remainder is financed with borrowed funds. Minimum margin requirements are set by the Federal Reserve. Margin requirements are currently 50%.

  39. Margin

  40. Basic Types of Transactions Thus in a basic margin transaction, if the share price is $50 and a round-lot is purchased: the value of the transaction is $5000 the purchaser must a provide a minimum of .5 x $5000 = $2500 of “equity” (i.e. their own funds) can borrow up to $2500 from the brokerage firm

  41. Basic Types of Transactions An investor can purchase more shares of a security through margin trading than could be purchased through a straight cash transaction. At $50 per share, an investor could purchase 50 shares with $2500 in a straight cash transaction. The same investor could purchase 100 shares in a margin trade with the same amount of cash.

  42. Basic Types of Transactions If the stock price were to rise to $60 per share, ignoring any other cash distributions and all transactions costs If the first investor were to sell the stock, they will make $10 per share on the 50 shares they purchased for a profit of $500 on an initial cash outlay of $2500 or a return of $500/$2500=.20 or 20%

  43. Basic Types of Transactions The second investor will make $10 a share on 100 shares purchased for a profit of $1000 on an initial outlay of $2500. $1000/$2500=.40 or 40% Thus the main purpose in margin trading is to enhance returns.

  44. Basic Types of Transactions It is important to recognize that increased returns are usually associated with increased risk. This is clearly the case with margin trading. If the price had gone down by $10 instead of up, the loss to pure cash trades would have been $500 on the outlay of $2500 for a return of -20%. The loss would have been $1000 on the $2500 outlay in the margin trade for a return of -40%.

  45. Basic Types of Transactions Thus margin trading magnifies potential gains and potential losses. Because the security being margined is always the ultimate source of gain or loss, the security selection process is critical to any margin trading strategy.

  46. Basic Types of Transactions Advantages of Margin Trading: Major Advantage - enhanced return Minor Advantage - potential for greater diversification

  47. Basic Types of Transactions Disadvantages of Margin Trading: Major Disadvantage - magnified losses Minor Disadvantage - cost of the margin loan, the rate charged is usually 1 to 3 percentage points above the prime lending rate

  48. Basic Types of Transactions Margin Trading requires the establishment of a Margin Account Margin Accounts are opened with a minimum of $2,000 cash securities cash & securities

  49. Basic Types of Transactions Investors are generally required to sign a hypothecation agreement. This agreement grants the brokerage firm the right to use any of the securities bought as collateral on a bank loan given to the broker. The broker will also require that securities bought on margin be registered in street name. This makes it easier for the broker to use them as collateral on any loan extended to the broker.

  50. Basic Types of Transactions Margin Credit (borrowing) can be obtained either from the brokerage house or from a bank. Most cases from the broker. Investors face two forms of margin requirements initial margin - the initial amount of equity required at the time of purchase maintenance margin - the absolute minimum amount of margin (equity) that an investor must maintain in the margin account

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