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Chapter 3

Chapter 3. Participating in the Market. Buying and Selling in the Market. Full service brokers Examples Merrill Lynch Salmon Smith Barney Broker determines investors’ objective Conservative Preservation of capital Income Growth plus income Growth Risk versus (expected) return.

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Chapter 3

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  1. Chapter3 Participating in the Market

  2. Buying and Selling in the Market • Full service brokers • Examples • Merrill Lynch • Salmon Smith Barney • Broker determines investors’ objective • Conservative • Preservation of capital • Income • Growth plus income • Growth • Risk versus (expected) return

  3. Buying and Selling in the Market -(continued) • Discount brokers and Online brokers • Low commissions • Stripped-down service • No investment advice • Communications usually by emails

  4. Cash or Margin Account • Cash account Full payment • Margin account Pay a percentage • Settlement in three (3) business days for either account • Margin percentage set by the Federal Reserve Bank • Used to control speculation • 10% in 1920s • 80% in 1968 • 50% since 1974

  5. Margin Account Example You purchase 100 shares at $60 per share and margin = 50%

  6. Margin Account Example (continued) Assume the stock rises to $80 per share.

  7. Margin Account Example (continued) What is the return on the initial investment?

  8. Margin Account Example (continued) Assume, instead, the stock drops to $40 per share.

  9. Margin Account Example (continued) What is the return on the initial investment?

  10. Long or Short? – That is the Question

  11. Short Sales Example You sold short 100 shares at $70 per share and margin is 50% If the price of the stock increases to $80, what will be the new value of your equity position?

  12. Types of Orders • Market order – usually trades close to the current market price • Limit orders • When buying – pay NO more than the limit price • When selling – receive no less than the limit price • Stop order – becomes market order when price is hit • When buying – placed above current price • When selling (“sell stop”) – placed below current price

  13. Length of Time for Executing Orders to Buy/Sell Securities • Day orders – expire at the end of the day • Good till canceled (GTC) – expire when investor decides to cancel it • Most brokerage firms let GTC orders automatically expire after 30 - 60 days

  14. Cost of Trading • Full-service brokerage • Merrill Lynch • Morgan Stanley • Discount brokers • Charles Schwab • Quick &Reilly • Online brokers • Ameritrade • E-trade

  15. Effects of Pricing Differential Example: 100 shares traded at $40/share i.e. total of $4,000

  16. Other Factors to Consider before Choosing the Type of Brokerage Service • Degree of sophistication of the investor • Degree of complexity of the investment • Capital gains tax implications • Potential merger offers • Retirement planning • Estate planning • ALL the above may outweigh savings in commissions

  17. The Merits and Drawbacks of Internet & Online Trading

  18. Taxes and the 2003 Tax Act • Legal tax advice provided only by a CPA or CFP (Certified Financial Planner) • Tax considerations could outweigh savings on brokerage commissions

  19. Calculating the Marginal Tax RatesExample: Single - taxable income is $36,000How much is your tax obligation?

  20. Calculating the Average TaxExample (continued) Single - taxable income of $36,000

  21. Capital Gains and Dividends • Capital gain or loss occurs when an asset held for investment purposes is sold • Assets held for more than one year • Long-term capital gain • Max tax rate: 15% • Includes dividends • Assets held for less than one year • Short-term capital gain • Taxed as ordinary income

  22. Comparing Taxes Long-term Capital Gains versus Short-term Capital Gains

  23. Measures of Price Performance: Market Indexes • Dow Jones Averages • Standard & Poor Indexes • Value Line Average • Other Market Indexes

  24. MEASURES OF PRICE PERFORMANCE COMPARE WITH MARKET INDEXESPlease click on the icon for more information on the indexes www.standardandpoors.com www.nasdaq.com www.russell.com

  25. Dow Jones Averages www.djindexes.com • Dow Jones Industrial Average (DJIA) • 30 large “industrial” companies • Serves as measure of entire U.S. market, covering: • financial services • technology • retail • entertainment • consumer goods • Dow Jones Transportation Average (DJTA) • 20 transportation stocks • Dow Jones Utilities Average (DJUA) • 15 utility stocks

  26. DOW JONES INDUSTRIAL AVERAGE - DJIA • The most popular index • “Blue-chip” index (i.e. stocks of very high quality) • Follows the general trend of the market • Comprised of more than 25% of market value of the 3,000 firms listed on NYSE • Price-weighted average

  27. Calculation of DJIA • Price Weighted Average • Bias toward high priced stocks • Initially calculated by adding up the component stocks' prices and dividing by the number of components • Later, divisor was adjusted to smooth out effects of stock splits

  28. Standard & Poor’s Indexes • S&P 500 – • Widely followed by professional money managers and security market researchers • Comprised of more than 75% of market value of the 3,000 firms listed on NYSE • In 2007, consisted of: • 369 Industrial firms • 16 Transportation firms • 48 Utilities • 67 Financial firms • Value-weighted index

  29. Other Standard & Poor's Indexes • S&P 400 MidCap Index • Composed of 400 middle-sized firms with market values between $1.2 billion and $9 billion • S&P 600 SmallCap Index • Companies smaller that MidCap • S&P 1500 Index • Combines • S&P 500 • S&P 600 & • S&P 400 • S&P 100 • 100 blue-chip stocks • CBOE has individual option contracts on this index • Closely mirrors performance of S&P 500 index

  30. Application Example • Standard & Poor’s Indexes • Value-weighted indexes • Each company weighted by its market value as a percentage of total market value for all firms Example – a value-weighted index comprising of three firms A, B, and C the weighting is shown on the next slide

  31. Application ExampleValue-weighted Indexes

  32. Value Line Average • 1,700 companies from NYSE, AMEX, and NASDAQ • Equal-weighted index • Weighted equally • Regardless of market price or total market value • Equal-weighting more closely conforms to the portfolio of individual investors

  33. The Complete List 100 Stocks in NAZDAQ-100 Please click on the following Hyperlink for the complete list NASDAQ-100 (the index itself) • Reflects Nasdaq's largest growth companies across major industry groups • All index components have a minimum market capitalization of $500 million, and an average daily trading volume of at least 100,000 shares

  34. The shadow of the Index • The Nasdaq 100 Index Tracking Stock (symbol) QQQQ is an Exchange Traded Fund which allows investors to essentially invest in all of the stocks that make up the Nasdaq 100 in a single security

  35. This graph shows how closely the shadow QQQ follows the Nasdaq

  36. Nasdaq Composite Index • Has become a particularly popular index since the 1990s http://www.nasdaq.com/

  37. Wilshire 5000 Equity Index • The most comprehensive index • Represents the total dollar volume of all U.S. equity issues with readily available price data from NYSE, AMEX and NASDAQ stock markets • Contains more than 5,000 stocks

  38. Other Market Indexes

  39. International Stock Averages • Dow Jones World Index • FTSE 100 - United Kingdom • Hang Seng - Hong Kong • Nikkei - Japan • DAX – Germany (Frankfurt DAX) • TSX - Canada • CAC 40 France

  40. Bond Market Indicators • Not widely followed by • Index or • Average • Gauged by • Interest-rate movements Rising interest rates falling bond prices Falling interest rates rising bond prices

  41. Other Categories of Bonds • Treasury Securities • Treasury notes • Treasury Bills • Treasury Bonds • Corporate debt • Mortgaged-backed securities • Municipal Bonds • Eurobonds

  42. Mutual Fund Averages • Mutual funds • Preferred choice of investment for many investors in the U.S. & worldwide • Broken into various categories to compute measures of performance • Starting point of the measurement period is very important in determining relative performance

  43. Important Consideration of looking at an INDEX • How much the index has changed over a given period of time • Hours (intraday) • Day • Week • Month • Quarter • Semi-annual • Year(s)

  44. Direction of Indexes • Direction of indexes are closely related • They do not necessarily move together • Use the appropriate index that represents the risk characteristics of the portfolio being measured

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