Chapter 2

1. Chapter 2 Security Markets: Present and Future

2. The Market Environment • Dramatic Changes: • Deregulation and other legal changes • Global consolidation and competition • Internet online brokerage and Electronic communication networks (ECNs) • Real-time quotes

3. The Market Environment • Dramatic Changes (continued): • 24 hour trading and record trading volume • Decimalization • Terrorism • Public ownership of securities exchanges

4. Markets: A way of exchanging assets Possible Characteristics of Markets

5. Market Efficiency and Liquidity • Efficient Markets: • Prices respond quickly to new information • Prices fluctuate little with successive trades • High volumes absorbed with little price change • Liquidity • Speed of converting an asset to cash at or close to its fair market value • Greater with more participants and continuous trading • Greater with low transaction costs

6. Competition and Allocation of Capital • All assets compete for investor funds • Investors choose assets to achieve desired risk-return trade-off • In efficient and liquid markets, investors quickly move capital to alternative investments in response to fresh information

7. Secondary Markets Markets for existing assets currently traded between investors • Provide increased liquidity and a place to convert existing assets to cash • Provide ability to adjust capital allocation to new information • Provides valuation for existing assets

8. Primary Markets Market for buying assets directly from their sources; the first market where an asset is originally bought and sold • Raises funds for issuer to expand capital base • Once sold, assets begin trading on secondary markets • Price competition on secondary markets enables primary markets to price new issues fairly

9. Organization of the Primary Markets: The Investment Banker • Investment Banker • Middleman involved in the distribution of securities from issuing corporation to investors

10. Underwriting Function • Underwriting • Guarantee by investment banker to purchase issuer’s securities at a fixed price • Eliminates risk of not selling whole issue • Investment banker usually “makes a market” to ensure a liquid market and wider distribution

11. Alternatives to Underwriting • Investment banker makes “best efforts” to sell security but issuer assumes risk of unsold securities • Securities may be sold directly to investors by the issuer in a public offering or in a private placement

12. Distribution On large issues, investment bankers may share the risk and burden of distribution by forming a “syndicate” A “Tombstone” advertising a stock or bond issue may list many underwriters distributing a security

13. Investment Banking Competition Top 10 Underwriters of Global Stocks and Bonds

14. Initial Public Offering (IPO) • The process of bringing private companies to the public market for the first time

15. Investment Banking Competition Top 10 Underwriters of Initial Public Offerings (IPOs)

16. Investment Banking Competition Top Investment Bankers by Category

17. Organization of the Secondary Markets • Organized Exchanges • Consolidated Tape • Listing Requirements for Firms • Listing Fees

18. Organization of the Secondary Markets • Organized Exchanges • National • New York Stock Exchange (NYSE) • American Stock Exchange (AMEX) • Nasdaq Stock Market • Regional • Chicago • Cincinnati • Philadelphia • Boston

19. Organization of the Secondary Markets • Organized Exchanges (continued) • Central trading location • Securities are bought and sold in an auction market • Brokers act as agents for buyers and sellers • “Open outcry” auction system is being replaced by electronic trading

20. Consolidated Tape • Allows brokers on any exchange to see prices of transactions on other exchanges in dually listed NYSE stocks • Such composite price data increases market efficiency and keeps prices competitive

21. Listing Requirements for Firms • To be traded, a stock must meet minimum listing requirements of an exchange • New York Stock Exchange (NYSE) has the most restrictive listing requirements • Stocks may be delisted for failing to meet criteria such as total market valuation

22. The Organization of the NYSE • NYSE Euronext is world’s largest exchange • Recently transformed into a for-profit corporation • Ticker symbol – NYX • Hybrid market consisting of traditional floor trading and electronic trading

23. Trading on the NYSE • Floor Brokers • Act as agents for clients and execute buy and sell orders on the floor of the exchange • House Brokers • Execute orders for customers of NYSE member firms such as Merrill Lynch, or for the firm’s direct account • Independent Brokers • Individuals or employees of small “boutique” firms that execute orders for member or nonmember firms, and help house brokers with overflow • Specialists • About ¼ of exchange membership • Each stock has a specialist assigned to it • Most specialists are responsible for more than one stock • Handle special orders such as “limit” bids or offers • Maintain a continuous, liquid, and orderly market in assigned stocks

24. The Nasdaq Stock Market • August 1, 2006: recognized as a national securities exchange by the Securities and Exchange Commission (SEC) • 2nd largest exchange in U.S. by dollar trading volume • For-profit company • Ticker symbol – NDAQ • Electronic stock exchange

25. The Nasdaq Stock Market • No central location • Trades executed electronically or by telephone • Dealers • Buy and sell securities for their own account rather than just act as agents processing orders • Belong to The National Association of Security Dealers (NASD) • Self-policing organization • Requires at least two market makers (dealers) for each security • Often 5 – 10 market makers for a security, even 20 market makers for government securities

26. Electronic Communication Networks (ECNs) • Also called alternative trading systems (ATSs) • Act as broker-dealer or as exchange • Retail and institutional investors, market makers, and broker-dealers • NYSE Arca (acquired by NYSE) • INET and BRUT (acquired by NASDAQ) Electronic trading systems that automatically match buy and sell orders at specified prices

27. Advantages of Electronic Communication Networks (ECNs) • Integrate markets • Allow anonymity in trading • Lower the cost of trading • Institutions can trade among themselves and bypass broker and trading fees • Permit “after-hours” trading, longer trading hours • Facilitate more competition • Facilitate smaller spreads

28. The American Stock Exchange (AMEX) • Securities of smaller firms than NYSE • Primarily for individual investors • Many listed firms do not meet liquidity needs of large institutional investors • One of largest markets for options on stocks and indexes • Central market for Exchange Traded Funds (EFTs) – approximately 100 listed • S&P 500 (SPDRS) • Dow Jones Industrial Average (DIAMONDS)

29. The Chicago Board Options Exchange • Competes with AMEX in trading options • Options on stocks • Options on stock market indexes

30. Futures Markets Trade the right to buy or sell a certain amount of a commodity or financial instrument at a set price for a specified period • Contracts are normally reversed (closed out) prior to expiration • The two largest futures exchanges: • The Chicago Mercantile Exchange (CME) • The Chicago Board of Trade (CBOT)

31. Over-the-Counter Markets • Over-the-counter bulletin board market (OTC.BB) • Small companies • No listing requirements • Companies must file regulatory reports with SEC • Pink Sheets • Companies choosing not to file with SEC • Little public information available

32. Over-the-Counter Markets • OTC markets exist for: • Stocks • Corporate Bonds • Mutual Funds • Federal Government Securities • State and Local Bonds • Commercial Paper • Negotiable Certificates of Deposits • Various other securities

33. Over-The-Counter Markets The “spread” • Difference between bid and asked price • Dealer profit earned by making a market Example: XYZ common stock is bid 10 and asked 10.50 Dealer will buy at least 100 shares at $10 per share or Dealer will sell 100 shares at $10.50 per share

34. Debt Securities Traded Over-the-Counter • Government securities • Largest dollar volume on the OTC • Billions of dollars in trades each week • Government security dealers trade securities in • Treasury bills • Treasury bonds • Federal agency securities • Federal National Mortgage Association issues (FNMA) • Government National Mortgage Association (GNMA) • Student Loan Marketing Association (Sallie Mae)

35. Regulation of Security Markets • Organized exchanges • Regulated by the Securities and Exchange Commission (SEC) • Self-regulated • The OTC market • Regulated by the National Association of Security Dealers (NASD) • Securities Act of 1933 • Securities Exchange Act of 1934 • Securities Acts Amendments of 1975

36. Securities Act of 1933 The “Truth in Securities” Act • Pertains to new issues of securities • Registration with SEC required for new issues of securities sold in more than one state • 20 day filing requirement in advance of date of new issue • Prospectus required for new issue • Officers and others can be sued for losses resulting from fraudulent or incomplete information in the prospectus

37. Securities Exchange Act of 1934 Created the Securities and Exchange Commission to enforce the securities laws • Established guidelines for insider trading • Board of Governors of the Federal Reserve responsible for setting margin requirements • Manipulation of securities by conspiracies between investors prohibited • SEC given control of proxy procedures • Required periodical reports from companies traded on exchanges • Required all exchanges to register with the SEC

38. Securities Exchange Act of 1975 Directed SEC to supervise development of a national securities market • Assumed extensive use of computers and electronic communication devices • Prohibited fixed commissions on public transactions • Prohibited banks, insurance companies, and other financial institutions from buying stock exchange memberships to save commission costs for their own institutional transactions

39. Investment Advisor Act of 1940 Created to protect the public from unethical investment advisors • Any adviser with more than 15 public clients (excluding tax accountants and lawyers) must register with the SEC • Registered advisers must file semi-annual reports

40. Investment Company Act of 1940 Provides oversight for mutual funds and investment companies dealing with small investors • Gives NASD authority to supervise and limit commissions and investment advisory fees on certain types of mutual funds

41. Securities Investor Protection Act of 1970 Established to oversee liquidation of brokerage firms • Securities Investor Protection Corporation (SIPC) • Insures investors’ accounts up to $500,000 in case of bankruptcy of brokerage firm • Does not insure market value losses while waiting for securities from bankrupt brokerage firms

42. Insider Trading • Definition of “insider” includes anyone with special non-public information • Punitive measures discourage illegal use of insider information for profits • Insiders may make proper long-term investments in corporations

43. Program Trading and Market Price Limits • Program trading • Computer-based trigger points are established in which large volumes of trades are initiated by institutional investors • may increase market volatility • blamed for the 508-point market crash on October 19, 1987 • “Circuit breakers” shut down the market briefly when there are specified dramatic drops in stock prices • Nasdaq, the American Stock Exchange, and the Chicago Board of Trade also discontinue trading if there is a halt on the NYSE

44. Exploring the Web