Financial Markets

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Financial Markets

• FIN 3600 Chapter 5Timothy R. Mayes, Ph.D.

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Size of Various Financial Markets
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What is a Market?

• A market is a public place where products or
  services are sold, either directly or through
  intermediaries.
• Markets are important for a number of reasons
• They provide a place (either physical or virtual)
  for the trading of goods or services.
• They provide for competition so that the best
  price may be found (this is called price
  discovery).
• They provide liquidity.

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Money vs. Capital Markets

• Money Market Short-term, high quality debt
  securities are traded here. These securities
  carry little or no default risk and have very
  little price risk due to their short maturities.
• Capital Market Long-term securities trade in
  the capital markets. These securities are
  subject to significant price risk, default risk,
  purchasing power risk, etc. due to their longer
  maturities.

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Primary vs. Secondary Markets

• Primary markets are where securities are
  initially sold. In this market the issuer
  receives the proceeds from the sale.
• Once securities have been sold into the primary
  market, they begin trading in the secondary
  markets. In the secondary markets the seller of
  the securities receives the proceeds, not the
  issuer.
• Primary markets would barely exist were it not
  for well functioning, efficient secondary
  markets. At the least, prices of securities would
  be far lower due to much higher required returns.
  How much would you pay for a security that you
  could never sell?
• There are also third and fourth markets. The
  third market is comprised of trades in listed
  securities away from the exchange where they are
  listed. This is an institutional market. The
  fourth market refers to trades directly between
  buyers and sellers.

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Organized vs. OTC Markets

• Organized markets are those which have a physical
  location where all trading takes place. For
  example, the NYSE, Amex, and regional exchanges
  are organized markets.
• Over the Counter (OTC) markets do not have
  physical locations. Instead, they are
  characterized by networks of dealers who are
  connected by telephone or computer networks. The
  Nasdaq is an example of an OTC market.

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Investment Bankers

• When securities are sold into the primary market,
  firms enlist the services of investment bankers.
• Investment bankers provide three basic services
  to companies
• Advice and counsel (before and after the sale)
• Underwriting
• Distribution

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Investment Banking Functions Advice and Counsel

• Investment bankers provide important advice on
  security issues, such as
• Pricing
• Size of the offering
• Timing of the offering
• Type of security (debt or equity)
• Special features (callability, convertibility,
  coupon rate, etc)
• Additionally, investment bankers often consult on
  issues of corporate governance, such as mergers.

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Investment Banking Functions Underwriting

• Once the company and investment banker agree as
  to the type of security, pricing, etc. the issue
  is ready to market.
• The investment banker may either
• Underwrite the issue here the investment banker
  purchases the issue and hopes to sell it at a
  higher price to the public (assumes price risk).
  This is also known as a firm commitment.
• Act as an agent Also known as a best efforts
  offering, the investment banker does not purchase
  the securities and merely markets them to the
  public.
• Typically only small, relatively unknown firms
  agree to a best efforts offering.

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Investment Banking FunctionsDistribution

• The final role of the investment banker is to
  actually sell the securities.
• Typically, the originating investment banking
  firm will form an underwriting group (syndicate)
  to spread the price risk.
• Next, a selling group consisting of the
  underwriting group and, perhaps, other brokerage
  firms is formed to sell the security. Each
  member of the selling group is given an
  allocation for which it is responsible.
• The selling group then allocates its share of the
  securities among interested customers.

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Investment Banking FunctionsDistribution (cont.)

• Before a new issue may actually be sold to
  investors, the originating underwriter must file
  a registration statement (Form S-1, or other Form
  S-x) with the Securities and Exchange Commission
  (SEC).
• This preliminary prospectus (red herring)
  contains information about the firm, the type of
  security being offered, and the proposed use of
  the proceeds.
• While it is being reviewed by the SEC, the
  preliminary prospectus is distributed to
  interested investors.
• The exact pricing, and often quantity, of the
  issue is determined the night before the actual
  offering.
• It is important to note that the SEC does not
  judge the quality of the issue and does not give
  investment advice. Its approval simply means
  that the prospectus meets all requirements
  concerning disclosure.
• For some time after the securities are sold, the
  investment banker will often participate in
  price-stabilizing trades (if the market tries to
  drive the price down, the IB will often step in
  to buy, thereby propping up the price).

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Largest Investment Bankers (2001)
Source Thomson Financial Securities Data Corp.
in Business Week, July 30, 2001.
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Domestic Stock Markets

• In the U.S. we have three major stock exchanges
• The New York Stock Exchange (NYSE)
• Nasdaq
• The American Stock Exchange (Amex)
• We also have several regional stock exchanges
• The Pacific Exchange (known mostly for options
  trading)
• The Boston Stock Exchange
• The Cincinnati Stock Exchange (all electronic,
  located in Chicago)
• The Chicago Stock Exchange (formerly the Midwest
  Stock Exchange)
• The Philadelphia Stock Exchange (known mostly for
  options trading)
• Small companies, or those which do not meet
  listing requirements may be traded on the OTC
  Bulletin Board or in the Pink Sheets.

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Domestic Stock Markets (cont.)

• Additionally, in the past several years (mostly
  since 1997) many electronic communications
  networks (ECNs) have begun trading stocks, and
  some are seeking exchange status
• The Island
• Archipelago (run by the Pacific Exchange)
• Instinet
• B-Trade (Bloomberg)
• NexTrade
• RediBook
• ECNs offer such advantages as lower costs,
  anonymity, open limit order books, and
  after-hours trading.

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The NYSE History

• The New York Stock and Exchange Board began on 17
  May 1792 under a buttonwood tree. Originally, 24
  brokers signed the Buttonwood Agreement in which
  they agreed to trade only among themselves and at
  a fixed commission rate (fixed commissions were
  the rule until 1975).
• In 1817 the exchange was moved into rented rooms
  at 40 Wall Street. They also wrote and approved
  a formal constitution.
• In 1863, the name was changed to The New York
  Stock Exchange.
• In 1903 the NYSE moved to its current home.
• Today, the NYSE Group is a publicly traded
  company (NYSE NYX).

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NYSE Current Statistics
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Nasdaq History and Operation

• The Nasdaq stock market began operations on 8
  February 1971. Prior to that, the NASD had
  regulatory authority over a very fragmented OTC
  market.
• Nasdaq originally, but no longer, stood for
  National Association of Securities Dealers
  Automated Quotation system.
• Unlike the NYSE and AMEX, Nasdaq is not an open
  outcry auction market, and does not use
  specialists. Instead, it uses a system of market
  makers.
• A market maker is a dealer who competes with
  others to get customer orders. The market maker
  posts his bid/ask quote on the system for all to
  see.
• Today, the Nasdaq is a publicly traded company
  (Nasdaq NDAQ).

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Differences Between Market Makers and Specialists

• The major difference between a specialist and a
  market maker is that a specialist is charged with
  maintaining an orderly market and is required to
  step in and buy when there are no buyers and sell
  when there are no sellers. Market makers may
  withdraw from the market at any time, though
  there are rules.
• There is only one specialist for an NYSE stock,
  but there are usually multiple market makers for
  Nasdaq stocks.

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Nasdaq Statistics
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AMEX History and Operation

• The American Stock Exchange (Amex) was originally
  known as the New York Curb Market because it was
  based outside the NYSE and traded stocks that
  were not traded on the NYSE.
• In 1921, the Curb was moved indoors. It was
  renamed in 1953.
• The Amex is something of a poor stepchild to the
  NYSE and has struggled somewhat to survive. It
  has turned to technology and new products
  (options, ETFs, etc) to survive.
• In 1998 the Amex was merged with the NASD, and
  today operates as an independent entity within
  the NASD.

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AMEX Statistics
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Stock Market Indices and Averages

• For more than 110 years, people have tracked the
  markets daily ups and downs using various
  indexes of overall market performance
• There are currently thousands of indices
  calculated by various information providers. Best
  known are
• Dow Jones Co
• Standard Poors
• Morgan Stanley Capital Markets (MSCI)
• Lehman Brothers (bond indices)
• Dow Jones alone currently publishes more than
  3,000 indices

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Stock Market Indices and Averages (cont.)

• A short list of the major indices
• Dow Jones Industrial Average (DJIA)
• Dow Jones Transportation Average (DJTA)
• Dow Jones Utility Average (DJUA)
• Standard Poors 500 Index (SP 500)
• Standard Poors 100 Index (SP 100, or OEX)
• Nasdaq Composite
• Nasdaq 100
• Value Line Arithmetic Index
• Value Line Geometric Index
• Wilshire Total Market Index (formerly Wilshire
  5000 index)

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Types of Indices and Averages

• There are essentially four methods of index or
  average construction
• Price Weighted
• Capitalization Weighted
• Equal Weighted Arithmetic
• Equal Weighted Geometric
• There are also some variations of these
  techniques. We will cover the basics.

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Example Data for Index Calculation
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Index Types Price-weighted Average

• A price-weighted average is calculated by adding
  up the prices of the index constituents and
  dividing by a divisor.
• The divisor begins as the number of constituents,
  but will change over time (to maintain price
  continuity) as
• Constituents change
• Stocks are split or pay a big stock dividend
• Divisions are spun off

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Index Types Price-weighted Average (cont.)

• The DJIA is the best-known price-weighted
  average.
• It was created by Charles Dow on 17 May 1896, and
  originally contained only 12 stocks (industrial
  stocks were less important at the time than the
  railroads).
• Today, General Electric is the only company left
  that was in the original average.
• Today, the DJIA contains 30 stocks and the
  divisor is about 0.14418073. (17 September 2002)
• Each 1 point change in a component therefore adds
  about 6.94 points to the value of the average.

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Index Types Price-weighted Average (cont.)

• As an example of calculating a price-weighted
  average, consider our sample data.
• On day 1, we start our average by adding up the
  prices and dividing by 3, to get a value of
  42.67.
• For day 2, we calculate the average the same way,
  and get a value of 43.
• For day 3, ABC has split 2-for-1 necessitating a
  change in the divisor. The new divisor is
  calculated (using day 2 closing prices adjusted
  for the split) such that the average begins day 3
  unchanged from day 2.

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Index Types Price-weighted Average (cont.)

• To calculate the divisor
• Now, to calculate the average on day 3
• From now on, until another adjustment is
  required, the divisor will be 2.279.

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Index TypesCapitalization-weighted

• A capitalization-weighted index is weighted by
  the total value of the outstanding shares (price
  x shares) rather than stock price.
• The best known cap-weighted index is the SP 500
  which contains 500 of the leading stocks in the
  U.S. markets (not necessarily the largest, though
  the SP 500 is considered a large-cap index).
• Currently, the total market value of the 500
  stocks is over 8.23 trillion. The divisor is
  9,237,672,206 (on 9/16/2002).

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Index TypesCapitalization-weighted (cont.)

• The current (9/25/2006) composition of the SP
  500 is shown below

Source Standard Poors
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Index TypesCapitalization-weighted (cont.)

• A capitalization-weighted index is calculated by
  dividing the total market cap of the stocks in
  the index by the index divisor.
• The divisor is determined at inception by
  dividing the total market cap by the desired
  beginning level of the index.
• The divisor will occasionally be adjusted for
  splits, changing constituents, spin-offs, etc.

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Index TypesCapitalization-weighted (cont.)

• As an example of calculating a capitalization-weig
  hted average, consider our sample data.
• Suppose that we want to set the initial index
  value at 100. First calculate the divisor, note
  that it is 239.
• Now, calculate the index for each day.
• Note that the split has no impact on the divisor.

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Index TypesEqual-weighted

• Both price-weighted and capitalization-weighted
  indices are affected most by certain stocks
  (either the highest priced, or the most
  valuable).
• An equally-weighted index gives each stock equal
  weight, it is most affected by those that have
  the biggest percentage changes.
• Value Line calculates two indices using equal
  weightings
• Value Line Geometric
• Value Line Arithmetic
• These indices both include about 1600 to 1700
  stocks, and vary only in the type of averaging
  they use.

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Index TypesEqual-weighted Geometric Average

• On June 30, 1961 Value Line introduced its Value
  Line Composite Index, which is an index of the
  geometric average of the percentage changes in
  its 1600 to 1700 stocks.
• An equally-weighted geometric index is calculated
  with the following equation
• Where Indext-1 is the previous days index value,
  and Pj,t and Pj,t-1 are todays price and
  yesterdays price for stock j.

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Index TypesEqual-weighted Geometric Average

• As an example, again consider our sample data.
• First, we arbitrarily set the beginning index
  value to 100 or whatever value seems appropriate.
• Next, calculate the percentage changes from the
  previous day, and calculate the geometric mean of
  these.
• Finally, multiply by the previous days index
  value.

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Index TypesEqual-weighted Arithmetic Average

• After complaints that the geometric index
  underestimated market performance relative to
  competing indices, on February 1, 1988 Value Line
  began calculating an arithmetic version of their
  index.
• This index is calculated using the same data as
  the geometric index, but the method of averaging
  is different.
• To calculate an equally-weighted arithmetic index
  use the following formula

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Index TypesEqual-weighted Arithmetic Average

• Once again, using the our sample data, and a day
  1 index value of 100, the index on days 2 and 3
  is
• Note that we have adjusted for the split within
  the calculation of the average return.

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Summary of Index Calculations
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Summary of Index Calculations (cont.)

• Notice that the total returns for each index are
  different, despite the fact that they are all
  measuring the average returns of the same group
  of stocks.
• This is not a contrived situation. The different
  weighting schemes will always lead to different
  returns.
• Note that the average price change of the three
  stocks is 1.88, so it would seem that the
  equally-weighted arithmetic average is closest to
  what really happened.
• However, one could easily argue that stocks with
  larger market caps are more important in the
  market, and therefore the cap-weighted index is
  better.
• The least defensible of the indices is the
  price-weighted average. There is no reason to
  believe that higher priced stocks are any more
  important than lower priced stocks (especially
  because when they split, they are automatically
  less important even though there is no economic
  change). Price weighting was only chosen by Dow
  simply because it was very easy to calculate in
  the days before computers and calculators.