Investment Markets and Transactions

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Investment Markets and Transactions

• Gitman-Joehnk
• Chapter 2

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Three Functions of Investment Markets

• Economic Function
• Continuous Pricing Function
• Fair Pricing Function

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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

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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

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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

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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
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Secondary market transactions (also called
after-market transactions) are carried out
using Organized Securities Exchanges Over-the-C
ounter Markets ECNs - electronic communication
networks
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Trading Systems

• Securities are traded through 3 different
  mechanisms
• specialist system
• market-makers system
• Super DOT ( electronically)

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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.

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Specialist System

• Specialists own gt 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

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Specialist System

• Broker for Paine Webber wires order to floor of
  exchange where PW employee receives it and takes
  it to the Specialists post
• the post is the specific location where IBM is
  traded on the exchange floor.
• The specialists 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.

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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

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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

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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 gt75 of trading volume is
  done via Super DOT

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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

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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

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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

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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

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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
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NYSE
Currently comprised of over 2300 firms with
listings of over 2900 stocks (common and
preferred) listings of over 2100 bonds
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NYSE
Members are assigned particular
roles Commission brokers - partners in a
brokerage firm and execute orders for their
firms 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
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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
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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
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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
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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
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NYSE
Those brokerage firm members designated as seat
holders are the only individuals allowed to make
transactions on the floor of NYSE.
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Other Exchanges
AMEX second largest organized exchange in the
US operates like the NYSE but with lower listing
requirements 660 seats gt 1,000 listed
stocks approximately 125 listed corporate bonds
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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 a
nd dealer quotes
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OTC Market
35,000 issues are traded OTC approximately 5,400
have an active market in which frequent trades
take place
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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
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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
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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 wid
er range of industries and securities securities
are traded in a larger number of
markets securities are denominated in different
currencies
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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 purchasi
ng ADR on US exchanges purchasing shares in
multinational firms that trade on US mkts.
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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
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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
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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.
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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 investors
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.
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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 investors own capital,
the remainder is financed with borrowed
funds. Minimum margin requirements are set by
the Federal Reserve. Margin requirements are
currently 50.
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Margin
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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
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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.
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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
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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.
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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.
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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.
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Basic Types of Transactions
Advantages of Margin Trading Major Advantage -
enhanced return Minor Advantage - potential for
greater diversification
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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
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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
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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.
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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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Basic Types of Transactions
Provided that the investor maintains an amount
ofequity in their margin account that is equal to
or greater than the initial margin requirement,
the investor is allowed to use the account in any
way they choose. If the value of the investors
holdings declines the margin in the margin
account will also decline. In this case, the
investor will have a restricted account. That
is, equity is less than initial margin.
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Basic Types of Transactions
An investor with a restricted account investors
are not allowed to do anything that
would reduce the margin any further withdrawal
of cash, for example, would reduce the margin
and not be permitted the use of cash to
purchase additional securities would not reduce
the margin and may be permitted
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Basic Types of Transactions
Maintenance Margin - the absolute minimum amount
of margin (read equity) that an investor must
maintain in the margin account at all
times. current minimum is 25 (may be set above
minimum by the brokerage firm) If the investors
equity should fall below the maintenance margin,
the investor will be subject to a margin call.
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Basic Types of Transactions
In a margin call, the investor is given a period
of time to bring their margin up to the level of
the initial margin. If the investor does not do
this, the broker is authorized to sell the
investors margined holdings until equity in the
account is restored to the initial margin.
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Basic Types of Transactions
Usefulness of margin calls protects the
brokerage house from having to absorb excessive
investor losses protects the investor from being
wiped out
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Margin Formulas
Margin is measured in terms of the investors
equity provided as collateral in the margin.
EQ denotes investors equity defined as Asset
Value - Debt Value AV denotes Asset Value
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Margin Formulas
example 1 Margin requirement is 60. Investor
purchases round-lot of XYZ stock currently
selling at 40 per using an initial margin of
70. Asset Value AV 40 x 100 4000 Debt
Value 4000 - (4,000 x .70) 1200 so
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Margin Formulas
example 1a Suppose the share price of the stock
rises to 45 per share. Asset Value
(AV)45x1004500 Debt Value(DV)1200
Thus the value of Margin increases as the share
price increases.
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Margin Formulas
example 1b At what share price would the margin
account become a restricted account? Since
MVlt.60 for a restricted account
Solve for X, Asset value necessary to produce
Margin.6 with Debt value 1200.
Since Px1003000, P30/share.
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Margin Formulas
Thus if share price falls below 30 per share,
margin value will fall below initial margin and
the account will be restricted.
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Margin Formulas
Buying Power is a measure of how much more can be
spent for securities without having to come up
with more cash. Bbuying power Minitial margin
requirement Ddebit or debt value Eaccount
equity, AV-DV B (1/M)-1E - D
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Margin Formulas
Return on Invested Capital (equity)
where RIC denotes return on invested capital IR
denotes income received IE denotes interest
expense on margin loan MVS denotes market value
of securities at sale MVP denotes market value of
securities at purchase IC denotes investors
invested capital or equity
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Uses of Margin Trading
Besides increased diversification and
magnification of profits from invested capital,
margin trading can be used for pyramiding. Pyram
iding-the use of paper profits in a margin
account to partly or fully finance the purchase
of additional securities.
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Pyramiding
-pyramiding can allow transactions to be made at
margins below the initial margin level -this
is accomplished because the investor will not
have to deposit additional cash or
securities -paper profits can produce an excess
margin which can then be used to acquire
additional securities
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Pyramiding
Margin trading can magnify losses possibly
leading to a restricted account or a margin
call Therefore, only investors that understand
the risks of margin trading and pyramiding and
the mechanics of margin trading should consider
it.
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Short Selling
Short Selling - occurs when an investor sells
shares that they do not own. Short selling can
be done with any security but in practice is
limited to common stock options Short Selling
is generally only done when the investor expects
the stocks price to fall.
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Short Selling
Mechanics of Short Selling Short seller must
make an initial equity deposit with the broker
determined by a short selling margin -the
initial deposit together with the proceeds from
the sale of the securities is intended to insure
the broker that the investor will have
sufficient funds to repurchase the securities
at a later date
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Short Selling
Generally the shares that are being shorted by
the investor are obtained from the brokerage
firm. Short sellers do not pay interest or fees
to the broker for the loan of the securities and
are not paid interest on the funds deposited with
the broker.
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Short Selling
Advantages of Short Selling -Major Advantage is
the chance to profit from a price
decline -Secondary Advantage is providing
protection for profits previously earned
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Short Selling
Disadvantages -Major disadvantage investors
face limited return possibilities since price
can fall no lower than zero however price rises
(thus potential losses) are unbounded
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Short Selling
Secondary disadvantage -short sellers can not
earn a dividend they do not own the stock and
must therefore remit any dividends to the
owner/lender -the mechanics are generally
handled by the broker
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Speculating with Shorts
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Hedging with Shorts
Using Short Sales to hedge is usually referred to
as hedging-against-the-box. The purpose is to
eliminate or at least minimize exposure to loss
of previously earned profits from a long
purchase.
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Shorting Against the Box
Assume that 100 shares of XYZ Corp. were
purchased at 30 pershare. A year later the
share price has risen to 40 per share. The
profit earned 10 x 100 1000 To lock-in
these profits, the investor could borrow and
short sell 100 shares of the company at 40.
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Shorting Against the Box
If the price were to rise to 50 per share -the
value of the long position will rise by 10 x
1001000 -the value of the short position will
decline by 10 x 1001000 Thus these two
changes will be offsetting, locking in the profit
previously earned.