Charles P. Jones, Investments: Analysis and Management,

1
How SecuritiesAre Traded

• Chapter 5
• Charles P. Jones, Investments Analysis and
  Management,
• Ninth Edition, John Wiley Sons
• Prepared by
• G.D. Koppenhaver, Iowa State University
• Additional Information by Axel Grossmann

2
Brokerage Operations

• Brokerage firms offer variety of services to
  inventors
• Information
• Advice
• Represent their customers in security
  transactions
• They earn
• commissions on executed trades,
• sales loads on mutual funds
• profits from securities sold from inventory
• underwriting fees and administrative account fees

3
Brokerage Operations

• Usually no personal contact
• Transactions are carried out by phone and
  computers
• Two types of brokers
• Full-service brokers
• Discount brokers
• On-Line Discount Brokers

4
Brokerage Operations

• Full-service brokers
• (e.g. Merrill Lyunch, Salomon Smith Barney, etc.)
• Execute customers orders
• Provide detailed advice and information
• Provide publications about stocks, industries,
  bonds
• Less than 50 of their income comes from
  commissions
• Selling mutual funds (load and sales charge)
• Trading for their own accounts
• Selling owned securities to customers
• Underwriting new issues (Selling IPOs)
• Account handling fees

5
Brokerage Operations

• Discount Brokers
• (e.g. Charles Schwab, Fidelity Investments, etc.)
• Execute customers orders
• Provide less detailed or no advice and
  information
• Research information is usually provided through
  outside sources
• Charge less
• On-Line Discount Brokers
• (e.g. E-trade)

6
Account Types

• Cash account
• Investor pays 100 of purchase price for
  securities
• Margin account
• Investor borrows part of the purchase price from
  the broker
• Minimum margin requirements
• Asset management account
• automatic reinvestment of excess cash balances in
  money market fund or gov. securities

7
Account Types

• Checks can be written against accounts assets
• Instant loans at a markup to call money rate
  based on the accounts assets
• Wrap account
• Brokers match investors with outside money
  managers
• Broker as a consultant and money manager
• All costs, fees wrapped into one
• Large minimum amounts

8
Fees and Costs

• Brokerage commissions differ by security, broker,
  and investor
• Discount brokers as low as 10
• Institutional investors have greatest negotiating
  power
• Dividend reinvestment plans (DRIP)
• permit reinvestment of dividends in additional
  stock
• Avoids commissions, administrative fees
• Direct stock purchase plans (DSPPS)
• Investors make their initial purchase directly
  from the company (zero to 0.07 a share)
• Price depends on daily closing price, no limit
  orders allowed
• Treasury direct Program

9
Orders in Auction Markets
1
2
3
Specialist for the stocks assigned to him
4
Trading post
3
Sales Personnel of Brokerage House
Commission Broker at Trading Floor
Public Investor Seller
2
1
10
Orders in Auction Markets

• 1) Public Investor gives buy/sell order to
  personnel of Brokerage house
• 2) Sales personnel transmits the order to trading
  floor via Switch/SuperDot system
• 3) Commission Broker takes the order to the
  trading post
• 4) Specialist
• Acts as Agent, Catalyst, and Auctioneer
• Acts as Broker
• Acts as Dealer

11
Orders in Auction Markets

• Specialist
• Acts as Agents
• Executes orders for the floor brokers
• Acts Catalyst
• Match sellers and buyers
• Acts Auctioneers
• Establish fair market price (best price for
  customers)
• Quote bids and offers
• Acts as Broker by maintaining the limit book
• Commission broker will leave limit order with the
  specialist to be filled when possible
• Receives part of the brokers fee

12
Orders in Auction Markets

• Specialist Acts as Dealer
• Stabilize Prices
• Ensure smooth trading and minimal fluctuations
• Provide Capital
• Minimizes sell and buy imbalance with own capital
• Specialist will buy from commission brokers with
  orders to sell and will sell to those with orders
  to buy
• Hopes to profit from a favorable spread between
  the two sides

13
NYSE Automation

• SuperDot An electronic order recording,
  reporting, routing, and matching system
• Specialists Electronic Book records and reports
  limit and market orders
• Pre-opening buy and sell orders matched and
  imbalance reported to specialist
• Opening Automated Report System (OARS)
• Helps to determine the opening price
• Members send orders directly to specialist for
  execution and confirmation

14
Orders in the Nasdaq Market

• Dealers ready to either buy or sell
• Bid price is highest offer price to buy
• Ask price is lowest price willing to sell
• Ask price - Bid price gt0 (dealer spread)
• Makes a market in the security
• More than one dealer for each security in
  over-the-counter markets
• Brokerage firm forwards order to one of several
  market-makers
• Market makers often share some of the spread with
  brokerage firms, called payment for order flow

15
Types of Orders

• Market orders
• Authorizes immediate transaction at best
  available price
• Effective for only one day
• Limit orders
• Specifies a particular market price before a
  transaction is authorized
• Effective for one day, until canceled, open
  orders
• No guarantee that order will be filled
• Stop orders
• Specifies a particular market price at which a
  market order is authorized
• To protect profits or limit losses if price
  declines

16
Settlement

• Most settlement dates are three business days
  after the trade date
• Legal ownership transferred and financial
  arrangements settled with brokerage firm
• Usually no physical possession of securities
• Customers allow their brokerage firms to keep
  their securities in its name street name
• Book-entry system reduces costs
• Transfer of securities and funds between exchange
  members facilitated by a clearinghouse

17
Regulation

• The financial system depends heavily on investors
  confidence
• Regulations
• Government regulations (primarily federal)
• Self-regulations
• Government Regulations
• Securities Act of 1993
• Register and full disclosure of IPOs
• Securities Exchange Act 1934
• Extended disclosure requirements to the secondary
  market
• Established the SEC
• Investment Company and Investment Adviser Act of
  1940
• Requires investment companies and advisers to
  register with SEC

18
Regulation

• The Security Exchange Commission (SEC) Act of
  1934
• Administers all securities law
• To protect investors
• Monitors public securities transactions
• Requires issuer registration for public offers
  and secondary market
• Ensures that investment companies and advisers
  flow the law affecting them
• Problem 200 examiners vers. 16,000 advicers and
  3,500 investment companies
• Investigates indications of violations such as
  insider trading

19
Regulation

• Stock exchanges are also self-regulated
• In own self-interest to regulate and monitor
  member behavior
• NYSE circuit-breakers attempt to reduce
  volatility
• National Association of Securities Dealers
  (NASD)
• Trade association that self-regulates brokers and
  dealers
• All brokers and dealers must register with the
  NASD
• NASD keeps record of information on individual
  brokers
• E.g. Employment information, Licenses,
  Investigations, criminal events, consumer
  complaints, etc.

20
Margin Accounts

• To open margin account, exchanges set minimum
  required deposit of cash or securities
• NYSE requires 2,000
• Investor then pays part of investment cost,
  borrows remainder from broker
• Margin is percent of total value that cannot be
  borrowed from broker
• Cash 100 loan value securities 50

21
Margin Accounts

• Federal Reserve sets the minimum initial margin
  on securities
• Unchanged since 1974 at 50
• Actual margin at any time cannot go below the
  maintenance margin level set by exchanges,
  brokers
• Investors equity changes with price
• Margin call when equity below maintenance level

22
Short Selling

• Investor borrows stock from broker or held in
  street name accounts
• Borrowed security sold in open market, to be
  repurchased later at an expected price lower than
  sale price
• Investor liable for declared dividends
• Short sale proceeds held by broker
• Demand loan of stock