Lecture Presentation Software

to accompany

Investment Analysis and

Portfolio Management
Seventh Edition
by
Frank K. Reilly & Keith C. Brown

Organizing and
functioning of
security market
 What is a market?
• Brings buyers and sellers together to aid in
the transfer of goods and services
• Does not require a physical location
• Both buyers and sellers benefit from the
market
Characteristics of a Good Market
• Availability of past transaction information
– must be timely and accurate
• Liquidity
– marketability
– price continuity
– depth
• Low Transaction costs
• Rapid adjustment of prices to new information
Organization of the Securities Market
• Primary markets
– Market where new securities are sold and funds
go to issuing unit
• Secondary markets
– Market where outstanding securities are bought
and sold by investors. The issuing unit does
not receive any funds in a secondary market
transaction
 Government Bond Issues
• 1. Treasury Bills – negotiable, non-interest
bearing securities with original maturities of one
year or less
• 2. Treasury Notes – original maturities of 2 to 10
years
• 3. Treasury Bonds – original maturities of more
than 10 years
 Municipal Bond Issues
• Sold by three methods
– Competitive bid
– Negotiation
– Private placement
• Underwriters sell the bonds to investors
– Origination
– Risk-bearing
– Distribution
 The Underwriting Function
• The investment banker purchases the entire
issue from the issuer and resells the security
to the investing public.
• The firm charges a commission for
providing this service.
• For municipal bonds, the underwriting
function is performed by both investment
banking firms and commercial banks
Corporate Bond and Stock Issues
New issues are divided into two groups
1. Seasoned new issues - new shares offered
by firms that already have stock
outstanding
2. Initial public offerings (IPOs) - a firm
selling its common stock to the public for
the first time
Underwriting Relationships with
Investment Bankers
1. Negotiated
– Most common
– Full services of underwriter
2. Competitive bids
– Corporation specifies securities offered
– Lower costs
– Reduced services of underwriter
3. Best-efforts
– Investment banker acts as broker
 Introduction of Rule 415
• Allows firms to register securities and sell them
piecemeal over the next two years
• Referred to as shelf registrations
• Great flexibility
• Reduces registration fees and expenses
• Allows requesting competitive bids from several
investment banking firms
• Mostly used for bond sales
Private Placements and Rule 144A
• Firms sells to a small group of
institutional investors without
extensive registration
• Lower issuing costs than public
offering
 Why Secondary Financial
Markets Are Important
• Provides liquidity to investors who
acquire securities in the primary market
• Results in lower required returns than if
issuers had to compensate for lower
liquidity
• Helps determine market pricing for new
issues
 Secondary Bond Market
• Secondary market for U.S. government and
municipal bonds
– U.S. government bonds traded by bond dealers
– Banks and investment firms make up municipal
market makers
• Secondary corporate bond market
– Traded through an OTC market
 Secondary Equity Markets
1. Major national stock exchanges
– New York, American, Tokyo, and London
stock exchanges
2. Regional stock exchanges
– Chicago, San Francisco, Boston, Osaka,
Nagoya, Dublin, Cincinnati
3. Over-the-counter (OTC) market
– Stocks not listed on organized exchange
 Trading Systems
• Pure auction market
– Buyers and sellers are matched by a broker at a
central location
– Price-driven market
• Dealer market
– Dealers provide liquidity by buying and selling
shares
– Dealers may compete against other dealers
Call Versus Continuous Markets
• Call markets trade individual stocks at
specified times to gather all orders and
determine a single price to satisfy the most
orders
• Used for opening prices on NYSE if orders
build up overnight or after trading is
suspended
• In a continuous market, trades occur at any
time the market is open
 National Stock Exchanges
• Large number of listed securities
• Prestige of firms listed
• Wide geographic dispersion of listed
firms
• Diverse clientele of buyers and sellers
 New York Stock Exchange
(NYSE)
• Largest organized securities market in
United States
• Established in 1817, but dates back to the
1792 Buttonwood Agreement by 24 brokers
• Over 3,000 companies with securities listed
• Total market value over $13 trillion
 American Stock Exchange
(AMEX)
• Started by a group who traded unlisted stocks at the
corner of Wall and Hanover Streets in New York as the
Outdoor Curb Market
• Emphasis on foreign securities
• Doesn’t trade stocks listed on NYSE
• Merged with the NASDAQ IN 1998 although they
continued to operate as separate markets
• Warrants traded on AMEX years before NYSE listed any
 Tokyo Stock Exchange (TSE)
• Largest of the eight exchanges in Japan
• Dominates the Japanese market
• Established in 1878 and reorganized in 1943, 1947, and
1949
• Price-drive system
• Domestic and foreign stocks listed
• Approximately 1700 stocks listed with a total market value
of $2.4 trillion
• Most active 150 stocks are traded on floor, others by
computer
London Stock Exchange (LSE)
• Largest securities market in the United Kingdom
• Trades listed and unlisted securities
– More than 2,600 companies listed
• Largest listing of foreign stocks on any exchange
• Total market value of more than $561billion
• Pricing system by competing dealers via
computers similar to NASDAQ system in U.S.
 Trends
• New exchanges in emerging economies
such as Russia, Poland, China, Hungary,
Peru, Sri Lanka
• Consolidation of existing exchanges in
developed countries
• Global twenty-four-hour market – made
possible by advances in technology
The Global Twenty-four Hour Market
• Investment firms “pass the book” around the world
to maintain nearly continuous trading by utilizing
markets at Tokyo, London, and New York
THE TRADING DAY
Local Time EST
TSE 09:00 - 11:00 23:00 - 01:00
13:00 - 15:00 03:00 - 05:00
LSE 08:15 - 16:15 02:15 - 10:15
NYSE 09:30 - 16:00 09:30 - 16:00
Over-the-Counter (OTC) Market
• Not a formal organization
• Largest segment of the U.S. secondary market
• Unlisted stocks and listed stocks (third market)
• Lenient requirements for listing on OTC
• 5,000 issues actively traded on NASDAQ NMS
(National Association of Securities Dealers Automated
Quotations National Market System)
• 1,000 issues on NASDAQ apart from NMS
• 1,000 issues not on NASDAQ
 Operation of the OTC

• Any stock may be traded as long as

it has a willing market maker to act
a dealer

• OTC is a negotiated market

 The NASDAQ System
• Automated electronic quotation system
• Dealers may elect to make markets in stocks
• All dealer quotes are available immediately
• Three levels of quotations provided
– Level 1 provides a single median representative quote for
the stocks on NASDAQ
– Level 2 shows quotes by all market makers
– Level 3 is for OTC market makers to change their quotes
shown
 Listing Requirements for
NASDAQ
• Two lists
– National Market System (NMS)
– Regular NASDAQ
• Four sets of requirements
– Initial listing - least stringent
– Automatic NMS inclusion - up to the minute
• Alternative 1 for profitable companies with
limited assets
• Alternative 2 for large but less profitable
 Third Market
• OTC trading of shares listed on an exchange
• Mostly well known stocks
– GM, IBM, AT&T, Xerox
• Competes with trades on exchange
• May be open when exchange is closed or
trading suspended
 Fourth Market
• Direct trading of securities between two
parties with no broker intermediary
• Usually both parties are institutions
• Can save transaction costs
• No data are available regarding its specific
size and growth
 Detailed Analysis of
Exchange Markets
• Exchange Membership

• Major Types of Orders

• Exchange Market Makers

 Exchange Membership
• Specialist
• Commission brokers
– Employees of a member firm who buy or sell for the
customers of the firm
• Floor brokers
– Independent members of an exchange who act as
broker for other members
• Registered traders
– Use their membership to buy and sell for their own
accounts
 Major Types of Orders
• Market orders
– Buy or sell at the best current price
– Provides immediate liquidity
• Limit orders
– Order specifies the buy or sell price
– Time specifications for order may vary
• Instantaneous - “fill or kill”, part of a day, a full
day, several days, a week, a month, or good until
canceled (GTC)
 Major Types of Orders
• Short sales
– Sell overpriced stock that you don’t own and
purchase it back later (at a lower price)
– Borrow the stock from another investor
(through your broker)
– Can only be made on an uptick trade
– Must pay any dividends to lender
– Margin requirements apply
 Major Types of Orders
• Special Orders
– Stop loss
• Conditional order to sell stock if it drops to a
given price
• Does not guarantee price you will get upon sale
• Market disruptions can cancel such orders
– Stop buy order
• Investor who sold short may want to limit loss if
stock increases in price
 Margin Transactions
• On any type order, instead of paying 100% cash,
borrow a portion of the transaction, using the stock
as collateral
• Interest rate on margin credit may be below prime
rate
• Regulations limit proportion borrowed
– Margin requirements are from 50% up
• Changes in price affect investor’s equity
 Margin Transactions
Buy 200 shares at $50 = $10,000 position
Borrow 50%, investment of $5,000
If price increases to $60, position
– Value is $12,000
– Less - $5,000 borrowed
– Leaves $7,000 equity for a
– $7,000/$12,000 = 58% equity position
 Margin Transactions
Buy 200 shares at $50 = $10,000 position
Borrow 50%, investment of $5,000
If price decreases to $40, position
– Value is $8,000
– Less - $5,000 borrowed
– Leaves $3,000 equity for a
– $3,000/$8,000 = 37.5% equity position
 Margin Transactions
• Initial margin requirement at least 50%. Set up by
the Fed.
• Maintenance margin
– Requirement proportion of equity to stock
– Protects broker if stock price declines
– Minimum requirement is 25%
– Margin call on undermargined account to meet
margin requirement
– If margin call not met, stock will be sold to pay off
the loan
 Exchange Market Makers
U.S. Markets
• Specialist is exchange member assigned to handle
particular stocks
– Has two roles:
– Broker to match buyers and sellers
– Dealer to maintain fair and orderly market
• Specialist has two income sources
– Broker commission, without risk
– Dealer trading income from profit, with risk
 The Impact of Block Trades
• Number and size of block trades has
increased
• This strains the exchange specialist system
– Capital - 10,000 share or larger blocks
– Commitment - large risk with large blocks
– Contacts - Rule 113 prohibited direct contact to
offer blocks to another institution
 The Impact of Block Trades
• Block houses are investment firms that help
institutions locate other institutions interested in
buying or selling blocks of stock
• A good block house has
1. The capital required to position a large block
2. The willingness to commit this capital to a block
transaction, and
3. Contacts among institutions
 Institutions and Stock Price
Volatility
• Empirical studies have not supported the
theory that institutional trading increases price
volatility
• Where trading is dominated by institutions,
actively involved institutions may provide
liquidity for one another and noninstitutional
investors
 New Trading Systems
• Daily trading volume has increased from 5
million shares to over a billion shares
• NYSE routinely handles days with volume
over a billion shares
• Technology has allowed the market process
to keep pace
 Super DOT
• Electronic order-routing system
• Member firms transmit market and limit
orders in NYSE securities to trading posts
or member firm’s booth
• Report of execution returned electronically
• 85% of NYSE market orders enter through
Super DOT system
 Display Book
• Electronic workstation that keeps
track of all limit orders and
incoming market orders, including
incoming Super Dot limit orders
 Market Order Processing
• Super Dot’s postopening market order
system is designed to accept member firms’
postopening market orders up to 3 million
shares
• Rapid execution and reporting of market
orders
• In 2000, orders executed and reported in
15-16 seconds on average
 Limit Order Processing
• Electronically files orders to be executed
when and if a specific price is reached
• Updates the Specialist’s Display Book
• Good-until-cancelled orders that are not
executed are stored until executed or
cancelled