1 1 Ch2&3 – MBA 567 Capital Market Overview Capital Markets Debt Common stock Preferred stock Derivative securities Security Trading Trading Trading Costs Buy on margin versus short sell

2 2 Ch2&3 – MBA 567 Major Types of Securities Debt Money market instruments Bonds Common stock Preferred stock Derivative securities

3 3 Ch2&3 – MBA 567 Markets and Instruments Money Market Debt Instruments Derivatives Capital Market Bonds Equity Derivatives

4 4 Ch2&3 – MBA 567 Money Market Instruments Treasury bills Certificates of deposit Commercial Paper Bankers Acceptances Eurodollars Repurchase Agreements Federal Funds LIBOR Market

5 5 Ch2&3 – MBA 567 Bond Markets US Treasury Bonds and Notes Agency Issues (Fed Gov) International Bonds Municipal Bonds Corporate Bonds Mortgage-Backed Securities

6 6 Ch2&3 – MBA 567 Municipal Bond Yields Interest income on most municipals is not subject to tax To compare the yields on municipals to other bonds use equivalent taxable yield (municipal return) / (1 – tax rate) Or solve for the tax rate that equates the two yields Tax rate = 1 – (municipal rate/taxable rate)

7 7 Ch2&3 – MBA 567 Capital Market - Equity Common stock Residual claim Limited liability Analyzing stocks – finance.yahoo.comfinance.yahoo.com Preferred stock Fixed dividends - limited Priority over common Tax treatment

8 8 Ch2&3 – MBA 567 Stock Market Indexes Uses Track average returns Comparing performance of managers Base of derivatives Factors in constructing or using an Index Representative? Broad or narrow? How is it constructed?

9 9 Ch2&3 – MBA 567 Examples of Indexes - Domestic Dow Jones Industrial Average (30 Stocks) Standard & Poor’s 500 Composite NASDAQ Composite NYSE Composite

10 Ch2&3 – MBA 567 Examples of Indexes - International Nikkei 225 & Nikkei 300 FTSE (Financial Times of London) Dax Region and Country Indexes EAFE Far East United Kingdom

11 Ch2&3 – MBA 567 Bond Indexes Lehman Brothers Merrill Lynch Salomon Brothers Specialized Indexes Merrill Lynch Mortgage

12 Ch2&3 – MBA 567 Construction of Indexes How are stocks weighted? Price weighted (DJIA) Market-value weighted (S&P500, NASDAQ) Equally weighted (Value Line Index) How returns are averaged? Arithmetic (DJIA and S&P500) Geometric (Value Line Index)

13 Ch2&3 – MBA 567 Derivatives Securities Options Basic Positions Call (Buy) Put (Sell) Terms Exercise Price Expiration Date Assets Futures Basic Positions Long (Buy) Short (Sell) Terms Delivery Date Assets

14 Ch2&3 – MBA 567 Tips on Investment Buy under-valued stocks Buy recent-past winners Don’t over trade – investing in stocks is costly You can buy bondsbonds Invest in real estatesreal estates

15 Ch2&3 – MBA 567 Security Trading Primary Market versus Secondary Market Types of Orders Trading Mechanisms Buy on margin and short selling

16 Ch2&3 – MBA 567 Primary vs. Secondary Security Sales Primary New issue Key factor: issuer receives the proceeds from the sale Secondary Existing owner sells to another party Issuing firm doesn’t receive proceeds and is not directly involved

17 Ch2&3 – MBA 567 How Firms Issue Securities Investment Banking Shelf Registration Private Placements Initial Public Offerings (IPOs)

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20 Ch2&3 – MBA 567 Shelf Registrations SEC Rule 415 Introduced in 1982 Ready to be issued – on the shelf

21 Ch2&3 – MBA 567 Initial Public Offerings Process Road shows Bookbuilding Underpricing Post sale returns Cost to the issuing firm See page 60-61

22 Ch2&3 – MBA 567 Figure 3.3 Average Initial Returns for IPOs in Various Countries

23 Ch2&3 – MBA 567 Figure 3.4 Long-term Relative Performance of Initial Public Offerings

24 Ch2&3 – MBA 567 Types of Orders Instructions to the brokers on how to complete the order Market Limit Stop orders Page 64-65

25 Ch2&3 – MBA 567 Figure 3.6 Price-Contingent Orders

26 Ch2&3 – MBA 567 Trading Mechanisms Dealer markets Electronic communication networks (ECNs) Specialists markets Page 66

27 Ch2&3 – MBA 567 U.S. Security Markets Nasdaq Small stock OTC Pink sheets Organized Exchanges New York Stock Exchange American Stock Exchange Regionals Electronic Communication Networks (ECNs) National Market System

28 Ch2&3 – MBA 567 Nasdaq National Market System Nasdaq SmallCap Market Levels of subscribers Level 1 – inside quotes (investors) Level 2 – receives all quotes but they can’t enter quotes Level 3 – dealers making markets SuperMontage

29 Ch2&3 – MBA 567 Table 3.1 Requirements for Listing on Nasdaq Markets

30 Ch2&3 – MBA 567 New York Stock Exchange Member functions Commission brokers Floor brokers Specialists Block houses SuperDot (70% of NYSE trading volume)

31 Ch2&3 – MBA 567 Table 3.3 NYSE Listing Requirements

32 Ch2&3 – MBA 567 Costs of Trading Commission: fee paid to broker for making the transaction Spread: cost of trading with dealer Bid: price dealer will buy from you Ask: price dealer will sell to you Spread: ask - bid Combination: on some trades both are paid

33 Ch2&3 – MBA 567 Margin Trading Using only a portion of the proceeds for an investment Borrow remaining component Maximum margin is currently 50%; you can borrow up to 50% of the stock value Set by the Fed Maintenance margin: minimum amount equity in trading can be before additional funds must be put into the account Margin call: notification from broker you must put up additional funds

34 Ch2&3 – MBA 567 Margin Trading - Initial Conditions Example 3.1 X Corp$100 60%Initial Margin 30%Maintenance Margin 100Shares Purchased Initial Position Stock $10,000 Borrowed $4,000 Equity $6,000

35 Ch2&3 – MBA 567 Margin Trading - Maintenance Margin Ex. 3.1 Stock price falls to $70 per share New Position Stock $7,000 Borrowed $4,000 Equity $3,000 Margin% = $3,000/$7,000 = 43%

36 Ch2&3 – MBA 567 Margin Trading - Margin Call Example 3.2 How far can the stock price fall before a margin call? The maintenance margin is 30%.

37 Ch2&3 – MBA 567 Short Sales Purpose: to profit from a decline in the price of a stock or security Mechanics Borrow stock through a dealer Sell it and deposit proceeds and margin in an account Closing out the position: buy the stock and return to the party from which is was borrowed

38 Ch2&3 – MBA 567 Short Sale - Initial Conditions Dot Bomb1,000 Shares 50%Initial Margin 30%Maintenance Margin $100Initial Price Sale Proceeds$100,000 Margin & Equity 50,000 Stock Owed 100,000 What if price increases to 110? How much can the stock price rise before a margin call?

39 Ch2&3 – MBA 567 Short Sale - Margin Call How much can the stock price rise before a margin call?