Chapter 16

Learning Objectives (part 1 of 3) Discuss why financial markets exist and the benefit they provide to society Explain the difference between the primary and secondary market Describe the IPO process and the role of DPOs Describe the different places where securities are traded, the different listing standards, and the different methods of trading Name the more common of the stock market indices

Learning Objectives (part 2 of 3) Distinguish between the types of brokers and brokerage firms Decide whether to order out stock or leave it in street name Analyze the benefits of DPPs and DRIPs Define the most common types of orders used in trading securities and explain the advantages and disadvantages of each Describe how buying on margin works.

Learning Objectives (part 3 of 3) Explain the process of selling short Describe how dollar cost averaging works Describe how to experiment in the market without actually investing cash Discuss the protections available to an investor Describe pyramid schemes and Ponzi schemes

Financial Markets They exist to facilitate the transfer of money from people with more cash than they currently need to people with less cash than they currently need The more efficient they are, the more opportunities for economic growth in a society

Primary vs. Secondary Markets Primary Markets Newly issued securities sold by the issuer (e.g., a company sells bonds to pay for a manufacturing plant) Usually no commission to buyer (seller pays full commission) Secondary Markets Issuer not involved, all trades between investors

IPOs and DPOs Initial Public Offering Firm sells stock to public for the first time Firm assisted by an investment banker Transaction covered by Security Act of ’33 Seller usually under prices slightly Direct Public Offering Firms attempt to bypass investment banker and sell stock directly to the public

Where are stocks traded? National Exchanges New York Stock Exchange (NYSE) American Stock Exchange (AMEX) Regional Stock Exchanges Midwest Stock Exchange Pacific Coast Stock Exchange Over the counter market (OTC) NASDAQ

Listing Standards Toughest for national exhanges For NYSE: At least 2,000 round-lot holders in the U.S., or At least 2,200 shareholders and a six- month average monthly volume of 100,000 shares, or At least 500 total shareholders and an average twelve-month volume of 1,000,000 shares.

Methods of Trading Specialist (e.g., used on NYSE) Assigned specific stocks Required to make markets move smoothly and to make continuous quotes available Dealers (e.g., used in the OTC) Can have multiple dealers per stock Both specialists and dealers use bid- asked spreads

Stock Market Indexes Dow Jones Industrial Average (DJIA) Dollar-weighted index Contains only 30 stocks Standard & Poor 500 (S&P 500) Value weighted index NYSE Composite Index NASDAQ Composite Wilshire 5000

Types of brokerage firms (1 of 2) Distinction becoming blurred over time Full-service brokers Customer deals with one specific broker Substantial services offered Highest commission rates Broker’s income based on annual commission volume generated Emphasis on office location

Types of brokerage firms (2 of 2) Discount brokers All brokers respond to all accounts Fewer services offered Brokers are salaried Few actual offices

Ordering out vs. street name Ordering out (taking possession) Direct communications from company (including dividends) Occasional direct benefits Street Name (leave at brokerage) No worry if lost or destroyed Immediacy of selling Simplification of tax information

Direct Purchase Plan Similar to IPO, buy stock directly from company but stock has active market Must leave stock in account with company Great for dollar averaging programs Ideal for new (young) investors

Dividend Reinvestment Program Like a dollar averaging program Shares must be on deposit with the company Still must declare dividends as taxable income Causes loss of portfolio diversification over time Great for new (young) investors

Types of Orders for Trading (1 of 2) Market Order Will be immediately executed No certainty as to price If a trade is a good idea, then “just do it”

Types of Orders for Trading (2 of 2) Limit order Specify price lower than market for buy Specify price higher than market for sell Execution NOT guaranteed Price guaranteed IF trade occurs “Penny wise, pound foolish”

Buying on margin (1 of 3) Computing the initial margin: Buy 100 shares of stock at $10 per share 100 shrs x $10 price = $1,000 total purchase $1,000 total purchase x 60% initial margin rate = $600 minimum initial cash provided $1,000total cash minimum initial cash = 400 maximum initial loan

Buying on margin (2 of 3) The Effect of Buying on Margin: ROE = ROA / m where ROE = investor’s return on equity, ROA = the return on the investment itself, and m = initial margin rate

Buying on margin (3 of 3) Buy 100 shares at $10 per share & stock goes to $15 per share => ROA = ($ $1000) / $1000 = +50% If buy stock on 60% margin (& ignore interest charges) => Initial investment = $600 Profit = $500 ($1,500 - $1,000) ROE = $500 / $600 = 83.33% Note: 83.33% = 50% /.60

Mechanics for selling a stock short (1 of 2)) TODAY: Investor places an order to sell (short) stock that is not owned Broker borrows the stock from someone else Broker sells the stock to someone who has no clue that the stock being acquired is a short sale (i.e., being shorted)

Mechanics for selling a stock short (2 of 2) IN THE FUTURE: Investor decides to close out the position and places an order to buy the stock Broker buys the stock from someone who has no clue the stock is being bought to cover a short sale Broker returns the stock to whoever loaned it for the short sale

Dollar Averaging (1 of 2) Commit to a program of buying a fixed dollar amount of an investment at predefined intervals (e.g., first of each month) This forces one to buy MORE shares when price low (and stock unattractive), and to buy LESS shares when price high (and stock looks great)

Dollar Averaging (2 of 2) This has the effect of reducing the average purchase price over time (as compared to buying a fixed number of shares on the same intervals) Ideal if purchases made out of income Poor strategy if have all of cash today, unless it is the only strategy that one would follow to invest

Playing the Market for Fun Can always do it “on paper” Time consuming and most people lose interest in a few days More interesting if done as a class game with extra credit points to the winners Several Internet sites allow one to construct and update a portfolio

Protections for Investors If brokerage firm fails => Securities Investor Protection Corporation (SIPC) If investor the victim of deception, fraud, etc. => Arbitration (if signed a binding agreement when opened account) National Association of Security Dealers Securities and Exchange Commission

Pyramid Schemes Partnerships or distributorships are sold (along with a product) Each seller of a partnership gets a percentage of the buyer’s revenues Great for the initial partners, not so good for the later partners

Ponzi Schemes Principal of initial investors is used to pay incredible “returns” to these investors Word-of-mouth by early investors brings in new investors Money from later investors used to pay returns to the early investors. All Ponzi schemes eventually collapse