1. Chapter 18. The Common Stock Market
Types of markets
Trading mechanics
Stock market indexes
Pricing efficiency

2. Common stock equity security ownership
entitled to distributed earnings
entitled to share of assets

3. I. Type of Markets exchanges OTC trading of
unlisted stocks & listed stocks
direct trading

4. Exchanges physical location for trading trading by members
own a seat on the exchange
stock traded on exchange are listed stocks

5. NYSE the “Big Board” about 2800 listed U.S. companies
& 450 non-U.S. companies
$18 trillion market value (2/04)
1366 seats (fixed)
seat price $2 million 2002
10/2003 $1.35 million

6. stocks trade at post on the trading floor
20 posts, trading about 100 stocks
each stock has one specialist
10 specialist firms, 470 specialists
each specialist has 5-10 stocks
process trades from floor brokers (5%) and electronically (95%)

7. role of the specialist
MUST maintain a fair and orderly market for stock
act as buyer or seller as needed (10% of trades)
match buyers and sellers
maintain order priority

8. the future of the specialist
may be phased on with next 5-10 years
recent SEC fines for improper trading for several major firms

9. AMEX
merged w/ Nasdaq 1998
specializes in equity derivative securities and closed-end funds

10. Regional exchanges
stocks may be listed on both NYSE and regional exchange
5 regional exchanges
cheaper seat prices

11. OTC markets electronic network of dealers all over the world ECNs
electronic communication networks
more than one dealer per stock
not obligated to make a market

12. Nasdaq not the only OTC system, but the largest
over 4000 companies listed
mkt. value $2 trillion (2/28/03)
leader in daily share volume
over 500 dealers
listing requirements

14. II. Trading Mechanics types of orders short selling
buying on the margin
institutional trading

15. Types of orders instructions from investors to brokers market order
buy/sell order to be executed at best price
-- get lowest price for buy order
-- get highest price for sell order

16. market order (cont.)
market orders given priority in trading
no guarantee of execution price
-- price could rise/fall from time order is placed to time it is executed

17. limit order
buy/sell order where investor specifies price range
“buy at $50 or less”
“sell at $52 or more”
specialist records orders in
limit order book

18. investor sets reservation price
BUT
no guarantee that limit order will be executed

19. stop order
order lies dormant
turns into market order when certain price (“the stop”) is reached
“buy if price rises to $60”
“sell if price falls to $58”
-- stop loss order

20. investor does not have to watch market
but in a volatile market stop could be triggered prematurely
-- end up trading unnecessarily

21. stop limit order
turns into limit order when stop is reached
“buy if price rises to $60, but only is executed at $65 or less”

22. market if touched order
turns into market order if certain price is reached
“buy if price falls to $55”
“sell if price rises to $62”

23. how long is an order good?
fill or kill order
executed when reaches trading floor, or canceled
good until canceled/open order
is good indefinitely

24. order size round lots lots of 100 shares odd lots less than 100 shares
more difficult to trade
block trades
10,000 shares or $200,000 value

25. short selling sale of borrowed stock
profit from belief that stock price is too high will fall soon
how?
borrow stock through broker
sell stock
buy and return later

26. short selling could further destabilize falling prices
tick test rules on exchange
short sales allowed if
uptick or zero uptick in price for previous trades:
$20.75, $21 (uptick)
$20.75, $20.75 (zero upick)
$20.75, $20 (downtick)

27. so short sellers
believe price will fall and SOON
but price not currently falling
face unlimited losses if price rises

28. Buying on the margin
buyer borrows part of purchase price of stock, using stock as collateral
borrow at call money rate
Fed sets initial margin requirement
minimum cash payment
50% since 1975

29. if stock price falls
collateral worth less
if collateral worth only 125% of loan (maintenance margin)
-- margin call
-- owner must put up more cash or sell stock
margin calls can worsen stock crash

30. example 1000 shares, $20 per share $20,000 cost
$10,000 cash, borrow $10,000
leverage
gains/losses on $20,000 capital
but tied up only $10,000 capital

31. if prices falls to $12,
value of stock $12,000
below 125% of $10,000 loan
get a margin call

32. Institutional trading
vs. retail trades
institutional trades are larger
special execution
over 50% of NYSE share volume

33. block trades large # shares in one stock executed in “upstairs” market
other firms directly take other side of trade
remainder executed on trading floor or Nasdaq (downstairs)

34. program trades large # shares, different stocks
used by mutual funds for asset allocation
want
low commissions
prevent frontrunning

35. what is frontrunning? brokers trade ahead of program trade
to benefit from anticipated price movements
due to large trade

36. example broker buys ahead of large buy order broker buys first
large buy order pushes up price
broker’s holdings increase in value
result
frontrunning starts to push up price, so firm does not get best price

37. agency basis brokers bid for trade by commission low commission, but
frontrunning likely

38. agency incentive agreement
set benchmark value for trade
based on last day’s prices
if broker does better
gets commission + bonus
higher commission, but
frontrunning less likely

39. III. Stock market indicators
measure average performance of a group of stocks
different indexes are highly correlated:
DJIA & S&P (1990s)
DJIA & NYSE .95

40. indexes differ due to stocks included in the index weighting of stocks
equal, price, value
average
arithmetic
geometric

41. stock exchange index includes all stocks listed on exchange
NYSE Composite
Nasdaq Composite
(both value weighted)

42. subjectively selected index
organization picks group of stocks to measure
Dow Jones Industrial average
S&P 500

43. DJIA price weighted 30 large blue chip companies
cross section of industries
leaders
large movements in DJIA may halt trading on NYSE

44. S&P 500 500 large blue chip companies value weighted
most popular benchmark for index funds

45. objectively selected index
inclusion of stock based on objective criteria
market value
Wilshire 5000
all publicly traded stocks
Russell 2000
largest 3000 companies, then take
smallest 2000 of those

46. IV. Pricing Efficiency of the Stock Market
what information is reflected in current stock prices?
what implications does this have for active vs. passive investment strategies?

47. 3 levels of price efficiency
what are they?
implication?
evidence for U.S. stock markets?

48. Weak form efficiency current stock prices reflect
information about past prices
and trading history

49. implication if markets are weak-form efficient
using past price/trading pattern to predict future stock prices will not work
so, technical analysis will fail to beat the market

50. evidence U.S. stock market is weak-form efficient
technical analysts do not beat the market
especially after trading costs

51. Semi strong form efficiency
current stock prices reflect
all publicly available information
relevant to stock
-- economic data
-- financial statements

52. implication
using public info to predict future stock prices will not work
fundamental analysis will fail to beat market

53. evidence
mixed
Yes
most actively managed portfolios do not outperform randomly selected portfolios

54. No.
certain pricing anomalies persist for long periods of time
January effect
size effect

55. Strong form efficiency
current stock prices reflect all information
public and private

56. implication impossible to predict future stock prices
stock prices are a random walk

57. evidence U.S. stock market is not strong form efficient why?
corporate insiders consistently outperform market
& they have access to private info

58. active strategy
using fundamental or technical analysis to select stocks to buy/sell
growth, sector, value funds
trading on this info increases
trading costs
tax consequences
odds of working are low

59. passive strategy
believe market is efficient, just capture long-run returns of market
buy-and-hold diversified portfolio
index funds
lower expenses, defer taxes
index funds outperform most actively managed funds