1. Securities Markets Economics 71a Spring 2007 Mayo, Chapter 3 Lecture notes 2.3

2. Outline  Markets  Orders  Positions  Information

3. Markets  Primary markets New issues (IPO’s, corporate and public debt)  Secondary markets Trading old stuff In many cases most activity in secondary

4. Money and Capital Markets  Money markets Short term securities (1 year or less)  Capital markets Longer term

5. Money Market Securities  Treasury bills U.S. government debt Short term (less than 1 year)  Commercial paper Short term corporate borrowing  Discount pricing Buy for $10, get paid $11 in future No interest payments

6. Capital Market Securities  Bonds (longer term borrowing) U.S. Treasury Municipal (tax free) Corporate More later

7. Capital Market Securities  Stocks Common stock Preferred stock International More later

8. Trading and Secondary Markets  Stock markets  Bond markets  Derivatives  Foreign Exchange

9. U.S. Stock Markets  New York Stock Exchange (NYSE)  National Association of Securities Dealers Automated Quotation (Nasdaq) American Stock Exchange (AMEX)

10. Continuous Trading  Market types Specialist Electronic dealer Open outcry Over the counter  NASDAQ  Upstairs (negotiated)  ECN (electronic crossing network)

11. ECN’s: Electronic Crossing Networks  Internet based trade networks  Customers can meet directly (no broker)  Used mostly by professional money managers  Advantage: fewer intermediaries  Disadvantage: less liquidity (Fewer people to trade with)  Fastest growing markets

12. Other Markets  Futures/Options  Foreign Exchange Spot versus forward  Bond

13. International Markets  Many major international stock markets London Tokyo China many more  US accounts for only 36% of the companies listed on stock markets around the world

14. International Investments  Purchase stocks or bonds in foreign countries  Purchase shares in foreign firms in U.S. (American Depository Receipts) ($/English)  Bonds can be issued in different currencies Eurobond: Intel issues $ denominated bond in Japan

15. Trading Hours  Most U.S. stock markets 9:30-4:00  Extended hours on electronic trading networks  “After hours trading”  International markets (local times)  Foreign exchange markets (24 hours)  Hours increasing : toward a 24 hour market

16. Outline  Markets  Orders  Positions  Information

17. Types of Orders  Market order  Limit order

18. Market Order  Buy or sell at the current market price  No restrictions  “Buy 50 shares at market”

19. Limit Orders  Buy when price drops below a limit  Sell when price moves above a limit  Example Limit buy at 50 (price at 60) Stock moves to 55 (nothing happens) Stock moves to 49 (order executed)  Advantage Might end up with a better price  Disadvantage Order might end up unfilled

20. Brokers  Enable trading of financial services  Dealer function  Access Mail Phone Internet

21. Types of Brokers  Full service Extensive research Merrill Lynch  Premium discount Limited research Charles Schwab  Basic discount No research E*trade  Classification is difficult

22. Transaction Costs  Commissions  Bid/ask spreads

23. Costs of Trading  Commissions Fixed Negotiated Varying structures (fixed + varying)  $20 + shares * C  Bid/ask spread  Buy at the ask  Sell at the bid

24. Bid/ask Spread  Example: Ask = 88.5 (buy) Bid = 88 (sell)  Spreads may change Over time Over stocks  Reveal the ease of trading a stock “Liquidity” again

25. Order Books  Order book List of current limit buy and sell orders  If you want to buy Can “hit” limit sell orders Walk up the book Higher price for more stock  If you want to sell Can “hit” limit buy orders Walk down the book  ECN’s and visible order books

26. Settlement and Delivery  Settlement dates Usually trade date + 3 days  Take delivery or leave shares with broker (street name)

27. Outline  Markets  Orders  Positions  Information

28. Long Purchase  Straight purchase of a security  Speculate that price will increase Buy at 100 Sell at 110 10% return

29. Margin Purchase  “Buying on margin”  Borrow money to buy stock  Buy at 75% margin 75% of money in investment is yours 25% is borrowed from broker or bank  Purchase $100 of stock at 75% margin You put in $75, and you borrow $25

30. Basic Margin Formula

31. Margins and Magnification  Example stock: Price = $100 Up: Price = $150 Down: Price = $75  If you purchased with your own money $100 total investment Up: + $50 Down: - $25

32. Margins and Magnification  Buy on 50% margin (zero interest charges)  $100 own, and $100 borrowed (needs to be paid back)  Purchase $200/$100 shares = 2 shares $100 total investment Up: 2*150 - 100 - 100 = $100 (50) Down: 2*75 - 100 - 100 = $-50 (-25)

33. Margin Buying  Borrowing money to buy stocks  Magnifies gains and losses  Can lose more than you put in Buy $200 of stock  $100 your own  $100 borrowed Stock goes to zero  Lose $100 of own investment, and  Owe $100 of borrowed money too

34. Maintenance Margins  Margin required for investor to maintain  If margin falls below this level investors must add more of their own money  “Margin call”  Common margin call Prices fall Margin rises Investor needs to come up with more funds

35. Margin Requirements  Common stock: 50%  Bonds: 50%  Options: 20% stock value  Futures: 2-10% of the contract value

36. Short Sales  Holding negative stock Sell stock you don’t have (borrow) Buy it back later Pay dividends yourself in between  Key issue Make money on a price fall Lose money on a rise  Betting against a stock

37. The Mechanics of a Short  Tell broker you want to sell 100 shares of IBM short (price = $50)  Broker “borrows” shares of 100 shares of IBM owned by another client  Sells it to someone for 50*100=5000, and pays this to you  You must keep this amount on account with broker  When dividends are to be paid, you pay broker, and broker pays the other client

38. The Mechanics of a Short  IBM goes down to $40 per share  You “buy” your 100 shares to take you back to zero, pay broker 40*100=4000.  Broker buys at market, and puts the shares back in the other person’s account  You make 5000-4000 = 1000 (less dividends)  Make money when price falls  Lose money when price rises

39. The Mechanics of a Short  IBM goes up to $60 per share  You “buy” your 100 shares to take you back to zero, pay broker 60*100=6000.  Broker buys at market, and puts the shares back in the other person’s account  You lose 5000-6000 = -1000 (less dividends)

40. Margins and Shorts  Broker requires additional funds to cover possible losses  Fraction of additional sale amount  Example Sell $5000 worth of stock at 50% margin Need to keep 1.5*5000 = 7500 on account with the broker When the price goes up, need to increase this “Margin call”

41. Oddities About Shorts  Can lose unbounded amounts of money Normally only lose what you put in With short price can go up forever, and your losses keep increasing  Also, broker can get in trouble if you default Other customer could lose original shares Often insured for this

42. Short Interest  Fraction of shares sold short  Measure of market pessimism in a stock  Common market indicator  Measures market pessimism

43. Squeeze Play  Assume Microsoft has a large number of short sellers  Price starts to rise Short sellers losing money Get nervous Buy stock to close out their short positions Prices rise more, more buying.. (etc. etc)

44. Outline  Markets  Orders  Positions  Information

45. Information Sources  Private Quicken and Yahoo finance Wall St. Journal (fee) Value line and Standard and Poors (fee) Brokerage firms Corporations  Government Federal Reserve SEC

46. Information Sources  Key publications Economic information  Federal reserve bulletins (economic info) Firm/investment data  Value Line Survey  Standard and Poor’s Handbook  Security firm reports  Firm annual reports

47. The Internet and Investing  Cheap and accessible information  Investor tools Charts Screening Calculators  Online trading

48. Investment Information on the Web  News articles NY times CBS Market watch CNN financial

49. More Investment Information  Stock information Yahoo Google Quicken  Historical information Yahoo Datastream (fee) Bloomberg (fee)

50. Warnings on Internet Information  Don’t use information to trade to frequently  Don’t believe everything you see on the web

51. More (biased) Information  Firm annual reports and accounting info  Analyst information Analysts recommend (buy, sell, hold) Problems:  Firms often are biased in what they tell analysts  Analysts are biased since stocks they analyze can be their own clients

52. Internet Tools  Education www.investorguide.com www.fool.com www.smartmoney.com  Calculators www.financenter.com

53. Internet Tools  Stock screening Quicken Yahoo Google  Plotting/graphics bigcharts.com smartmoney.com

54. Market Indices  Summarize market movements  Examples Dow Jones Industrial (30 stocks) NYSE Composite S&P 500 Composite (500 stocks) NASDAQ Composite Nikkei (Japan) Wilshire 5000 Sector indices

55. Index Construction  Weighted sum  Weighting options Equal w = (1/N) Relative value of the firm (S&P, NASDAQ)  Value weighting Odd (Dow Jones)

56. Index Uses  Summary of the market  Investor benchmark (performance check) Compare own result to index  Investment target Index mutual fund

57. Index Problems  Index is not constant Additions and removals Changing weights  As stock increases in value, share in index increases  Index can drift towards growing sectors in the market