342chapter18
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hiTRANSCRIPT
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Chapter 18. The Common Stock Chapter 18. The Common Stock MarketMarketChapter 18. The Common Stock Chapter 18. The Common Stock MarketMarket
• Types of markets
• Trading mechanics
• Stock market indexes
• Pricing efficiency
• Types of markets
• Trading mechanics
• Stock market indexes
• Pricing efficiency
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Common stockCommon stockCommon stockCommon stock
• equity security• ownership• entitled to distributed earnings• entitled to share of assets
• equity security• ownership• entitled to distributed earnings• entitled to share of assets
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I. Type of MarketsI. Type of MarketsI. Type of MarketsI. Type of Markets
• exchanges
• OTC trading of
• unlisted stocks & listed stocks
• direct trading
• exchanges
• OTC trading of
• unlisted stocks & listed stocks
• direct trading
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ExchangesExchangesExchangesExchanges
• physical location for trading
• trading by members• own a seat on the exchange
• stock traded on exchange are listed stocks
• physical location for trading
• trading by members• own a seat on the exchange
• stock traded on exchange are listed stocks
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NYSENYSENYSENYSE
• 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
• 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
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• 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%)
• 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%)
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role of the specialistrole of the specialistrole of the specialistrole 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
• 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
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the future of the specialistthe future of the specialistthe future of the specialistthe future of the specialist
• may be phased on with next 5-10 years
• recent SEC fines for improper trading for several major firms
• may be phased on with next 5-10 years
• recent SEC fines for improper trading for several major firms
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AMEXAMEXAMEXAMEX
• merged w/ Nasdaq 1998
• specializes in equity derivative securities and closed-end funds
• merged w/ Nasdaq 1998
• specializes in equity derivative securities and closed-end funds
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Regional exchangesRegional exchangesRegional exchangesRegional exchanges
• stocks may be listed on both NYSE and regional exchange
• 5 regional exchanges
• cheaper seat prices
• stocks may be listed on both NYSE and regional exchange
• 5 regional exchanges
• cheaper seat prices
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OTC marketsOTC marketsOTC marketsOTC 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
• electronic network of dealers all over the world
• ECNs• electronic communication
networks
• more than one dealer per stock• not obligated to make a market
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NasdaqNasdaqNasdaqNasdaq
• 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
• 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
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II. Trading MechanicsII. Trading MechanicsII. Trading MechanicsII. Trading Mechanics
• types of orders
• short selling
• buying on the margin
• institutional trading
• types of orders
• short selling
• buying on the margin
• institutional trading
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Types of ordersTypes of ordersTypes of ordersTypes 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
• 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
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• 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
• 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
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• 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
• 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
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• investor sets reservation price
BUT• no guarantee that limit order will
be executed
• investor sets reservation price
BUT• no guarantee that limit order will
be executed
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• 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
• 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
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• investor does not have to watch market• but in a volatile market stop could be
triggered prematurely
-- end up trading unnecessarily
• investor does not have to watch market• but in a volatile market stop could be
triggered prematurely
-- end up trading unnecessarily
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• 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”
• 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”
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• 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”
• 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”
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how long is an order good?how long is an order good?how long is an order good?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
• fill or kill order• executed when reaches trading
floor, or canceled
• good until canceled/open order• is good indefinitely
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order sizeorder sizeorder sizeorder 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
• 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
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short sellingshort sellingshort sellingshort 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
• 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
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• 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)
• 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)
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• so short sellers• believe price will fall and SOON• but price not currently falling• face unlimited losses if price rises
• so short sellers• believe price will fall and SOON• but price not currently falling• face unlimited losses if price rises
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Buying on the marginBuying on the marginBuying on the marginBuying 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
• 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
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• 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
• 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
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exampleexampleexampleexample
• 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
• 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
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• if prices falls to $12,• value of stock $12,000• below 125% of $10,000 loan• get a margin call
• if prices falls to $12,• value of stock $12,000• below 125% of $10,000 loan• get a margin call
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Institutional tradingInstitutional tradingInstitutional tradingInstitutional trading
• vs. retail trades• institutional trades are larger• special execution• over 50% of NYSE share volume
• vs. retail trades• institutional trades are larger• special execution• over 50% of NYSE share volume
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block tradesblock tradesblock tradesblock 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)
• 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)
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program tradesprogram tradesprogram tradesprogram trades
• large # shares, different stocks
• used by mutual funds for asset allocation
• want• low commissions• prevent frontrunning
• large # shares, different stocks
• used by mutual funds for asset allocation
• want• low commissions• prevent frontrunning
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what is frontrunning?what is frontrunning?what is frontrunning?what is frontrunning?
• brokers trade ahead of program trade• to benefit from anticipated price
movements• due to large trade
• brokers trade ahead of program trade• to benefit from anticipated price
movements• due to large trade
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exampleexampleexampleexample
• 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
• 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
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agency basisagency basisagency basisagency basis
• brokers bid for trade by commission
• low commission, but
• frontrunning likely
• brokers bid for trade by commission
• low commission, but
• frontrunning likely
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agency incentive agreementagency incentive agreementagency incentive agreementagency 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
• set benchmark value for trade• based on last day’s prices
• if broker does better• gets commission + bonus
• higher commission, but
• frontrunning less likely
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III. Stock market indicatorsIII. Stock market indicatorsIII. Stock market indicatorsIII. Stock market indicators
• measure average performance of a group of stocks
• different indexes are highly correlated:• DJIA & S&P 500 .991 (1990s)• DJIA & NYSE .95
• measure average performance of a group of stocks
• different indexes are highly correlated:• DJIA & S&P 500 .991 (1990s)• DJIA & NYSE .95
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indexes differ due toindexes differ due toindexes differ due toindexes differ due to
• stocks included in the index
• weighting of stocks• equal, price, value
• average• arithmetic• geometric
• stocks included in the index
• weighting of stocks• equal, price, value
• average• arithmetic• geometric
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stock exchange indexstock exchange indexstock exchange indexstock exchange index
• includes all stocks listed on exchange
• NYSE Composite
• Nasdaq Composite
• (both value weighted)
• includes all stocks listed on exchange
• NYSE Composite
• Nasdaq Composite
• (both value weighted)
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subjectively selected indexsubjectively selected indexsubjectively selected indexsubjectively selected index
• organization picks group of stocks to measure
• Dow Jones Industrial average
• S&P 500
• organization picks group of stocks to measure
• Dow Jones Industrial average
• S&P 500
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DJIADJIADJIADJIA
• price weighted
• 30 large blue chip companies• cross section of industries• leaders
• large movements in DJIA may halt trading on NYSE
• price weighted
• 30 large blue chip companies• cross section of industries• leaders
• large movements in DJIA may halt trading on NYSE
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S&P 500S&P 500S&P 500S&P 500
• 500 large blue chip companies
• value weighted
• most popular benchmark for index funds
• 500 large blue chip companies
• value weighted
• most popular benchmark for index funds
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objectively selected indexobjectively selected indexobjectively selected indexobjectively 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
• 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
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IV. Pricing Efficiency of theIV. Pricing Efficiency of the Stock Market Stock Market
IV. Pricing Efficiency of theIV. Pricing Efficiency of the Stock Market Stock Market
• what information is reflected in current stock prices?• what implications does this have
for active vs. passive investment strategies?
• what information is reflected in current stock prices?• what implications does this have
for active vs. passive investment strategies?
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3 levels of price efficiency3 levels of price efficiency3 levels of price efficiency3 levels of price efficiency
• what are they?
• implication?
• evidence for U.S. stock markets?
• what are they?
• implication?
• evidence for U.S. stock markets?
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Weak form efficiencyWeak form efficiencyWeak form efficiencyWeak form efficiency
• current stock prices reflect • information about past prices • and trading history
• current stock prices reflect • information about past prices • and trading history
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implicationimplicationimplicationimplication
• 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
• 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
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evidenceevidenceevidenceevidence
• U.S. stock market is weak-form efficient
• technical analysts do not beat the market• especially after trading costs
• U.S. stock market is weak-form efficient
• technical analysts do not beat the market• especially after trading costs
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Semi strong form efficiencySemi strong form efficiencySemi strong form efficiencySemi strong form efficiency
• current stock prices reflect• all publicly available information
relevant to stock
-- economic data
-- financial statements
• current stock prices reflect• all publicly available information
relevant to stock
-- economic data
-- financial statements
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implicationimplicationimplicationimplication
• using public info to predict future stock prices will not work• fundamental analysis will fail to
beat market
• using public info to predict future stock prices will not work• fundamental analysis will fail to
beat market
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evidenceevidenceevidenceevidence
• mixed
• Yes• most actively managed portfolios
do not outperform randomly selected portfolios
• mixed
• Yes• most actively managed portfolios
do not outperform randomly selected portfolios
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• No.• certain pricing anomalies persist
for long periods of time• January effect• size effect
• No.• certain pricing anomalies persist
for long periods of time• January effect• size effect
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Strong form efficiencyStrong form efficiencyStrong form efficiencyStrong form efficiency
• current stock prices reflect all information• public and private
• current stock prices reflect all information• public and private
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implicationimplicationimplicationimplication
• impossible to predict future stock prices• stock prices are a random walk
• impossible to predict future stock prices• stock prices are a random walk
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evidenceevidenceevidenceevidence
• U.S. stock market is not strong form efficient
• why?• corporate insiders consistently
outperform market• & they have access to private info
• U.S. stock market is not strong form efficient
• why?• corporate insiders consistently
outperform market• & they have access to private info
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active strategyactive strategyactive strategyactive 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
• 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
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passive strategypassive strategypassive strategypassive 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
• 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