chapter 16. learning objectives (part 1 of 3) discuss why financial markets exist and the benefit...
TRANSCRIPT
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 - 600 minimum initial cash = 400 maximum initial loan
Buying on margin (2 of 3)
The Effect of Buying on Margin:
ROE = ROA / m
whereROE = 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 = ($1500 - $1000) / $1000 = +50%
If buy stock on 60% margin (& ignore interest charges) =>
Initial investment = $600Profit = $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