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