Chapter 18. The Common Stock Market

• Types of markets• Trading mechanics• Stock market indexes• Pricing efficiency

Common stock

• equity security• ownership• entitled to distributed earnings• entitled to share of assets

I. Type of Markets

•exchanges•OTC trading of •unlisted stocks & listed stocks

•direct trading

Exchanges

• physical location for trading• trading by members

• own a seat on the exchange

• stock traded on exchange are listed stocks

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

• 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%)

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

the future of the specialist

• may be phased on with next 5-10 years• recent SEC fines for improper trading for several major firms

AMEX

• merged w/ Nasdaq 1998• specializes in equity derivative securities and closed-end funds

Regional exchanges

• stocks may be listed on both NYSE and regional exchange• 5 regional exchanges• cheaper seat prices

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

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

II. Trading Mechanics

• types of orders• short selling• buying on the margin• institutional trading

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

• 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

• 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

• investor sets reservation priceBUT• no guarantee that limit order will be executed

• 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

• investor does not have to watch market• but in a volatile market stop could be triggered prematurely

-- end up trading unnecessarily

• 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”

• 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”

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

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

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

• 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)

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

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

• 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

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

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

Institutional trading

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

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)

program trades

• large # shares, different stocks• used by mutual funds for asset allocation• want

• low commissions• prevent frontrunning

what is frontrunning?

• brokers trade ahead of program trade• to benefit from anticipated price movements• due to large trade

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

agency basis

• brokers bid for trade by commission• low commission, but• frontrunning likely

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

III. 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

indexes differ due to

• stocks included in the index• weighting of stocks

• equal, price, value

• average• arithmetic• geometric

stock exchange index

• includes all stocks listed on exchange• NYSE Composite• Nasdaq Composite• (both value weighted)

subjectively selected index

• organization picks group of stocks to measure• Dow Jones Industrial average• S&P 500

DJIA

• price weighted• 30 large blue chip companies

• cross section of industries• leaders

• large movements in DJIA may halt trading on NYSE

S&P 500

• 500 large blue chip companies• value weighted• most popular benchmark for index funds

objectively selected index

• inclusion of stock based on objective criteria•market value

•Wilshire 5000•all publicly traded stocks

•Russell 2000• largest 3000 companies, then takesmallest 2000 of those

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?

3 levels of price efficiency

• what are they?• implication?• evidence for U.S. stock markets?

Weak form efficiency

• current stock prices reflect • information about past prices • and trading history

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

evidence

• U.S. stock market is weak-form efficient• technical analysts do not beat the market

• especially after trading costs

Semi strong form efficiency

• current stock prices reflect• all publicly available informationrelevant to stock

-- economic data-- financial statements

implication

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

evidence

• mixed• Yes

• most actively managed portfolios do not outperform randomly selected portfolios

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

Strong form efficiency

• current stock prices reflect all information• public and private

implication

• impossible to predict future stock prices• stock prices are a random walk

evidence

• U.S. stock market is not strong form efficient• why?

• corporate insiders consistently outperform market• & they have access to private info

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

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