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5

The Stock Market

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Learning Objectives

1. How firms raise capital2. The difference between primary and secondary

stock markets.3. The workings of the New York Stock Exchange.4. How NASDAQ operates.

5. How to calculate index returns. 6. How to read and understand the stock market

information reported in the financial press.

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How do firms raise capital?• Private Funding

• Private equity • Venture capital

• “First Stage” or “Ground Floor” • “Second Stage” or “Mezzanine”

• Public Funding• Primary versus Secondary markets• Investment banking firms

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Private Equity and Venture Capital

• Private Equity = equity financing for nonpublic companies.

• Target firms typically:• Have no assets other than an idea

• Are run by fledgling entrepreneurs with no track record.

• Venture capital (VC) = important part of the private equity market

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Venture Capital, I• Venture Capital = financing new, often high-risk,

start-ups.• Individual venture capitalists invest their own

money.• Venture capital firms pool funds from various

sources, like• Individuals• Pension funds• Insurance companies

• Start-ups that succeed can provide enormous profits.

• Large corporations

• University endowments

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Venture Capital, II• To limit their risk:

• Venture capitalists generally provide financing in stages.

• Venture capitalists actively help run the company.

• At each stage, enough money is invested to reach the next stage.• Ground-floor financing• Mezzanine Level financing

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Venture Capital, II

• At each stage of financing:• The value of the founder’s stake grows • The probability of success rises

• If goals are not met, the venture capitalists withhold further financing.

• If a start-up succeeds:• Big payoff = sale or IPO• Either way, investment bankers often

involved.

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Public Funding• Equity Offerings

• IPOs• Seasoned Equity Offerings

• Investment banking firms• Underwriting • Dutch Auction Underwriting

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The Primary and Secondary Stock Markets• Primary market

• Where investors purchase newly issued securities• Initial public offering (IPO):

• When a company offers stock for sale to the public for the first time

• Secondary market • Where investors trade previously issued securities.

An investor can trade:• Directly with other investors.• Indirectly through a broker • Directly with a dealer

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Initial Public Offering

Select Investment banker

Design the stock issue

Arrange underwriting

Submit prospectus to SEC

Circulate prospectus

Finalize prospectus

Tombstones placed

Sell shares

SEC approves preliminary prospectus

COMPANY INVESTMENT BANKER

Prepare preliminary prospectus (red herring)

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IPO Tombstone

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Dutch or Uniform Price AuctionBuyers:

•Bid a price and number of sharesSeller:

•Work down the list of bidders•Determine the highest price at which they can sell the desired number of shares

All successful bidders pay the same price per share.

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Dutch Price Auction Example

Bidder Quantity BidA 500 $20B 400 18C 250 16D 350 15E 200 12

The company wants to sell 1,500 shares of stock.

Bidder Quantity Bid Σ QtyA 500 $20 500B 400 18 900C 250 16 1150D 350 15 1500E 200 12 1700

The firm will sell 1,500 shares at $15 per share.

Bidders A, B, C, and D will get shares.

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The Secondary Market for Common Stock Organized Exchanges & Markets

• NYSE (1792)

• NASDAQ (1971)

• The Regional Exchanges• American Stock Exchange (1842; NYSE-Euronext, 2008)• Boston Stock Exchange (1834; Nasdaq, 2007)• Chicago Stock Exchange (1882)• Cincinnati Stock Exchange (1885; NSX, 2003)• Pacific Stock Exchange (1882; Arca, 2005; NYSE,2006)• Philadelphia Stock Exchange (1790; Nasdaq acquired 2008)

• Electronic Communications Networks (ECNs)

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Brokers vs. Dealers• Broker

• Brings buyers and sellers together to trade• Does not hold inventory• Think “Real Estate Broker”

• Dealer• Maintains an inventory• Stands ready to buy or sell based on published

quotes• Think “Used Car Dealer”

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Bid and Ask Quotes• Bid price:

• The price a dealer is willing to pay investors for a security

• Ask price:• The price at which a dealer is willing to sell a

security

• Bid-ask spread, or spread:• Difference between the bid and ask prices

• Inside Quotes:• Highest Bid, Lowest Ask

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The New York Stock Exchange

• NYSE = The “Big Board”

• Physical location exchange

• History:• Founded in 1792 as a not-for-profit corporation

• In current Wall Street building since early 1900’s

• For-profit, public NY state corporation in 2006

• Merged with Euronext N.V. in 2007

• Launched NYSE Euronext, the largest stock exchange in the world

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NYSE Seats and Trading Licenses

• Historically, the NYSE had 1,366 exchange members. These members:• Were said to own “seats” on the exchange.• Collectively owned the exchange

• Professionals managed the exchange.

• Regularly bought and sold seats • Record seat price: $3 million in 2005

• Seat holders could buy and sell securities on the exchange floor without paying commissions.

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NYSE Seats and Trading Licenses

• In 2006, NYSE went public• Instead of purchasing seats, exchange

members purchase trading licenses:• Number limited to 1,500

• In 2007, a license would set you back a cool $55,000—per year.

• Having a license entitles the holder to buy and sell securities on the floor of the exchange.

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NYSE-Listed Stocks• 2006 Listings:

• Global market value = $25 trillion

• Minimum Listing Requirements• Number of shareholders• Trading activity• Number and value of shares held in public hands• Annual earnings

• Listing Fees:• Initial listing fee and annual listing fees• Based on the number of shares

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Operation of the NYSE

• The fundamental business of the NYSE is to attract and process order flow.

• In 2007, the average trading volume on the NYSE was over 2 billion shares a day.

• Volume breakdown: • About one-third from individual investors.

• Almost half from institutional investors.

• The remainder represents NYSE-member trading, mostly from specialists acting as market makers.

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Types of NYSE Members• Specialists, or market makers:

• Obligated to maintain a “fair and orderly market”

• “The Crowd”• Commission brokers:

• Execute customer orders to buy and sell stocks

• Floor brokers, or Two-dollar brokers• Execute orders when commission brokers busy

• Less important due to SuperDOT system (designated order turnaround)

• Floor traders • Independently trade for their own accounts

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NYSE Floor Activity• There are a number of specialist’s posts, each with a

roughly figure-eight shape, on the floor of the exchange.

• At the telephone booths, commission brokers:• Receive customer orders.• Walk out to specialist’s posts where the orders can be executed,• Return to confirm order executions, and receive new customer

orders.

• Coat colors indicate the person’s job or position.

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Watching Trading on the Web

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The New York Stock Exchange

NSYEFounding date May 17, 1792Physical location/trading floor YesTypcially referred to as: "The listed market"; "The Big Board"Brokers Yes; specialistsDealers Yes; specialistsMarket maker per stock 1 specialistElectronic trading SuperDOT SystemSignature Index NYSE CompositeListing requirements Yes

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NASDAQ• “National Association of Securities Dealers

Automated Quotations”

• 2nd largest stock market in U.S. in terms of $ volume• More companies listed than the NYSE.• Volume usually exceeds NYSE volume

• Computer network• Disseminates price quotes to subscribers• No trading floor or physical location

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NASDAQ• An Over-the-counter (OTC) market:

• Dealers = “market makers”• Multiple dealers per stock• Competing market makers• Buy and sell from inventory

• Three separate markets:• The Global Select Market• The Global Market• The Capital Market

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The NASDAQ System

• The NASDAQ network provides bid and ask prices as well as recent transaction information.

• The bid and ask prices for the NASDAQ represent inside quotes.• The highest bid

• The lowest ask

• For a small fee, you can have access to “Level II” quotes.• Displays all bids and asks

• Frequently displays the market maker identity

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NASDAQNASDAQ

Founding date 1971Physical location/trading floor No; computer networkTypcially referred to as: "The over-the-counter market"Brokers NoDealers Yes; market makersMarket maker per stock Multiple market makersElectronic trading All electronicSignature Index NASDAQ 100Listing requirements NMS - Yes

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NYSE vs. NASDAQ

NSYE NASDAQFounding date May 17, 1792 1971Physical location Yes No; computer networkTypcially referred to as: "The listed market" "The over-the-counter market"Brokers Yes; specialists NoDealers Yes; specialists Yes; market makersMarket maker per stock 1 specialist Multiple market makersElectronic trading SuperDOT System All electronicSignature Index NYSE Composite NASDAQ 100Listing requirements Yes NMS - Yes

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Other Market Venues• The “Third Market”

• Off-exchange trading of exchange-listed securities

• The “Fourth Market”• Direct trading of both NYSE and NASDAQ stocks among

investors. • ECNs provide an avenue for fourth market trading.

• ECNs • Electronic Communications Networks

• The Regional Exchanges • Chicago, Cincinnati (NSX) • Dually-listed stocks

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NASDAQ, II.• In the late 1990s, the NASDAQ system

opened to electronic communications networks (ECNs)

• ECNs are basically websites that allow investors to trade directly with one another.

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Stock Market Order Types

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Market and Limit Orders

Market LimitPrice Best price available Best price; not > limit

Execution Immediate Only if limit metPrice Best price available Best price; not < limit

Execution Immediate Only if limit met

Buy

Sell

Market Order: “Buy 100 shares of IBM at the market”

“Sell 200 shares of GE at the market”

Limit Order: “Buy 100 shares of IBM at $100 or better”

“Sell 200 shares of GE at $35 or better”

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Stock Market Information

• The most widely followed barometer of day-to-day stock market activity is the Dow Jones Industrial Average (DJIA), or “Dow” for short.

• The DJIA is an index of the stock prices of 30 large companies representative of American industry.

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The Dow Jones Industrial Average

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Yields on DJIA Component Stocks

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Stock Market Indexes• Distinguishing features:

• Market covered

• Types of stocks included

• Number of stocks included

• Index calculation technique• Price-weighted• Value-weighted

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Index Weighting• Price-Weighted

• Stocks held in proportion to their share price• Higher priced stock = higher weight

• DJIA (3/08/2008: DJIA divisor = 0.122834016)

• Adjusted for stock splits

• Value-Weighted• Stocks held in proportion to their total company

market values• Company with larger market value = higher weight

• S&P 500

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Stock Market Indexes, III.

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Price- vs. Value-Weighted

The Price-Weighted Index = Average share price

The Value-Weighted Index = Total Market Value (# shares x Price)

Shares

Stock Outstanding BOY EOY % r BOY EOY % r

ABC 20 million $50 $52 4% $1,000 $1,040 4%

XYZ 100 million $25 $30 20% $2,500 $3,000 20%

Price-Weighted Index 38 41 9%

Value-Weighted Index 3500 4040 15%

Total Market ValuePrice per Share

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Adjusting a Price-Weighted Divisor

• Initial divisor = number of stocks in index

• Divisor Adjusted:

• For stock splits

• For changes in the composition of the index

• Closing on Day 1 must = Day 2 opening

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Price-Weighted: Changing the Divisor

Day 1 of Index: Company Price

GM 40.56Nordstrom 25.91Lowe's 53.68Sum: 120.15

Index: 40.05 (Divisor = 3)

Before Day 2: Replace Lowe's with Home Depot, selling at $32.90

To keep the value of the Index the same, i.e., 40.05:

GM 40.56Nordstrom 25.91Home Depot 32.90Sum: 99.37

99.37 / Divisor = 40.05, if Divisor is: 2.481148564

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Adjusting for a Stock Split

Shares

Stock Outstanding EOD BOD

20 million $50

40 million $25

XYZ 100 million $25 $30

Price-Weighted Index 37.50 37.50

2 1.4665Divisor

Price per Share

ABC

Closing on Day 1 must = Day 2 opening

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Useful Internet Sites• www.hoovers.com (information on Initial Public Offerings, or IPOs)• www.nyse.com (website for the New York Stock Exchange)• www.nasdaq.com (website for the NASDAQ)• averages.dowjones.com (The Dow Jones Industrial Average)• www.russell.com (the Russell Indexes)• www.barra.com (reference for “value” and “growth” indexes)• www.djindexes.com (reference for current divisor for the DIJA)• www.standardpoors.com (website for S&P 500)• www.nni.nikkei.co.jp (website for Japan’s Nikkei 225 index)