Lecture 10

Stock Markets

I. Background on Common Stocks

II. Market Microstructure

I. Background on Common Stocks

Definition

Types of stock market transactions:

1. IPO transactions 2. Primary Market 3. Secondary Market

2

Organized Stock exchanges:

Specialists: stand ready to buy or sell.

Floor brokers execute stock transactions for clients.

Over-the-Counter Market:

Market-makers: quote bid/ask prices

Brokers: bring buyers and sellers together.

Brokerage firms

Investors

StockA certificate representing partial ownership in a corporation

Dividend Gain Capital Gain

Common stocks and preferred stocks:

Voting rights Cumulative dividends

Stocks and bonds:

Payoff patternsTaxes

II. Market Microstructure

Types of orders:

Example:

$35 $35

$33.50

$ 33.25

$ 31 $31

3

Market order

Buy or sell a stock at the best possible price in the markets.

Limit order

Buy (sell) at a specified price that is lower (higher) than current market price.

Stop order

Buy (sell) at a specified price that is higher (lower) than current market price.

Limit order to sell

Limit order to buy

Stop order to buy

Stop order to sell

From the standpoint of brokers:

Market orders are easiest to execute.Limit orders are the easiest to reap customers. Stop orders are the most difficult to execute.

Margin trading: (borrow $$$ to buy stocks)

Return = (SP – INV – B – i + D) / INV

Margin requirement: INV / (INV + B)(Initial investment paid by investors) / (Total value of investment amount)

Margin call: (INV – Potential Loss) / (INV+B) (When stock price declines to certain level, brokerage firm may call investors to provide more collateral (cash or stocks) or to sell the stock.)

Example: Purchase stock on margin

The margin requirement is 50%. The margin call is set at 30%. Stock price: $ 50Interest rate on margin borrowing: 5%Expected dividend: $5

$ 75 Return = (75 – 25 – 25 – 1.25 + 5) / 25 = 115% Return = (75 – 50 + 5) / 50 = 60%

$ 50INV=$25 B=$25

$ 40 Margin call: (25-10) / (25+25) = 30%Return = (40 – 25 –25 –1.25 +5) / 25 = -

25% Return = (40 – 50 + 5) / 50 = -10%

4

Short sales (borrow stocks to sell)

Profit = SS – BB – D

Collateral requirement:

Short Sale Squeeze: When stock price increases to certain level, brokerage firm may require investors to

cover the short positions.

Example: Short sales

Stock price: $ 50Expected dividend: $5

$ 75 Return = (50 – 75 – 5) = - 30

$50SS=$50

$ 40 Return = 50 – 40 – 5 = 5

5

~ Short interest ratio:

Short interest ratio =Number of short shares / average daily trading volume.

A high short-interest ratio indicates high level of short-selling activity in the market.