THIRD LECTURE ON INVESTMENT ANALYSIS

SECURITIES EXCHANGE

Securities Exchanges

• Trading Systems-Although stock exchanges are similar in that only qualified stocks can be traded by individuals who are members of the exchange, they can differ in their trading systems.

• Types of trading systems – there are two types of trading systems

• An exchange can use one or a combination of two trading systems.

Trading systems

1. A pure auction market, is one in which interested buyers and sellers submit bid and ask prices for a given stock to a central location where the orders are matched by a broker

• A broker does not own the stock but acts as a facilitating agent.

• Participants refer to this system as price-driven because shares of stock are sold to the investor with the highest bid price and bought from the seller with the lowest offering price.

Trading systems

• 2.A dealer market is where individual dealers provide liquidity for investors by buying and selling the shares of stock for themselves.

• This system HAS numerous dealers who will compete against each other to provide the highest bid prices when you are selling and the lowest asking price when you are buying stock.

Call versus Continuous Markets• The operation of exchanges can differ in terms of when

and how the stocks are traded1. A call market-trading for individual stocks takes place

at specified times.• The intent is to gather all the bids and asks for the

stock and attempt to arrive at a single price where the quantity demanded is as close as possible to the quantity supplied.

• Call markets are generally used during the early stages of development of an exchange

• when there are few stocks listed or a small number of active investors/traders.

continuous market

• In a continuous market, trades occur at any time the market is open

• Stocks in this continuous market are priced either by auction or by dealers

• If it is a dealer market, dealers are willing to make a market in the stock

• which means that they are willing to buy or sell for their own account at a specified bid and ask price

Continuous market

• If it is an auction market, enough buyers and sellers are trading to allow the market to be continuous.

• There should be willing buyers and sellers of stock

Brokers

• A broker is a representative appointed by an individual investor

• Brokers have two conflicting roles– An advisor: a broker can offer investment advice and

information– A sales person: brokers are rewarded through commission

and have an incentive to encourage trade

• A full service broker is a brokerage house that can offer a full range of services including investment advice and portfolio management

Brokers

• A discount broker offers a restricted range of services at a lower price

• To complete a trade additional brokers are needed• A floor broker is located on the floor of the exchange

and does the actual buying and selling• A specialist ensures trade happens by holding an

inventory of stock and posting prices

Buying Common Stocks

• Open an account with a brokerage and specify 1. Name of firm 2. Buy or sell

3. Size of order4. How long until order is cancelled5. Type of order

Buying Common Stocks

• TIME LIMIT this is the time within which the broker should attempt to fill the order

• Day order – fill during the day it is entered or else cancel

• Open order (or Good Till Cancelled) – remains in effect until filled or cancelled

• Fill-or-kill – cancelled if not executed immediately

Buying Common Stocks

• Type of Order1. Market Order – buy or sell, with broker making best

efforti. price uncertainii. execution certain2. Limit Order – A limit price is specifiedi. a maximum if buyingii. a minimum if sellingiii. execution uncertainiv. price certain

Buying Common Stocks• Type of Ordera)Stop Order – a stop price is specifiedi. Sell if price falls below the stop priceii. Buy if price rises above the stop priceiii. Execution is certain if stop price passediv. Price is uncertainb) Stop Limit Orderi. A minimum price is placed below the stop-price for a sell or ii. A maximum price is placed above the stop-price for a buyiii. Price is certain within a rangeiv. Execution is uncertain

Margin Account• A margin account with a broker allows for limited borrowing to

purchase assets• A margin account needs a hypothecation agreement hypothecation

is a contract which pledges or creates a lien on collateral to secure a debt, where the debtor keeps possession of the collateral.

a) broker can pledge securities as collateralb) broker can lend the securities to others• For a. and b., shares are held in street name

A term used for describing a stock that is held in the name of a brokerage firm, instead of the actual purchaser of the stock.

• Owned legally by brokerage• Dividends, voting rights, reports go to investor

Margin Account

• Margin Purchase– Borrow money from broker to invest– The cost of borrowing is interest plus a service charge

• Actual margin• Actual margin =market value of assets-loan market value of assets

Margin account• A margin account is marked to market at the end of

each trading day– A daily calculation of actual margin

• A margin account is subject to a maintenance margin requirement – The minimum acceptable value of the actual margin

• If actual margin < maintenance margin then a margin call is issued

• The investor is obliged to add cash or securities to the margin account

Margin and Return

• Buying on the margin raises return• Example– Let purchase price of a security be k50– Let price of security now be k65– Assume 100 units were purchased and no dividends

were paid– Return on cash purchase cash return = 65-50 =30% 50

Margin and Return

• Return on margin purchase– Total cost = k50 x 100 = k5000– Interest rate = 11%– Initial margin = 60% so loan = k2000 Margin return=(65-50)x100-2000x0.11 =42.7%

5000 x.60

Margin and Return

• But if price falls– Assume price now is k40 rather than k65

cash return= 40-50 = -20% 50Margin return=(40-50)x100-2000x0.11 = -40.7% 5000 x.6

Margin and Return– Hence buying on the margin also magnifies losses– Conclusion: use margin when belief is that prices will rise

Short Sales

• A short sale is the sale of a security you do not own

• This is achieved by borrowing share certificates from someone else

• The borrowing process is arranged by a broker• To allow shares to be borrowed the broker either– a. Uses shares held in street name– b. Borrows from another broker

Short Sales

• Margin– There is a risk involved so short seller (A) must

make an initial margin advance to the broker– The broker then calculates the margin each day– Short sales should be used when prices are

expected to fall

SECURITY MARKET INDEXES• security market index is a means to measure the

growth of value of a set of securities• Security market indexes such as the dow jones,

fts,cac ,lusex ect have specific uses 1.A primary application is to use the index values to compute total returns and risk for an

aggregate market or some component of a market• over a specified time period and• use the rates of return and risk measures computed as

a benchmark to judge the performance of individual portfolios

SECURITY MARKET INDEXES

2.Indicator series are also used to develop an index portfolio

• the creation of index funds, whose purpose is to track the performance of the specified market series (index) over time

SECURITY MARKET INDEXES

3.Securities analysts, portfolio managers, and others use security market indexes to examine

• factors that influence aggregate security price movements

• the indexes are used to measure aggregate market movements

SECURITY MARKET INDEXES

4.Another group interested in an aggregate market series is “technicians,”

• Technicians believe past price changes can be used to predict future price movements.

• For example, to project future stock price movements, technicians would plot and analyze price and volume changes for a stock market series like the Dow Jones Industrial Average.

SECURITY MARKET INDEXES

5.securty indexes are used in portfolio and capital market theory which implies that the relevant risk for an individual risky asset is its systematic risk,

• systematic risk is the relationship between the rates of return for a risky asset and the rates of return for a market portfolio of risky assets.

• Therefore, in this case, an aggregate market index is used as a proxy for the market portfolio of

• risky assets.

security market indexes are used• As benchmarks to evaluate the performance of

professional money managers• To create and monitor an index fund• To measure market rates of return in economic

studies• For predicting future market movements by

technicians• As a proxy for the market portfolio of risky assets

when calculating the systematic risk of an asset

STOCK MARKET INDICATOR SERIES

1.Dow Jones Industrial Average• The best-known price-weighted series • The oldest and most popular stock market

indicator series• The DJIA is a price-weighted average of 30

large, well-known industrial stocks that are generally the leaders in their industry (blue

chips).

Nikkei–Dow Jones Average

• Also known as the Nikkei Stock Average Index• The Nikkei–Dow Jones Average is an

arithmetic average of prices for 225 stocks on the First Section of the Tokyo Stock Exchange (TSE).

OTHER SECURITY MARKET INDEXES

1. Standard & Poor’s Composite 500 Index (S&P 500), which comprises about 500 stocks,

2. NASDAQ Composite Index, started on February 5, 1971 with a base value of 100, comprises most of the stocks on the NASDAQ trading system, and consists of many technology companies.

3. DAX (Germany)4. Hang Seng (Hong Kong) 5. FTSE (U.K.)6. TSX (Canada).

SECURITY MARKET INDEXES

• To accurately measure the growth of a market, an index must have a sufficient sample size of securities which are representative of the particular market that the index seeks to measure.