Chapter 1

Web Extension 1B

A Closer Look at the Stock

Markets

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Topics in Web Extension
 Stock indexes
 Regulation
 Overview of investment banking
 Stock trading

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Stock Indexes
 Stock indexes try to measure some
aspect of the market
 The differ with respect to:
 Composition (types of stock in the index)
 Weighting (how the individual stocks are
aggregated into an index)

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Index Composition
 Replicate a particular exchange
 Measure a country’s most important
stocks
 Measure a particular business sector
 Measure a particular investment “style”
 Measure an international region

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Composition by Exchange
 NYSE Composite
 Nasdaq Composite

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Composition by Business
Sector
 Many different index providers, such as:
 Dow Jones
 Amex
 Morgan Stanley
 Many different sectors, such as:
 Airlines
 Biotechnology
 Chemicals
 Consumer retailers
 Technology

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Composition by “Style”
 Two important investment styles are by the
size of the firm and by its growth prospects.
Growth is measure by high-expected sales
growth and high price-book ratios (value
stocks have lower growth and lower price-
book ratios)
 Examples:
 Russell 1000 Growth
 Russell Midcap Value

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Composition by International
Region
 Morgan Stanley Capital International
(MSCI)
 EAFE (Europe, Asia, Far East) Index
 Emerging Markets Index
 Pacific Index

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Stock Weighting in Indexes
 Price weighted
 DJIA
 Market-value weighted
 S&P500
 Nasdaq Composite

 Equally weighted
 Value Line Index
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Regulation of Securities
Markets
 Government Regulation– such as SEC.
 Insider trading oversight (SEC)
 Margin oversight (Federal Reserve)
 Self-regulation– such as NASD.
 Circuit Breakers– automatic halt in trading
if stock prices have exceptional changes.

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Public vs. Private Offerings
 Public offerings: registered with the SEC and
sale is made to the investing public.
 Shelf registration (Rule 415, since 1982) allows firms to
register an offering and sell parts of the offering over time.
 Private offering: Sale to a limited number of
sophisticated investors not requiring the protection of
registration.
- Dominated by institutions.
- Very active market for debt securities.
- Not as active for stock offerings.

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Investment Banking and
Security Offerings
 Underwritten vs. “Best Efforts”
 Underwritten: firm commitment on proceeds to
the issuing firm.
 Best Efforts: no firm commitment.
 Negotiated vs. Competitive Bid
 Negotiated: issuing firm negotiates terms with
investment banker. Usually a 7% spread.
 Competitive bid: issuer structures the offering
and secures bids (more common in bonds than
stocks).

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Initial Public Offerings
 Initial Public Offerings (IPOs)
 Underpricing—Average increase is 14% on
first day.
 Performance– Underperforms similar stock
during three years after IPO.

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Costs of Trading
 Commission: fee paid to broker for making
the transaction
 Spread: cost of trading with dealer
 Bid: price dealer will buy from you
 Ask: price dealer will sell to you
 Spread: ask - bid
 “Price Impact”– Large sales or purchase
might cause prices to change.
 “Payment for Order Flow”– Exchange will pay
brokers to direct orders to them.

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The Specialist at the NYSE
 Handles around 10-20 stocks (one per
specialist)
 Stocks trade at the “specialist’s post”
 “Makes a market” by matching buyers/seller
and by buying/selling from own inventory
 Goal is to “maintain a fair and orderly
market” so that price changes are smooth
 Specialist loses money when smoothing the
market, but makes it back during normal
conditions

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Trading Away from Exchanges
 Third Market– trading listed stocks but
not through exchange
 Institutional market: to facilitate trades of
larger blocks of securities.
 Involves services of dealers and brokers
 Fourth Market– institutions trading with
institutions
 No middleman involved in the transaction
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Margin Trading
 Investor uses only a portion of own
capital for an investment.
 Borrows remaining component.
 Margin arrangements differ for stocks
and futures.

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Stock Margin Trading
 Maximum initial margin
 Currently 50%
 Set by the Fed
 Maintenance margin
 Minimum level of equity margin if prices
change
 Margin call
 Call for more equity funds

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Short Sales Mechanics
 Opening a short position:
 Borrow stock through a dealer.
 Sell it
 Deposit proceeds and margin in account.
 Closing out the position:
 Buy the stock
 Return to the party from which it was
borrowed.

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Short Sales Purposes and
Features
 Purpose: to profit from a decline in the
price of a stock or security.
 Must pay the broker the equivalent of
any dividends paid by the stock
 “Uptick” restrictions– can only sell short
when the ask price of a stock is higher
than the last transaction
 Unlimited loss potential

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