PowerPoint Lecture on Equities
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Chapter 3:Equities
• What are equities? What are some features of equities?
• How are equities sold?– In the primary market?– In the secondary market?
• How do stock markets operate?• What are some of the ways that we can
invest in stocks?
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What are equities?
• Equity means partial ownership– Of house or company
• Common stock (or common shares) are ownership in firms– Owners are called
shareholders or shareowners
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Why own equities?• Entitled to after-tax earnings of firm
– Earnings are after everyone else is paid off
– After bondholders and other claimholders (“residual”)
• Receive dividends (usually)• Expect stock price to increase
– Future earnings prospects determine stock price
• Right to vote and participate in decisions of firm• Limited liability
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Some basic terminology
• Authorized shares is the maximum number of shares that the board of directors has agreed to sell
• Outstanding shares is the number of authorized shares that has actually been sold
• Treasury shares are repurchased shares by the firm– Do not have voting rights nor earn dividends
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Basic terminology p.2
• Classified stock (e.g. Class A shares, Class B shares, etc.) may vary in terms of ownership rights– Usually difference is in voting rights and
dividends
• Even though shareholders own the firm, the worst they can do is lose the amount invested due to limited liability
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Dividends
• Payments to shareholders in cash or securities typically made quarterly
• Dividends are not an obligation of the firm• Declaration date is made by board• Ex-dividend date is the date that the stock
begins trading without the right to the declared dividend– Drops in value
• Payable date is when firm pays dividend
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Stock splits / reverse splits
• In a stock split, firm redefines shares into smaller units– Total market value of firm is unaffected– Can be 2-for-1, 3-for-1, 3-for-2, etc.– Example of a 2-for-1 stock split: A shareholder with
100 shares at $60 per share will have 200 shares at $30 per share
• Reverse splits consolidate shares• Argument for stock splits: firms want prices that
are most accessible
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Why do firms sell stock?
• Firms need additional capital to fund activities and need for cash goes beyond borrowing
• They sell in the primary market• Firms use an initial public offering (IPO) to
sell stock to investors for the first time• Firms who sell stock who have already
gone public make a “seasoned offering”
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How do firms sell stock?
• An underwriter is the investment bank / broker that assists in selling securities– Set offer price after gathering information about
demand for security
• Firm issues prospectus which details information about the security, the company, its management, and history
• Red herring is a prospectus that is stamped in red “not yet registered with SEC”
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Securities and Exchange Commission (SEC)
• Administers securities laws
• Companies must register all securities with SEC
• Makes sure companies provide necessary disclosure information to investors
• Firms must subsequently file financial reports
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Other types of sales• Subscription right is an offer to existing
shareholders who get a “discount” from the offer price
• Private placement is when an entire issue is bought by some large investor– Avoids SEC registration– There are restrictions on buyers
• Standby commitment is when underwriter steps in to buy unsold shares of an issue
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Trading Shares of Stock
• What happens after shares are issued?
• How does someone sell their shares?
• What are the institutional details of buying and selling stock?
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Market types• Direct search market - buyers and sellers must find
each other• Brokered market - brokers provide search services• Dealer market - dealers buy and sell on their own
account• Auction market - buyers and seller converge at
one location• Primary vs. secondary markets
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Continuous market vs. Call market
• Continuous market is when prices reflect the continuous order flow
• In a call market, orders are collected until there is an auction– Auctions happen periodically through the day– Market price determined from the auction
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Price vs. Order driven• In a price driven market, market makers compete
and are placed between buyers and sellers– NASDAQ and London
• In an order driven market, buyers and sellers come together directly– Germany, France, Canada
• US and Japan use order driven market with market makers to ensure continuous trading
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Yes, more terminology• Transparency means no closed door deals
– Everyone gets to see what the deal was
• Information based trade is when a trade is made because of some informed investor
• Informationless trade or noise trade is one done for liquidity purposes
• Making a trade has an execution cost if it affects the price that would have existed had the trade not been made
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Some Secondary Markets
• New York Stock Exchange (NYSE)• American Stock Exchange (Amex)• Regional exchanges
– Pacific (LA)– Midwest (Chicago)– Philadelphia– Boston– Cincinnati
• NASDAQ
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Stock Exchanges• Stock exchange is where members trade for
themselves and their clients– There are several exchanges in the US
• In order to trade on the exchange, you must have a “seat” (Seats are tradable assets, too)
• In order for a stock to be “listed” on an exchange, it must meet certain requirements– Market cap, number of shares, income, number
of shareholders, etc.
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Who works in the markets?• Brokers are agents of an investing client
and they take no position in securities
• Dealers keep their own inventory– Supplies immediacy
• Market maker is a dealer who guarantees to be ready to buy or sell
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Bid-Ask spread• Bid is the highest amount that a buyer will
pay for the security• Ask is the lowest price they are willing to
sell• Bid-ask spread is difference between the
prices• It is a cost of transacting
– Lower spread means more efficiency
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NASDAQ
• National Association of Securities Dealers Automated Quotations– A.k.a. the over-the-counter market (OTC)
• Began as the way to buy non-listed stocks
• It has grown to include many listed stocks, as well as many bonds
• Many new stock issues start here
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NASDAQ Trading
• NASDAQ uses a dealer system
• Market makers post a bid and ask price for any stock they wish
• Buyers and sellers choose dealer and then contact directly– Usually through broker
• Competition among many dealers
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NASDAQ Subscriptions
• Subscribers have three levels of price data• Level 1
– get best buy/sell price (called bid-ask), last price, market summary
• Level 2– Level 1 plus quotes for all market makers
• Level 3– Level 2 plus ability to enter prices
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NYSE Trading
1. Customer calls local broker
2. Local broker routes order to member broker on trading floor
3. Member broker goes to the “post” on the floor where specific stock is trading
4. Trade with other brokers waiting by post (or wait)
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The specialist• Specialist is appointed by the exchange as the only
market maker for a particular security– One per security
• Assures that market is fair and orderly– Must step in and transact if others are not willing– Must post bid and ask prices
• Aside from being market maker, he or she sets the opening and closing prices
• Small orders go through computer (SuperDOT) directly to specialist
• Specialist keeps order book and has a lot of information
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Fragmented market
• Orders may now be placed at various places– NYSE, regional exchange, OTC
• When orders are not traded in the same way, the market is called “fragmented”
• SEC established a national market system for securities– Centralized reporting and quotation system
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Electronic Communication Networks (ECNs)
• Not really stock exchanges, but only provide a link between buyers and sellers– Essentially a chat room
for trading stocks
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I want stock - how do I place an order?
• Round lot is “standard” number of shares– Usually 100 shares for each round lot
• Odd lot is some fraction of a round lot
• Broken lot is a few small shares
• Berkshire Hathaway sells exclusively in odd and broken lots
• Commissions are usually higher for odd lots
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Ticker symbol
• Ticker symbol is the code identifier for a security assigned by exchange– NYSE, Amex has up to
3 characters, NASDAQ has 4 or sometimes 5 characters
• MSFT is Microsoft, F is Ford, IBM is IBM
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Types of Orders
• Preferential trading rules says that trader should act for his or her client before their own
• Market order– Execute immediately at the best possible price– Delay may mean movement in prices
• Limit order– Execute at a given price or better– May never be executed
• Limit order book is kept by specialist and orders are executed as market dictates
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More orders• Stop order
– Get out of market as it moves against you
– Becomes market order when stop price is met
• Market-if-touched order– Stop order but limit is on the other side
– Becomes market order if level is met
• Stop limit order– Stop order that becomes a limit order if level is met
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Even more orders
• Good through order lasts for a number of days– Most other orders last only a day
• Open order a.k.a. good ‘til canceled
• All-or-none vs. any-part– Can a portion of the order be executed?
• Fill-or-kill must be filled immediately or else
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Commissions
• Discount brokers only execute trades– Commissions are less
• Full service broker may provide other services– Most important is advice
• Commission charge (%) decreases with the size of trade
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Some institutional investor terminology
• They are now big players in markets– Insurance companies, pension funds, trusts
• Block trades are when over 10,000 shares or $200,000 are traded– Can put strain on specialist
• Program trades involve transactions of many securities simultaneously
• Frontrunning is when broker knows of a deal and trades on their own account
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Circuit breakers• Result of 1987 crash to
attempt to stop panic / euphoria– Adopted in 1988
• Some activity is reduced if price movements in the Dow Jones Industrial Average index are “large”
• Ranges from cutting off computerized trading to closing the market
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Buying on margin• If you borrow some of the money to buy a
security, you are buying on margin– The security is collateral
• The margin is the percentage that you contribute– Margin requirements are set by Federal Reserve
• The investment is leveraged so profit and loss scenarios are magnified
Margin
1Leverage
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The margin account
• Your margin is deposited into an account
• Due to falling prices, if your account falls below a maintenance margin, you must contribute additional funds
• The requirement for depositing more funds is called a margin call
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Buy low, sell high … or the reverse
• When buying, you expect the price to increase• If you expect the price to fall, you can “short sell”• Here you do not own the shares but borrow them
from someone else• You cover your position by purchasing the securities
at a later date• Short seller must pay the dividends to owner• You must post 150% margin, maintain 130%
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Uptick rules• To prevent price instability, there are rules
as to when one can short sell
• Uptick trade rule allows short sales only after the last price change was positive
• Zero uptick trade rule allows short trades when last price change was zero, but the prior price change was positive
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Stock Market Index
• Provide snapshot of stock market movement– Is the market up or
down?
• Different indices will look at different “parts” of the market– Large companies, small
companies, technology
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Price Weighted Index
• Arithmetic average of securities in index
• Pit is price of asset i at time t, Dt is the divisor at time t, and n is the number of securities in the index
• Divisor is adjusted for stock splits• The Dow Jones Industrial Average is a price weighted index of 30 industrial
companies (large blue chips)
n
i t
it
D
PIndex
1
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Value Weighted Index• Based on change in total market value of all stocks
• Where Qit is the number of outstanding shares and P i0 and Qi0 are the starting date values• May be dominated by large market value firms• S&P 500 is 400 industrials, 40 utilities, 40 financials, and 20 transportation
100*
100
1
n
iii
n
iitit
QP
QPIndex
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Geometric or Unweighted index
• Look at geometric average of percentage changes in prices
• Value line is a geometric index
1
1
1 1
t
nn
i it
itt Index
P
PIndex
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Other Indices
• Nasdaq composite– MVW, all stocks on NASDAQ (over 5,000)
• Russell 2000– MVW, small stocks
• Wilshire 5000– MVW, total market index (over 7,000 stocks)
• International– Hang Seng, Nikkei, FTSE
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Summary
• Equities are ownership of company
• Securities are usually sold through brokers
• Secondary markets include NYSE, NASDAQ
• There are different types of orders
• Several ways to invest in stock– On margin, short sell