The Global Stock Market

1
The Global Stock Market

• Chapter 6

2
Background

• A variety of different stock markets exist
• For instance, Germanys market is over 400 years
  old while Tanzanias began in 1998
• Macedonia has only two companies trading on its
  stock exchange while India has 5,840
• The market capitalization of the U.S. is 10
  trillion while that of Guatemala is only 2
  billion (in U.S. dollars)
• Many stock markets also trade other financial
  instruments
• Consolidations are merging stock markets and
  technology is pulling national markets together

3
The Global Stock Market

• Aggregate market capitalization of equity shares
  in the world grew from 9.6 trillion in 1990 to
  over 35 trillion in 2000
• An average rate of 14.8 annually
• Financial capital is very mobile
• In 1990 the Tokyo Stock Exchange was 30.5 of the
  global market but only 12.7 in 1999
• North America increased its share of the world
  equity market from 28.0 (1990) to 50.28 (1999)

4
The Global Stock Market

• Technological advances are automating experienced
  stock exchange employees out of jobs
• Stock markets are active in every time zone

5
Brokerage Services

• Brokers
• Sales people (earning a commission) employed by
  dealers
• Have no money invested in the dealers security
  inventory
• Help create markets by buying and selling from
  employers inventory
• Brokerage firms extend credit (margin accounts)
  to clients
• Enables client to do more securities trading

6
Brokerage Services

• Types of stock brokerage services
• Full-service
• Take buy and sell orders
• Extend margin credit to customers
• Hold clients securities in safe keeping
• Collect cash dividends
• Provide free investment research
• Perform hand-holding services
• Pleasant telephone conversations
• Investment counseling
• Birthday cards
• All paid for by clients trading commissions
• Range from 30 - 150 for one common stock
  transaction

• Examples
• Merrill Lynch
• Goldman Sachs
• PaineWebber
• Morgan Stanley Dean Witter
• Salomon Smith Barney

7
Brokerage Services

• Discount Brokers
• Simply take orders
• Offer little or no investment advice
• No hand-holding services provided
• Little opportunity for churning
• Lower commissions
• Range from 20 to 50
• Examples
• Charles Schwab Company
• Quick Reilly
• Muriel Siebert
• Jack White Company
• Fidelity Investments
• Vanguard Brokerage Services

8
Brokerage Services

• Electronic brokers
• Take buy and sell orders via Internet
• No hand-holding services
• May provide investment research
• May or may not be free
• Low commissions
• Range from almost free to 35 a trade
• Examples
• Discover Brokerage
• DLJdirect
• ETrade
• Archipelago
• Bloomberg Tradebook
• Accutrade

• Ameritrade
• Charles Schwab
• SURETRADE
• Wall Street Access
• CyberCorp.com

9
Transacting

• When making a trade, the investor must specify
• Type of order
• Whether or not margin will be involved

10
Types of Trading Orders

• Market orderorder to buy or sell ASAP at the
  current market price
• Simplest, most common order type
• Executed immediately with virtual certainty
• Limit orderorder to buy or sell with a limit
• Limit as to the maximum price paid for a buy
  order
• Limit as to the minimum price received for a sell
  order
• If order cannot be immediately transacted, it is
  recorded in the market-makers limit order book
  and held for possible future execution
• Order may never be executed if limit price is not
  reached
• May attach a time frame to the limit order

11
Types of Trading Orders

• Stop orders
• To buy (sell) are written at prices greater
  (lower) than the current market price
• Activated when (if) the market price reaches the
  stop price
• Once activated becomes a market order
• Dangers with stop orders
• Execution price cannot be known in advance
• Investor may be whip-sawed in volatile market
• Variation on stop order
• Stop limit orders
• When stop order is activated it becomes a limit
  order rather than a market order

12
Types of Trading Orders

• Scale order
• Requires buying or selling part of the order at
  each price as market prices change
• Cumbersome and not all brokers accept them
• Fill or kill (FOK) order
• Specifies price at which order must be filled or
  order is immediately canceled
• Good till canceled order
• Remains in effect until canceled
• Day ordermust be filled on the day order is
  issued
• Market on close ordercan only be executed at the
  days closing price

13
Trading on Margin

• When opening a new account with a brokerage firm,
  can have either
• Cash account
• Must pay cash for securities
• Margin account
• Offers ability to buy securities on credit
• Money put forth by investor serves as a down
  payment
• Amount investors may borrow is controlled by the
  Federal Reserve Board of Governors
• For example, the Fed may stipulate a 60 margin,
  meaning the investor must put forth at least 60
  of the purchase price

14
Trading on Margin

• Federal Reserves margin requirements for stocks
• Varied from 10 (1929) to 100 (1940)
• In recent years has been 50
• Margin requirements are different for different
  types of securities

15
How Margin Works

• Example You wish to purchase 100 shares of XYZ
  Company for a price of 100 per share. The
  initial margin requirement is 50.
• Purchase price is 100 x 100 shares 10,000
• You put forth 50, or 5,000
• Borrow the remaining 5,000 from your broker
• Broker charges you the brokers call rate for a
  margin loan

16
How Margin Works

• Assume that the market value of the stock rises
  to 150 a share
• Your total profit will be 50 a share times 100
  shares, or 5,000, ignoring interest (on margin
  loan), taxes and commissions
• Your return is 100 Profit of 5,000 ?
  Investment of 5,000
• If you had not used margin, you could have only
  afforded 50 shares, and your profit would only
  have been 2,500
• Your return would have been 50 Profit of
  2,500 ? Investment of 5,000

17
How Margin Works

• Assume that the market value of the stock falls
  to 50 a share
• Current market value of the investment is now
  only 5,000 (which exactly equals the amount that
  was borrowed from the broker)
• Your total loss will be 50 a share times 100
  shares, or 5,000, ignoring interest (on margin
  loan), taxes and commissions
• Your return is -100 Loss of 5,000 ?
  Investment of 5,000
• If you had not used margin, you could have only
  afforded 50 shares, and your loss would only have
  been 2,500
• Your return would have been -50 Loss of 2,500
  ? Investment of 5,000

18
Maintenance Margin

• If a margined portfolio decreases sufficiently in
  value, investor will receive a margin call
• Investor must put up more margin money ASAP
• Otherwise, broker liquidates enough of the
  investors securities to bring account up to the
  required minimum margin
• Easy for broker to do because investor with a
  margined account must keep securities at the
  brokers office as collateral for their loan
• The NYSE has a maintenance margin requirement of
  25
• Investors equity cannot fall below 25 of the
  accounts market value
• Or, investors loan amount cannot exceed 75 of
  the accounts market value

19
Maintenance Margin

• Continuing the example, if you had purchased
  10,000 of stock with a 50 margin, you would
  face a margin call when
• Market value of stock dropped below 6,666.67
• Because your loan of 5,000 cannot exceed 75 of
  the market value of portfolio
• 75 X 5,000
• X 6,666.67
• Some brokers set a higher maintenance margin than
  the 25 minimum

20
Investment Banks Make Primary Markets

• Initial public offerings (IPOs) occur when
  corporations and governments issue new securities
  into the primary market
• Sometimes corporations and governments with
  existing securities raise additional capital by
  issuing a new issue of seasoned securities
• Investment bankers find buyers for both IPOs and
  seasoned new issues

21
Investment Banks

• A few thousand investment banking firms exist in
  the U.S., including
• Merrill Lynch Co.
• Morgan Stanley Dean Witter
• Lehman Brothers
• Credit Suisse First Boston
• Goldman, Sachs Co.
• Salomon Smith Barney
• Bear Stearns Cos.
• Paine Webber

22
Investment Bankers Functions

• Each public offering has four steps
• Consulting with the issuer
• Carrying out administrative duties
• Underwriting the issue
• Distributing the securities to investors

23
Consulting

• The investment bank that serves as the IPOs
  originator must analyze the clients needs and
  suggest a financing plan
• What type of security should be issued?
• How much financing is needed?
• When should the new securities be issued?
• The originator will also manage
• The underwriting syndicate
• Ranges from 5 to 200 investment banking firms
  that share the financing and underwriting risk
• The selling group
• Investment banks and brokerage firms that sell
  the securities to investors

24
Administration

• Deals with legal issues associated with an IPO
• Helps obtain necessary government permissions
• Has the prospectus printed
• Makes public announcements

25
Underwriting

• An underwriter guarantees the issuer will receive
  a pre-specified amount of cash for the new
  securities
• Days or weeks from the time the underwriter buys
  the securities from the issuer till they sell the
  securities to the investors are very risky to
  underwriter
• Market conditions may fluctuate and underwriter
  may lose money on the securities because they
  have to sell them at a lower price
• It is important to set the right price for an
  IPO
• If price is too high, underwriters may not be
  able to sell securities
• If price is too low, issuer may find it costly to
  issue securities

26
Distribution

• Investment banker may sell securities to a wide
  group of investors
• Or may act as intermediary between issuer and
  buyer in a private placement
• The difference between the investment bankers
  cost and the sale price is known as the spread
• Ranges from 5 16 for stocks
• About 4 for bonds

27
Electronic Investment Bankers

• There are several investment banking firms
  offering internet services
• DLJdirect
• Freidman, Billings, Ramsey Group
• EOffering
• OpenIPO
• E-InvestmentBank
• Wit Capital
• Vary in size and sophistication

28
Full Disclosure

• In U.S. the SEC requires most primary issues be
  accompanied by a prospectus
• 10 to 20 page document that fully discloses,
  among other items
• Purpose for which the proceeds of the issue will
  be spent
• Offering price to the public
• Offering price for special groups, in any
• Underwriters fees
• Net proceeds to the issuer
• Information on the issuers products, history and
  location
• Names and remuneration of officers
• Detailed statement of capitalization
• Detailed financial statements
• Details about any pending litigation

29
Full Disclosure

• Approval of a prospectus by the SEC does not mean
  the investment is a good value, but that all the
  necessary information required by the SEC has
  been disclosed
• Full disclosure allows investors to estimate
  value of new securities

30
Secondary Market

• Once securities are issued in the primary market,
  they can begin trading in the secondary market
• Types of secondary markets
• Organized exchange run by dealers (NYSE)
• Electronic market in which dealers compete with
  one another (Nasdaq)
• Electronic communication networks

31
NYSE

• New York Stock Exchange (www.nyse.com) lists
  approximately
• 3000 common and preferred stocks issued by
  American corporations
• 300 foreign stocks
• 250 American Depository Receipts (ADRs)
• Also trades bonds

32
NYSE

• Each stock traded on the NYSE is assigned a
  specialist who must
• Continuously post bid and ask prices for the
  stocks in which they make a market
• Stand at assigned posts on the trading floor
• Act as market-makers (dealer)
• Always ready to buy at their bid price and sell
  at their ask (or offer) price
• Invest their own capital (risky) but may earn a
  return
• Execute orders for others (broker)
• Earn the bid-ask spread on every transaction

33
Decimalization

• A tick represents the minimum amount by which a
  price can change
• Prior to 1997 the tick was 1/8 but then became
  1/16
• However the tick size is now 1 since the
  exchanges instituted decimalization
• Expected to reduce the bid-ask spread and trading
  costs

34
NYSE Listing Requirements

• To be listed on the NYSE must have
• A minimum taxable annual income of 2.5 million
• A minimum net tangible assets of 18 million
• A minimum of 1.1 million shares of publicly held
  stock with a minimum market value of 18 million
• A minimum number of 2,000 investors owning
  round-lots (100 shares)
• One specialist

35
NYSE Operations

• Approximately 460 specialists with about 8 stocks
  assigned to each specialists trading post
• About 1,500 trading booths with telephones
  surround the perimeter of the trading floor
• Allows for order transmission and confirmation
  between brokers offices and exchange floor
• NYSE has 1,366 members who must own a seat on the
  exchange
• Almost all members are either specialists or
  floor brokers

36
Floor Brokers

• Buy and sell securities for the clients of
  brokerage houses or for their own accounts
• Order process
• Broker receives order via phone from the
  brokerage
• Walks to trading floor and executes transaction
  at the specialists post
• Phones brokerage and provides confirmation

37
Specialists

• Accepts obligation to make a fair and orderly
  market by
• Selling shares out of their own inventory if
  there are more buy orders than sell orders (or by
  raising the price of the security they control)
• Buying shares for their own inventory if there
  are more sell orders than buy orders (or by
  lowering the price of the stock)
• Keeps a limit order book (LOB) for each stock in
  which they make a market

38
Limit Order Book

• Today is kept on a computer
• Records buy and sell orders from potential
  traders
• Outlines the supply and demand curves that
  determine market price of security
• Helps specialists earn trading profits

39
NYSE

• NYSE has lagged behind other organizations in
  terms of technology
• Uses Super Designated Order Turnaround (SuperDOT)
  system
• Routes small market orders and limit orders
  directly from member firms to specialists
• Bypasses floor brokers
• Specialists usually let PCs execute SuperDOT
  transactions automatically

40
Block Trades

• A single transaction involving 10,000 or more
  shares
• Increased steadily throughout the 1960s-1980s but
  leveled off in the 1990s
• Specialists are not involved in block trades that
  occur outside the NYSE by block positioners
• Special brokers/dealers that line up multiple
  buyers for a large block
• Some large investment banks have a block
  positioning department
• Have the capital to carry a large block for a few
  days and the connections to distribute it
• The upstairs market
• Economies of scale lead to small commissions per
  share

41
Nasdaq Market

• Electronic, over-the-counter (OTC) market
• Lists over 15 of the worlds stock market
  capitalization
• Over 6,400 common and preferred stocks
• About 320 foreign stocks
• About 140 ADRs

42
Nasdaq Market

• National Association of Securities Dealers
  Automated Quotations (Nasdaq) is the
  communications network that services the OTC
  market
• About 61,000 computer terminals are connected to
  Nasdaqs mainframe via phone lines
• Can obtain current bid and ask prices for all
  Nasdaq stocks
• Updated continuously by about 540 competing
  Nasdaq market-makers (dealers)
• Investors broker can access the system to find
  the best bid/ask price for a security
• Broker then calls dealer to execute transaction
  as trades cannot be executed via Nasdaq computer

43
Nasdaq Market

• Centralizes a geographically dispersed market
  into a mainframe computer
• When a broker or dealer inquires about a
  securitys price, bid-ask quotes are instantly
  provided even if the dealers are many miles apart
• Designed to handle up to 20,000 stocks
• Currently lists about 6,500 actively traded
  stocks
• In 1999 Nasdaq merged with AMEX
• Nasdaq plans to cross-list stocks with various
  international exchanges
• Positioning itself to more effectively compete
  with NYSE

44
CQS, ITS and Law of One Price

• SEC requires that the Consolidated Quotation
  System (CQS) report current transactions for
  NYSE, OTC, AMEX, regional U.S. stock exchanges
  and the third market
• Helps investors find the best prices
• CQS cannot perform executions
• SEC urged NYSE to create the Intermarket Trading
  System (ITS)
• Electronic trading network linking various U.S.
  markets
• Nasdaq supplemented ITS with an electronic
  communications network called Primex
• Gives faster access to NYSE-listed stocks
• Combining CQS with ITS and Primex allows
  arbitrageurs to enforce the law of one price

45
Non-Nasdaq National Quotation Bureau (NQB)

• To be included in Nasdaqs national daily list, a
  stock must have
• At least two market makers
• A minimum of 1,500 stockholders
• Significant investor interest
• A stock not meeting these requirements are listed
  with the National Quotation Bureau (NQB)
• NQB lists 3,600 stocks, some of which are not
  actively traded
• Includes
• Domestic U.S. micro-cap stocks
• Shares in foreign corporations that cannot be
  listed on an organized exchange
• ADRS and GDRs for stocks that do not meet the
  accounting standards for listing on an organized
  exchange

46
Third U.S. Market

• Third marketsubset of OTC market where
  exchange-listed stocks are traded
• Competes with organized exchanges
• Offers cost savings in the form of better bid-ask
  prices
• Nasdaq and regional stock exchanges are the core
  of the third market
• For instance, in 1999 Chicago Stock Exchange
  (CHX) traded over 90 of the NYSE-listed stocks
• Majority of CHXs trading volume is from dual
  listings
• CHX pays for order flow
• Specialists take a penny or so (per share) from
  their bid-ask spread and give it to brokers to
  encourage brokers to execute their orders on the
  CHX rather than NYSE

47
Fourth U.S. Market

• Fourth marketa network of market-makers, block
  traders and institutions
• Bypass normal dealer services and negotiate
  directly with each other
• Instinet (short for Institutional Network) has
  operated in the fourth market since 1970
• Has computer terminals in over 5,000 subscribers
  offices
• Millions of shares are traded in secrecy daily
  via Instinet
• Commissions range from 2 to 8 a share

48
Order Crossing Networks

• An electronic communication network that tries to
  match buy and sell orders
• The price may be
• The last reported price from an organized
  exchange
• Midway between the current bid-ask prices on an
  organized exchange
• Traders may pay a fixed annual fee to use
  alternative market systems
• Variable trading costs are zero
• Rapid executions are possible if the other half
  of the transaction is already present in network
• Offers anonymity
• Sometimes the network is not operating when it is
  needed
• Or the other half of the transaction is
  unavailable

49
Order Crossing Networks

• Instinet operates the Crossing Network and
  competes with Investment Technology Groups (ITG)
  Portfolio System for Institutiional Trading
  (POSIT)
• Bloomberg runs Tradebooka continuous matching
  system mainly for Nasdaq stocks
• In 1999 Bloomberg ITG created SuperECN
• Offers a crossing network with a larger order
  flow
• Other crossing networks include
• Investors Liquidity Network by Fidelity
  Investors
• E-Crossnet is for European stocks

50
Electronic Order Working Systems

• Electronic order working systems
• Screen telecommunication networks, capture
  current market information and use it to make
  ongoing transactions
• Needs the following information
• Securities that are to be traded
• Limit order prices
• Quantities available at different prices
• Binding time limits
• Markets where the securities are traded
• Any additional information

51
Electronic Order Working Systems

• Various EOWS include
• QuantEX by Investment Technology Group
• Order Management System by Instinet
• Lattice Trading System by Credit Suisse First
  Boston
• REDIBook
• Archipelago Exchange

52
Electronic Stock Exchanges

• Arizona Stock Exchange (AZX)
• Formed in 1990 in Phoenix
• Periodic call market
• Automated auction process that attempts to equate
  the supply and demand for a broad list of common
  stocks at a few specified times each trading day
• Client submits order as if it were a limit order
• The limit order book is open to all participants,
  but anonymity of participants is maintained
• Each time an auction occurs, the AZX computer
  calculates supply and demand curves for each
  security being auctioned
• The intersection of the curve determines the
  securitys market clearing price
• All sell (buy) orders below (above) the market
  clearing price are matched
• On a daily basis, about two dozen institutional
  investors used the AZX system, trading several
  hundred thousand shares

53
Electronic Stock Exchanges

• European Association of Securities Dealers
  Automated Quotations (EASDAQ)
• Based in Brussels
• Nasdaq acquired EASDAQ in 2001
• Lists and trades about 50 technology stocks
• Primex
• Patterned after NYSE
• Takes a customers buy or sell order to the NYSE
  and other competing exchanges in search of best
  available price
• Allows users to haggle for the best prices

54
Electronic Stock Exchanges

• Tradepoint
• Conducts auctions for U.K. equities
• Operates with a transparent order book
• Jiway
• Stockbrokers can transact with each other in over
  6,000 European and American stocks
• Auctions off the right to be the designated
  market-maker for each stock in its system to
  member firms
• Provides custody services, etc.

55
Electronic Stock Exchanges

• European Alliance
• Informal alliance of eight stock exchanges,
  including
• London Stock Exchange
• Amsterdam Stock Exchange
• Brussels Stock Exchange
• Reg ATS Exchanges
• SEC rule that allows alternative trading systems
  in the U.S. to register as stock exchanges
• Exchanges must
• report their prices via the Consolidated
  Quotation System
• Operate as a self-regulating organization
• Participate in the intermarket trading system

56
The Twenty-First Century

• In 1999 NYSE and Nasdaq announced that they are
  interested in reorganizing as for-profit
  corporations
• Would allow them to raise outside capital in
  order to obtain better technology
• In 2000 Merrill Lynch started an electronic
  brokerage subsidiarythe last full-service
  brokerage in U.S. to do so
• In 2000 several companies submitted a joint
  proposal to SEC to establish a central limit
  order book
• Would reduce market fragmentation and increase
  transparency within U.S.

57
The Twenty-First Century

• Electronic technology will continue to accelerate
  change
• Trading volume will increase as transaction costs
  fall
• There will be pressure on stock exchanges and
  ECNs to consolidate
• A global market will eventually emerge

58
Liquidity

• Perfectly liquid assets are highly marketable
• Do not suffer from a decline in price if they are
  liquidated quickly
• For example, the U.S. dollar is perfectly liquid
  whereas most real estate is not because
• To quickly sell a house, seller must offer a
  price discount
• Real estate brokers commonly have commissions of
  6 of the property value

59
Liquidity Continuum

• Assets categorized from most liquid to least
  liquid
• U.S. dollar bills
• U.S. Treasury bonds
• NYSE-listed stocks and large Nasdaq stocks (such
  as Microsoft)
• Nasdaq stocks
• Corporate bonds
• Most municipal bonds
• Most real estate
• Art objects and collectibles

Investors pay a liquidity premium for the
convenience of owning liquid assets.
60
Liquidity in Securities Markets

• A liquid securities market possesses the
  following qualities
• Depthbuy-sell orders exists both above and below
  the price at which the security is transacting
• A market lacking depth is shallow
• Breadthwhen a large amount of buy-sell orders as
  described above exist
• Markets lacking breadth are called thin markets
• Resiliencyif new orders occur in response to
  price changes due to temporary order imbalances

61
Transaction Costs

• Direct transaction costs
• Brokers commissions
• Income taxes
• Transfer fees
• Custodial fees
• Outlays for research information
• Indirect transaction costs
• Bid-ask spreaddetermined by the cost of
  market-making expenses such as
• Interest expense for financing inventory of
  securities
• Risk premium for investing capital
• Administrative costs

62
Transaction Costs

• Indirect transaction costs
• Market impact
• Buying (selling) tends to bid up (down) the price
  of a security
• Large transactions tend to move prices more than
  smaller transactions
• Opportunity cost (implicit)
• Decay of information value of a trade incurred
  when market moves against a trader waiting to
  trade
• Tends to increase with time between decision to
  trade and the actual execution of the trade

63
Transaction Costs

• Total transactions costs can range from less than
  1 of the value to much of the investors return
  (in countries with high capital gains taxes)
• The cost of transaction varies inversely with the
  markets liquidity
• Large cap stocks are usually more actively traded
  than small cap
• Thus, small cap stocks generally have a higher
  transaction cost
• Large industrialized nations generally have lower
  transaction costs because
• The stock markets are more active
• More political stability
• More efficient legal systems

64
The Bottom Line

• Small and large stock markets provide varying
  degrees of liquidity
• Institutional investors may use block positioners
  to execute large trades
• Full-service brokers charge high commissions
• Discount brokers, electronic brokers or ECNs
  offer less costly services
• Most trades are market orders, however other
  order types exist

65
The Bottom Line

• Investors may buy on margineffectively borrowing
  money from their brokerage
• Margin trading enhances gains and losses
• Investment bankers assist their clients in
  raising money in the primary market
• Organizing distribution syndicates
• Underwriting the issue
• Distributing the securities

66
The Bottom Line

• NYSE is the largest stock market in the world
• Continuous auction market
• Specialists
• NASDAQ is a large electronic market
• ECNs involve several different categories of
  market technology
• Technology is
• Increasing the array of brokerage services
• Increasing the competition between brokerage
• Reducing transaction costs
• Speeding executions
• Creating new types of stock exchanges
• Altering the IPO process
• Integrating the worlds stock markets into a
  global one