Lecture Presentation Software to accompany Investment Analysis and Portfolio Management Seventh Edition by Frank K. Reilly

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Lecture Presentation Software to
accompanyInvestment Analysis and Portfolio
ManagementSeventh Editionby Frank K. Reilly
Keith C. Brown
Chapter 4
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Chapter 4 Organization and Functioning of
Securities Markets

• Questions to be answered
• What is the purpose and function of a market?
• What are the characteristics that determine the
  quality of a market?
• What is the difference between a primary and
  secondary capital market and how do these markets
  support each other?

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Chapter 4 Organization and Functioning of
Securities Markets

• What are the national exchanges and how are the
  major security markets becoming linked (what is
  meant by passing the book)?
• What are the regional stock exchanges and the
  over-the-counter (OTC) market?
• What are the alternative market-making
  arrangements available on the exchanges and the
  OCT market?

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Chapter 4 Organization and Functioning of
Securities Markets

• What are the major types of orders available to
  investors and market makers?
• What are the major functions of a specialist on
  the NYSE and how does the specialist differ from
  the central market maker on other exchanges?
• What are the major factors that have caused the
  significant changes in markets around the world
  in the past 10 to 15 years?

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Chapter 4 Organization and Functioning of
Securities Markets

• What are some of the major changes in world
  capital markets expected over the next decade?

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What is a market?

• Brings buyers and sellers together to aid in the
  transfer of goods and services
• Does not require a physical location
• Both buyers and sellers benefit from the market

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Characteristics of a Good Market

• Availability of past transaction information
• must be timely and accurate
• Liquidity
• marketability
• price continuity
• depth
• Low Transaction costs
• Rapid adjustment of prices to new information

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Organization of the Securities Market

• Primary markets
• Market where new securities are sold and funds go
  to issuing unit
• Secondary markets
• Market where outstanding securities are bought
  and sold by investors. The issuing unit does not
  receive any funds in a secondary market
  transaction

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Government Bond Issues

• 1. Treasury Bills negotiable, non-interest
  bearing securities with original maturities of
  one year or less
• 2. Treasury Notes original maturities of 2 to
  10 years
• 3. Treasury Bonds original maturities of more
  than 10 years

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Municipal Bond Issues

• Sold by three methods
• Competitive bid
• Negotiation
• Private placement
• Underwriters sell the bonds to investors
• Origination
• Risk-bearing
• Distribution

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The Underwriting Function

• The investment banker purchases the entire issue
  from the issuer and resells the security to the
  investing public.
• The firm charges a commission for providing this
  service.
• For municipal bonds, the underwriting function is
  performed by both investment banking firms and
  commercial banks

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Corporate Bond and Stock Issues

• New issues are divided into two groups
• Seasoned new issues - new shares offered by firms
  that already have stock outstanding
• Initial public offerings (IPOs) - a firm selling
  its common stock to the public for the first time

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Underwriting Relationships with Investment Bankers

• 1. Negotiated
• Most common
• Full services of underwriter
• 2. Competitive bids
• Corporation specifies securities offered
• Lower costs
• Reduced services of underwriter
• 3. Best-efforts
• Investment banker acts as broker

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Introduction of Rule 415

• Allows firms to register securities and sell them
  piecemeal over the next two years
• Referred to as shelf registrations
• Great flexibility
• Reduces registration fees and expenses
• Allows requesting competitive bids from several
  investment banking firms
• Mostly used for bond sales

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Private Placements and Rule 144A

• Firms sells to a small group of institutional
  investors without extensive registration
• Lower issuing costs than public offering

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Why Secondary Financial Markets Are Important

• Provides liquidity to investors who acquire
  securities in the primary market
• Results in lower required returns than if issuers
  had to compensate for lower liquidity
• Helps determine market pricing for new issues

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Secondary Bond Market

• Secondary market for U.S. government and
  municipal bonds
• U.S. government bonds traded by bond dealers
• Banks and investment firms make up municipal
  market makers
• Secondary corporate bond market
• Traded through an OTC market

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Financial Futures

• Bond futures are traded in
• Chicago Board of Trade (CBOT)
• Chicago Mercantile Exchange (CME)

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Secondary Equity Markets

• 1. Major national stock exchanges
• New York, American, Tokyo, and London stock
  exchanges
• 2. Regional stock exchanges
• Chicago, San Francisco, Boston, Osaka, Nagoya,
  Dublin, Cincinnati
• 3. Over-the-counter (OTC) market
• Stocks not listed on organized exchange

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Trading Systems

• Pure auction market
• Buyers and sellers are matched by a broker at a
  central location
• Price-driven market
• Dealer market
• Dealers provide liquidity by buying and selling
  shares
• Dealers may compete against other dealers

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Call Versus Continuous Markets

• Call markets trade individual stocks at specified
  times to gather all orders and determine a single
  price to satisfy the most orders
• Used for opening prices on NYSE if orders build
  up overnight or after trading is suspended
• In a continuous market, trades occur at any time
  the market is open

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National Stock Exchanges

• Large number of listed securities
• Prestige of firms listed
• Wide geographic dispersion of listed firms
• Diverse clientele of buyers and sellers

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New York Stock Exchange (NYSE)

• Largest organized securities market in United
  States
• Established in 1817, but dates back to the 1792
  Buttonwood Agreement by 24 brokers
• Over 3,000 companies with securities listed
• Total market value over 13 trillion

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American Stock Exchange (AMEX)

• Started by a group who traded unlisted stocks at
  the corner of Wall and Hanover Streets in New
  York as the Outdoor Curb Market
• Emphasis on foreign securities
• Doesnt trade stocks listed on NYSE
• Merged with the NASDAQ IN 1998 although they
  continued to operate as separate markets
• Warrants traded on AMEX years before NYSE listed
  any

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Tokyo Stock Exchange (TSE)

• Largest of the eight exchanges in Japan
• Dominates the Japanese market
• Established in 1878 and reorganized in 1943,
  1947, and 1949
• Price-drive system
• Domestic and foreign stocks listed
• Approximately 1700 stocks listed with a total
  market value of 2.4 trillion
• Most active 150 stocks are traded on floor,
  others by computer

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London Stock Exchange (LSE)

• Largest securities market in the United Kingdom
• Trades listed and unlisted securities
• More than 2,600 companies listed
• Largest listing of foreign stocks on any exchange
• Total market value of more than 561billion
• Pricing system by competing dealers via computers
  similar to NASDAQ system in U.S.

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Trends

• New exchanges in emerging economies such as
  Russia, Poland, China, Hungary, Peru, Sri Lanka
• Consolidation of existing exchanges in developed
  countries
• Global twenty-four-hour market made possible by
  advances in technology

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Recent Consolidations

• In 1995, Germanys three largest exchanges merged
  into the one in Frankfurt
• NASD merged with AMEX
• Philadelphia Stock Exchange merged with NASD/AMEX
• CBOE merged with Pacific Exchange
• The Amsterdam, Brussels and Paris exchanges
  formed an alliance
• The Stockholm, Copenhagen, and Oslo exchanges
  formed an alliance called the Nordic Country
  Alliance

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The Global Twenty-four Hour Market

• Investment firms pass the book around the world
  to maintain nearly continuous trading by
  utilizing markets at Tokyo, London, and New York
• THE TRADING DAY
• Local Time EST
• TSE 0900 - 1100 2300 - 0100
• 1300 - 1500 0300 - 0500
• LSE 0815 - 1615 0215 - 1015
• NYSE 0930 - 1600 0930 - 1600

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Regional Exchanges

• Stocks not listed on a formal exchange
• Listing requirements vary
• Listed stocks
• Allow brokers that are not members of a national
  exchange access to securities
• Regional Exchanges in United States
• Chicago, Boston, Cincinnati, Pacific, Philadelphia

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Over-the-Counter (OTC) Market

• Not a formal organization
• Largest segment of the U.S. secondary market
• Unlisted stocks and listed stocks (third market)
• Lenient requirements for listing on OTC
• 5,000 issues actively traded on NASDAQ NMS
  (National Association of Securities Dealers
  Automated Quotations National Market System)
• 1,000 issues on NASDAQ apart from NMS
• 1,000 issues not on NASDAQ

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Operation of the OTC

• Any stock may be traded as long as it has a
  willing market maker to act a dealer
• OTC is a negotiated market

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The NASDAQ System

• Automated electronic quotation system
• Dealers may elect to make markets in stocks
• All dealer quotes are available immediately
• Three levels of quotations provided
• Level 1 provides a single median representative
  quote for the stocks on NASDAQ
• Level 2 shows quotes by all market makers
• Level 3 is for OTC market makers to change their
  quotes shown

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Listing Requirements for NASDAQ

• Two lists
• National Market System (NMS)
• Regular NASDAQ
• Four sets of requirements
• Initial listing - least stringent
• Automatic NMS inclusion - up to the minute
• Alternative 1 for profitable companies with
  limited assets
• Alternative 2 for large but less profitable

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Third Market

• OTC trading of shares listed on an exchange
• Mostly well known stocks
• GM, IBM, ATT, Xerox
• Competes with trades on exchange
• May be open when exchange is closed or trading
  suspended

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Fourth Market

• Direct trading of securities between two parties
  with no broker intermediary
• Usually both parties are institutions
• Can save transaction costs
• No data are available regarding its specific size
  and growth

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Detailed Analysis ofExchange Markets

• Exchange Membership
• Major Types of Orders
• Exchange Market Makers

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Exchange Membership

• Specialist
• Commission brokers
• Employees of a member firm who buy or sell for
  the customers of the firm
• Floor brokers
• Independent members of an exchange who act as
  broker for other members
• Registered traders
• Use their membership to buy and sell for their
  own accounts

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Major Types of Orders

• Market orders
• Buy or sell at the best current price
• Provides immediate liquidity
• Limit orders
• Order specifies the buy or sell price
• Time specifications for order may vary
• Instantaneous - fill or kill, part of a day, a
  full day, several days, a week, a month, or good
  until canceled (GTC)

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Major Types of Orders

• Short sales
• Sell overpriced stock that you dont own and
  purchase it back later (at a lower price)
• Borrow the stock from another investor (through
  your broker)
• Can only be made on an uptick trade
• Must pay any dividends to lender
• Margin requirements apply

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Major Types of Orders

• Special Orders
• Stop loss
• Conditional order to sell stock if it drops to a
  given price
• Does not guarantee price you will get upon sale
• Market disruptions can cancel such orders
• Stop buy order
• Investor who sold short may want to limit loss if
  stock increases in price

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Margin Transactions

• On any type order, instead of paying 100 cash,
  borrow a portion of the transaction, using the
  stock as collateral
• Interest rate on margin credit may be below prime
  rate
• Regulations limit proportion borrowed
• Margin requirements are from 50 up
• Changes in price affect investors equity

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Margin Transactions

• Buy 200 shares at 50 10,000 position
• Borrow 50, investment of 5,000
• If price increases to 60, position
• Value is 12,000
• Less - 5,000 borrowed
• Leaves 7,000 equity for a
• 7,000/12,000 58 equity position

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Margin Transactions

• Buy 200 shares at 50 10,000 position
• Borrow 50, investment of 5,000
• If price decreases to 40, position
• Value is 8,000
• Less - 5,000 borrowed
• Leaves 3,000 equity for a
• 3,000/8,000 37.5 equity position

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Margin Transactions

• Initial margin requirement at least 50. Set up
  by the Fed.
• Maintenance margin
• Requirement proportion of equity to stock
• Protects broker if stock price declines
• Minimum requirement is 25
• Margin call on undermargined account to meet
  margin requirement
• If margin call not met, stock will be sold to pay
  off the loan

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Exchange Market MakersU.S. Markets

• Specialist is exchange member assigned to handle
  particular stocks
• Has two roles
• Broker to match buyers and sellers
• Dealer to maintain fair and orderly market
• Specialist has two income sources
• Broker commission, without risk
• Dealer trading income from profit, with risk

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Exchange Market MakersTokyo Stock Exchange (TSE)

• Regular members
• Several employees allowed on trading floor
• Trading clerks for customers accounts
• Buy and sell for own accounts
• Saitori member
• Hundreds of employees on trading floor
• Intermediary clerks
• Brokers among members
• Maintain limit orders

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TSE Membership

• Membership requires corporate license
• Four types of license are available and may be
  combined
• 1. Trade securities as a dealer
• 2. Trade as a broker
• 3. Underwrite new securities on secondary
  offerings
• 4. Handle retail distribution of securities
• Capital requirements vary by license

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London Stock Exchange

• Brokers trade on behalf of their customers
• Jobbers buy and sell as principals
• Membership based on experience and competence
• Membership fee 1 of gross revenues

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Changes in the Securities Markets

• Since 1965, the growth of trading by large
  financial institutions has had many effects
• Negotiated (competitive) commission rates
• Influence on block trades
• Impact on stock price volatility
• Development of National Market System (NMS)

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Negotiated Commission Rates

• NYSE minimum commission schedule prohibited price
  cutting since 1792
• No price break for large orders
• Initial reaction was give-ups paid to a
  designated firm - soft dollars paid for market
  research
• Third market competed with flexible commissions
  and grew
• Fostered development of the fourth market

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Negotiated Commission Rates

• In 1970 SEC began phasing in negotiated
  commissions
• Commission rates have fallen
• Discount brokerage firms compete openly
• Many brokerage and research firms have merged or
  liquidated

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The Impact of Block Trades

• Number and size of block trades has increased
• This strains the exchange specialist system
• Capital - 10,000 share or larger blocks
• Commitment - large risk with large blocks
• Contacts - Rule 113 prohibited direct contact to
  offer blocks to another institution

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The Impact of Block Trades

• Block houses are investment firms that help
  institutions locate other institutions interested
  in buying or selling blocks of stock
• A good block house has
• The capital required to position a large block
• The willingness to commit this capital to a block
  transaction, and
• Contacts among institutions

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Institutions and Stock Price Volatility

• Empirical studies have not supported the theory
  that institutional trading increases price
  volatility
• Where trading is dominated by institutions,
  actively involved institutions may provide
  liquidity for one another and noninstitutional
  investors

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National Market Systems (NMS)

• NMS has been advocated by financial institutions
  to provide greater efficiency, competition, and
  lower cost of transactions
• NMS is expected to have
• 1. Centralized reporting of all transactions
• 2. Centralized quotation system
• 3. Centralized limit order book (CLOB)
• 4. Competition among all qualified market makers

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1. Centralized Reporting

• Should record all transactions of a stock,
  regardless of location
• NYSE started a central tape in June 1975 covering
  all NYSE stocks traded on other exchanges and OTC

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2. Centralized Quotation System

• List quotes for a stock from all market makers on
  the national exchanges, regional exchanges, and
  OTC
• Brokers would complete trades on the market with
  the best quote
• Intermarket Trading System (ITS) developed by
  American, Boston, Chicago, New York, Pacific, and
  Philadelphia Stock Exchanges and NASD

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3. Centralized Limit Order Book

• Should contain all limit orders from all markets
• Should be visible to all traders
• All market makers and traders could fill orders
  on it
• Technology exists, but NYSE specialists fill most
  limit orders and oppose CLOB because they do not
  want to share this lucrative business

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4. Competition Among All Qualified Market Makers
(Rule 390)

• Market makers compete on OTC market
• Competition reduces bid-ask spread
• NYSE opposes competition and argues that central
  auction results in best market and execution
• NYSE Rule 390 requires members to obtain
  permission of the exchange before trading a
  listed stock off the exchange, forcing
  transactions to the exchange to create a central
  market

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New Trading Systems

• Daily trading volume has increased from 5 million
  shares to over a billion shares
• NYSE routinely handles days with volume over a
  billion shares
• Technology has allowed the market process to keep
  pace

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Super DOT

• Electronic order-routing system
• Member firms transmit market and limit orders in
  NYSE securities to trading posts or member firms
  booth
• Report of execution returned electronically
• 85 of NYSE market orders enter through Super DOT
  system

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Display Book

• Electronic workstation that keeps track of all
  limit orders and incoming market orders,
  including incoming Super Dot limit orders

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Opening Automated Report Service (OARS)

• Pre-opening market orders for Super Dot system
• OARS automatically and continuously pairs buy and
  sell orders
• Presents imbalance to the specialist prior to the
  opening of a stock
• Helps determine opening price and potential need
  for preopening call market

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Market Order Processing

• Super Dots postopening market order system is
  designed to accept member firms postopening
  market orders up to 3 million shares
• Rapid execution and reporting of market orders
• In 2000, orders executed and reported in 15-16
  seconds on average

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Limit Order Processing

• Electronically files orders to be executed when
  and if a specific price is reached
• Updates the Specialists Display Book
• Good-until-cancelled orders that are not executed
  are stored until executed or cancelled

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Global Market Changes

• NYSE Off-hours trading
• Crossing Session I provides for trading stocks at
  NYSE closing prices after the regular session
  from 415 PM to 500 PM
• Crossing Session II provides for trading a
  collection of at least 15 NYSE stocks with a
  market value of at least 1 million from 400 PM
  to 515 PM

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Global Market Changes

• Listing foreign stocks on the NYSE
• Future growth will be in foreign countries and
  hence listing foreign stocks is a priority for
  the NYSE
• Problem Foreign accounting standards are less
  stringent than SEC requirements for NYSE listing

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London Stock ExchangeOctober 27, 1986 Big Bang

• Brokers can act as market makers
• Jobbers can deal with the public and institutions
• Commissions are negotiable
• Gilt market was restructured like U.S. government
  securities market
• Trades reported on Stock Exchange Automated
  Quotations (SEAQ)

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Effects of the Big Bang

• Competitive market makers SEAQ reduced number
  of people on the trading floor
• More activity in the system, but profit margin
  has reduced from competition
• Many firms have merged or been acquired by
  foreign firms

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Tokyo Stock Exchange (TSE)

• 1998 brought TSE its own Big Bang introducing
  more competition in trading commissions and
  competition among market participants

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Paris Bourse

• The big brokerage house monopoly on stock trading
  has been opened up to French and foreign banks
• Investment firms are merging with banks to
  acquire capital needed to trade in world market
• Continuous auction market introduced to replace
  call market

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Future Developments

• Continuing consolidation of security exchanges
• More specialized investment companies
• Changes in the financial services industry
• Financial supermarkets
• Financial boutiques
• Advances in technology
• Computerized trading
• 24-hour market of the future may be floorless,
  global, and highly automated

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The InternetInvestments Online

• www.quote.com
• www.sec.gov
• www.nyse.com
• www.nasdaq-amex.com
• www.etrade.com
• www.schwab.com
• www.ml.com

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Future topicsChapter 5

• Uses of security-market indexes
• Stock market indicator series
• Bond market indicator series