Chapter 3: Equities

1
Chapter 3Equities

• 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?

2
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

3
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

4
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

5
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

6
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

7
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

8
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

9
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

10
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

11
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

12
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?

13
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

14
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

15
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

16
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

17
Some Secondary Markets

• New York Stock Exchange (NYSE)
• American Stock Exchange (Amex)
• Regional exchanges
• Pacific (LA)
• Midwest (Chicago)
• Philadelphia
• Boston
• Cincinnati
• NASDAQ

18
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.

19
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

20
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

21
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

22
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

23
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

24
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)

25
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

26
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

27
Electronic Communication Networks (ECNs)

• Not really stock exchanges, but only provide a
  link between buyers and sellers
• Essentially a chat room for trading stocks

28
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

29
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

30
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

31
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

32
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

33
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

34
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

35
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

36
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

37
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

38
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

39
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

40
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

41
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)

42
Value Weighted Index

• Based on change in total market value of all
  stocks

• Where Qit is the number of outstanding shares and
  Pi0 and Qi0 are the starting date values
• May be dominated by large market value firms
• SP 500 is 400 industrials, 40 utilities, 40
  financials, and 20 transportation

43
Geometric or Unweighted index

• Look at geometric average of percentage changes
  in prices

• Value line is a geometric index

44
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

45
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