Lecture Note 1

1
Lecture Note 1

• Introduction to Capital Markets
• How Securities are Traded in the Markets

2
Capital Markets

• Primary markets for new issues.
• Firms raise funds in primary markets.
• Secondary markets for existing securities.
• Secondary markets provide liquidity.
• Liquidity measures how easy it is to buy or sell
  securities.
• Stocks vs. real estate assets
• Large stocks vs. small stocks

3
The Role of the Stock Exchange

• A stock exchange
• Provides a (secondary) market place for the
  trading of securities
• Administers the listing requirements for firms
  listed
• Ensures the market is informed (disclosure
  requirements).
• ASX is the national stock exchange in Australia.

4
ASX Listing Requirements

• A minimum of 1m issued capital and at least 500
  shareholders, each with a parcel of at least
  2000 each
• An aggregate profit before tax for the past 3
  years of at least 1m, or 0.4m in the last year
  before listing Or should have net tangible
  assets of at least 2m.

5
US Stock Markets

• There are seven stock exchanges in the US. The
  most influential one is the New York Stock
  Exchange (NYSE). Stocks traded on an exchange are
  called listed.
• NASDAQ -- The automatic quotation system for the
  over-the-counter market. Most technology firms
  are traded here.
• Partial requirements for listing in the NYSE and
  the Nasdaq can be found in Table 3.2 Table 3.4.

6
Market Indexes

• All Ordinaries Indexes (All-Ords) Share Price
  Index, Accumulation Index (or Total Return
  index).
• Total return index includes both dividend income
  and capital appreciation
• Dow Jones Industrial Average.
• S P 500.
• NASDAQ Index.
• MSCI (Morgan Stanley Capital International)
  indexes.
• Bond Market Indicators.

7
Price-weighted vs. Market-value-weighted

• Example
• Price-weighted from 5.5 to 6, gt 9.09.
• Mkt-value-weighted from 350 to 440, gt 25.71.

8
How to Handle Stock Split?

• It wont affect the market-value-weighted
  indexes.
• If ABC were to split two for one, then P1 4,
  but the total shares 200.
• To keep the price-weighted average increase at
  9.09, the new divisor should be (44)/d 6.
• d 1.3333, down from 2.

9
Brokering vs Dealing

• A dealer maintains inventory. She earns her
  living from the difference between her buying
  price (bid price) and her selling price (ask
  price). A dealer exposes herself to price risk.
• The difference between the bid and ask prices is
  called the bid-ask spread, which is a measure of
  liquidity.
• A broker does not maintain inventory gains
  commission on each transaction he makes.
• Some brokerage houses are full service shops,
  others are discounters.
• Internet trading offers deep discount in
  commissions.

10
Orders of Trades

• Market Order (quantity alone) an order to buy or
  sell at a price which will complete the
  transaction promptly.
• Limited Order (quantity and price) an order to
  buy or sell at a specified price or better.
• Good-for-day
• Good-till-cancelled

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Stop Loss Order

• Stop-loss order an order not to be executed
  unless the stock hits a price limit.
• It is similar to a limit order except the
  execution is in the opposite direction.
• It is often used as a portfolio insurance
  strategy.

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How are Shares Traded?

• In the Australian Stock Exchange (ASX), the
  market is order driven.
• All share trading is conducted through
  stockbrokers computer terminals using a system
  called SEATS (Stock Exchange Automated Trading
  System).
• The SEATS matches buy orders with sell orders.
  Large trades by institutions (block transactions)
  can be done off the market at mutually agreed
  prices.

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An Example of the Limit-Order Book

• Suppose the following orders have been recorded
• Note the bid-ask spread is said to be at
  3.05-3.06 in the order driven market such as
  the ASX.

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How are Orders Filled?

• If there is a market order to buy 3000 shares,
  then the order is filled at 3.06.
• Seconds later, another market buy order for 3000
  shares is in, then this buyer will get the first
  1000 shares at 3.06, and the remaining shares at
  3.08 per share.
• Note the order book changes constantly as new
  orders come in.

15
NYSE and Specialist

• The NYSE is a specialist system. A specialist is
  a broker as well as a dealer.
• There are only seven specialist firms now in the
  NYSE.
• The specialist has to set the bid-ask spread and
  to prepare to trade from his own account at any
  time to maintain market liquidity.

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Specialists Role

• A specialist has to put his own bid-ask spread.
  His duty is to give investors the best price
  available.
• In our example, suppose he quotes the spread
  3.05-3.07. Then when the second market buy
  order comes in, the order will be filled at 3.06
  for the first 1000 shares, and 3.07 for the
  remaining shares.
• Only a small percentage of trades is actually
  going through the specialist.
• The role of floor traders and the value of
  seats
• Block trades

17
NASDAQ

• The NASDAQ is an automated quotation system for
  over-the-counter stocks in the U.S.
• Dealers compete business with their own bid-ask
  quotes. The NASDAQ market is heavily represented
  by technology firms.
• Many Australian firms are listed either in the
  NYSE or the NASDAQ markets (i.e. American
  Depository Receipts or ADRs) for the ease of
  raising capital in the U.S.
• For example, NAB, Telstra, Orbital Engine are
  traded on the NYSE, while Amcor, Santos are
  traded on the NASDAQ, see http//www.ssga.com/libr
  ary/resh/vtalaganaradrsaustralianstocks20040827/pa
  ge.html for a partial list.

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How are Bonds Traded?

• In the U.S., some corporate bonds from large
  companies are traded on stock exchanges.
  Government bonds and other corporate bonds are
  traded on over-the-counter markets.
• In Australia, although the ASX lists a number of
  corporate bonds, trades in these interest rate
  securities are usually thin.

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Buying on Margin

• You can borrow money from your brokers to invest
  in the share market. Buying on margin increases
  the expected returns as well as risk in your
  portfolio.
• Initial margin the percentage of your own money
  in the initial portfolio.
• Maintenance margin below which you will get the
  margin call from your broker, requiring you to
  put more money into the margin account.

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An Example of Margin Call

• An investor pays 6,000 toward the purchase of
  100 shares of XYZ at 100 per share, borrowing
  the rest from the broker.
• Suppose the maintenance margin is 30, when will
  the investor get a margin call if the price
  drops?

21
Short Sales

• A short sale allows investors to borrow shares of
  stock from a broker and sells it.
• Short sellers must return the shares and pay the
  lender of the security any dividends paid during
  the short sale.
• If you speculate that the stock price will fall,
  then you may short. Sell high and then buy low.
• There is also a margin requirement for short
  sellers.

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An Example of Short Sale

• Suppose you want to short sell 1000 shares of XYZ
  at a price of 100/share. Suppose the broker has
  a 50 margin requirement. Then you have to
  deposit 50,000 in your account with the broker.
• Assume the maintenance margin is 30, when will
  you get a margin call if the price rises?

23
Trading Costs

• Explicit costs
• commissions paid to brokers
• capital gains tax
• Implicit costs
• bid-ask spread
• market impact
• opportunity cost such as missed opportunity for
  limit orders, which is difficult to measure