A Closer Look at the Stock Markets

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1 We b E x t e n s i o n 1 C A Closer Look at the Stock Markets This Web Extension provides additional discussion of stock markets and trading, beginning with stock indexes. Stock Indexes Stock indexes try to measure the performance of various parts of the stock market. Some indexes try to measure a particular stock market exchange, such as the Nasdaq Composite and the NYSE Composite. Rather than cover all companies listed on an exchange, others try to measure the largest companies in a country, irrespective of the exchange, such as the Dow Jones Industrial Average (DJIA) and the Standard & Poor s 500 (S&P 500). Similar indexes exist for international stock exchanges, such as the Nikkei 225 (Tokyo), the FTSE 100 (London), the Dax 30 (Germany), and the Hang Seng (Hong Kong). Some indexes try to measure all stocks in a country, such as the Wilshire 5000, and some take the middle road, such as the Value Line Index, which includes the stocks in the S&P 500 plus over 1,000 other stocks. Other indexes measure certain segments of the market, such as different industries or sectors. For example, Dow Jones, the Amex, and Morgan Stanley provide indexes for many sectors, including airlines, automobiles, biotechnology, chemicals, consumer retailers, and technology. Some indexes try to measure different styles, such as growth versus value. For example, the Russell Investment Group provides a family of indexes based on firm size and growth prospects. They have a variety of indexes containing stocks with different market capitalizations, from very small firms (Russell Microcap Index), to medium-sized firms (Russell Midcap Index), to very large firms (Russell Top 50 Index). They also categorize firms with respect to growth and value, with growth firms having higher forecasted growth rates and higher price-to-book ratios. For example, the Russell 1000 Growth Index has the largest 1,000 firms that are also growth firms. Indexes also exist for different selections of international stocks. For example, the Morgan Stanley Capital International (MSCI) EAFE is an index composed of firms from Europe, Australia, and the Far East. MSCI also provides indexes for other combinations of countries, such as its Emerging Markets Index or its Pacific Index. Stock indexes differ in the choice of stocks included and in how the index values are calculated. For example, the DJIA is a price-weighted index. Although the actual calculations are a little more complex, a price-weighted index is basically calculated as though you owned one share of each stock in the index. Therefore, high-priced shares will have a larger impact on the index than low-priced shares. 5569X_03_web_1C.indd 1C-1 1/28/08 6:25:41 PM

2 1C-2 Web Extension 1C A Closer Look at the Stock Markets The S&P 500 and the Nasdaq Composite indexes are value-weighted indexes. Each stock in the index is weighted by its market capitalization. In essence, this is as though you owned every share of stock in all the companies in the index. Therefore, price changes for large companies will have a greater impact on the value of the index than changes for small companies. The Value Line Index is an equally-weighted index, which assumes that you have an equal amount of money invested in each stock. Regulations The regulation of securities markets is extremely important to the financial health and growth of our economy. The U.S. regulatory system provides strong protection for creditors and minority shareholders. This gives investors the confidence to buy stocks in the secondary market and provide capital to companies, and has an enormous impact on the degree of innovation in the United States. Some would argue that securities market regulations impose an unfair burden on public companies. Instead, it is the securities market regulations that have helped create the thriving market for public companies that we have. Consider the following sequence: investors would be less willing to invest in startup companies if the companies had few prospects of ever going public. This is because it is through going public that the original investors are able to harvest their investment and reap a return. But there would be few initial public offerings if a liquid market for small companies stock did not exist. And there would be no such liquid market without strong regulations. Indeed, prior to the adoption of modern securities market regulations, the market for small company stocks was rife with fraud and corruption, and only the most sophisticated and knowledgeable investors were able to trade with relative safety. Therefore, there is a direct link between regulatory protection and economic innovation. In addition to regulating the process for issuing securities, the Securities and Exchange Commission (SEC) regulates all national stock exchanges and has control over trading by corporate insiders. The SEC also has the power to prohibit stock price manipulation by such devices as pools (large amounts of money used to buy or sell stocks to artificially affect prices) or wash sales (sales between members of the same group to record artificial transaction prices). Control over credit used to buy securities is exercised by the Federal Reserve Board through margin requirements, which are discussed later in this extension. The various exchanges work closely with the SEC to police transactions and to maintain the integrity and credibility of the system. For example, the National Association of Securities Dealers (NASD) cooperates with the SEC to police trading in its dealer and OTC markets. Most exchanges also have provisions to limit the risk faced by their participants, such as circuit breakers, which automatically halt trading if stock prices have exceptional changes. For example, the NYSE and all other major U.S. exchanges temporarily suspended trading in the days following the September 11, 2001, attack on the World Trade Center and the Pentagon. Overview of Underwriting and Initial Public Offerings A public offering is a securities sale made to the investing public. It must be registered with the SEC. Shelf registration (Rule 415, since 1982) allows firms to register an offering and sell parts of the offering over time. In a private offering, the securities are sold to a

3 Trading Costs 1C-3 limited number of sophisticated investors. Most of these investors are institutional investors. In addition, there is a very active private placement market for debt securities. The private placement market for stocks is not so active, but it is growing rapidly. As described in the chapter, investment banks help companies raise money by selling debt and stock. The investment banker might underwrite the issue by making a firm commitment to sell the firm s stock at a price that is agreed upon by the investment banker and the firm. In some situations involving very small, risky firms, the investment banker might not guarantee the proceeds, but will try to sell the issue on a best efforts basis. For most stock transactions, the fees charged by the investment banker are negotiated between the issuing firm and the investment banker. In practice, the fee is usually set at 7% of the proceeds. For example, if the offering price is $10.00, the investment banker will pay the firm $9.30 per share and keep $0.70. For many plain vanilla bond offerings, the fees are based on competitive bids by one or more investment banks. Initial public offerings are characterized by two interesting phenomena. First, it appears as though the offering price is set too low on average, because the increase during the first day averages 14%. In other words, if the offering price were $20, then the price at the end of the day would be $ If the company had set the offering price at $22.80, the company could have sold the stock and raised an extra $2.80 per share. This extra $2.80 is called money left on the table. Even though the stock has a run-up in price during the first day, it appears that IPOs underperform similar stocks over the three years following the IPO. Trading Stocks This section describes some special features associated with trading stocks, including the cost of trading, trading at or away from the exchanges, margin trading, and short sales. Trading Costs First, individual traders must pay a commission, which is a fee paid to a broker for making the transaction. In the old days (10 years ago!), most brokers charged relatively high fees (around 2% of the value of the trade). If investors did not trade in round lots of 100 shares, then the commission was even higher. With the advent of Internet trading and fixed-commission trades (such as $8 per trade), individuals now pay much lower commissions. But commissions are just part of the cost. The spread is the cost of trading with the dealer. The dealer s bid price is the price that the dealer is willing to pay a seller, and the asked price is the price that the dealer is willing to charge a buyer. The spread is the difference: spread asked price bid price. The dealer s profit depends on the spread. If the spread is large, then investors end up paying more for their purchases and receiving less from their sales. During the last decade competition between dealers has done much to reduce the spread. Large sales or purchases might cause prices to change, at least in the short run. In other words, an investor with a lot of shares to sell might not be able to sell all of the shares in one transaction, and the sales price might be driven down by the time the sale is completed. This is called price impact, and it is another cost of trading. Current regulations direct orders to be placed with the best deal. For example, suppose an investor wishes to purchase 100 shares for $30 per share. If there is one offer to sell at $29.90 and another at $29.95, then the broker must direct the deal to the one that is best for the client, which is the lower sales price of $29.90 in this example. But if there is not currently an offer outstanding that exactly matches the client s order size, then the broker

4 1C-4 Web Extension 1C A Closer Look at the Stock Markets has some latitude as to where the client s trade will be sent. Sometimes an exchange will pay brokers to direct orders to them, a process called payment for order flow. If this delays the transaction or if it ends up transacted at a higher spread, then this is a cost of trading incurred by the investor. The Specialist When an order reaches the floor of the NYSE, the trade might occur between two brokers. For example, if a broker representing a client wishing to sell a particular stock can locate another broker representing a client who wishes to buy that stock, the two brokers might complete the transaction on behalf of their clients. However, many trades are conducted through the specialist. Each specialist, who is a member of the NYSE, has a particular location called a post and handles approximately 10 to 20 stocks, each of which is assigned to a single specialist. The specialist makes a market by matching buyers with sellers. If there is no matching buyer, then the specialist might buy the stock herself or himself; if there is no matching seller, then the specialist might sell from her or his own inventory. The specialist s goal is to maintain a fair and orderly market so that price changes are smooth. When prices are falling rapidly, the specialist steps in and buys stock to maintain a smooth path. This means that the specialist is buying stock while it is falling. When prices are rising rapidly, the specialist steps in and sells stock to maintain a smooth path. This means that the specialist is selling stock while it is rising. In other words, during rising or falling markets, the specialist is buying high and selling low, a recipe for disaster. But during normal times, when the market is neither rising nor falling rapidly, the specialist trades on his own account. With superior information, the specialist makes exceptional returns during these periods. Trading Away from the Market Issuing new stock is a transaction in the primary market. Buying or selling existing stock at an exchange is called the secondary market. The third market is when listed stocks are traded but not through an exchange. Take for example the institutional market, which facilitates trades of larger blocks of securities. This third market still utilizes the services of dealers and brokers. The fourth market is when institutions trade directly with other institutions without the services of any middlemen.

5 Margin Trading Buying on the margin means that the investor uses only a portion of his or her own money and borrows the rest. Margin requirements are set by the Federal Reserve and differ for stocks and futures. For stocks, the maximum initial margin is 50%. This means that if your broker is willing to lend you the money, you can borrow half the money required to buy stocks. However, if the stock price falls, then the ratio of the amount you have borrowed to the value of the stock falls. Your equity in the position, defined as the stock value minus the amount you owe, has fallen. You are required to keep this equity percentage above a minimum level, called the maintenance margin. If your equity percentage falls below this level, you will receive a margin call from your broker, requiring you to deposit more funds with him or her. Short Sales Short Sales 1C-5 Opening a short position in a stock means that you borrow stock through a dealer and then sell it. The sale proceeds are usually deposited with the broker. For example, suppose you sell IBM short for $50. You do not owe your broker $50; you owe one share of IBM stock. If IBM goes down to $40, you can use the $50 you received from the short sale to buy the stock for $40. After returning the stock to the broker (which is called closing out the short position), you are left with a $10 profit, less any commission. But if the price of IBM increases, then your broker may require you to close out the position, even though that means you have lost money in the deal. Also, if the stock pays a dividend, you must make an equivalent payment to the broker. As this example shows, a short sale is a way to profit from a decline in the price of a stock or security. However, there is considerable risk. When a stock is owned, the investor can lose only 100% of the investment. But with a short sale, there is no limit to the potential loss. An investor is limited from taking a short position during falling markets by the uptick restriction. This means that an investor can sell a stock short only if the sales price is higher than the previous sales price. This prevents investors from seeing a falling trend and then selling short, which would lead to even more downward pressure on the stock price. Of course, this means that investors can take short positions only when the stock is moving up, a time when short positions might end up losing money.

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