Investment Portfolio Management - 01 - Gitman

7/31/2019 Investment Portfolio Management - 01 - Gitman

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Copyright 2011 Pearson Prentice Hall. All rights reserved.2-2

Securities Markets and Transactions

Learning Goals

1. Identify the basic types of securities markets anddescribe their characteristics.

2. Explain the initial public offering (IPO) process.

3. Describe broker and dealer markets, and discuss howthey differ from alternative trading systems.


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Securities Markets and Transactions

Learning Goals (contd)

4. Review the key aspects of the globalization ofsecurities markets, and discuss the importance of

international securities markets.

5. Discuss trading hours and regulation ofsecurities markets.

6. Explain long purchases, margin transactions andshort sales.


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Types of Markets

Money Markets: the market where short-term securitiesare bought and sold

Capital Market: the market where long-term securities

such as stocks and bonds are boughtand sold

Primary Market: the market in which new issues ofsecurities are sold to the public

Secondary Market: the market in which securities aretraded after they have been issued


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Primary Markets

Initial Public Offering (IPO) First public sale of a companys stock

Requires SEC approval

Three Choices to Market Securities in PrimaryMarket Public offering

Rights offering

Private Placement


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Table 2.1 Annual IPO Data, 19992008


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Going Public: The IPO Process

Underwriting the offering: promoting the stock andfacilitating the sale of the companys shares

Prospectus: registration statement describing the issueand the issuer

Red Herring: preliminary prospectus available during thewaiting period

Quiet Period: time period after prospectus is filed when

company must restrict what is said about the company Road Show: series of presentations to potential

investors


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Figure 2.1 Cover of a PreliminaryProspectus for a Stock Issue


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The Investment Bankers Role

Underwriting the Issue: purchases the security at agreed-on priceand bears the risk of reselling it to the public

Underwriting Syndicate: group formed by investment banker toshare the financial risk of underwriting

Selling Group: other brokerage firms that help the underwritingsyndicate sell issue to the public

Tombstone: public announcement of issue and role of participantsin underwriting process

Investment Banker Compensation: typically in the form of adiscount on the sale price of the securities


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Figure 2.2 The Selling Processfor a Large Security Issue


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Secondary Markets

Secondary Market: the market in which securities aretraded after they have been issued

Role of Secondary Markets Provides liquidity to security purchasers

Provides continuous pricing mechanism Securities Exchanges: forums where buyers and sellers

of securities are brought together to execute trades

Nasdaq Market: employs an all-electronic trading

platform to execute trades Over-the-counter (OTC) Market: involves trading in

smaller, unlisted securities


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Broker Markets and Dealer Markets

Broker Markets: consists of national and regionalsecurities exchanges 60% of the total dollar volume of all shares in U.S. stock market

trade here

New York Stock Exchange (NYSE) is largest and most well-known

Trades are executed when a buyer and a seller are broughttogether by a broker and the trade takes place directly betweenthe buyer and seller

Dealer Markets: consists of both the Nasdaq market andthe OTC market Trades are executed with a dealer (market maker) in the middle.

Sellers sell to a market maker at a stated price. The marketmaker then offers the securities to a buyer.


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Copyright 2011 Pearson Prentice Hall. All rights reserved. 2-13

Figure 2.3 Broker and Dealer Markets


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Broker Markets (contd)

Regional Stock Exchanges Typically lists between 100500 companies, usually with local and

regional appeal Listing requirements are more lenient than NYSE Often include stocks that are also listed on NYSE or NYSE Amex

Best-known: Midwest, Pacific, Philadelphia, Boston, and Cincinnati Options Exchanges

Allows trading of options Best-known: Chicago Board Options Exchange (CBOE)

Futures Exchanges

Allows trading of financial futures Best-known: Chicago Board of Trade (CBT)


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Dealer Markets

No centralized trading floor; comprised of market makers linked bytelecommunications network Both IPOs and secondarydistributions are sold on OTC

40% of the total dollar volume of all shares in U.S. stock market trade

here Both IPOs and secondary distributions are sold on OTC

Bid Price: the highest price offered by market maker to purchase agiven security

Ask Price: the lowest price at which a market maker is willing to

sell a given security


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Dealer Markets

Nasdaq Largest dealer market Lists large companies (Microsoft, Intel, Dell, eBay) and smaller

companies

Over-the-counter (OTC) Bulletin Board

Lists smaller companies that cannot or dont wish to be listed onNasdaq

Companies are regulated by SEC

Over-the-counter (OTC) Pink Sheets

Lists smaller companies that are not regulated by SEC Liquidity is minimal or almost non-existent

Very risky; many nearly worthless stocks


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Alternative Trading Systems

Third Market Large institutional investors go through market makers that are not

members of a securities exchange Institutional investors (mutual funds, life insurance companies, pension

funds) receive reduced trading costs due to large sizeof transactions

Fourth Market Large institutional investors deal directly with each other to bypass

market makers Electronic Communications Networks (ECNs) allow direct trading ECNs most effective for high-volume, actively traded securities


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General Market Conditions

Bull Market Favorable markets

Rising prices

Investor/consumer optimism

Economic growth and recovery Government stimulus

Bear Market Unfavorable markets

Falling prices Investor/consumer pessimism

Economic slowdown

Government restraint


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Globalization of Securities Markets

Diversification: the inclusion of a number of differentinvestment vehicles in a portfolio to increase returns orreduce risks

Use of International Securities Improves Diversification More industries and securities available Securities denominated in different currencies Opportunities in rapidly expanding economies

International Investment Performance

Opportunities for high returns Foreign securities markets do not necessarily move with the U.S.

securities market Foreign securities markets tend to be more risky than U.S.

markets


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Globalization ofSecurities Markets (contd)

Indirect Ways to Invest in Foreign Securities Purchase shares of U.S.-based multinational with

substantial foreign operations

Direct Ways to Invest in Foreign Securities Purchase securities on foreign stock exchanges Buy securities of foreign companies that trade on U.S.

stock exchanges

Buy American Depositary Receipts (ADRs): dollardenominated receipts for stocks of foreign companiesheld in vaults of banks


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Risks of International Investing

Usual Investment Risks Still Apply

Government Policies Risks Unstable foreign governments

Different laws in trade, labor or taxation

Different economic and political conditions Less stringent regulation of foreign securities markets

Currency Exchange Rate Risks Value of foreign currency fluctuates compared to

U.S. dollar

Value of foreign investments can go up and down with exchangerate fluctuations


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Trading Hours of Securities Markets

Regular Trading Session for U.S. Exchangesand Nasdaq 9:30 A.M. to 4:00 P.M. Eastern time

Extended-Hours Electronic-Trading Sessions

NYSE: 4:15 to 5:00 P.M. Eastern time

Nasdaq: 4:00 P.M. to 6:30 P.M. Eastern time

Regional exchanges also have after-hours trading sessions

Orders only filled if matched with identical opposing orders


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Regulation of Securities Markets

Insider Trading Use of nonpublic information about a company to make profitable

securities transactions

Blue Sky Laws

Laws imposed by individual states to regulate sellers of securities Intended to prevent investors from being sold nothing but bluesky


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Regulation of Securities Markets

Investment Advisors Act of 1940 Required investment advisers to make full disclosure about their

backgrounds and their investments, as well as register with theSEC

Securities Acts Amendments of 1975 Abolished fixed-commissions and established an electronic

communications network to make stock pricing more competitive

Insider Trading and Fraud Act of 1988 Prohibited insider trading on nonpublic information

Sarbanes-Oxley Act of 2002 Tightened accounting and audit guidelines to reduce corporate

fraud


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Basic Typesof Securities Transactions

Long Purchase

Investor buys and holds securities

Buy low and sell high

Make money when prices go up


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Basic Typesof Securities Transactions (contd)

Margin Trading

Uses borrowed funds to purchase securities

Currently owned securities used as collateral for margin loanfrom broker

Margin requirements set by Federal Reserve Board Determines the minimum amount of equity required

On $4,445 purchase with 50% margin requirement, investor puts up$2,222.50 and broker will lend remaining $2,222.50

Can be used for common stocks, preferred stocks, bonds, mutualfunds, options, warrants and futures


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Table 2.4 Initial Margin Requirementsfor Various Types of Securities


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Margin Trading

Advantages Allows use of financial leverage

Magnifies profits

Disadvantages Magnifies losses

Interest expense on margin loan

Margin calls


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Margin Formulas

Basic Margin Formula

Example of Using Margin

Margin Value of securities Debit balance

Value of securities

V D

V

Margin V D

V $6,500

$1,200$6,500

0.815 81.5%


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Table 2.3 The Effect of MarginTrading on Security Returns


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Margin Formulas (contd)

Return on Invested Capital

Example of Return on Invested Capital

Return on

invested capital

from a margin

transaction

Total

current

income

received

Total

interest

paid on

margin loan

Market

value of

securities

at sale

Market

value of

securities

at purchase

Amount of equity at purchase

Return on

invested capital

from a margin

transaction

$100 $125 $7,500 $5,000

$2,500

$2,475

$2,500 0.99 99%


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Basic Typesof Securities Transactions

Short Selling

Investor sells securities they dont own

Investor borrows securities from broker

Broker lends securities owned by other investors thatare held in street name

Sell high and buy low

Investors make money when stock pricesgo down


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Short Selling

Advantages Chance to profit when stock price declines

Disadvantages

Limited return opportunities: stock price cannot gobelow $0.00

Unlimited risks: stock price can go up anunlimited amount

If stock price goes up, short seller still needs to buyshares to pay back the borrowed shares to thebroker

Short sellers may not earn dividends


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Table 2.5 The Mechanics of a Short Sale


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Chapter 2 Review

Learning Goals

1. Identify the basic types of securities markets anddescribe their characteristics.

2. Explain the initial public offering (IPO) process.

3. Describe broker and dealer markets, and discuss howthey differ from alternative trading systems.


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Chapter 2 Review (contd)

Learning Goals (contd)

4. Review the key aspects of the globalization ofsecurities markets, and discuss the importance of

international securities markets.5. Discuss trading hours and regulation of

securities markets.

6. Explain long purchases, margin transactions andshort sales.


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Table 2.6 Margin Positions on Short Sales

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Investment Portfolio Management - 01 - Gitman