Download pdf - "Markets: An Overview" by Jimmy Gentry

Markets: An Overview

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Jan. 2, 2013

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Donald W. Reynolds National Center for Business Journalism

at Arizona State University

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n  James K. Gentry, Ph.D. n  Clyde M. Reed Teaching Professor n  School of Journalism and Mass Communications n  University of Kansas n  [email protected]

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Risk-Return Relationship

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Basic Types of Risk

n  Systematic or market n  Unsystematic or nonmarket. Also called

“business risk.” Can be diversified away.

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Specific Types of Risk n  Financial risk, credit risk, default risk n  Market risk n  Interest-rate risk n  Purchasing power or inflation risk n  Event risk n  Exchange-rate or foreign-exchange risk n  Liquidity risk n  Political or sovereign risk n  Tax risk

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Types of Businesses n  Sole proprietorship n  Partnership n  Corporation

n  Limited liability n  Greater access to capital n  Permanency n  Flexibility n  Double taxation

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Types of Structures

n  Private corporations n  Public corporations n  Nonprofits

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Types of Investments

n  Stocks n  Bonds n  Other

n  Options, futures, commodities, real estate, collectibles, currencies

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Types of Markets

n  Equity: Stocks n  Credit: Bonds, debt or fixed income n  Others

n  Derivatives (such as options and futures), commodities, real estate, collectibles, currencies

n  Historically, the amount of long-term debt financing issued in the U.S. greatly exceeds the volume of equity financing.

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Stock

n  Stockholders want: n  Stock price to increase n  Dependable dividend stream n  Increase in size of dividend

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Types of Stock

n  Common stock n  Preferred stock

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Common Stock

n  Risk: Lose your money if company falters

n  Reward: Owners share in success when company does well. n  Appreciation n  Dividends

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Dividends

n  Represent a return on capital invested by shareholders.

n  Board must declare dividend for it to be paid. n  Dividend payment is not a business expense.

It is an after-tax expense. n  Usually relationship between company’s age

and size, and the dividends it pays.

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Preferred Stock n  Reduced risk, but reward may be limited n  Dividend amount is stated and is paid before

dividends on common. n  If company is liquidated, holders are

preferred over common holders. n  Dividends don’t necessarily increase if

company prospers.

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Bond n  Bond is debt a company owes n  Individual or company “loans” money to the

company by buying a bond n  Bond pays interest over a fixed period of time n  Principal is repaid to the lender or holder of the

bond at end of the term n  Interest rate is typically fixed when the bond is

sold (i.e., fixed-income security) n  Interest rate is comparable to what other

bonds, with that rating, are paying Strictly Financials

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Bond Terminology n  Interest rate: Fixed percentage of the bond’s

purchase price that is paid annually to the bond holder

n  Yield: Return on investment if bond is held to maturity. Equals interest rate. If bond is traded before maturity date, yield could change, although interest rate stays the same.

n  Par value: Dollar amount paid for bond at time of issue

n  Maturity date: When bond comes due Strictly Financials

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Issuers Prefer Bonds n  When companies need to raise funds, they

can issue stock or sell bonds. n  They often prefer bonds, in part because

issuing more stock can dilute the value of shares investors already own.

n  Bonds also may have income-tax advantages.

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A Quasi-Bond?

n  Is preferred-stock debt (i.e., a bond) in disguise?

n  Preferred holders have a “guaranteed” dividend. Is that like the fixed interest rate of a bond?

n  Why do investors pick common, preferred or bonds?

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Risk and Reward

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Yield Curve Y

ield

Maturity

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Equity or Securities Markets

n  Primary market n  Go public n  Private placement

n  Secondary market

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Going Public

n  Entrepreneurs have an idea. Company grows with an investment from the private-equity market (venture capital).

n  Owners decide to “go public.” n  Register with SEC to make an initial

public offering or IPO. n  Investment bankers typically underwrite

the offering through a syndicate.

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Going Public (cont.)

n  Company prepares a prospectus, which is a detailed analysis of the company’s financial history, its products and services, as well as management’s background and experience.

n  Prospectus should identify and assess risk factors the company faces.

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IPO Terms

n  Prospectus n  Road show n  Quiet period n  Lockup period

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Shelf Registration

n  Firm can file one registration statement for a relatively large block of stock and sell parts over a two-year period.

n  This can reduce red tape and costs, and because stock can be sold directly to institutional investors, can eliminate the underwriting fee.

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Private Placement

n  New issues can be sold in large lots to a small group of buyers. Lets start-up firms show appeal by raising capital on their own.

n  Additional shares later can be offered through an underwriter.

n  Many debt issues are placed privately, usually to large buyers such as insurance companies.

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Secondary Offering

n  If company already is public, it can sell more stock through a secondary offering. n  Causes dilution

n  Major owners sell their shares. They get the funds, so no dilution.

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New York Stock Exchange

n  In March 1792, Wall Street leaders met to establish an improved auction market.

n  In May 1792, 24 men signed an agreement to trade securities only among themselves, maintain fixed commission rates and avoid other auctions.

n  Considered the origination of NYSE Strictly Financials

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NYSE (cont.)

n  Until March 2006, was owned by 1,366 seat-holding members

n  Highest price ever paid for a seat was $4 million.

n  Price was determined by auction.

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NYSE Members n  Floor brokers

n  House brokers n  Independent brokers

n  Specialists n  Manage auction process n  Execute orders for brokers n  Serve as catalysts n  Provide capital n  Stabilize prices

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Making an Order

n  Tell your broker or “registered representative” to buy or sell a stock at the current price, or market price. Called a market order.

n  If you name the price to buy or sell, you’re making a limit order.

n  Tell your broker to buy or sell once the price hits a specific price, you’re placing a stop order at a stop price.

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Trading on the NYSE Floor

n  Trading occurs in the “Big Room.” n  Numerous stations, each with a roughly

figure-eight shape, with counters and screens above. Called “trading posts.”

n  Each counter is a “specialist’s” post.

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NYSE Floor (cont.)

n  Order comes to the booth that is rented by a brokerage house.

n  Floor broker takes order to appropriate specialist’s post.

n  Specialist keeps a list of unfilled orders. Processes orders as prices move.

n  Specialist’s job is to maintain an orderly market in the stock (match buyers/sellers).

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NYSE Floor (cont.)

n  Stocks or groups of stocks are traded at trading posts near the specialists’ positions.

n  Floor brokers can use a specialist or trade between themselves, called trading in the “crowd.”

n  Terminals display the stock’s activity. n  After every trade, a reporter records the stock

symbol, price and initiating broker. n  Successful trades are confirmed.

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NYSE Floor (Then & Now)

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Round or Odd Lots

n  Round lots: Buying or selling stock in multiples of 100 shares

n  Odd lots: Buying or selling stock in other quantities

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Who Holds Your Stock?

n  Virtually all investors leave shares in their brokerage account in what’s called the street name. Investor retains beneficial ownership, though.

n  This offers safe storage. n  You can get tangible certificates if you

want them. Typically, you must pay for them.

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SuperDOT System

n  Super Designated Order Turnaround System n  Allows orders to be sent electronically to

specialist rather than phoned to floor trader. n  Can handle trades of 100,000 shares or less.

Priority to orders of 2,100 shares or less. n  More than three-fourths of NYSE executed

orders involve SuperDOT system. n  Originally for small trades. Increasingly big

role in portfolio or basket trading. Strictly Financials

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American Stock Exchange

n  Non-members of NYSE couldn’t afford office space, so traded in the street

n  1842: New York Curb Exchange n  By late 1870s ,known as “curbstone

brokers,” and their market was known as the Curb.

n  Merged with NASDAQ in 1998 n  Acquired by NYSE Euronext in 2009

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NASDAQ

n  National Association of Securities Dealers Automated Quotations system

n  NASDAQ is a computer network with no physical location for trading.

n  Uses a multiple market-maker system, not the specialist system

n  About 4,000-plus companies

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Trading on the NASDAQ

n  Trading is through an open-market, multiple-dealer system, with many market makers and broker-dealers competing for transactions.

n  Computer network checks for matches, which can be handled instantly.

n  Market makers buy and sell, and maintain an inventory of shares.

n  Broker-dealers are “independent” firms and business units of banks and investment firms.

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In Which Market?

n  In general, but with exceptions: n  NYSE: Oldest, largest, best known n  AMEX: Smaller, younger n  NASDAQ: Youngest, least experienced n  Some of NYSE’s most actively traded

stocks are also quoted on the NASDAQ.

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ECNs

n  Electronic Communications Networks n  Are basically websites that allow

investors to trade directly with one another

n  Eliminates trading through an exchange n  Archipelago and Instinet best known n  BATS Trading

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NYSE - Archipelago Marriage

n  Merged in March 2006 to create NYSE Group Inc., a publicly held company.

n  Largest merger ever between securities exchanges.

n  Combined leading equities market with most successful electronic exchange.

n  Archipelago: low fees, user-friendly technology

NYSE Euronext

n  Merged April 2007 n  Operates world’s largest, most liquid

exchange with diverse products and services

n  Six equities exchanges in five countries and six derivatives exchanges

Deutsche Borse Purchase Of NYSE Euronext Blocked

n  Worked on a deal since early 2011. n  Would have created world’s largest

trading entity. n  EU blocked the merger on Feb. 1, 2012,

fearing the new company would be a near monopoly.

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NYSE ‘Hybrid Market’

n  Floor trading and automated trading n  Specialists or Archipelago strengths n  Why? Customers’ desire for faster

access to liquidity and greater anonymity

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NASDAQ Response

n  NASDAQ acquired Instinet Group Inc., another ECN

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Exchanges v. OTC Market

n  Stocks in almost 10,000 companies aren’t listed on any exchanges.

n  They are traded “over the counter” (OTC)

n  Typically handled by phone or computer n  Generally, comparatively inexpensive

and infrequently, or “thinly,” traded

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BATS Global Markets

n  Newer exchange, founded in 2005 n  Located in Kansas City n  Competes on technology and cost n  Developed its own software platform n  Also offers an options-trading platform n  An ECN

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U.S Equities Market Share 2012 2011

n  NYSE 23% 27.5% n  Arca 12% 14% n  Floor 11% 13.5%

n  NASDAQ 19% 21.5% n  BATS 13% 12%

n  Direct Edge 9% 8%

October 2012

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Direct Edge n  Another ECN n  Has exchange status


Dark Pools n  Also “Dark Liquidity” or “Dark Pool Liquidity” n  Lightly regulated trading not open to the public. n  Mostly involves block trades by institutions away from

public exchanges so trades are anonymous. n  Main advantage to institutional investors: Can buy or

sell in large blocks without other investors knowing since neither size of trade or trader’s identity are revealed. Prices are reported after trades completed.

n  Also means some market participants are disadvantaged since they can’t see trades executed and prices paid, so this market is not transparent.


High-Frequency Trading

n  Also known as “high-speed trading.” n  Electronic-trading strategies driven by

statistics and algorithms. n  WSJ reported in 2011 that by some

measures, such firms make up 5 of every 10 stock trades in the U.S. each day.


High-Frequency Trading

n  Research has shown that algorithmic trading broadly makes prices less volatile and reduces the overall cost of trading.

n  These firms’ ability to buy and sell large blocks of securities in fractions of a second has raised fears that ordinary investors are being left behind. Much criticism.


Second Markets

n  Markets where illiquid assets are traded. n  Employees or investors can sell private

company stock or options, bankruptcy claims, restricted stock, structured products, loans.

n  Examples: Facebook, Zynga, Groupon. n  Buyers: Hedge funds, private equity funds,

individuals. n  Largest are Second Market, SharesPost

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Stock Ownership

n  In 2011, 54% of Americans said they had money in the stock market, either in an individual stock, a mutual fund or self-directed 401(k) or IRA

n  This was down from 56% in ‘10 and 57% in ‘09. High in the 21st Century was 67% in ‘02 and 65% in ‘07.

n  Gallup, April 2011

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Stock Ownership

n  87% of upper-income Americans ($75,000 or more annually) own stocks.

n  83% of postgraduates and 73% of college graduates own stocks.

n  64% of Republicans hold stocks, compared with half of Democrats and independents.

n  Ages 50 to 64 are most likely to say they have money in the stock market.

n  Gallup, April 2011

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Institutional Investors

n  Organizations that invest their own assets or pool those they hold in trust for others.

n  Examples: Investment companies (including mutual funds), pension systems, insurance companies, universities and banks.

n  Trade regularly and in tremendous volume. n  Must buy or sell at least 10,000 shares for a

transaction to be an “institutional trade.”

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Changing Attitudes

n  Institutional investors who own large blocks of stock are increasingly demanding a say in corporate management.

n  Socially or environmentally conscious individual shareholders also are becoming more involved.

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Stock Market Averages n  Dow Jones Industrial Average: Best known

and most widely reported market indicator n  Made up of 30 industrial companies n  Dow Jones Transportation Average: 20

airlines, railroads and trucking companies n  Dow Jones Utility Average: 15 gas, electric

and power companies n  Dow Jones 65 Composite Average: all 65

companies in the other three averages

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Stock Market Indexes n  NYSE Composite Index: All stocks traded on

the NYSE. n  Standard & Poor’s 500 Index: Broad base of

500 stocks. Considered benchmark for large-stock investors.

n  NASDAQ Stock Market Composite Index: Stocks traded through its electronic system. Often more volatile because of types of companies it covers.

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Market Indexes (cont.) n  AMEX Composite: Companies on the AMEX. n  Russell 2000: Follows smallest two-thirds of

the 3,000 largest U.S. companies. Includes many IPOs of past few years. Benchmark for small-company stocks.

n  Value-Line: 1,700 common stocks. n  Wilshire 5000: Broadest index, including

nearly all stocks traded in U.S. markets.

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Reg FD, Disclosure and Guidance

n  Regulation Fair Disclosure, October 2000

n  Bars public issuers from selectively revealing material nonpublic information to securities analysts, broker-dealers, investment advisers, and institutional investors, before disclosing it to the public.

n  Tension: Guidance vs. disclosure Strictly Financials

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Stock Split

n  If stock price increases significantly, a company might do a split to lower the price, which it expects to stimulate trading.

n  In a split, more shares are available, but total market value is still the same.

n  Price may move up after split, therefore increasing the value of your stock.

n  Reverse split: Exchange more shares for fewer, say 10 for five. To boost share price.

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Credit or Debt Markets

n  Historically, the amount of long-term debt financing issued in the U.S. greatly exceeds the volume of equity financing.

n  Short-term or “money market” n  Bond market


Money Market

n  Commercial paper n  Bankers’ acceptance n  Repurchase agreements n  Certificates of deposit n  Municipal notes n  Treasury bills n  Money-market mutual funds

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Who Issues Bonds

n  Issued by U.S. companies n  Issued by the U.S. Treasury n  Issued by federal, state and local

government agencies n  Issued by overseas companies and

governments. When sold in dollars, are sometimes called Yankee Bonds.

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Issuers Prefer Bonds

n  When companies need to raise money, they can issue stock or sell bonds

n  They often prefer bonds, in part because issuing more stock tends to dilute the value of shares investors already own.

n  Bonds also may have income-tax advantages

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Treasury Issues

n  Life, or term, is fixed at time of issue n  Treasury bill: One year or less n  Treasury note: One to 10 years n  Treasury bond: 10 years or more n  Generally, the longer the term, the

higher the interest rate

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How Bonds Are Traded

n  Most already issued bonds are traded over the counter.

n  Bonds also can be purchased from the inventory of a brokerage firm that might make a market in the bonds.

n  Commissions and markups

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Rating Bonds

n  Standard & Poor’s, Moody’s Investors Services and Fitch are best known.

n  Corporate, international and municipal bonds are rated.

n  Credit ratings influence interest rates. n  If a company’s rating is downgraded,

investors demand a higher yield.

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Bond Rating Code

n  Aaa/AAA: Best quality n  Aa/AA: High quality

n  A/A: High-medium quality

n  Baa/BBB: Medium quality n  Ba/BB: Some speculative element n  B/B: Future default risk

n  Caa/CCC: Poor quality, default danger n  Ca/CC: Highly speculative n  C/C: Lowest rated, poor prospects

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