1. Securities Markets
Economics 71a
Spring 2007
Mayo, Chapter 3
Lecture notes 2.3

2. Outline
Markets
Orders
Positions
Information

3. Markets
Primary markets

New issues (IPO’s, corporate and public
debt)
Secondary markets

Trading old stuff

In many cases most activity in secondary

4. Money and Capital Markets
Money markets

Short term securities (1 year or less)
Capital markets

Longer term

5. Money Market Securities
 Treasury bills

U.S. government debt

Short term (less than 1 year)
 Commercial paper

Short term corporate borrowing
 Discount pricing

Buy for $10, get paid $11 in future

No interest payments

6. Capital Market Securities
Bonds (longer term borrowing)

U.S. Treasury

Municipal (tax free)

Corporate

More later

7. Capital Market Securities
Stocks

Common stock

Preferred stock

International

More later

8. Trading and Secondary
Markets
Stock markets
Bond markets
Derivatives
Foreign Exchange

9. U.S. Stock Markets
New York Stock Exchange (NYSE)
National Association of Securities
Dealers Automated Quotation (Nasdaq)

American Stock Exchange (AMEX)

10. Continuous Trading
Market types

Specialist

Electronic dealer

Open outcry

Over the counter

NASDAQ

Upstairs (negotiated)

ECN (electronic crossing network)

11. ECN’s: Electronic Crossing
Networks
 Internet based trade networks
 Customers can meet directly (no broker)
 Used mostly by professional money
managers
 Advantage: fewer intermediaries
 Disadvantage: less liquidity

(Fewer people to trade with)
 Fastest growing markets

12. Other Markets
Futures/Options
Foreign Exchange

Spot versus forward
Bond

13. International Markets
Many major international stock markets

London

Tokyo

China

many more
US accounts for only 36% of the
companies listed on stock markets
around the world

14. International Investments
 Purchase stocks or bonds in foreign countries
 Purchase shares in foreign firms in U.S.
(American Depository Receipts) ($/English)
 Bonds can be issued in different currencies

Eurobond: Intel issues $ denominated bond in
Japan

15. Trading Hours
 Most U.S. stock markets

9:30-4:00
 Extended hours on electronic trading
networks
 “After hours trading”
 International markets (local times)
 Foreign exchange markets (24 hours)
 Hours increasing : toward a 24 hour market

16. Outline
Markets
Orders
Positions
Information

17. Types of Orders
Market order
Limit order

18. Market Order
Buy or sell at the current market price
No restrictions
“Buy 50 shares at market”

19. Limit Orders
 Buy when price drops below a limit
 Sell when price moves above a limit
 Example

Limit buy at 50 (price at 60)

Stock moves to 55 (nothing happens)

Stock moves to 49 (order executed)
 Advantage

Might end up with a better price
 Disadvantage

Order might end up unfilled

20. Brokers
 Enable trading of financial services
 Dealer function
 Access

Mail

Phone

Internet

21. Types of Brokers
 Full service

Extensive research

Merrill Lynch
 Premium discount

Limited research

Charles Schwab
 Basic discount

No research

E*trade
 Classification is difficult

22. Transaction Costs
Commissions
Bid/ask spreads

23. Costs of Trading
Commissions

Fixed

Negotiated

Varying structures (fixed + varying)

$20 + shares * C
Bid/ask spread

Buy at the ask

Sell at the bid

24. Bid/ask Spread
Example:

Ask = 88.5 (buy)

Bid = 88 (sell)
Spreads may change

Over time

Over stocks
Reveal the ease of trading a stock

“Liquidity” again

25. Order Books
 Order book

List of current limit buy and sell orders
 If you want to buy

Can “hit” limit sell orders

Walk up the book

Higher price for more stock
 If you want to sell

Can “hit” limit buy orders

Walk down the book
 ECN’s and visible order books

26. Settlement and Delivery
Settlement dates

Usually trade date + 3 days
Take delivery or leave shares with
broker (street name)

27. Outline
Markets
Orders
Positions
Information

28. Long Purchase
Straight purchase of a security
Speculate that price will increase

Buy at 100

Sell at 110

10% return

29. Margin Purchase
“Buying on margin”
Borrow money to buy stock
Buy at 75% margin

75% of money in investment is yours

25% is borrowed from broker or bank
Purchase $100 of stock at 75% margin

You put in $75, and you borrow $25

30. Basic Margin Formula
Margin=
Totalvalue−Borrowedfunds
Totalvalue

31. Margins and Magnification
Example stock: Price = $100

Up: Price = $150

Down: Price = $75
If you purchased with your own money

$100 total investment

Up: + $50

Down: - $25

32. Margins and Magnification
Buy on 50% margin (zero interest
charges)
$100 own, and $100 borrowed (needs
to be paid back)
Purchase $200/$100 shares = 2 shares

$100 total investment

Up: 2*150 - 100 - 100 = $100 (50)

Down: 2*75 - 100 - 100 = $-50 (-25)

33. Margin Buying
 Borrowing money to buy stocks
 Magnifies gains and losses
 Can lose more than you put in

Buy $200 of stock

$100 your own

$100 borrowed

Stock goes to zero

Lose $100 of own investment, and

Owe $100 of borrowed money too

34. Maintenance Margins
Margin required for investor to maintain
If margin falls below this level investors
must add more of their own money
“Margin call”
Common margin call

Prices fall

Margin rises

Investor needs to come up with more funds

35. Margin Requirements
Common stock: 50%
Bonds: 50%
Options: 20% stock value
Futures: 2-10% of the contract value

36. Short Sales
Holding negative stock

Sell stock you don’t have (borrow)

Buy it back later

Pay dividends yourself in between
Key issue

Make money on a price fall

Lose money on a rise
Betting against a stock

37. The Mechanics of a Short
 Tell broker you want to sell 100 shares of IBM
short (price = $50)
 Broker “borrows” shares of 100 shares of IBM
owned by another client
 Sells it to someone for 50*100=5000, and
pays this to you
 You must keep this amount on account with
broker
 When dividends are to be paid, you pay
broker, and broker pays the other client

38. The Mechanics of a Short
 IBM goes down to $40 per share
 You “buy” your 100 shares to take you back to zero,
pay broker 40*100=4000.
 Broker buys at market, and puts the shares back in
the other person’s account
 You make 5000-4000 = 1000 (less dividends)
 Make money when price falls
 Lose money when price rises

39. The Mechanics of a Short
 IBM goes up to $60 per share
 You “buy” your 100 shares to take you back to zero,
pay broker 60*100=6000.
 Broker buys at market, and puts the shares back in
the other person’s account
 You lose 5000-6000 = -1000 (less dividends)

40. Margins and Shorts
 Broker requires additional funds to cover
possible losses
 Fraction of additional sale amount
 Example

Sell $5000 worth of stock at 50% margin

Need to keep 1.5*5000 = 7500 on account with
the broker

When the price goes up, need to increase this

“Margin call”

41. Oddities About Shorts
 Can lose unbounded amounts of money

Normally only lose what you put in

With short price can go up forever, and your losses keep
increasing
 Also, broker can get in trouble if you default

Other customer could lose original shares

Often insured for this

42. Short Interest
Fraction of shares sold short
Measure of market pessimism in a
stock
Common market indicator
Measures market pessimism

43. Squeeze Play
Assume Microsoft has a large number
of short sellers
Price starts to rise

Short sellers losing money

Get nervous

Buy stock to close out their short positions

Prices rise more, more buying .. (etc. etc)

44. Outline
Markets
Orders
Positions
Information

45. Information Sources
 Private

Quicken and Yahoo finance

Wall St. Journal (fee)

Value line and Standard and Poors (fee)

Brokerage firms

Corporations
 Government

Federal Reserve

SEC

46. Information Sources
Key publications

Economic information

Federal reserve bulletins (economic info)

Firm/investment data

Value Line Survey

Standard and Poor’s Handbook

Security firm reports

Firm annual reports

47. The Internet and Investing
Cheap and accessible information
Investor tools

Charts

Screening

Calculators
Online trading

48. Investment Information on the
Web
News articles

NY times

CBS Market watch

CNN financial

49. More Investment Information
Stock information

Yahoo

Google

Quicken
Historical information

Yahoo

Datastream (fee)

Bloomberg (fee)

50. Warnings on Internet
Information
Don’t use information to trade to
frequently
Don’t believe everything you see on the
web

51. More (biased) Information
Firm annual reports and accounting info
Analyst information

Analysts recommend (buy, sell, hold)

Problems:

Firms often are biased in what they tell analysts

Analysts are biased since stocks they analyze
can be their own clients

52. Internet Tools
Education

www.investorguide.com

www.fool.com

www.smartmoney.com
Calculators

www.financenter.com

53. Internet Tools
Stock screening

Quicken

Yahoo

Google
Plotting/graphics

bigcharts.com

smartmoney.com

54. Market Indices
 Summarize market movements
 Examples

Dow Jones Industrial (30 stocks)

NYSE Composite

S&P 500 Composite (500 stocks)

NASDAQ Composite

Nikkei (Japan)

Wilshire 5000

Sector indices

55. Index Construction
 Weighted sum
 Weighting options

Equal w = (1/N)

Relative value of the firm (S&P, NASDAQ)

Value weighting

Odd (Dow Jones)
Pt,I = wj Pt,j
j=1
N
∑
1= wj
j=1
N
∑

56. Index Uses
Summary of the market
Investor benchmark (performance
check)

Compare own result to index
Investment target

Index mutual fund

57. Index Problems
Index is not constant

Additions and removals

Changing weights
As stock increases in value, share in
index increases
Index can drift towards growing sectors
in the market