Chapter 4: CHAPTER OVERVIEW

Securities Markets

Chapter 4 is designed to cover the markets where financial assets trade, with particular emphasis on equity markets. This chapter is a followup to Chapter 2 which discussed the financial assets available to investors through direct investing, with primary emphasis on marketable securities. Primary markets are discussed at the outset of the chapter for completeness and as a contrast to secondary markets, which are the main focus of Chapter 4. nvestment banking functions are considered, with a detailed discussion of the underwriting function. !ew trends in investment banking also are covered, including the shelf rule and the unsyndicated stock offering. "lobal investment banking is analy#ed because of its increasing importance. Chapter 4 provides an analysis of the structure of secondary markets, with securities organi#ed by where they are traded. Terminology is e$plained, and the functioning of the markets, primarily the !%&' and !asdaq, are considered in some detail. (ecause of the increasing importance of !asdaq, it is given special attention. t is recommended that instructors spend some time developing the differences between the !%&' and !asdaq, and discuss the possible future forms that markets may assume. Chapter 4 includes brief discussions of bond markets and derivatives markets, both of which are considered in more detail in their respective chapters. )oreign markets are discussed in some detail so that students will have some idea of what is happening around the world. !ew trends are analy#ed, such as *in+house* trading by institutional investors. This chapter also contains a discussion of ma,or market indices, including the -ow .ones /verages, the &0P nde$es, and brief descriptions of /me$, !asdaq, and foreign stock indices. This discussion has been e$panded from the 1th edition. /ppendi$ 4+/ contains more details on the construction and composition of these market indicators.

37

The chapter contains a discussion of the changing securities markets. This begins with the stimulus for the many changes that have transpired in recent years++ institutional pressure and the &ecurities /cts /mendments of 2314++and ends with the current and pro,ected status of the markets. /n up+to+the+minute analysis of the changing nature of 5all &treet is presented here, including the globali#ation of securities markets and the !%&'6s role in the global marketplace. 7bviously, the structure of the securities markets continues to change, and instructors can update developments as they choose. CHAPTER OBJECTIVES

To e$plain primary and secondary markets in terms of their components and organi#ational structure. To e$plain terminology 8e.g., broker, specialist, and so forth9 pertaining to markets and participants. To emphasi#e the structure and functioning of the secondary markets, with emphasis on the !%&' and !asdaq. To discuss the changes that have occurred in the secondary markets and that may occur in the ne$t few years.

38

MAJOR CHAPTER HEADIN S !C"#te#ts$ The I%p"rta#ce "& 'i#a#cia( Markets :allocationally efficient vs. operationally efficient; The Pri%ar) Markets : P7s;

The nvestment (anker :definition< what they do< underwriting, syndicate, prospectus< shelf rule< role of analysts in touting stock; "lobal nvestment (anking :managing the global offering< privati#ation; Private Placements :advantages and disadvantages of private placements;

The Sec"#*ar) Markets++E,uities

/uction =arkets :!%&'< specialists< /&'< regional e$changes; !egotiated =arkets :!/&-< !asdaq< !asdaq>!=&; 'lectronic Communications !etworks 8'C!s9 :definition< e$amples of 'C!s< nstinet< in+house trading; n+?ouse Trading )oreign =arkets :description of many foreign markets< relative si#es; Comparisons of 'quity =arkets :share volume for all @. &. equities markets, and dollar volume of equity trading in ma,or world markets; &tock =arket ndicators

39

:-ow .ones< &0P< /me$< !asdaq< relationships< foreign markets; Other Sec"#*ar) Markets

(ond =arkets :the trading of each of the four ma,or types of bonds; -erivatives =arkets :where options and futures trade;

The Cha#-i#- Securities Markets :the stimulus for market changes< national market system< inter+market trading system< other changes; The (".a(i/ati"# "& Securities Markets :new trends on !asdaq and the e$changes< the !%&'As role in the global marketplace; Appe#*i0 4+A St"ck Market I#*ices

POINTS TO NOTE ABO1T CHAPTER 4 Ta.(es a#* 'i-ures Table 4+2 is new for the Bth edition. t illustrates how a value+weighted inde$ is constructed and calculated. This methodology applies to most inde$es such as the &0P 4CC nde$. )igure 4+2 is useful for illustrating the underwriting process in a simple manner. t shows at a glance the ma,or steps in the underwriting process. )igure 4+2 organi#es the secondary markets by type of security. t is based on a three+part classification of equities, bonds, and puts and calls. )igure 4+D is new for the Bth edition. some basic facts about the !%&'. t contains

40

)igure 4+4 is new for the Bth edition. t is part of the !%&' website and discusses the role of both brokers and specialists. )igure 4+4 shows a comparison of number of companies traded for the !%&', /me$, and !asdaq. !asdaq, of course, dominates in terms of number of companies traded. (oth !asdaq and the !%&' completely dominate the /me$. )igure 4+E shows a comparison of share volume for !asdaq, !%&', and /me$. !asdaq is the volume leader, with some E2 percent of total shares traded in 2CCC. B"0e* I#serts (o$ 4+2 is taken from Business Week and discusses after+hours trading. This is relevant in today6s world because of the significance of the 'C!s.

41

ANSWERS TO END+O'+CHAPTER 21ESTIONS 4+34 )inancial markets are essential for both businesses and governments in raising capital to finance their operations. (oth e$perience demands for funds that are not in balance with their actual funds on hand. )inancial markets are absolutely essential to the functioning of our capitalistic economy. Technically, primary markets can e$ist without secondary markets since new securities can be sold to investors. )or e$ample, bonds could be sold to institutional investors to be held until they mature. ?owever, investors would have difficulty reselling these securities if they needed to, and many would be discouraged from buying them because of this reason. 4+54 nvestment bankers act as intermediaries between issuers and investors. They provide several functions, includingF 829 an advisory function, wherein they offer advice to clients concerning the issuance of new securities< an underwriting function, consisting of the purchase of securities from an issuer and their subsequent sale to investors< a marketing function, involving the sale of the securities to the investing public.

829

8D9 4+64

n a primary offering involving investment bankers, the potential issuer of the securities meets with an investment banking firm for advice on selling the new issue. n a negotiated bid arrangement, these two parties negotiate and work together on the issue. &ubsequently, the investment banker, working with other investment banking firms 8i.e., a syndicate9, underwrites the issue< that is, the investment bankers purchase the securities from the issuer, thereby assuming the risk involved in actually selling the securities. /fter all legal requirements have been met 8e.g., the issue is registered with the &'C9, the selling group sells

42

the securities to the public via brokers who contact their customers about the issue. 4+44 The e,uit) %arkets in the @nited &tates consist of the organi#ed e$changes 8the !%&', the /='G, and the regional e$changes9 and the over+ the+counter market. H Auction markets, involving e$changes, include a bidding 8auction9 process in a specific physical location with brokers representing buyers and sellers. The over-the-counter market is a negotiated market, where dealers make the market in securities by standing ready to buy from, and sell to, investors based on bid+ask prices.

4+74

Commission brokers are members of brokerage houses with memberships on e$changes. They act as brokers for customers. nvestment bankers act as middlemen between the issuers of the securities and the purchasers, in the same way that brokers do. &ome firms offer both investment banking and retail brokerage services. &pecialists are members of e$changes who are assigned to particular stocks on an e$change. They are charged by the e$change with maintaining a continuous, orderly market in their assigned stocks. They do this by going against the market, buying 8selling9 when the public is selling 8buying9. &pecialists act as brokers by e$ecuting orders for other brokers for a commission. They act as dealers by buying and selling specific stocks for their own accounts.

4+84

4+94

&pecialists should be, and are, closely monitored and regulated. (ecause they maintain the limit books, they have knowledge of all limit orders on either side of the current market price. They are charged with acting for the public interest by maintaining an orderly market< simultaneously, they buy and sell for their own accounts in hopes of profiting from the spread between purchases and

43

sales. Clearly, specialists must be closely regulated because of these potentially conflicting roles. 4+:4 / specialist on the e$change often acts as a dealer, buying and selling for his or her own account. This is e$actly what an 7TC dealer does. NASD stands for the Nati"#a( Ass"ciati"# "& Securit) Dea(ers, a self+ regulating body of brokers and dealers that oversees 7TC practices. !/&- licenses brokers and handles the punishment for violators of its prescribed fair practices. Nas*a, is the acronym for the NASD Aut"%ate* 2u"tati"# S)ste%, a computeri#ed communications network providing current bid+ask prices for thousands of 7TC stocks simply by pressing buttons on a terminal. 4+3<4 The thir* %arket involves 7TC transactions in securities listed on the organi#ed e$changes. The &"urth %arket involves direct transactions among large institutions, bypassing intermediaries such as brokers and dealers. 4+334 The two primary factors accounting for the rapid changes in @.&. securities markets areF 829 829 4+354 Pressure by institutional investors, who have emerged as the dominant force in the market. The &ecurities /cts /mendments of 2314, which called for a national market system.

4+;4

The !%&' has favored the T& system because !%&' brokers can ignore better quotes on other e$changes. The system does not guarantee that orders will be routed to the e$change offering the best price. nvestors have become increasingly interested in equity markets around the world because the @nited &tates now accounts for only about one+third of the worldAs stock market capitali#ation. =any equity markets e$ist. '$amples in the developed countries

4+364

44

include the @nited Iingdom, )rance, "ermany, taly, &wit#erland, .apan, ?ong Iong, and Canada. @.&. investors are also interested in the stock markets of emerging countries such as =e$ico, (ra#il, and ndonesia. (ased on the dollar volume of equity trading in ma,or world markets for the year 2334 the !%&' dominated, followed by !asdaq, Jondon, and Tokyo. !/&- members in the @nited Iingdom can use !asdaq as if they were located in this country. The !asdaq nternational =arket started in 2332, trading 7TC stocks early in the morning during regular trading hours in Jondon. /lthough the !%&' has already traded several hundred foreign stocks, it would like to trade hundreds more in order not to become a Kregional e$changeL in the global marketplace. 44344 The !asdaq !ational =arket &ystem combines the system of competitive multiple market makers in the 7TC market with the continuous reporting of trades found on the organi#ed e$changes. The conventional 7TC market has multiple dealers, but stocks are reported on a bid+ask basis. The !asdaq>!=& could be a prototype for the future structure of a national market system. t would appear to combine the best elements from the organi#ed e$changes and the 7TC market, but in terms of e$ecution the issue is unsettled. /n auction market such as the !%&' also offers advantages. 4+374 The -ow+.ones ndustrial /verage is a price+ weighted average of DC large 8blue+chip stocks9 trading on the !%&'. The &0P 4CC Composite nde$ is a market value inde$ consisting of 4CC stocks, with a base period set to 2C 82342+234D9. These measures are the two most often+used indicators of what stocks in general are doing. The -ow+.ones /verages are carried by The Wall Street Journal, while the &0P 4CC nde$ is the indicator most often used by institutional investors.

45

4+384

B(ue chip st"cks are large, well+established and well+known companies with long records of earnings and dividends. They are typically traded on the !%&'. '$amples include Coca+Cola, "eneral 'lectric, =erck, Philip =orris, and (= 8despite any recent problems9. The EA'E I#*e0, or the 'uropean, /ustralia, and )ar 'ast nde$, is a value+weighted inde$ of the equity performance of ma,or foreign markets. t is, in effect, a non+/merican world inde$. B("cks are defined as transactions involving at least 2C,CCC shares. Jarge+block activity on the !%&' is an indicator of institutional investor participation in equity trading. The total number of large+block transactions has increased over the years on the !%&', with an average of 2D,3E2 blocks changing hands daily by the end of 233B. (lock volume accounted for about 43 percent of the !%&'6s reported volume at the end of 233B, amounting to some BD billion shares. The !%&'6s role in global trading will depend on several events. The !%&' position is that investors need a public auction market. /nother important variable is the listing of big foreign stocks on the !%&'. /bout half of the foreign listings on the !%&' occurred only in the last few years. The !%&' wants to list more, but the &'C has been reluctant because of accounting differences between countries. nstinet, a part of the fourth market, is an electronic trading network that handles a few billion shares each year. t allows institutions to trade among themselves. (rokers can use nstinet to trade !asdaq stocks, thus taking business from dealers in that market. n+house trading refers to internal trading by fund managers within one company without the use of a broker or an e$change. Traders agree to buy and sell in+house, or cross+trade, perhaps at the ne$t closing price. )idelity nvestments operates an in+house trading system for its own funds because of the large amount of buying and selling it does

4+394

4+3:4

4+3;4

4+5<4

4+534

46

every day. Jarge international investors will benefit from in+house trading. 4+554 /lthough a few bonds trade on the !%&' and /&', the bond market is primarily an 7TC market. /ll federal, agency, and municipal bonds trade 7TC, and most corporates. "rowth stocks are the most likely stocks to split. /s high+priced stocks split and their prices decline, they lose relative importance in the -. /, which is a price+weighted series. ?igh+price stocks carry more weight than do low+priced stocks in such a series. nstitutional investors have become increasing important on !asdaq. )or !asdaq national market stocks, by 2331 institutions accounted for about 4B percent of shares held as well as for about 4B percent of the market value of holdings. =errill Jynch acts as the lead investment banker in bringing out a new issue, or P7. n effect, =errill Jynch 8and the syndicate, if any9 purchases the securities from the issuer and resell them to the public, hoping to profit by the spread between the two prices. t assumes the risk involved in adverse price movements.

4+564

4+544

44574

47