FIN221: Lecture 2 Notes
Chapters 4 and 5
The Role of Financial Markets
• Help firms and governments raise cash by
selling claims against themselves
• Provide a place where investors can act
on their beliefs
• Help allocate cash to where it is most
productive
• Help lower the cost of exchange
Investment Banking
• Client advice includes type and features of
security, offer price, and timing of sale
• Underwriting services: Risk of selling to
investors assumed from issuer
• Coordinates marketing by helping issuer
register securities, issue prospectus, and
sell securities
Securities Markets
Chapter 4
Charles P. Jones, Investments: Analysis and Management,
Eighth Edition, John Wiley & Sons
Prepared by
G.D. Koppenhaver, Iowa State University
Markets in New Securities
• New securities are issued in a primary
market
– Initial public offerings versus seasoned new
issues
• Issue facilitated by investment banker
– Specialists in advice, design, and sales
– Intermediaries between issuer and investor
Investment Banking
• Rule 415 (shelf rule) allows certain issuers
to sell new securities over time after filing
a single registration
– Reduces issuance cost
• A private placement means new securities
are sold directly to investors, bypassing
the open market
– Registration not required
1
 Secondary Markets
• Markets where investors trade previously
issued securities
• Auction markets involve bidding in a
specific physical location
– Brokers represent investors for a fee
– Others trade for their own account
• Negotiated markets consist of
decentralized dealer network
Over-the-counter Markets
• Network of dealers standing ready to
either buy or sell securities at specified
prices
– Dealers profit from spread between buy and
sell prices
– Handle unlisted securities
• NASDAQ: Competing dealers make
markets in OTC stocks
Foreign Markets
• US equity markets account for a third of
world’s stock market capitalization
– Many different equity markets exist
• Emerging market: Stable political system,
low regulation, low standardization in
trading activity
– Risks: Illiquidity, lack of information, political
uncertainty
Stock Exchanges
• NYSE is a secondary, auction market in
equity shares
– Not-for-profit organization of members
– Listing requirements for traded firms
– “Specialists” assigned to each traded equity to
make a market in that stock
• AMEX and regional exchanges list smaller
firms, have less volume than NYSE
Third and Fourth Markets
• Third Market: Over-the-counter
transactions in securities listed on
organized exchanges
• Fourth market: Trading network among
investors interested in buying and selling
large blocks of stock
– Brokers, dealers bypassed so costs low
– Electronic or telephone network
Equity Market Indicators
• Provide a composite report of market
behavior on a given day
• Dow Jones Industrial Average
– Composed of 30 “blue-chip” stocks
– Price-weighted index: Essentially adds the
prices of 30 stocks, divides by 30
• Adjusted for stock splits, stock dividends
– Oldest, most well-known measure
2
 Equity Market Indicators
• Standard & Poor’s Composite Index
– Composed of 500 “large” firm stocks
– Expressed as index number relative to a base
index value of 10 (1941-43)
– Value-weighted index: Prices and shares
outstanding considered
• Indicates how much the average equity value of
the 500 firms in the index has increased relative to
the base period
Bond Markets
• Secondary bond market is primarily an
over-the-counter network of dealers
– NYSE features an automated bond system to
execute orders.
• Mostly corporate bonds, thinly traded
– Treasury and agency bonds actively trade in
dealer markets
• Municipal bonds less actively traded
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Equity Market Indicators
• NYSE and NASDAQ Composite Indices
– Value-weighted indices of broad markets
• Nikkei 225 Average
– Price-weighted index of 225 actively -traded
stocks on the Tokyo Stock Exchange
Market Developments
• Growth of institutional trading associated
with:
– Block trading of stocks (transactions of at
least 10,000 shares)
• Affects market structure and operation
– Negotiated, not fixed, commissions
• Evolution of National Market System
– Centralized system for price and activity
reporting, order routing and sequencing
How Securities Are Traded
Chapter 5
Charles P. Jones, Investments: Analysis and Management,
Eighth Edition, John Wiley & Sons
Prepared by
G.D. Koppenhaver, Iowa State University
3
 Brokerage Operations
• Brokerage firms earn commissions on
executed trades, sales loads on mutual
funds, profits from securities sold from
inventory, underwriting fees and
administrative account fees
– Full-service brokers offer order execution,
information on markets and firms, and
investment advice
– Discount brokers offer order execution
Account Types
• Cash management account
– Checks can be written against account’s
assets
– Instant loans at a markup to call money rate
based on the account’s assets
• Wrap account: Brokers match investors
with outside money managers
– All costs, fees wrapped into one
Orders in Auction Markets
• Most NYSE volume from matched public
buy and sell orders
• Specialists act as both brokers and
dealers in the stocks assigned to them
– Maintain the limit order book
– Keep a fair and orderly market by providing
liquidity
Account Types
• Cash account: Investor pays 100% of
purchase price for securities
• Margin account: Investor borrows part of
the purchase price from the broker
• Asset management account: automatic
reinvestment of excess cash balances in
money market fund
Fees and Costs
• Brokerage commissions differ by security,
broker, and investor
– Institutional investors have greatest
negotiating power
• Dividend reinvestment plans permit
reinvestment of dividends in additional
stock
– Avoids commissions, administrative fees
NYSE Automation
• SuperDot: An electronic order recording,
reporting, routing, and matching system
– Specialist’s Electronic Book records and
reports limit and market orders
– Preopening buy and sell orders matched and
imbalance reported to specialist
– Members send orders directly to specialist for
execution and confirmation
4
 Orders in OTC Markets
• Dealers ready to either buy or sell
– Bid price is highest offer price to buy
– Ask price is lowest price willing to sell
• Ask price - Bid price >0 (dealer spread)
– “Makes a market” in the security
– More than one dealer for each security in
over-the-counter markets
Settlement
• Most settlement dates are three business
days after the trade date
– Legal ownership transferred and financial
arrangements settled with brokerage firm
– Book-entry system reduces costs
• Transfer of securities and funds between
exchange members facilitated by a
clearinghouse
Regulation
• Stock exchanges are also self-regulated
– In own self -interest to regulate and monitor
member behavior
– NYSE “circuit-breakers” attempt to reduce
volatility
• NASD: Trade association that regulates
OTC brokers and dealers
Types of Orders
• Market orders: Authorizes immediate
transaction at best available price
• Limit orders: Specifies a particular market
price before a transaction is authorized
• Stop orders: Specifies a particular market
price at which a market order is authorized
Regulation
• SEC Act of 1934 created the Securities
and Exchange Commission
– Administers all securities law
– Monitors public securities transactions
• Requires issuer registration for public offers
• Investigates indications of violations such as
“insider trading”
• Securities Investor Protection Act of 1970:
insures accounts
Margin Accounts
• To open margin account, exchanges set
minimum required deposit of cash or
securities
• Investor then pays part of investment cost,
borrows remainder from broker
– Margin is percent of total value that cannot be
borrowed from broker
• Cash: 100% loan value; securities: 50%
5
 Margin Accounts
• Federal Reserve sets the minimum initial
margin on securities
– Unchanged since 1974 at 50%
• Actual margin at any time cannot go below
the maintenance margin level set by
exchanges, brokers
– Investor’s equity changes with price
– Margin call when equity below maintenance
level
Short Selling
• Investor borrows stock from broker or held
in “street name” accounts
• Borrowed security sold in open market, to
be repurchased later at an expected price
lower than sale price
– Investor liable for declared dividends
– Short sale proceeds held by broker
– Demand loan of stock