Beruflich Dokumente
Kultur Dokumente
3.88 1.77
2.65
United State
15.03
Europe
Japan
Canada/Australia/New
54.97 Zealand
Pacific Basin
reprinted from Saunders Cornett “Financial markets and institutions,” 3rd edition, McGraw-Hill Irwin 2006
Copyright © 2006 Scott Bauguess
Market Value of Common Stock
Outstanding
(billions of dollars)
14000
12000
10000
8000
6000
4000
2000
0
1994 1997 2000 2004
reprinted from Saunders Cornett “Financial markets and institutions,” 3rd edition, McGraw-Hill Irwin 2006
Copyright © 2006 Scott Bauguess
Role of Primary Markets
Serve to reduces the adverse selection process in raising capital
1. Underwriters (investment banks) certify firm type by taking firms public (IPO)
2. Rating agencies certify debt issues
3. Government provides strict framework for the registration process
Information production
1. Continuous trading – assets are priced daily
2. Low cost - look for stock price online
1. A central location (trading floor) where the exchange of financial securities takes
place
2. Central agents match buyers and sellers (one point of contact)
1. Auctioneer determines the market clearing price prior to trading in the following manner:
2. Auctioneer proposes a price
3. Representatives (buyers and sellers) privately indicate whether or not they are a buyer or
seller at that price.
4. If equilibrium (net buys = net sells) is not reached, then auctioneer proposes adjusted price.
5. Process continues until auctioneer finds the market clearing price.
6. Once this price is determined, then all trades occur simultaneously
• Free rider problem: All private information is revealed prior to trading since trading
does not occur until a market clearing price is revealed. The price moves to
equilibrium prior to the first trade, so even uninformed investors benefit (free-ride) off
the private information of informed investors.
• London Gold Bullion market is a call market – prices set twice daily.
Dealers: Take inventory on their own account in a traded asset to facilitate trading (car
dealer, investment or commercial bank)
Broker-dealers: act as agents in addition to holding inventory and trading on their own
account
Market-Makers: A dealer that is tasked with keeping the market running smoothly,
and may be a privileged/regulatory activity (NYSE specialist)
2. Brokers: transmit investor orders (E*Trade, Schwab, Fidelity, Merrill Lynch, Ameritrade etc.)
3. Dealers: trade on their own account (Goldman Sachs, Morgan Stanley, JP Morgan, Merrill Lynch
& other investment banks)
4. Market Makers: Dealer-brokers who are required to trade to keep market moving smoothly
(NASD member firms and NYSE specialists). Market makers profit through two avenue streams:
• In an idealized market, Market makers would need only match orders and charge a small
fee. However, if trade imbalances occur (more buys than sells or vice-versa), then the
market-maker is required to take a position to smooth trading.
Household
Householdsector
sector $3,070.9
$3,070.9 $5,689.6
$5,689.6 $6,132.7
$6,132.7 39.2
39.2
State
Stateand
andlocal
localgov.
gov. 10.6
10.6 79.0
79.0 87.6
87.6 0.6
0.6
Rest
Restofofworld
world 397.7
397.7 919.5
919.5 1,670.3
1,670.3 10.7
10.7
Depository
Depositoryinst.
inst. 180.6
180.6 331.4
331.4 260.1
260.1 1.7
1.7
Life
Lifeins.
ins.co.
co. 246.1
246.1 558.6
558.6 962.4
962.4 6.2
6.2
Other
Otherins.
ins.co.
co. 112.1
112.1 186.0
186.0 187.5
187.5 1.2
1.2
Private
Privatepension
pensionfunds
funds 996.3
996.3 1,863.9
1,863.9 1,536.3
1,536.3 9.8
9.8
Public
Publicpension
pensionfunds
funds 557.4
557.4 1,431.7
1,431.7 1,180.3
1,180.3 7.5
7.5
Mutual
Mutualfunds
funds 709.6
709.6 2,018.7
2,018.7 3,431.7
3,431.7 22.0
22.0
Closed-end
Closed-endfundsfunds 31.9
31.9 50.2
50.2 70.8
70.8 0.4
0.4
Brokers
Brokersand anddealers
dealers 20.1
20.1 51.9
51.9 107.5
107.5 0.7
0.7
reprinted from Saunders Cornett “Financial markets and institutions,” 3rd edition, McGraw-Hill Irwin 2006
Copyright © 2006 Scott Bauguess
Brokers, Dealers and Market Makers
Brokers, dealers, broker-dealers and market makers enter the market to reduce the
trading costs incurred by investors
1. Easier to buy a new car from a dealer with a car-lot of 1,000 cars than visiting the same
number of cars at the individual residences of private sellers
3. Brokers match buyers and sellers that might not otherwise find each other (real estate
agents can pull up listing on the MLS and quickly show a buyer available properties)
1. Bid Price: Price dealer pays investors or price investors receive from dealers.
2. Ask Price: Price dealer receives from investors or price investor pays dealer.
3. Spread = Ask - Bid
The size of the spread is indicative of the amount of risk associated with ownership in the
security, including:
Bid-Ask spreads increase with risk, particularly when a security is illiquid, volatile or there
is a threat that insiders (informed investors) are trading on private information
Security B has a larger spread: Relative to Security A, B likely has (1) more risk,
(2) more informed traders, or is less liquid.
Membership:
1. Market makers must be member of the exchange. Members pay for the right to
trade in a security (buy a seat on the exchange).
2. Not all seats are created equal – The right to trade IBM shares may be more
profitable than the right to trade 7-Eleven
Is the biggest and most prestigious national exchange with 2,800 listed companies
and a market value of $13.3 Trillion (13/30/05).
The NYSE has 1366 exchange members (seats) which themselves trade at prices
upwards of 2 million dollars. These firms collectively own the exchange; however,
they do not run the exchange
Seat holders are allowed to buy and sell securities on the exchange floor without
paying commissions
Trades over 3,800 stocks (Market cap of $3.6 Trillion – 12/31/05) on a virtual trading floor
– a network of computer systems – and over 500 market makers.
Market characteristics
1. Negotiated system with Multiple Market Makers – as many as 20 market makers may list quotes
on Microsoft (MSFT).
2. Although smaller aggregate market cap, share volume on the Nasdaq larger than NYSE, with
almost 500 billions shares traded annually.
3. There are listing requirement for NASDAQ firms, but even so, this is referred to as the “unlisted”
firm market, because initially the NASDAQ served those firms that could not list on an
exchange. Historically, firms would switch to the NYSE from NASDAQ when they were
sufficiently mature, but since the late 1980’s, many firms remained, particularly in the high-tech
sectors (Microsoft, Oracle, Cisco etc.). Now the NASDAQ is on par with the NYSE.
4. Market makers post bid-ask spreads, but are only required to fill those quotes up to 1,000
shares, so doing so in not costly relative to the risks of a specialist.
5. Nasdaq is actually two separate markets: Nasdaq National Market (NNM) and Nasdaq small
cap market.
1. ECNs were initially formed as a private network to execute trades, but have
since been popularized with competitive pricing
2. NASDAQ was opened to ECN’s in late 1990’s which spurred their growth. ECN
orders are transmitted to NASDAQ and are displayed along side market makers
3. ECNs are not market makers, do not act as a dealer holding inventory, but
simply broker order matching. Investors can trade directly with one another
through an ECN, by passing the regular market structure
5. Execute after hour trades (past 4PM Eastern time) – greater than 70 million
shares a day
1. buy limit order at $85 – Investor will buy only if the share price drops to $85 or
lower
2. sell limit order at $99 – Investor will sell if the share price rises to $99
3. buy stop order at $99 – Investor will buy once the price rises to $99
4. sell stop order at $85 – Investor will sell if the share price drops to $85
Open Order: This order is good until the investor cancels it, but no more than 3
months.
Odd Lot: < 100 shares. Firms often try to buy-out owners of odd lots since
shareholders impose significant expense to the firm. Firm must send out
annual reports and proxy statements to each owners of the firm. And these
costs might be more than the aggregate investment value of an odd lot.
----- The shares must eventually be returned to the original IBM shareholder ----
• Investor returns to the market and buys 100 shares at the new prevailing price, and
returns the shares.
Short selling constraints are believed by many to be one contributing factor for
over valued share prices like we saw in the dot.com era.
Example: Investor places $10,000 into a brokerage account to by shares of Acme Lubbock
Inc at $100/share
1. No leverage: Investor A purchases 100 shares worth $10,000.
2. Leverage: Investor B purchases 200 shares, borrowing $10,000 for the extra shares
Return
100%
in market
portfolio
Rm M
Rf
Margin trading can facilitate efficient markets by creating investment opportunities that
might not otherwise be available.
Margin Call: When an investor drops below, the current margin limit, the
brokerage requires:
1. additional cash put into the account
2. liquidation of securities to the extent that margin requirements are met
3. If the investor fails to put up additional cash, then the broker has the authority to
sell securities for the investors account
4. Some brokerages set different margin limits by restricting which stocks can be
margined
• High volatility stocks like xoom.com or etoys (both now bankrupt) may not
be marginable
Popular examples
1. Dow Jones 30
2. Nasdaq composite
3. NYSE Composite
4. Russell 1000
5. S&P 500
6. Wilshire 5000
7. Value line composite
Most indices, like the SP500 are value weighted, but the DJIA is price weighted. Price
weighting is problematic when stock splits occur, and because of this, the DJIA has to
use an index divisor.
The top 10 holdings represent 21% of the entire market capitalization of the index, but
represents only 2% of the total firms – would be 2% if equal weighted.