Traditionally, the bond market has not been friendly to individual investors. Currently, individual investors can buy bonds directly only from the Federal government.20 Moving beyond Treasuries, investors generally must use a broker to buy bonds.
Most bonds trade over the counter, which means there is no centralized marketplace or exchange. The bond market is actually a dealer to dealer market, with brokerage firms employing traders to deal in specific types of bonds. Bond brokers are generally buying bonds for their own accounts, and reselling them at a profit. Brokers typically earn a spread (the difference between the current market price and the cost to buy the bonds) and may also add a service charge to the transaction. A small number of corporate bonds are listed on the exchanges.
Better bond information has become available because of the Internet. More sites are offering pricing information. For example, Fidelity Investments allows you to access screens of all the major bond categories. Fidelity’s onlinefixed income service, called Open Bond Market, offers an inventory of more than 15,000fixed-income securities. Other brokeragefirms also offer bonds, often charging a flat fee. Keep in mind that the fees do not tell investors the spreads between the buy and sell prices that are imbedded in the transactions.
20As noted in Chapter 2, TreasuryDirect allows investors to maintain accounts directly with the U.S. Treasury online, buying bills, notes, and bonds at auction without paying a commission.
Global DowSMIndex A stock market index designed to reflect the global stock market as it actually exists in terms of industries and regions
S o m e P r a c t i c a l A d v i c e
Although changes such as those made by Fidelity are benefiting bond investors, buying bonds still has its challenges. For example, municipals normally come in units of $5,000. Commissions are not obvious, but transaction costs typically range from 0.5 percent to
3 percent of principal depending on the size of the order. Because yields on municipals are low to start with, it is critical for investors to minimize their costs when buying bonds either directly or indirectly.
Derivatives Markets
We discuss the details of derivatives markets in their respective chapters. At this point, however, we can note that options trade on thefloor of exchanges, such as the Chicago Board Options Exchange, using a system of market makers. A bid and asked price is quoted by the market maker, andfloor brokers can trade with the market maker or with otherfloor brokers.
Futures contracts traditionally were traded on exchanges in designated“pits,”using as a trading mechanism an open-outcry process. Under this system, the pit trader offers to buy or sell contracts at an offered price and other pit traders are free to transact if they wish. Futures markets now tend to be electronic. For example, the CME Globex electronic trading platform is an electronic marketplace with a wide range of products across all asset classes. Investors can trade around the clock and around the world, with millisecond response time.
The Globalization of Markets
Instinet, mentioned earlier in the chapter, is an electronic trading mechanism allowing large investors (primarily institutions) to trade with each other electronically at any hour. Through such sources as Instinet, stock prices can change quickly although the exchanges themselves are closed. The after-hours trading is particularly important when significant news events occur, or when an institutional investor simply is anxious to trade a position. Such activity could lead to the 24-hour trading for stocks such as that which already exists for currencies.
What about bonds? In today’s world, bonds increasingly are being traded at all hours around the globe, more so than stocks. The emergence of global offerings means that bonds are traded around the clock, and around the world. The U.S. Treasury securities market in par- ticular has become a 24-hour-a-day marketplace. The result of this global trading in bonds is that bond dealers and investors are having to adapt to the new demands of the marketplace, being available to react and trade at all hours of the day and night. This includes new employees in various locales, expanded hours, and computer terminals in the home.
Investors can more easily trade on a global basis today. For example, E*Trade, a bro- keragefirm, offers investors the chance to trade not only in Germany, France, Canada, and the UK, but also in Japan and Hong Kong. They can also diversify infive local currencies.
Summary
⁄ Financial markets include primary markets, where new securities are sold, and secondary markets, where existing securities are traded.
⁄ Primary markets involve investment bankers who specialize in selling new securities. They offer the
issuer several functions, including advisory, under- writing, and marketing services.
⁄ Alternatives to the traditional public placements include private placements.
⁄ We now live in a global economy, where funds can be raised around the world.
⁄ Secondary markets consist of equity markets, bond markets, and derivative markets.
⁄ The equity markets consist of auction markets (exchanges), negotiated markets, and electronic com- munication networks (ECNs) that match investor orders. Brokers act as intermediaries, representing both buyers and sellers; dealers make markets in securities, buying and selling for their own account.
⁄ On the New York Stock Exchange (NYSE), long thought of as the premier secondary market, specia- lists act to provide a continuous market for NYSE stocks. Alternatively, investors can use Arca, the ECN associated with the NYSE.
⁄ The Amex, on which fewer and generally smaller stocks trade, resembles the NYSE in its operations. It agreed to merge with the NYSE in 2008.
⁄ The NASDAQ Stock Market is an electronic network of terminals linking together hundreds of market makers who compete for investor orders by buying and selling for their own account.
⁄ Investors have become increasingly interested in equity markets around the world because the United States now accounts for only about one-third of the
world’s stock market capitalization. Many equity markets exist.
⁄ The best-known stock market indicator in the United States is the Dow Jones Industrial Average (DJIA), computed from 30 leading industrial stocks.
⁄ Standard & Poor’s 500-stock Composite Index is carried in the popular press, and investors often refer to it as a“good”measure of what the overall market is doing, at least for large NYSE stocks. Other indexes cover various market segments.
⁄ Although a few corporate bonds are traded on exchanges, most bond trading occurs in the over-the- counter (OTC) market involving a network of dealers.
⁄ Treasury bonds and federal agency bonds enjoy broad markets, while the markets for municipal bonds and corporate bonds are often less liquid.
⁄ Derivatives markets involve options and futures con- tracts. Puts and calls are traded on option exchanges using market makers, while futures contracts traded were traded in pits using an open-outcry system but increasingly are traded in electronic markets.
⁄ Securities markets increasingly are linked globally. For example, we now have the NYSE Euronext, and the CME Group offers a wide range of options and futures products to serve customers around the globe.
Questions
4-1 Discuss the importance of thefinancial markets to the U.S. economy. Can primary markets exist without secondary markets?
4-2 Discuss the functions of an investment banker.
4-3 Outline the process for a primary offering of securities involving investment bankers.
4-4 Outline the structure of equity markets in the United States. Distinguish between auction mar- kets and negotiated markets.
4-5 In what way is an investment banker similar to a commission broker?
4-6 Explain the role of the Designated Market Makers, the successors to specialists. Refer to the NYSE for information.
4-7 Since the NYSE features a fully automated auction, why do you think it also features a physical auction as well?
4-8 Is there any similarity between a NASDAQ market maker and a Designated Market Maker on an exchange?
4-9 Explain the difference between NASD and NASDAQ.
4-10 Explain what an ECN is.
4-11 What advantages do ECNs offer?
4-12 Why do you think the New York Stock Exchange in 2005 agreed to a merger with ArcaEx, a very different type of marketplace?
4-13 What is an OTC security? How are such securities traded?
4-14 In terms of how they are constructed, what are the two primary types of stock indexes currently being used in the United States?
4-15 What is the Dow Jones Industrial Average? How does it differ from the S&P 500 Composite Index?
4-16 What is meant by the termblue-chip stocks? Cite three examples.
4-17 What is the EAFE Index?
4-18 What is meant by block activity on the NYSE?
How important is it on the NYSE?
4-19 Why can the NYSE now describe itself as a hybrid market, given its long history of using specialists?
4-20 Approximately how many stocks are listed on the NYSE? Does NASDAQ have more listed?
4-21 What is meant by in-house trading? Who is likely to benefit from this activity?
4-22 What is meant by the statement, “The bond market is primarily an OTC market?”
4-23 How is the DJIA biased against growth stocks?
4-24 Using The Wall Street Journal or a comparable source of information, determine the current divisor for the DJIA.
4-25 Which would have a greater impact on the DJIA:
a 10 percent change in the price of Altria, or a 10 percent change in the price of Pfizer?
4-26 Assume that AT&T and Altria, both of which are in the DJIA and in the S&P 500, have approxi- mately equivalent market values (price multiplied by the number of shares outstanding) but very different market prices (which in fact is the case).
Would a 5 percent move in each stock have about the same effect on the S&P 500 Index?
4-27 As an investor with a portfolio of stocks, would you rather see the S&P 500 Index and DJIA performing in a similar manner over some period of time, or quite differently?
Problems
4-1 Assume that you construct a price-weighted index of 20 stocks. The sum of the prices of these stocks is $2,000. The divisor for this index is 20, and the value of this index is 100. Now assume that one of the 20 stocks, with an average price of $100, has a two-for-one stock split, while the value of the other stocks remains unchanged.
a. If you make no adjustment to the index, what will be the new value of the index?
b. What does the new divisor have to be to keep the value of the index unchanged at 100?
CFA
4-2 An analyst gathered the following data about stocks J, K, and L, which together form a value- weighted index:
December 31, Year 1 December 31, Year 2 Stock Price Shares Outstanding Price Shares Outstanding
J $30 10,000 $50 10,000
K $30 6,000 $25 12,000*
L $40 8,000 $60 8,000
*2 for 1 stock split.
The ending value-weighted index (base index5100) is closest to a. 112.50.
b. 133.33.
c. 136.17.
d. 137.28.
4-3 Assume that you have a stock currently priced at $580 that moves exactly proportional to the S&P 500 Index. Over a six-month period the index moves from 1,325.83 to 1,440.67. What should the price of your stock be?
4-4 Assume the DJIA is at 10,000. Some people are predicting that this index could lose 50 percent because of the economy’s difficulties. If that were to happen, what percentage rate of return would be necessary to restore the index to its former level?
4-5 The 52-week low for the NASDAQ index occurred on 9/4/09 at 1982.05, while the 52-week high occurred on 4/26/10 at 2,535.28. For the DJIA, the dates are the same, and the com- parable numbers are 9,302.28 and 11,308.95. Which market performed better during that time period?
Computational Problems
4-1 Assume that the DJIA closed at 13,327 one day recently, and the divisor was .12493117.
a. What is the sum of the prices of the 30 stocks in the index, given this information?
b. Assume that one stock in the index, Pfizer, moved $4.40 that day, while the index itself moved about 102 points (to close at 13,327). What percentage of the total movement in the DJIA that day was accounted for by the movement in Pfizer?
c. Now assume that one of the 30 stocks had a 2-for-1 stock split that day, declining from
$47.50 to $23.75. What would the new divisor have to be to keep the index unchanged at 13,327?
4-2 The DJIA reached a level of 11,722.98 in January 2000, and the S&P 500 reached a level of 1,527.46 in March 2000. Prior to that, on one particular day, the DJIA was at 10,995.63 and the S&P 500 was at 1,281.91.
a. What percentage gain was necessary in each index for it to advance to the two levels indicated above, given the two lower prices stated?
b. If the S&P index declined 7.62 percent over the following year from 1,281.91, what would its new level be?
4-3 From October 2007 to March 2009 the market declined about 57 percent. It then advanced in one year about 69 percent. Determine by calculations if investors were ahead after the advance, or not?
4-4 For the 20th century, the compound annual average return on the S&P 500 was 10.35 percent. How much would $1 have grown to over these 100 years?
Spreadsheet Exercises
4-1 Assume that the spreadsheet below shows the closing prices for the S&P 500 Index for the month of November 2012. Using a column with six decimal places:
a. Calculate the daily percentage changes in the S&P 500 Index. The last daily change is for 11/1/2012, resulting in 21 daily changes.
b. Calculate the average daily change in the Index, shown to 6 decimal places.
c. State the average daily change in the S&P 500 Index for the month of November 2012 as a percentage.
d. State theimpliedmonthly change in the S&P 500 Index for the month of November 2012 as a percentage. (Notice the wordimplied—this in fact is not the correct percentage change for the month, as we will learn when we discuss the difference between the arithmetic mean and the geometric mean).
Date Closing Pr
11/30/2012 1,400.38
11/29/2012 1,398.26
11/28/2012 1,390.84
11/27/2012 1,385.35
11/23/2012 1,375.93
11/22/2012 1,394.35
11/21/2012 1,390.71
11/20/2012 1,413.4
11/19/2012 1,426.63
11/16/2012 1,425.35
11/15/2012 1,423.57
11/14/2012 1,408.66
11/13/2012 1,403.04
11/12/2012 1,403.58
11/9/2012 1,388.28
11/8/2012 1,397.68
11/7/2012 1,392.57
11/6/2012 1,418.26
11/5/2012 1,407.49
11/2/2012 1,413.9
11/1/2012 1,409.34
10/31/2012 1,385.59
Average5
4-2 The spreadsheet below contains the total returns for the S&P 500 Index for the years 2000–
2009 in decimal form. This 10-year period has been called the“Lost Decade.”
a. Calculate the average annual total return (geometric mean) for this index for this 10-year period. Interpret your result.
b. What was the cumulative wealth on December 31, 2009, per dollar invested on January 1, 2000?
c. What was the cumulative wealth on December 31, 2002, per dollar invested on January 1, 2000?
d. Given a $100 investment in the S&P 500 Index on January 1, 2000, in what year did this investmentfinally break above $100?
2000 0.9088
2001 0.8812
2002 0.7791
2003 1.2867
2004 1.1087
2005 1.0491
2006 1.1574
2007 1.0549
2008 0.63
2009 1.2646
Checking Your Understanding
4-1 The term “underwriting” technically involves a firm commitment, meaning the investment bankers have agreed to purchase the securities outright from the issuer. This is different, for example, from a“best effort,”where the risk of selling the issue is shared by the issuer and the underwriters.
4-2 The underwriters have an incentive to quickly sell an issue, thereby reducing their risk as well as enhancing their reputation as successful investment bankers.
4-3 The NYSE is the oldest stock exchange in the United States. NASDAQ only recently became an exchange. The NYSE trades many large, very well-known companies, while NASDAQ trades some smaller companies that are not well known, as well as some of the most important technology companies in the world. NASDAQ now has more companies listed than the NYSE.
The NYSE is a physical location market while NASDAQ is based on dealers or market makers.
The merger between the NYSE and ArcaEx marked a significant change in the way the NYSE operates.
4-4 NASDAQ is a marketplace distinguishable by its trading mechanisms and processes. The term over-the-counter market has traditionally referred to the trading of securities not listed on the organized exchanges.
4-5 Companies may have to disclose less information on NASDAQ, or may prefer having multiple market makers for their stock. On the other hand, companies may prefer to have their shares traded on the NYSE, long considered to be the premier secondary market for the trading of equities.
4-6 The DJIA is a price-weighted index, while almost all others are market-value–weighted. Also, it consists of only 30 stocks.
4-7 The S&P 500 Index is affected by the size of the companies in the index because it is a market- value–weighted index. Therefore, each stock’s weight in the index is proportionate to its market value.
chapter 5 All Financial Markets Have Regulations and Trading Practices
N
owthat you know what investing alternatives are available to you, both direct and indirect, and where they trade, you need to consider the details of trading securities as you prepare to invest your inheritance. What type of brokerage account will best meet your needs? What type of orders can you use to buy and sell securities? How well does the securities legislation in place today protect you from the many pitfalls awaiting you as an investor? Should you take additional risk by buying stocks on margin, and if so, how do you go about trading on margin? Should you bet on security price declines by selling short, or is this technique too risky for average investors? Details, details, but investors must deal with them. Unless you master these details, you will not be able to take full advantage of the trading opportunities thatfinancial markets offer. Furthermore, you will be at the mercy of others who may not have your best interests at heart.In Chapter 4 we considered how securities markets are organized. In this chapter we learn the mechanics of trading securities which investors must know in order to operate successfully in the marketplace. Chapter 5 discusses various details involved in trading securities, critical information for every investor. Brokeragefirms and their activities are analyzed, as are the types of orders to buy and sell securities, and the handling of these orders. The regulation of the securities markets is discussed. Finally, the various aspects of trading securities that investors often encounter are considered. Although the details of trading, like the organization of securities markets, continue to evolve, the basic procedures remain the same.
AFTER READING THIS CHAPTER YOU WILL BE ABLE TO:
⁄ Explain brokers’ roles and how brokerage firms operate.
⁄ Understand the types of orders investors use in trading securities.
⁄ Assess the role of regulation in the securities markets.
⁄ Appreciate how margin trading and short selling contribute to investor opportunities.
Introduction
Could you as an investor carry out the following transactions? If so, how?
1.Buy Treasury securities directly from the Treasury, bypassing brokers.
2.Buy any stock you want directly from the company, bypassing brokers.
3.Specify an exact price or better on a stock you buy or sell if your order is executed.
4.Buy securities by only putting up half the cost.
5.Sell a stock you don’t own in an attempt to make money on the transaction.