Investment management and portfolios, Slides of Investment Management and Portfolio Theory

Download Investment management and portfolios and more Slides Investment Management and Portfolio Theory in PDF only on Docsity! Lecture Presentation Software to accompany Investment Analysis and Portfolio Management Seventh Edition by Frank K. Reilly & Keith C. Brown Chapter 4 Chapter 4 Organization and Functioning of Securities Markets Questions to be answered: • What is the purpose and function of a market? • What are the characteristics that determine the quality of a market? • What is the difference between a primary and secondary capital market and how do these markets support each other? Chapter 4 Organization and Functioning of Securities Markets • What are some of the major changes in world capital markets expected over the next decade? What is a market? • Brings buyers and sellers together to aid in the transfer of goods and services • Does not require a physical location • Both buyers and sellers benefit from the market Characteristics of a Good Market • Availability of past transaction information – must be timely and accurate • Liquidity – marketability – price continuity – depth • Low Transaction costs • Rapid adjustment of prices to new information Municipal Bond Issues • Sold by three methods – Competitive bid – Negotiation – Private placement • Underwriters sell the bonds to investors – Origination – Risk-bearing – Distribution The Underwriting Function • The investment banker purchases the entire issue from the issuer and resells the security to the investing public. • The firm charges a commission for providing this service. • For municipal bonds, the underwriting function is performed by both investment banking firms and commercial banks Corporate Bond and Stock Issues New issues are divided into two groups 1. Seasoned new issues - new shares offered by firms that already have stock outstanding 2. Initial public offerings (IPOs) - a firm selling its common stock to the public for the first time Private Placements and Rule 144A • Firms sells to a small group of institutional investors without extensive registration • Lower issuing costs than public offering Why Secondary Financial Markets Are Important • Provides liquidity to investors who acquire securities in the primary market • Results in lower required returns than if issuers had to compensate for lower liquidity • Helps determine market pricing for new issues Secondary Bond Market • Secondary market for U.S. government and municipal bonds – U.S. government bonds traded by bond dealers – Banks and investment firms make up municipal market makers • Secondary corporate bond market – Traded through an OTC market Trading Systems • Pure auction market – Buyers and sellers are matched by a broker at a central location – Price-driven market • Dealer market – Dealers provide liquidity by buying and selling shares – Dealers may compete against other dealers Call Versus Continuous Markets • Call markets trade individual stocks at specified times to gather all orders and determine a single price to satisfy the most orders • Used for opening prices on NYSE if orders build up overnight or after trading is suspended • In a continuous market, trades occur at any time the market is open National Stock Exchanges • Large number of listed securities • Prestige of firms listed • Wide geographic dispersion of listed firms • Diverse clientele of buyers and sellers Tokyo Stock Exchange (TSE) • Largest of the eight exchanges in Japan • Dominates the Japanese market • Established in 1878 and reorganized in 1943, 1947, and 1949 • Price-drive system • Domestic and foreign stocks listed • Approximately 1700 stocks listed with a total market value of $2.4 trillion • Most active 150 stocks are traded on floor, others by computer London Stock Exchange (LSE) • Largest securities market in the United Kingdom • Trades listed and unlisted securities – More than 2,600 companies listed • Largest listing of foreign stocks on any exchange • Total market value of more than $561billion • Pricing system by competing dealers via computers similar to NASDAQ system in U.S. Trends • New exchanges in emerging economies such as Russia, Poland, China, Hungary, Peru, Sri Lanka • Consolidation of existing exchanges in developed countries • Global twenty-four-hour market – made possible by advances in technology Regional Exchanges • Stocks not listed on a formal exchange – Listing requirements vary • Listed stocks – Allow brokers that are not members of a national exchange access to securities • Regional Exchanges in United States – Chicago, Boston, Cincinnati, Pacific, Philadelphia Over-the-Counter (OTC) Market • Not a formal organization • Largest segment of the U.S. secondary market • Unlisted stocks and listed stocks (third market) • Lenient requirements for listing on OTC • 5,000 issues actively traded on NASDAQ NMS (National Association of Securities Dealers Automated Quotations National Market System) • 1,000 issues on NASDAQ apart from NMS • 1,000 issues not on NASDAQ Operation of the OTC • Any stock may be traded as long as it has a willing market maker to act a dealer • OTC is a negotiated market Third Market • OTC trading of shares listed on an exchange • Mostly well known stocks – GM, IBM, AT&T, Xerox • Competes with trades on exchange • May be open when exchange is closed or trading suspended Fourth Market • Direct trading of securities between two parties with no broker intermediary • Usually both parties are institutions • Can save transaction costs • No data are available regarding its specific size and growth Detailed Analysis of Exchange Markets • Exchange Membership • Major Types of Orders • Exchange Market Makers Major Types of Orders • Short sales – Sell overpriced stock that you don’t own and purchase it back later (at a lower price) – Borrow the stock from another investor (through your broker) – Can only be made on an uptick trade – Must pay any dividends to lender – Margin requirements apply Major Types of Orders • Special Orders – Stop loss • Conditional order to sell stock if it drops to a given price • Does not guarantee price you will get upon sale • Market disruptions can cancel such orders – Stop buy order • Investor who sold short may want to limit loss if stock increases in price Margin Transactions • On any type order, instead of paying 100% cash, borrow a portion of the transaction, using the stock as collateral • Interest rate on margin credit may be below prime rate • Regulations limit proportion borrowed – Margin requirements are from 50% up • Changes in price affect investor’s equity Margin Transactions • Initial margin requirement at least 50%. Set up by the Fed. • Maintenance margin – Requirement proportion of equity to stock – Protects broker if stock price declines – Minimum requirement is 25% – Margin call on undermargined account to meet margin requirement – If margin call not met, stock will be sold to pay off the loan Exchange Market Makers U.S. Markets • Specialist is exchange member assigned to handle particular stocks – Has two roles: – Broker to match buyers and sellers – Dealer to maintain fair and orderly market • Specialist has two income sources – Broker commission, without risk – Dealer trading income from profit, with risk Exchange Market Makers Tokyo Stock Exchange (TSE) • Regular members – Several employees allowed on trading floor – Trading clerks for customers accounts – Buy and sell for own accounts • Saitori member – Hundreds of employees on trading floor – Intermediary clerks – Brokers among members – Maintain limit orders Changes in the Securities Markets • Since 1965, the growth of trading by large financial institutions has had many effects – Negotiated (competitive) commission rates – Influence on block trades – Impact on stock price volatility – Development of National Market System (NMS) Negotiated Commission Rates • NYSE minimum commission schedule prohibited price cutting since 1792 • No price break for large orders – Initial reaction was “give-ups” paid to a designated firm - soft dollars paid for market research – Third market competed with flexible commissions and grew – Fostered development of the fourth market Negotiated Commission Rates • In 1970 SEC began phasing in negotiated commissions – Commission rates have fallen – Discount brokerage firms compete openly – Many brokerage and research firms have merged or liquidated Institutions and Stock Price Volatility • Empirical studies have not supported the theory that institutional trading increases price volatility • Where trading is dominated by institutions, actively involved institutions may provide liquidity for one another and noninstitutional investors National Market Systems (NMS) • NMS has been advocated by financial institutions to provide greater efficiency, competition, and lower cost of transactions • NMS is expected to have: – 1. Centralized reporting of all transactions – 2. Centralized quotation system – 3. Centralized limit order book (CLOB) – 4. Competition among all qualified market makers 1. Centralized Reporting • Should record all transactions of a stock, regardless of location • NYSE started a central tape in June 1975 covering all NYSE stocks traded on other exchanges and OTC 4. Competition Among All Qualified Market Makers (Rule 390) • Market makers compete on OTC market • Competition reduces bid-ask spread • NYSE opposes competition and argues that central auction results in best market and execution • NYSE Rule 390 requires members to obtain permission of the exchange before trading a listed stock off the exchange, forcing transactions to the exchange to create a central market New Trading Systems • Daily trading volume has increased from 5 million shares to over a billion shares • NYSE routinely handles days with volume over a billion shares • Technology has allowed the market process to keep pace Super DOT • Electronic order-routing system • Member firms transmit market and limit orders in NYSE securities to trading posts or member firm’s booth • Report of execution returned electronically • 85% of NYSE market orders enter through Super DOT system Market Order Processing • Super Dot’s postopening market order system is designed to accept member firms’ postopening market orders up to 3 million shares • Rapid execution and reporting of market orders • In 2000, orders executed and reported in 15-16 seconds on average Limit Order Processing • Electronically files orders to be executed when and if a specific price is reached • Updates the Specialist’s Display Book • Good-until-cancelled orders that are not executed are stored until executed or cancelled Global Market Changes • NYSE Off-hours trading – Crossing Session I provides for trading stocks at NYSE closing prices after the regular session from 4:15 PM to 5:00 PM – Crossing Session II provides for trading a collection of at least 15 NYSE stocks with a market value of at least $1 million from 4:00 PM to 5:15 PM Effects of the Big Bang • Competitive market makers & SEAQ reduced number of people on the trading floor • More activity in the system, but profit margin has reduced from competition • Many firms have merged or been acquired by foreign firms Tokyo Stock Exchange (TSE) • 1998 brought TSE its own Big Bang introducing more competition in trading commissions and competition among market participants Paris Bourse • The big brokerage house monopoly on stock trading has been opened up to French and foreign banks • Investment firms are merging with banks to acquire capital needed to trade in world market • Continuous auction market introduced to replace call market