Lecture Note 1

Introduction to Capital Markets;

How Securities are Traded in the Markets

Capital Markets

• Primary markets: for new issues. – Firms raise funds in primary markets.

• Secondary markets: for existing securities.– Secondary markets provide liquidity.

• Liquidity measures how easy it is to buy or sell securities.– Stocks vs. real estate assets

– Large stocks vs. small stocks

The Role of the Stock Exchange

• A stock exchange– Provides a (secondary) market place for the trading of

securities;

– Administers the listing requirements for firms listed;

– Ensures the market is informed (disclosure requirements).

• ASX is the national stock exchange in Australia.

ASX Listing Requirements

• A minimum of $1m issued capital and at least 500 shareholders, each with a parcel of at least $2000 each;

• An aggregate profit before tax for the past 3 years of at least $1m, or $0.4m in the last year before listing; Or should have net tangible assets of at least $2m.

US Stock Markets

• There are seven stock exchanges in the US. The most influential one is the New York Stock Exchange (NYSE). Stocks traded on an exchange are called listed.

• NASDAQ -- The automatic quotation system for the over-the-counter market. Most technology firms are traded here.

• Partial requirements for listing in the NYSE and the Nasdaq can be found in Table 3.2 & Table 3.4.

Market Indexes

• All Ordinaries Indexes (All-Ords): Share Price Index, Accumulation Index (or Total Return index).– Total return index includes both dividend income and capital

appreciation

• Dow Jones Industrial Average.

• S & P 500.

• NASDAQ Index.

• MSCI (Morgan Stanley Capital International) indexes.

• Bond Market Indicators.

Price-weighted vs. Market-value-weighted

• Example:

• Price-weighted: from 5.5 to 6, ==> 9.09%.• Mkt-value-weighted: from 350 to 440, ==> 25.71%.

Company Shares P0 P1

ABC 100 6 8

XYZ 20 5 4

How to Handle Stock Split?

• It won’t affect the market-value-weighted indexes.

• If ABC were to split two for one, then P1’= $4, but the total shares = 200.

• To keep the price-weighted average increase at 9.09%, the new divisor should be (4+4)/d = 6.

d = 1.3333, down from 2.

Brokering vs Dealing

• A dealer maintains inventory. She earns her living from the difference between her buying price (bid price) and her selling price (ask price). A dealer exposes herself to price risk.– The difference between the bid and ask prices is called the bid-ask

spread, which is a measure of liquidity.

• A broker does not maintain inventory: gains commission on each transaction he makes.– Some brokerage houses are full service shops, others are

discounters.

– Internet trading offers deep discount in commissions.

Orders of Trades

• Market Order (quantity alone): an order to buy or sell at a price which will complete the transaction promptly.

• Limited Order (quantity and price): an order to buy or sell at a specified price or better.– Good-for-day

– Good-till-cancelled

Stop Loss Order

• Stop-loss order: an order not to be executed unless the stock hits a price limit.

• It is similar to a limit order except the execution is in the opposite direction.

• It is often used as a portfolio insurance strategy.

How are Shares Traded?

• In the Australian Stock Exchange (ASX), the market is order driven.

• All share trading is conducted through stockbrokers’ computer terminals using a system called SEATS (Stock Exchange Automated Trading System).

• The SEATS matches buy orders with sell orders. Large trades by institutions (block transactions) can be done off the market at mutually agreed prices.

An Example of the Limit-Order Book

• Suppose the following orders have been recorded:

• Note: the bid-ask spread is said to be at $3.05-$3.06 in the order driven market such as the ASX.

Buy Orders---------------------$3.05 for 1000sh.$3.02 for 3000sh.$3.00 for 500sh.

Sell Orders---------------------$3.06 for 4000sh.$3.08 for 2000sh.$3.10 for 5000sh

How are Orders Filled?

• If there is a market order to buy 3000 shares, then the order is filled at $3.06.

• Seconds later, another market buy order for 3000 shares is in, then this buyer will get the first 1000 shares at $3.06, and the remaining shares at $3.08 per share.

• Note: the order book changes constantly as new orders come in.

NYSE and Specialist

• The NYSE is a specialist system. A specialist is a broker as well as a dealer.– There are only seven specialist firms now in the NYSE.

• The specialist has to set the bid-ask spread and to prepare to trade from his own account at any time to maintain market liquidity.

Specialist’s Role

• A specialist has to put his own bid-ask spread. His duty is to give investors the best price available.

• In our example, suppose he quotes the spread $3.05-$3.07. Then when the second market buy order comes in, the order will be filled at $3.06 for the first 1000 shares, and $3.07 for the remaining shares.

• Only a small percentage of trades is actually going through the specialist.– The role of floor traders and the value of “seats”

– Block trades

NASDAQ

• The NASDAQ is an automated quotation system for over-the-counter stocks in the U.S.

• Dealers compete business with their own bid-ask quotes. The NASDAQ market is heavily represented by technology firms.

• Many Australian firms are listed either in the NYSE or the NASDAQ markets (i.e. American Depository Receipts or ADRs) for the ease of raising capital in the U.S.– For example, NAB, Telstra, Orbital Engine are traded on the NYSE,

while Amcor, Santos are traded on the NASDAQ, see http://www.ssga.com/library/resh/vtalaganaradrsaustralianstocks20040827/page.html for a partial list.

How are Bonds Traded?

• In the U.S., some corporate bonds from large companies are traded on stock exchanges. Government bonds and other corporate bonds are traded on over-the-counter markets.

• In Australia, although the ASX lists a number of corporate bonds, trades in these interest rate securities are usually thin.

Buying on Margin

• You can borrow money from your brokers to invest in the share market. Buying on margin increases the expected returns as well as risk in your portfolio.

• Initial margin: the percentage of your own money in the initial portfolio.

• Maintenance margin: below which you will get the margin call from your broker, requiring you to put more money into the margin account.

An Example of Margin Call

• An investor pays $6,000 toward the purchase of 100 shares of XYZ at $100 per share, borrowing the rest from the broker.

• Suppose the maintenance margin is 30%, when will the investor get a margin call if the price drops?

Short Sales

• A short sale allows investors to borrow shares of stock from a broker and sells it.

• Short sellers must return the shares and pay the lender of the security any dividends paid during the short sale.

• If you speculate that the stock price will fall, then you may short. “Sell high and then buy low.”

• There is also a margin requirement for short sellers.

An Example of Short Sale

• Suppose you want to short sell 1000 shares of XYZ at a price of $100/share. Suppose the broker has a 50% margin requirement. Then you have to deposit $50,000 in your account with the broker.

• Assume the maintenance margin is 30%, when will you get a margin call if the price rises?

Trading Costs

• Explicit costs: – commissions paid to brokers

– capital gains tax

• Implicit costs: – bid-ask spread

– market impact

– opportunity cost such as missed opportunity for limit orders, which is difficult to measure