Stock Basics 2

download Stock Basics 2

of 52

Transcript of Stock Basics 2

  • 8/9/2019 Stock Basics 2

    1/52

    Infosys Technologies Limited, SBU2

    TABLES OF CONTENT

    ACKNOWLEDGEMENT.................................................................................................................................................3

    PREFACE...........................................................................................................................................................................4

    STOCKS - BASICS............................................................................................................................................................5

    PREFERRED SHARES .............................................................................................................................................................6AMERICAN DEPOSITARY RECEIPTS (ADRS) ...........................................................................................................................7DIVIDENDS .........................................................................................................................................................................8HOWCANYOUTRYTOPREDICTWHATTHEDIVIDENDWILLBEBEFOREITISDECLARED? .................................................................9TYPESOF INDEXES: .........................................................................................................................................................10

    Type A index .............................................................................................................................................................10

    Type B index ............................................................................................................................................................10

    Type C index .............................................................................................................................................................11

    THE DOW JONES INDUSTRIAL AVERAGE ...............................................................................................................................11

    OTHERINDEXES ................................................................................................................................................................11US Indexes: ...............................................................................................................................................................11

    Non-US Indexes: .......................................................................................................................................................12IPOS (INITIAL PUBLIC OFFERINGS).....................................................................................................................................12

    Introduction to IPOs .................................................................................................................................................12

    The Mechanics of Stock Offerings ............................................................................................................................13

    The Underwriting Process ........................................................................................................................................14

    MARKET CAPITALIZATION ..................................................................................................................................................16REPURCHASINGBY COMPANIES (ALSOCALLED BUYBACK)......................................................................................................16STOCKSPLITS ...................................................................................................................................................................16WARRANTS ......................................................................................................................................................................17

    BONDS - BASICS............................................................................................................................................................18

    MOODY BOND RATINGS .....................................................................................................................................................19BOND TERMINOLOGY .........................................................................................................................................................20

    Advance Refunding:...................................................................................................................................................20Callable Bond:...........................................................................................................................................................20

    Discount Bond:..........................................................................................................................................................20

    Double Barreled: ......................................................................................................................................................20

    Face Value:................................................................................................................................................................20

    Par Value: .................................................................................................................................................................20

    Premium Bond:..........................................................................................................................................................20

    Principal:...................................................................................................................................................................20

    Revenue Bonds:.........................................................................................................................................................20Sinking Fund:............................................................................................................................................................20

    Yield:..........................................................................................................................................................................21

    Yield to Maturity:.......................................................................................................................................................21RELATIONSHIPOF PRICEAND INTEREST RATE ........................................................................................................................21TREASURY DEBT INSTRUMENTS ...........................................................................................................................................21ZERO-COUPONBONDS ........................................................................................................................................................21

    DERIVATIVES - BASICS..............................................................................................................................................23

    FUTURES ..........................................................................................................................................................................24Commodity futures.....................................................................................................................................................24

    Stock index futures.....................................................................................................................................................24

    Interest rate futures (including deposit futures, bill futures and government bond futures).....................................24

    1

  • 8/9/2019 Stock Basics 2

    2/52

    Infosys Technologies Limited, SBU2

    STOCKOPTION BASICS ......................................................................................................................................................25CALL OPTION....................................................................................................................................................................26PUT OPTION......................................................................................................................................................................27LEAPS ...........................................................................................................................................................................28

    EXCHANGES..................................................................................................................................................................29

    MARKET MAKERSAND SPECIALISTS ....................................................................................................................................29THE NASDAQ ...............................................................................................................................................................29THE NEW YORKSTOCKEXCHANGE ....................................................................................................................................29OVERTHE COUNTER (OTC)..............................................................................................................................................29

    TRADING.........................................................................................................................................................................30

    AFTERHOURS .................................................................................................................................................................30BID, ASK, AND SPREAD .....................................................................................................................................................31BROKER............................................................................................................................................................................31INTRODUCING BROKER......................................................................................................................................................32

    DISCOUNT BROKERS ..........................................................................................................................................................33DIRECT INVESTINGAND DRIPS .........................................................................................................................................34FREE RIDE RULES .............................................................................................................................................................34

    MARGIN TRADING..............................................................................................................................................................35DELIVERY-VERSUS-PAYMENT................................................................................................................................................37INSIDERS TRADING..............................................................................................................................................................37JARGONAND TERMINOLOGY ................................................................................................................................................37CLEARING PROCESS............................................................................................................................................................39NETTING...........................................................................................................................................................................40PORTFOLIO MANAGEMENT...................................................................................................................................................40DAY, GTC, LIMIT, AND STOP-LOSS ORDERS .......................................................................................................................40PINKSHEET STOCKS ..........................................................................................................................................................42PROCESS DATE .................................................................................................................................................................42ROUND LOTSOF SHARES ....................................................................................................................................................42SIZEOFTHE MARKET ........................................................................................................................................................45TICK, UPTICK, AND DOWNTICK ...........................................................................................................................................45

    TRANSFERRINGAN ACCOUNT ..............................................................................................................................................45

    APPNEDIX-1....................................................................................................................................................................46

    APPENDIX - 2.................................................................................................................................................................49

    APPNEDIX-3....................................................................................................................................................................51

    REFERENCES.................................................................................................................................................................52

    2

  • 8/9/2019 Stock Basics 2

    3/52

    Infosys Technologies Limited, SBU2

    Acknowledgement

    As in all undertakings of this kind, I have gained valuable advice from many people. I amespecially thankful to Joydeep and Sachin whose valuable comments and suggestions went a longway in bringing this manual to a successful conclusion. I am also thankful the various moduleleaders of Goldman Sachs project for their valuable time in explaining me the details functionalaspects of the project.

    Anil Kumar Jena.29th June 1998.

    3

  • 8/9/2019 Stock Basics 2

    4/52

    Infosys Technologies Limited, SBU2

    Preface

    This manual is about the securities and trading in various securities. It is aimed at providing a

    comprehensive introduction to various securities traded in the market place (U.S) and the tradingmechanism. The approach is from a laymans perspective and aimed at the people joining SBU2afresh. Though the idea was to prepare a manual which can be helpful for the people in GoldmanSachs project, this manual would be helpful to people who are in other projects but are related tosecurities.

    This book has been divided into five parts covering stocks, bonds, derivatives, Stock exchanges andtrading. Each part starts with the basics of that particular topic and goes to more detailed coveringlater. Appendix 1 provides the areas of the operation of Goldman Sachs and the people not workingin the project can skip this section.

    Even though the manual is designed for the freshers, it can be a good reading for the people whoare going onsite. Apart from the manual the people who are going onsite can supplement theirknowledge by reading Security analysis and portfolio Management by Donald E. Fischer andRonald J. Jordan (Chapter 1 and 2. This book is available in IIM, Bangalore library of whichInfosys is a corporate member.)

    Some of the sections in this manual will make advanced reading (Italicised in the manual) and

    the freshers can skip these sections. These sections are designed for the people going onsite.

    This manual might need two readings and will take 6-7 hours in all. I sincerely hope the readersfind this manual interesting and helpful. The manual, though touches upon the all the basics, to the

    keen reader, will provide with many loose ends. Please feel free to ask any doubt you may haveregarding the topics covered or any other areas of finance. I will be most happy to answer yourqueries.

    HAPPY LEARNING!!!

    Anil Kumar [email protected]

    4

  • 8/9/2019 Stock Basics 2

    5/52

    Infosys Technologies Limited, SBU2

    Stocks - Basics

    Perhaps we should start by looking at the basics: What is stock? Why does a company issue stock?

    Why do investors pay good money for little pieces of paper called stock certificates? What doinvestors look for? What about Value Line ratings and what about dividends?

    Stock is nothing but a piece of ownership of a company. The owner of a stock is owner of thecompany to the extent of his/her holding as a percentage of the total stock floating in the market.Since the stockholder is the owner of the company, he obviously has right on the profit of thecompany. At the end of the year when the profit gets distributed, he/she also gets some bootydepending upon his/her share. This we call as dividend. Now this is more of bookish definition. Letus understand stock in more detail.

    To start with, if a company wants to raise capital (money) one of its options is to issue stock. It has

    other methods, such as issuing bonds and getting a loan from the bank. But stock raises capitalwithout creating debt, without creating a legal obligation to repay those funds.

    What do the buyers of the stock -- the new owners of the company -- expect for their investment?The popular answer, the answer many people would give is: they expect to make lots of money;they expect other people to pay them more than they paid themselves. Well, that doesn't just happenrandomly or by chance (well, maybe sometimes it does, who knows?)

    The less popular, less simple answer is: shareholders -- the company's owners -- expect theirinvestment to earn more, for the company, than other forms of investment. If that happens, if thereturn on investment is high, the price tends to increase. Why?

    Who really knows? But it is true that within an industry the Price/Earnings (i.e., P/E) ratio tends tostay within a narrow range over any reasonable period of time -- measured in months or a year orso.

    So if the earnings go up, the price goes up. And investors look for companies whose earnings arelikely to go up. How much?

    There's a number -- the accountants call it Shareholder Equity -- which in some magical senserepresents the amount of money the investors have invested in the company. I say magical becausewhile it translates to (Assets - Liabilities) there is often a lot of accounting trickery that goes into

    determining Assets and Liabilities.

    But looking at Shareholder Equity, (and dividing that by the number of shares held to get the bookvalue per share) if a company is able to earn, say, $1.50 on a stock whose book value is $10, that's a15% return. That's actually a good return these days, much better than you can get in a bank or C/Dor Treasury bond, and so people might be more encouraged to buy, while sellers are anxious tohold on. So the price might be bid up to the point where sellers might be persuaded to sell.

    5

  • 8/9/2019 Stock Basics 2

    6/52

    Infosys Technologies Limited, SBU2

    A measure that is also sometimes used to assess the price is the Price/Book (i.e., P/B) ratio. This isjust the stock price at a particular time divided by the book value.

    What about dividends? Dividends are certainly more tangible income than potential earningsincreases and stock price increases, so what does it mean when a dividend is non-existent or verylow? And what do people mean when they talk about a stock's yield?

    To begin with the easy question first, the yield is the annual dividend divided by the stock price.For example, if company XYZ is paying $.25 per quarter ($1.00 per year and XYZ is trading at $10per share, the yield is 10%. A company paying no or low dividends (zero or low yield) is reallysaying to its investors -- its owners, "We believe we can earn more, and return more value toshareholders by retaining the earnings, by putting that money to work, than by paying it out and nothaving it to invest in new plant or goods or salaries." And having said that, they are expected toearn a good return on not only their previous equity, but on the increased equity represented byretained earnings.

    So a company whose book value last year was $10 and who retains its entire $1.50 earningsincreases its book value to 11.50 less certain expenses. That increased book value - let's say it isnow $11 -- means the company must earn at least $1.65 this year Just to keep up with its 15%return on equity. If the company earns $1.80, the owners have indeed made a good investment, andother investors, seeking to get in on a good thing, bid up the price.

    That's the theory anyway. In spite of that, many investors still buy or sell based on what somecommentator says or on announcement of a new product or on the hiring (or resignation) of a keyofficer, or on general sexiness of the company's products. And that will always happen.

    Preferred Shares

    Preferred stocks combine characteristics of common stocks and bonds. Garden-variety preferredshares are a lot like general obligation bonds/debentures; they are called shares, but carry with thema set dividend, much like the interest on a bond. Preferred shares also do not normally vote, whichdistinguishes them from the common shares. While today there are a lot of different kinds of hybridpreferred issues, such as a call on the gold production of Freeport McMoran Copper and Gold tothe point where they will deliver it, we will consider characteristics of the most ordinary variety ofpreferred shares. In general, a preferred has a fixed dividend (as a bond pays interest), aredemption price (as a bond), and perhaps a redemption date (like a bond). Unlike a stock, itnormally does not participate in the appreciation (or drop) of the common stock (it trades like a

    bond). Preferreds can be thought of as the lowest-possible grade bonds. The big point is that thedividend must be paid from after-tax money, making them a very expensive form of capitalization.

    One difference from bonds is that in liquidation (e.g. following bankruptcy), bondholder claimshave priority over preferred shares, which in turn have priority over common shares (in that sense,the preferred shares are "preferred"). These shares are also preferred (hence the name) with respectto payment of dividends, while common shares may have a rising, falling or omitted dividends.Normally a common dividend may not be paid unless the preferred shares are fully paid. In many

    6

  • 8/9/2019 Stock Basics 2

    7/52

    Infosys Technologies Limited, SBU2

    cases (sometimes called "cumulative preferred"), not only must the current preferred dividend bepaid, but also any missed preferred dividends (from earlier time periods) must be made up beforeany common dividend may be paid.

    Basically, preferreds stand between the bonds and the common shares in the pecking order. So if acompany goes bankrupt, and the bondholders get paid off, the preferreds have next call on theassets - and unless they get something, the common shareholders don't either.

    Some preferred shares also carry with them a conversion privilege (and hence may be called"convertible preferred"), normally at a fixed number of shares of common per share of preferred. Ifthe value of the common shares into which a preferred share maybe converted is low, the preferredwill perform price-wise as if it were a bond; that is often the case soon after issue. If, however, thecommon shares rise in value enough, the value of the preferred will be determined more by theconversion feature than by its value as a pseudo-bond. Thus, convertible preferred might performlike a bond early in its life (and its value as a pseudo-bond will be a floor under its price) and, if allgoes well, as a (multiple of) common stock later in its life when the conversion value governs.

    And as time has gone on, even more elaborate variations have been introduced. The primary reasonis that a firm can tailor its cost of funds between that of the common stock and bonds by tailoring apreferred issue. But it isn't a bond on the books - and it costs more than common stock.

    American Depositary Receipts (ADRs)

    An American Depositary Receipt (ADR) is a share of stock of an investment in shares of a non-UScorporation. The shares of the non-US corporation trade on a non-US exchange, while the ADRs,perhaps somewhat obviously, trade on a US exchange. This mechanism makes it straightforwardfor a US investor to invest in a foreign issue. ADRs were first introduced in 1927.

    Two banks are generally involved in maintaining an ADR on a US exchange: an investment bankand a depositary bank. The investment bank purchases the foreign shares and offers them for sale inthe US. The depositary bank handles the issuance and cancellation of ADRs certificates backed byordinary shares based on investor orders, as well as other services provided to an issuer of ADRs,but is not involved in selling the ADRs.

    To establish an ADR, an investment bank arranges to buy the shares on a foreign market and issuethe ADRs on the US markets.

    For example, BigCitibank might purchase 25 million shares of a non-US stock. Call it InfosysTechnologies Limited (INFOSYS). Perhaps INFOSYS trades on the Paris exchange, whereBigCitibank bought them. BigCitibank would then register with the SEC and offer for sale sharesof INFOSYS ADRs.

    7

  • 8/9/2019 Stock Basics 2

    8/52

    Infosys Technologies Limited, SBU2

    INFOSYS ADRs are valued in dollars, and BigCitibank could apply to the NYSE to list them. Ineffect, they are repackaged INFOSYS shares, backed by INFOSYS shares owned by BigCitibank,and they would then trade like any other stock on the NYSE.

    BigCitibank would take a management fee for their efforts, and the number of INFOSYS sharesrepresented by INFOSYS ADRs would effectively decrease, so the price would go down a slightamount; or INFOSYS itself might pay BigCitibank their fee in return for helping to establish a USmarket for INFOSYS. Naturally, currency fluctuations will affect the US Dollar price of the ADR.

    BigCitibank would set up an arrangement with another large financial institution for that institutionto act as the depositary bank for the ADRs. The depositary would handle the day-to-day interactionwith holders of the ADRs.

    Dividends paid by INFOSYS are received by BigCitibank and distributed proportionally toINFOSYS ADR holders. If INFOSYS withholds (foreign) tax on the dividends before thisdistribution, then BigCitibank will withhold a proportional amount before distributing the dividendto ADR holders, and will report on a Form 1099-Div both the gross dividend and the amount offoreign tax withheld.

    Dividends

    Dividend, as discussed earlier, is nothing but the portion of the profit, which is distributed amongthe shareholders. Dividend is always a percentage of the face value of the share. If the face value ofthe stock is $10, and the company declares 10% dividend, then you get $1 for each share you hold.Now remember that, not all of profit is distributed. Part of it is retained so that it can be used forfurther growth of the company or some contingency. This part is aptly called Reserve.

    A company may periodically declare cash and/or stock dividends

    . This article deals with cashdividends on common stock. Two paragraphs also discuss dividends on Mutual Fund shares. Aseparate article elsewhere in this manual discusses stock splits and stock dividends.

    The Board of Directors of a company decides if it will declare a dividend, how often it will declareit, and the dates associated with the dividend. Quarterly payment of dividends is very common,annually or semiannually is less common, and many companies don't pay dividends at all. Othercompanies from time to time will declare an extra or special dividend. Mutual funds sometimesdeclare a year-end dividend and maybe one or more other dividends.

    If the Board declares a dividend, it will announce that the dividend (of a set amount) will be paid to

    Shareholders of record as of the RECORD DATE

    and will be paid or distributed on the

    Stock dividend is nothing but the dividend in forms of stock and is the distribution of stocks to the existing stockholders as apercentage of the present holding. If the stock dividend is 1:2, you will get 1 stock extra for every 2 stocks you hold.

    Record Date: The date on which the tally is taken for who the shareholders are. The shareholders as of that date are eligible fordividend. So if you buy some stock and sold it just before the record date, you can as well forget the dividend. So bad !!!

    8

  • 8/9/2019 Stock Basics 2

    9/52

    Infosys Technologies Limited, SBU2

    DISTRIBUTION DATE (sometimes called the Payable Date).

    Before we begin the discussion of dates and date cutoffs, it's important to note that three-daysettlements (T+3) became effective 7 June 1995. In other words, the SEC's T+3 rule states that allstock trades must be settled within 3 business days.

    In order to be a shareholder of record on the RECORD DATE you must own the shares on that date(when the books close for that day). Since virtually all stock trades by brokers on exchanges aresettled in 3 (business) days, you must buy the shares at least 3 days before the RECORD DATE inorder to be the shareholder of record on the RECORD DATE. So the (RECORD DATE - 3 days) isthe day that the shareholder of record needs to own the stock to collect the dividend. He can sell itthe very next day and still get the dividend.

    If you bought it at least 3 business days before the RECORD date and still owned it at the end ofthe RECORD DATE, you get the dividend. (Even if you ask your broker to sell it the day after the(RECORD DATE - 3 days), it will not have settled until after the RECORD DATE so you will ownit on the RECORD DATE.)

    So someone who buys the stock on the (RECORD DATE - 2 days) does not get the dividend. Astock paying a 50c quarterly dividend might well be expected to trade for 50c less on that date, allthings being equal. In other words, it trades for its previous price, Except for the Dividend. So the(RECORD DATE - 2 days) is often called the EX-DIV date. In the financial listings, an x indicatesthat.

    How can you try to predict what the dividend will be before it is declared?

    Many companies declare regulardividends every quarter, so if you look at the last dividend paid,

    you can guess the next dividend will be the same. Exception: when the Board of IBM, for example,announces it can no longer guarantee to maintain the dividend, you might well expect the dividendto drop, drastically, next quarter. The financial listings in the newspapers show the expectedannual dividend, and other listings show the dividends declared by Boards of directors theprevious day, along with their dates.

    Other companies declare less regular dividends. Companies, whose shares trade as are verydependent on currency market fluctuations, so will pay differing amounts from time to time.Some companies may be temporarily prohibited from paying dividends on their common stock,usually because they have missed payments on their bonds and/or preferred stock.

    On the DISTRIBUTION DATE shareholders of record on the RECORD date will get the dividend.If you own the shares yourself, the company will mail you a check. If you participate in a DRIP(Dividend reinvestment Plan, see article on DRIPs elsewhere in this manual) and elect to reinvest

    the dividend, you will have the dividend credited to your DRIP account and purchase shares, andif your stock is held by your broker for you, the broker will receive the dividend from the companyand credit it to your account.

    9

  • 8/9/2019 Stock Basics 2

    10/52

    Infosys Technologies Limited, SBU2

    Dividends on preferred stock work very much like common stock, except they are much morepredictable. Since most of the time they are mentioned at the time of issue.

    Finally, just a bit of accounting information. Earnings are always calculated first, and then thedirectors of a company decide what to do with those earnings. They can distribute the earnings tothe stockholders in the form of dividends, retain the earnings, or take the money and head forBrazil (NB: the last option tends to make the stockholders angry and get the local district attorneyon the case :-). Utilities and seasonal companies often pay out dividends that exceed earnings - thistends to prop up the stock price nicely - but of course no company can do that year after year.

    Types of Indexes:

    Indexes are the barometers of the market and are indicators of how the market is moving. They areconstructed by taking some of the stocks, which are indicative of the market. The sample is suchthat they represent various sectors of economy. The better the sampling, the better is the indication.They are constructed by taking n number of stocks. The examples below give idea about variousindexes. This list is by no way exhaustive. Investors use different indexes depending upon theirrequirements. For example the mutual funds use indexes, which are fairly broad based (That is inindex, which is constructed by taking more number of shares into consideration. The reason -Better sample which will represent the market better).

    There are three major classes of indexes in use today in the US. They are:

    A - equally weighted price indexAn example is the Dow Jones Industrial AverageB - market-capitalization-weighted indexAn example is the S&P Industrial AverageC - equally-weighted returns indexThe only one of its kind is the Value-Line index.

    Of these, A and B are widely used.

    Type A indexAs the name suggests, the index is calculated by taking the average of the prices of a set of

    companies:

    Index = Sum(Prices of N companies) / N

    Type B indexIn this index, each of the N company's price is weighted by the market capitalization of the

    company.

    Sum (Company market capitalization * Price) over N companiesIndex = ------------------------------------------------------------

    Market capitalization for these N companies

    10

  • 8/9/2019 Stock Basics 2

    11/52

    Infosys Technologies Limited, SBU2

    Type C indexHere the index is the average of the returns of a certain set of companies. Value Line publishes

    two versions of it:

    the arithmetic index : (VLAI/N) = 1 * Sum(N returns)the geometric index : VLGI = {Product(1 + return) over N}^{1/n}, which is just the

    geometric mean of the N returns.

    The Dow Jones Industrial Average

    The Dow Jones averages are computed by summing the prices of the stocks in the average and thendividing by a constant called the "divisor". The divisor for the Dow Jones Industrial Average(DJIA) is adjusted periodically to reflect splits in the stocks making up the average. The divisorwas originally 30 but has been reduced over the years to a value far less than one. The current valueof the divisor is about 0.35; the precise value is published in the Wall Street Journal and Barron's.

    According to Dow Jones, the industrial average started out with 12 stocks in 1896. Those originalstocks, for all of you trivia buffs out there, were American Cotton Oil, American Sugar, AmericanTobacco, Chicago Gas, Distilling and Cattle Feeding, General Electric (the only survivor), LacledeGas, National Lead, North American, Tennesee Coal and Iron, U.S. Leather preferred, and U.S.Rubber. The number of stocks was increased to 20 in 1916. The 30-stock average made its debut in1928, and the number has remained constant ever since.

    The most recent change was made effective 17 March 1997, when Hewlett-Packard, Johnson &Johnson, Travelers Group, and Wal-Mart joined the average, replacing Bethlehem Steel, Texaco,Westinghouse Electric and Woolworth.

    Other Indexes

    US Indexes:

    AMEX CompositeA capitalization-weighted index of all stocks trading on the ASE.

    NASDAQ 100The 100 largest non-financial stocks on the NASDAQ exchange.

    NASDAQ CompositeMidcap index made up of all the OTC stocks that trade on the NASDAQ Market System.15% of the US market.

    NYSE CompositeA capitalization-weighted index of all stocks trading on the NYSE.

    11

  • 8/9/2019 Stock Basics 2

    12/52

    Infosys Technologies Limited, SBU2

    Standard & Poor's 500Made up of 400 industrial stocks, 20 transportation stocks, 40 utility, and 40 financial.Market value (#of common shares * price per share) weighted. Dividend returns notincluded in index. Represents about 70% of US stock market. Cap range 73 to 75,000million.

    Value Line CompositeIt is a price-weighted index as opposed to a capitalization index. Many think this givesbetter tracking of investment results, since it is not over-weighted in IBM, for example, andmost individuals are likewise not weighted by market cap in their portfolios (unless theybuy index funds).

    Non-US Indexes:

    CAC-40 (France)The CAC-Quarante, this is 40 stocks on the Paris Stock Exchange formed into an index.The futures contract on this index is probably the most heavily traded futures contract inthe world.

    DAX (Germany)The German share index DAX tracks the 30 most heavily traded stocks (based on the pastthree years of data) on the Frankfurt exchange.

    FTSE-100 (Great Britain)Commonly known as 'footsie'. Consists of a weighted arithmetical index of 100 leading UKequities by market capitalization. Calculated on a minute-by-minute basis. The footsiebasically represents the bulk of the UK market activity.

    Nikkei (Japan)"Nikkei" is an abbreviation of "nihon keizai" -- "nihon" is Japanese for "Japan", while"keizai" is "business, finance, economy" etc. Nikkei is also the name of Japan's version ofthe WSJ. The nikkei is sometimes called the "Japanese Dow," in that it is the most popularand commonly quoted Japanese market index.

    BSE (Sensex)A capitalization weighted index, which is constructed by taking 30 blue chip shares intoconsideration. The selection of the shares is done one basis of various parameters. Some ofthem are market capitalization, Number of floating shares, Volume of transaction etc.

    NSE (Nifty)A capitalization weighted index, which has been constructed by taking 50 shares intoconsideration.

    IPOs (Initial Public Offerings)

    Introduction to IPOs

    12

  • 8/9/2019 Stock Basics 2

    13/52

    Infosys Technologies Limited, SBU2

    When a company whose stock is not publicly traded wants to offer that stock to the general public,it usually asks an "underwriter" to help it do this work. The underwriter is almost always aninvestment banking company, and the underwriter may put together a syndicate of severalinvestment banking companies and brokers. The underwriter agrees to pay the issuer a certain pricefor a minimum number of shares, and then must resell those shares to buyers, often clients of theunderwriting firm or its commercial brokerage cousin. Each member of the syndicate will agree toresell a certain number of shares. The underwriters charge a fee for their services.

    For example, if BigGlom Corporation (BGC) wants to offer its privately- held stock to the public,it may contact BigBankBrokers (BBB) to handle the underwriting. BGC and BBB may agree that1 million shares of BGC common will be offered to the public at $10 per share. BBB's fee for thisservice will be $0.60 per share, so that BGC receives $9,400,000. BBB may ask several other firmsto join in a syndicate and to help it market these shares to the public.

    A tentative date will be set, and the issuer will issue a preliminary prospectus detailing all sorts offinancial and business information, usually with the underwriter's active assistance.

    Usually, terms and conditions of the offer are subject to change up until the issuer and underwriteragree to the final offer. The issuer then releases the stock to the underwriter and the underwriterreleases the stock to the public. It is now up to the underwriter to make sure those shares get sold,or else the underwriter is stuck with the shares.

    The issuer and the underwriting syndicate jointly determine the price of a new issue. Theapproximate price listed in the red herring (the preliminary prospectus - often with words in redletters which say this is preliminary and the price is not yet set) may or may not be close to the finalissue price.

    Consider NetManage, NETM, which started trading on NASDAQ on Tuesday, 21 Sep 1993. Thepreliminary prospectus said they expected to release the stock at $9-10 per share. It was released at$16/share and traded two days later at $26+. In this case, there could have been sufficient demandthat both the issuer (who would like to set the price as high as possible) and the underwriters (whoreceive a commission of perhaps 6%, but who also must resell the entire issue) agreed to issue at16. If it then jumped to 26 on or slightly after opening, both parties underestimated demand. Thishappens fairly often.

    The Mechanics of Stock Offerings

    The Securities Act of 1933, also known as the Full Disclosure Act, the New Issues Act, the Truth inSecurities Act, and the Prospectus Act governs the issue of new issue corporate securities. TheSecurities Act of 1933 attempts to protect investors by requiring full disclosure of all materialinformation in connection with the offering of new securities. Part of meeting the full disclosureclause of the Act of 1933, requires that corporate issuers must file a registration statement andpreliminary prospectus (also know as a red herring) with the SEC. The Registration statement mustcontain the following information:

    13

  • 8/9/2019 Stock Basics 2

    14/52

    Infosys Technologies Limited, SBU2

    1. A description of the issuer's business.2. The names and addresses of the key company officers, with salary and a 5 yearbusiness history on each.3. The amount of ownership of the key officers.4. The company's capitalization and description of how the proceeds from the offeringwill be used. Any legal proceedings that the company is involved in.

    Once the registration statement and preliminary prospectus are filed with the SEC, a 20 daycooling-off period begins. During the cooling-off period the new issue may be discussed withpotential buyers, but the broker is prohibited from sending any materials (including Value Line andS&P sheets) other than the preliminary prospectus.

    Testing receptivity to the new issue is known as gathering "indications of interest." An indication ofinterest does not obligate or bind the customer to purchase the issue when it becomes available,since all sales are prohibited until the security has cleared registration.

    A final prospectus is issued when the registration statement becomes effective (when theregistration statement has cleared). The final prospectus contains all of the information in thepreliminary prospectus (plus any amendments), as well as the final price of the issue, and theunderwriting spread.

    The clearing of a security for distribution does not indicate that the SEC approves of the issue. TheSEC ensures only that all necessary information has been filed, but does not attest to the accuracyof the information, nor does it pass judgment on the investment merit of the issue. Anyrepresentation that the SEC has approved of the issue is a violation of federal law.

    The Underwriting Process

    The underwriting process begins with the decision of what type of offering the company needs. Thecompany usually consults with an investment banker to determine how best to structure the offeringand how it should be distributed.

    Securities are usually offered in either the new issue, or the additional issue market. Initial PublicOfferings (IPOs) are issues from companies first going public, while additional issues are fromcompanies that are already publicly traded.

    In addition to the IPO and additional issue offerings, offerings may be further classified as:

    Primary Offerings: Proceeds go to the issuing corporation.

    Secondary Offerings: Proceeds go to a major stockholder who is selling all or part of his/herequity in the corporation.

    Split Offerings: A combination of primary and secondary offerings.

    Shelf Offering: Under SEC Rule 415 - allows the issuer to sell securities over a two year periodas the funds are needed.

    14

  • 8/9/2019 Stock Basics 2

    15/52

    Infosys Technologies Limited, SBU2

    The next step in the underwriting process is to form the syndicate (and selling group if needed).Because most new issues are too large for one underwriter to effectively manage, the investmentbanker, also known as the underwriting manager, invites other investment bankers to participate ina joint distribution of the offering. The group of investment bankers is known as the syndicate.Members of the syndicate usually make a firm commitment to distribute a certain percentage of theentire offering and are held financially responsible for any unsold portions. Selling groups ofchosen brokerages, are often formed to assist the syndicate members meet their obligations todistribute the new securities. Members of the selling group usually act on a " best efforts" basis andare not financially responsible for any unsold portions.

    Under the most common type of underwriting, firm commitment, the managing underwriter makesa commitment to the issuing corporation to purchase all shares being offered. If part of the newissue goes unsold, any losses are distributed among the members of the syndicate.

    Whenever new shares are issued, there is a spread between what the underwriters buy the stockfrom the issuing corporation for and the price at which the shares are offered to the public (PublicOffering Price, POP). The price paid to the issuer is known as the underwriting proceeds. Thespread between the POP and the underwriting proceeds is split into the following components:

    Manager's Fee: Goes to the managing underwriter for negotiating and managing theoffering.

    Underwriting Fee: Goes to the managing underwriter and syndicate members forassuming the risk of buying the securities from the issuing corporation.

    Selling Concession - Goes to the managing underwriter, the syndicate members, andto selling group members for placing the securities with investors.

    The underwriting fee is usually distributed to the three groups in the following percentages:

    Manager's Fee 10% - 20% of the spread

    Underwriting Fee 20% - 30% of the spread

    Selling Concession 50% - 60% of the spread

    In most underwritings, the underwriting manager agrees to maintain a secondary market for thenewly issued securities. In the case of "hot issues" there is already a demand in the secondarymarket and no stabilization of the stock price is needed. However many times the managingunderwriter will need to stabilize the price to keep it from falling too far below the POP. SEC Rule

    10b-7 outlines what steps are considered stabilization and what constitutes market manipulation.The managing underwriter may enter bids (offers to buy) at prices that bear little or no relationshipto actual supply and demand, just so as the bid does not exceed the POP. In addition, theunderwriter may not enter a stabilizing bid higher than the highest bid of an independent marketmaker, nor may the underwriter buy stock ahead of an independent market maker.

    Managing underwriters may also discourage selling through the use of a syndicate penalty bid.Although the customer is not penalized, both the broker and the brokerage firm are required to

    15

  • 8/9/2019 Stock Basics 2

    16/52

    Infosys Technologies Limited, SBU2

    rebate the selling concession back to the syndicate. Many brokerages will further penalize thebroker by also requiring that the commission from the sell be rebated back to the brokerage firm.

    Market Capitalization

    The market capitalization (or "cap") of a stock is simply the market value of all outstanding sharesand is computed by multiplying the market price by the number of outstanding shares. Forexample, a publicly held company with 10 million shares outstanding that trade at US$20 eachwould have a market capitalization of 200 million US$.

    The value for a stock's "cap" is used to segment the universe of stocks into various chunks,including large-cap, mid-cap, and small-cap, etc. There are no hard-and-fast rules that defineprecisely what it means for a company to be in one of these categories, but there is some generalagreement. Generally

    Large-cap: Over $5 billion

    Mid-cap: $500 million to $5 billion

    Small-cap: $150 million to $500 million

    Micro-cap: Below $150 million

    Repurchasing by Companies (Also called Buy back)

    Companies may repurchase their own stock on the open market, usually common shares, for manyreasons. In theory, the buyback should not be a short-term fix to the stock price but a rational use ofcash, implying that a company's best investment alternative is to buy back its stock. Normally these

    purchases are done with free cash flow, but not always. What happens is that if earnings stayconstant, the reduced number of shares will result in higher earnings per share, which, all else beingequal will result, should result, in a higher stock price.

    But note that there is a difference between announcing a buyback and actually buying back stock.Just the announcement usually helps the stock price, but what really counts is that they actuallybuy back stock. Not all "announced share buybacks" are actually implemented. Some areannounced just for the short-term bounce that usually comes with the announcement.

    Stock Splits

    Ordinary splits occur when a publicly held company distributes more stock to holders of existingstock. A stock split, say 2-for-1, is when a company simply issues one additional share for everyone outstanding. After the split, there will be two shares for every one pre-split share. (So it iscalled a "2-for-1 split.") If the stock was at $50 per share, after the split, each share is worth $25,because the company's net assets didn't increase, only the number of outstanding shares.

    16

  • 8/9/2019 Stock Basics 2

    17/52

    Infosys Technologies Limited, SBU2

    Sometimes an ordinary split is referred in terms of percentage. A 2:1 split is a 100% stock split canalso be called 100% stock dividend or 100% stock split. (A 50% split would be a 3:2 split or 50%stock dividend). Each stockholder will get 1 more share of stock for every 2 shares owned.

    Reverse splits occur when a company wants to raise the price of their stock, so it no longer lookslike a "penny stock" but looks more like a self-respecting stock. Or they might want to conduct amassive reverse split to eliminate small holders. If a $1 stock is split 1:10 the new shares will beworth $10. Holders will have to trade in their 10 Old Shares to receive 1 New Share.

    Warrants

    A warrant is a financial instrument, which was issued with certain conditions. The issuer of thatwarrant sets those conditions. Sometimes the warrant and common or preferred convertible stockare issued by a startup company bundled together as "units" and at some later date the units willsplit into warrants and stock. This is a common financing method for some startup companies.

    As an example of a "condition," there may be an exchange privilege which lets you exchange 1warrant plus $25 in cash (or even no cash at all) for 100 shares of common stock in the corporation,any time after some fixed date and before some other designated date. (And often the issuer canextend the "expiration date.")

    So there are some similarities between warrants and call options for common stock.

    Both allow holders to exercise the warrant/option before an expiration date, for a certain number ofshares. But independent parties, such as a member of the Chicago Board Options Exchange, issuethe option while the warrant is issued and guaranteed by the corporate issuer itself. The lifetime ofa warrant is often measured in years, while the lifetime of a call option in months. Sometimes theissuer will try to establish a market for the warrant, and even try to register it with a listedexchange. The price can then be obtained from any broker. Other times the warrant will beprivately held, or not registered with an exchange, and the price is less obvious, as is true with non-listed stocks.

    17

  • 8/9/2019 Stock Basics 2

    18/52

    Infosys Technologies Limited, SBU2

    Bonds - Basics

    A bond is just an organization's IOU; i.e., a promise to repay a sum of money at a certain interest

    rate and over a certain period of time. In other words, a bond is a debt instrument

    . Other commonterms for these debt instruments are notes and debentures. Most bonds pay a fixed rate of interest

    (variable rate

    bonds are slowly coming into more use though) for a fixed period of time.

    Why do organizations issue bonds? Let's say a corporation needs to build a new office building, orneeds to purchase manufacturing equipment, or needs to purchase aircraft. Or maybe a citygovernment needs to construct a new school, repair streets, or renovate the sewers. Whatever theneed, a large sum of money will be needed to get the job done.

    One way is to arrange for banks or others to lend the money. But a generally less expensive way isto issue (sell) bonds. The organization will agree to pay some interest rate on the bonds and further

    agree to redeem the bonds (i.e., buy them back) at some time in the future (the redemption date).This process is nothing but the taking back of the certificate and returning of the principal.

    Companies of all sizes issue corporate bonds. Bondholders are not owners of the corporation. But ifthe company gets in financial trouble and needs to dissolve, bondholders must be paid off in fullbefore stockholders get anything. If the corporation defaults on any bond payment, any bondholdercan go into bankruptcy court and request the corporation be placed in bankruptcy.

    Municipal bonds are issued by cities, states, and other local agencies and may or may not be as safeas corporate bonds. The taxing authority of the state of town backs some municipal bonds, whileothers rely on earning income to pay the bond interest and principal. Municipal bonds are not

    taxable by the federal government (some might be subject to A Minimum Tax, AMT) and so don'thave to pay as much interest as equivalent corporate bonds.

    U.S. Bonds are issued by the Treasury Department and other government agencies and areconsidered to be safer than corporate bonds, so they pay less interest than similar term corporatebonds. Treasury bonds are not taxable by the state and some states do not tax bonds of othergovernment agencies. Shorter-term bonds are called notes and much shorter term bonds (a year orless) are called bills, and these have different minimum purchase amounts.

    Debt instruments are nothing but loans taken by either company or the govt. or the municipality. There are varioustypes of debt instruments like debenture, bond, notes, bills and many more. The name varies depending upon the issueror nature of the instrument. But one common characteristic of most of them is that, they all carry some coupon Interestrate. I say most and not all because Zero coupon bonds do not carry any coupon rate. We will discuss about theseinstruments else where in this document.

    Variable rate of interest: The interest of these securities are linked to some reference rate, many cases to LIBOR(London Inter Bank Offer Rate). They may be some basis points above LIBOR, say 200 basis points. This meansLIBOR + 2%. If LIBOR is 5%, then the interest comes to 7%. Depending upon the LIBOR movement, the interest rateon the bond also varies.

    18

  • 8/9/2019 Stock Basics 2

    19/52

    Infosys Technologies Limited, SBU2

    In the U.S., corporate bonds are often issued in units of $1,000. When municipalities issue bonds,they are usually in units of $5,000. Interest payments are usually made every 6 months.

    The price of a bond is a function of prevailing interest rates. As rates go up, the price of the bondgoes down, because that particular bond becomes less attractive (i.e., pays less interest) whencompared to current offerings. As rates go down, the price of the bond goes up, because thatparticular bond becomes more attractive (i.e., pays more interest) when compared to currentofferings. The price also fluctuates in response to the risk perceived for the debt of the particularorganization. For example, if a company is in bankruptcy, the price of that company's bonds willbe low because there may be considerable doubt that the company will ever be able to redeem thebonds.

    On the redemption date, bonds are usually redeemed at "par", meaning the company pays backexactly what the bondholders paid it way back when. Most bonds also allow the bond issuer toredeem the bonds at any time before the redemption date, usually at par but sometimes at a higherprice. This is known as "calling" the bonds and frequently happens when interest rates fall, becausethe company can sell new bonds at a lower interest rate (also called the "coupon") and pay off theolder, more expensive bonds with the proceeds of the new sale. By doing so the company may beable to lower their cost of funds considerably.

    Who buys bonds? Many individuals buy bonds. And of course Investment banks like GoldmanSachs buy bonds. Banks buy bonds. Money market funds often need short-term cash equivalents,so they buy bonds expiring in a short time. People who are very adverse to risk might buy USTreasuries, as they are the standard for safety. Foreign governments whose own economy is veryshaky often buy Treasuries.

    In general, bonds pay a bit more interest than federally insured instruments such as Certificate of

    Deposit, (CD) because the bond buyer is taking on more risk as compared to buying a CD. Manyrating services (Moody's is probably the largest) help bond buyers assess the risks of any bond issueby rating them

    Moody Bond Ratings

    Moody's Bond Ratings are intended to characterize the risk of holding a bond. These ratings, or riskassessments, in part determine the interest that an issuer must pay to attract purchasers to the bonds.All information herein was obtained from Moody's Bond Record. The symbols used are AAA, AA,BAA, etc. They symbolize the risk associated with that particular instrument as regards to the

    payment of principle and the interest. Another rating agency which is not as big, neverthelessfamous is Standard & Poor' (Popularly known as S&P). They have different symbols for denotingvarious degrees of risk associated with the debt instruments.

    19

  • 8/9/2019 Stock Basics 2

    20/52

    Infosys Technologies Limited, SBU2

    Bond Terminology

    Advance Refunding:

    The replacement of debt prior to the original call date

    via the issuance of refunding bonds.

    Callable Bond:A bond that can be redeemed by the issuer prior to its maturity. Usually a premium is paid to thebond owner when the bond is called.

    Certificate of Participation (COP):Financing whereby an investor purchases a share of the lease revenues of a program rather than thebond being secured by those revenues. Usually issued by authorities through which capital is raisedand lease payments are made. The authority usually uses the proceeds to construct a facility that isleased to the municipality, releasing the municipality from restrictions on the amount of debt thatthey can incur.

    Discount Bond:A bond that is valued at less than its face amount.

    Double Barreled:Bonds secured by the pledge of two or more sources of repayment.

    Face Value:The stated principal amount of a bond. Also called par value. Bond issued below this price arecalled below par and the ones which are issued above the face value, are called above par.

    Par Value:The face value of a bond, generally $1,000.

    Premium Bond:A bond that is valued at more than its face amount.

    Principal:The amount owed; the face value of a debt.

    Revenue Bonds:Bonds secured by the revenues derived from a particular service provided by the issuer.

    Sinking Fund:A bond with special funds set aside to retire the term bonds of a revenue issued each year accordingto a set schedule. Usually takes effect 15 years from date of issuance. Bonds are retired throughcalls, open market purchases, or tenders.

    See Options Basics for detailed explanation

    20

  • 8/9/2019 Stock Basics 2

    21/52

    Infosys Technologies Limited, SBU2

    Yield:A measure of the income generated by a bond. The amount of interest paid on a bond divided bythe price.

    Yield to Maturity:

    The rate of return1

    (ROR) anticipated on a bond if it is held until the maturity date.

    Relationship of Price and Interest Rate

    The basic relationship between the price of a bond and prevailing market interest rates is aninverse relationship. This is actually pretty straightforward. For example, if you have a 6% bond(this means that it pays $60 annually per $1000 of face value) and interest rates jump to 8%,wouldn't you agree that your bond should be worth less now if you were to sell it?

    Treasury Debt Instruments

    The US Treasury Department periodically borrows money and issues IOUs in the form of bills,notes, or bonds ("Treasuries"). The differences are in their maturities and denominations:

    Bill Note BondMaturity Up to 1 year 1-10 years 10-30/40 years

    Denomination $1,000 $1,000 $1,000Minimum $10,000 $1,000 $1,000

    Zero-Coupon bonds

    Not too many years ago every bond had coupons attached to it. Every so often, usually every 6months, bond owners would take a scissors to the bond, clip out the coupon, and present the couponto the bond issuer or to a bank for payment. Those were "bearer bonds" meaning the bearer (theperson who had physical possession of the bond) owned it. Today, many bonds are issued as

    "registered" which means even if you don't get to touch the actual bond at all, it will be registeredin your name and interest will be mailed to you every 6 months. It is not too common to see suchcoupons. Registered bonds will not generally have coupons, but may still pay interest each year. It'ssort of like the issuer is clipping the coupons for you and mailing you a check. But if they payinterest periodically, they are still called Coupon Bonds, just as if the coupons were attached.

    Rate of return is the amount you get back on the principal and is always in percentage term.

    21

  • 8/9/2019 Stock Basics 2

    22/52

    Infosys Technologies Limited, SBU2

    When the bond matures, the issuer redeems the bond and pays you the face amount. You may havepaid $1000 for the bond 20 years ago and you have received interest every 6 months for the last 20years, and you now redeem the matured bond for $1000.

    A Zero-coupon bond has no coupons and there is no interest paid. But at maturity, the issuerpromises to redeem the bond at face value. Obviously, the original cost of a $1000 bond is muchless than $1000. The actual price depends on: a) the holding period -- the number of years tomaturity, b) the prevailing interest rates, and c) the risk involved (with the bond issuer).

    The US Treasury also issues Zero Coupon Bonds. The ``Separate Trading of Registered Interestand Principal of Securities'' (a.k.a. STRIPS) program was introduced in February 1986. All new T-Bonds and T-notes with maturities greater than 10 years are eligible. As of 1987, the securitiesclear through the Federal Reserve's books entry system. As of December 1988, 65% of the ZERO-COUPON Treasury market consisted of those created under the STRIPS program.

    22

  • 8/9/2019 Stock Basics 2

    23/52

    Infosys Technologies Limited, SBU2

    Derivatives - Basics

    A derivative is a financial instrument that does not constitute ownership, but a promise to convey

    ownership. Examples are options and futures. The simplest example is a call option on a stock. Inthe case of a call option, the risk is that the person who writes the call (sells it and assumes the risk)may not be in business to live up to their promise when the time comes. In standardized optionssold through the Options Clearing House, there are supposed to be sufficient safeguards for thesmall investor against this.

    Before discussing derivatives, it's important to describe their basis. All derivatives are based onsome underlying cash product hence the name derivative. These "cash" products are:

    Spot Foreign Exchange: This is the buying and selling of foreign currency at the exchange ratesthat you see quoted on the news. As these rates change relative to your "home currency" (dollars if

    you are in the US), so you make or lose money.

    Commodities: These include grain, pork bellies, coffee beans, orange juice, etc.

    Equities (termed "stocks" in the US): Generally the common shares of various companies.

    Bonds of various different varieties (e.g., they may be Eurobonds, domestic bonds, fixed interest/ floating rate notes, etc.). Bonds are medium to long-term negotiable debt securities issued bygovernments, government agencies, federal bodies (states), supra-national organizations such as theWorld Bank, and companies. Negotiable means that they may be freely traded without reference tothe issuer of the security. That they are debt securities means that in the event that the company

    goes bankrupt. Bondholders will be repaid their debt in full before the holders of unsecuritised debtget any of their principal back.

    Short term ("money market") negotiable debt securities such as T-Bills (issued bygovernments), Commercial Paper (issued by companies) or Bankers Acceptances. These are muchlike bonds, differing mainly in their maturity "Short" term is usually defined as being up to 1 yearin maturity. "Medium term" is commonly taken to mean form 1 to 5 years in maturity, and "longterm" anything above that.

    Over the Counter ("OTC") money market products such as loans / deposits. These products arebased upon borrowing or lending. They are known as "over the counter" because each trade is an

    individual contract between the 2 counter parties making the trade. They are neither negotiable norsecuritised. Hence if I lend your company money, I cannot trade that loan contract to someone elsewithout your prior consent. Additionally if you default, I will not get paid until holders of yourcompany's debt securities are repaid in full. I will however, be paid in full before the equity holderssee a penny.

    23

  • 8/9/2019 Stock Basics 2

    24/52

    Infosys Technologies Limited, SBU2

    Derivative products are contracts, which have been constructed, based on one of the "cash"products described above. Examples of these products include options and futures. Futures arecommonly available in the following flavors (defined by the underlying "cash" product):

    Commodity futures

    Stock index futures

    Interest rate futures (including deposit futures, bill futures and government bondfutures)

    Futures

    Roughly speaking, a futures contract is an agreement to buy (or sell) some commodity at a fixedprice on a fixed date. Futures are commonly available in the following flavors (defined by theunderlying "cash" product):

    Commodity futuresA commodity future, for example an orange-juice future contract, gives you the right to buy (orsell) some huge amount of orange juice at a fixed price on some date.

    Stock index futuresSince you can't really buy an index, these are settled in cash.

    Interest rate futures (including deposit futures, bill futures and government bond futures)

    These are usually settled in cash as well.

    Futures are explicitly designed to allow the transfer of risk from those who want less risk to thosewho want more risk. They do this by offering several features:

    1. Liquidity2. Leverage (a small amount of money controls a much larger amount) A high degreeof correlation between changes in the futures price and changes in price of the underlyinginstrument.

    This is usually ensured via the mechanism of basis trading. In the case of the commodity future, if Isell you a commodity future then I am promising to deliver X amount of the commodity to you at agiven price (fixed now) at a given date in the future.

    This means that if the price of the future becomes too high relative to the price of the commoditytoday, I can borrow money to buy the commodity now and sell a futures contract (on margin). Ifthe difference in price between the two is great enough then I will be able to repay the interest andprincipal on the loan and still have some risk less profit i.e. a pure arbitrage.

    Conversely, if the price of the future falls too far below that of the commodity, then I can sell thecommodity short and purchase the future. I can (presumably) borrow the commodity until the

    24

  • 8/9/2019 Stock Basics 2

    25/52

    Infosys Technologies Limited, SBU2

    futures delivery date and then cover my short when I take delivery of some of the commodity at thefutures delivery date. I say presumably borrow the commodity since this is the way bond futuresare designed to work; I am not certain that commodities can be borrowed.

    Either of these 2 arbitrage trades are known as "basis trades" as you are trading the "basis" (don'task me why it's called that) between the future and the underlying "cash product".

    Stock Option Basics

    An option is a contract between a buyer and a seller. The option is connected to something, such asa listed stock, an exchange index, futures contracts, or real estate. For simplicity, this article willdiscuss only options connected to listed stocks. An option gives its owner the right to buy or sell anunderlying asset on or before a given date at a fixed price. For example, you may enjoy the optionto buy a certain apartment on or before 31st Dec of this year for $5,00,000. On that date even if themarket price is more than $500,000 (Say $600,000), the option write will be compelled to sell thehouse. On the other hand if the price is less than $500, 000 (say $400,000), the option holder is notobliged to buy the house. Options represent a special kind of financial contract under which theoption holder enjoys the right, but has no obligation, to do something.

    Now let us understand how this instrument originates. The owner of the house may expect that theprice of the house will go down (below $500,000). At the same time some buyer expects that theprice will go up. Since the owner wants $500,000 for the house, he is willing to write an option. Hemay sell the option for say $100. Now if the price goes below $500,000 on the expiry date, thebuyer will not exercise the option and instead will buy another house for the going market price.The loss is only the price of the option i.e. $100. On the other hand if the price goes up then he willexercise the option and buy the house for $500,000. If the market price is $600,000 he will make aprofit of $99,900 ($100,000-100). On the other hand the owner gets lower than the market price.However remember that he was willing to sell it for $500,000 and was afraid that the price may godown. Hence this instrument originates due to varying perceptions of the buyers and sellers. In thereal life options are written for shares, index, etc.

    The key terms and phrases employed in discussing options are as follows.

    Option holder and option writer: The option holder is the buyer of the option and the writer is theseller of the option. (Remember, option is nothing but a contract which binds both buyer and theseller to do a specific act on a certain date.)

    Exercise price and the strike price: The price at which the option holder can buy and/or sell theunderlying asset is called the exercise or the strike price. In the above example strike price is$5,00,000.

    Expiration date or Maturity date: The date when the option expires or matures is referred to asthe expiration date or maturity date. After this date the option is worth less. In the above example31st Dec is the expiry date.

    25

  • 8/9/2019 Stock Basics 2

    26/52

    Infosys Technologies Limited, SBU2

    Exercising the option: The act of buying or selling the underlying asset as per the option contract.

    European and American option: A European option can be exercised only on the date of expiry,where as the American option can be exercised on or before the date of expiry.

    The option is designated by:

    1. Name of the associated stock2. Strike price3. Expiration date4. The premium paid for the option, plus brokers commission.

    The two most popular types of options are Calls and Puts.

    Call Option

    Example: The Wall Street Journal might list an IBM Oct 90 Call @ $2.00. Translation: This is aCall Option. The company associated with it is IBM. The strike price is $90.00. In other words, ifyou own this option, you can buy IBM at $90.00, even if it is then trading on the NYSE @ $100.00.

    The option expires on the third Saturday following the third Friday1

    of October in the year it waspurchased (an option is worthless and useless once it expires). If you want to buy the option, it willcost you $2.00 plus brokers commissions. If you want to sell the option, you will get $2.00 lesscommission.

    In general, options are written on blocks of 100s of shares. So when you buy "1" IBM Oct 90 Call@ $2.00 you actually are buying a contract to buy 100 shares of IBM @ $90 per share ($9,000) onor before the expiration date in October. You will pay $200 plus commission to buy the call.

    If you wish to exercise your option you call your broker and say you want to exercise your option.Your broker will arrange for the person who sold you your option (For we sys guys and girls afinancial fiction: A computer matches up buyers with sellers in a magical way) to sell you 100shares of IBM for $9,000 plus commission.

    If you instead wish to sell (sell=write) that option you instruct your broker that you wish to write 1Call IBM Oct 90s, and the very next day your account will be credited with $200 less commission.If IBM does not reach $90 before the call expires, the option writer gets to keep that $200 (lesscommission) If the stock does reach above $90, you will probably be "called." If you are called youmust deliver the stock. Your broker will sell IBM stock for $9000 (and charge commission). If youowned the stock, that's OK; your shares will simply be sold. If you did not own the stock yourbroker will buy the stock at market price and immediately sell it at $9000. You pay commissionseach way.

    Generally the day is the third Saturday following the third Friday.

    26

  • 8/9/2019 Stock Basics 2

    27/52

    Infosys Technologies Limited, SBU2

    If you write a Call option and own the stock that's called "Covered Call Writing." If you don't ownthe stock its called "Naked Call Writing." It is quite risky to write naked calls, since the price of thestock could zoom up and you would have to buy it at the market price. In fact, some firms willdisallow naked calls altogether for some or all customers. That is, they may require a certain levelof experience (or a big pile of cash).

    When the strike price of a call is above the current market price of the associated stock, the call is"out of the money," and when the strike price of a call is below the current market price of theassociated stock, the call is "in the money." Note that not all options are available at all prices:certain out-of-the-money options might not be able to be bought or sold. There is no point inwriting a Out of Money Call as no one in general will be ready to buy that.

    Options traders rarely exercise the option and buy (or sell) the underlying security. Instead, theybuy back the option (if they originally wrote a put) or sell the option (if the originally bought acall). This saves commissions and all that. For example, you would buy a Feb 70 call today for $7and, hopefully, sell it tomorrow for $8, rather than actually calling the option (giving you the rightto buy stock), buying the underlying stock, then turning around and selling the stock again. Paying

    commissions on those two stock trades gets expensive

    .

    Put Option

    The other common option is the PUT. If you buy a put from me, you gain the right to sell me yourstock at the strike price on or before the expiration date. Puts are almost the mirror-image of calls.Covered puts are a simple means of locking in profits on the covered security, although there arealso some tax implications for this hedging move.

    The expiration of options contributes to the once-per-quarter "triple-witching day." which is a dayon which three derivative instruments all expire on the same day. Stock index futures, stock indexoptions and options on individual stocks all expire on this day, and because of this, trading volumeis usually especially high on the stock exchanges that day. In 1987, the expiration of key indexcontracts was changed from the close of trading on that day to the open of trading on that day,which helped reduce the volatility of the markets somewhat by giving specialists more time tomatch orders.

    You will frequently hear about both volume and open interest in reference to options (really anyderivative contract). Volume is quite simply the number of contracts traded on a given day. Theopen interest is slightly more complicated. The open interest figure for a given option is the numberof contracts outstanding at a given time. The open interest increases (you might say that an openinterest is created) when trader A opens a new position by buying an option from trader B who didnot previously hold a position in that option (B wrote the option, or in the lingo, was "short" theoption). When trader A closes out the position by selling the option, the open interest with either

    Since the commission is some percentage of the price, the price of the stock being more, you will end up paying a lot ofcommission, if you go for exercising of the option and then reversing the process.

    27

  • 8/9/2019 Stock Basics 2

    28/52

    Infosys Technologies Limited, SBU2

    remain the same or go down. If A sells to someone who did not have a position before, or wasalready long, the open interest does not change. If A sells to someone who had a short position, theopen interest decreases by one.

    LEAPs

    A Long-term Equity anticipation Security, or "LEAP", is essentially an option with a much longerterm than traditional stock or index options. Like options, a stock-related LEAP may be a call or aput, meaning that the owner has the right to purchase or sell shares of the stock at a given price onor before some set, future date. Unlike options, the given date may be up to 2.5 years away. LEAPsymbols are three alphabetic characters; those expiring in 1998 begin with W, 1999 with V.

    28

  • 8/9/2019 Stock Basics 2

    29/52

    Infosys Technologies Limited, SBU2

    Exchanges

    Market Makers and Specialists

    Both Market Makers (MMs) and Specialists (specs) make market in stocks. MMs are part of theNational Association of Securities Dealers market (NASD), sometimes called Over The Counter(OTC), and specs work on the New York Stock Exchange (NYSE). These people serve almostsimilar function. (The roles of specialists have been explained in detail in the later sections)

    The NASDAQ

    NASDAQ is an abbreviation for the National Association of Securities Dealers AutomatedQuotation system. It is also commonly, and confusingly, called the OTC market. The NASDAQ

    market is an interdealer market represented by over 600 securities dealers trading more than 15,000different issues. These dealers are called market makers (MMs). Unlike the New York StockExchange (NYSE), the NASDAQ market does not operate as an auction market (see the article onthe NYSE). Instead, market makers are expected to compete against each other to post the bestquotes (best bid/ask prices).

    The New York Stock Exchange

    The NYSE uses an agency auction market system, which is designed to allow the public to meet thepublic as much as possible. The majority of volume (approx 88%) occurs with no intervention from

    the dealer. Specialists (specs) make markets in stocks and work on the NYSE. The responsibility ofa spec is to make a fair and orderly market in the issues assigned to them. They must yield to publicorders which means they may not trade for their own account when there are public bids and offers.The spec has an affirmative obligation to eliminate imbalances of supply and demand when theyoccur. The exchange has strict guidelines for trading depth and continuity that must be observed.Specs are subject to fines and censures if they fail to perform this function. NYSE specs have largecapital requirements and are overseen by Market Surveillance at the NYSE. Specs are required tomake a continuous market. Another auction-based exchange is AMEX (American StockExchange), which accounts for 3% of all exchange volume. NYSE accounts for 85%.

    Over The Counter (OTC)

    The over the counter market (OTC) is not a central physical marketplace but a collection of broker-dealers scattered across the country. This market is more a way of doing business than a place.Buying and selling in unlisted stocks are matched not through the auction process on the floor of anexchange but through negotiated bidding, over a massive network of telephone and teletype wiresthat link thousands of securities firms in the U.S and abroad. Example: NASDAQ

    29

  • 8/9/2019 Stock Basics 2

    30/52

    Infosys Technologies Limited, SBU2

    Trading

    Let us see, as an investor, how you can or will go about investing and once you give the order for

    buy or sell, what events happen. Typically, once you instruct your broker about your order, a chainof events set off. Without going into complete detail on each step, let us trace the process.

    First, let us trace how a round lot order to buy 800 shares of McDonalds. You call up your brokerand find out what is the going market price. Say, the price is $60. Now if you put the market orderthen the chance is that you will get the share for $60. (I am saying chance because, by the time yourorder gets executed, the price may actually change.). Now say you put the order with the broker.Now the written order is wired to NY office of the brokerage firm. From there it is phoned to aclerk of the firm on the floor of the NYSE. The clerk notifies a member partner of the firm (onlymembers are allowed to trade) via an annunciator board system. After collecting the order from theclerk, the member goes to the specialist who is dealing with MCD and confirms the ask and bid

    price. If the price is still $60, he executes the order. The member notes the transaction and withwhom it was made, an exchange reported the transaction for reporting to the ticker, and the phoneclerk phones you saying that the trade has been executed.

    (Please reread the above once again after going through the entire trading chapter to have a betterunderstanding of the whole process.)

    After Hours

    After-hours trading is a form of big-block trading that indeed does occur after the market closes

    for a period of time. Much of this trading is supported by Instinet, a network operated by Reutersthat helps buyers meet sellers (there's no physical exchange where someone like a specialistworks). Apparently, (I am not too sure!!!), this trading is NOT part of the reported closing pricesyou see in the newspapers. The data is apparently reported separately, at least on professional-level data systems. After-hours trading may experience significant deviations in price from theday's close, usually due to announcements made after the markets have closed.

    But even the little guy can play after hours. The other markets can also affect a stock's pricebetween 4PM and 9:30 AM EST. People tend to forget the global view. When the NYSE closes, thePacific Exchange in LA opens. Then the Tokyo market opens around dinnertime in the U.S.Tokyo's closing bell marks the beginning of trading in Johannesburg, followed 2 hours later by

    London. Then, 2 hours before London closes, the NYSE opens back up. All 24 hours are covered byat least one market (the Pacific Exchange from 4 to 7 PM is the only exchange open during thosethree hours, but it completes the 24 hour day.) With so many multinational companies on manydifferent markets, stock prices are inevitably going to have some discrepancy between the closingand opening bells on the Big Board.

    30

  • 8/9/2019 Stock Basics 2

    31/52

    Infosys Technologies Limited, SBU2

    Bid, Ask, and Spread

    If you want to buy or sell a stock or other security on the open market, you normally trade viaagents on the market scene who specialize in that particular security. These people stand ready to

    sell you a security for some asking price (the "ask") if you would like to buy it. Or, if you own thesecurity already and would like to sell it, they will buy the security from you for some offer price(the "bid"). The difference between the bid and ask is called the spread. Stocks that are heavilytraded tend to have very narrow spreads (e.g., 1/8 of a point), but stocks that are lightly traded canhave spreads that are significant, even as high as several dollars.

    So why is there a spread? The short answer is "profit." The long answer goes to the heart of modernmarkets, namely the question of liquidity. Liquidity basically means that someone is ready to buyor sell significant quantities of a security at any time. In the stock market, market makers orspecialists (depending on the exchange) buy stocks from the public at the bid and sell stocks to thepublic at the ask (called "making a market in the stock"). At most times (unless the market is

    crashing, etc.) these people stand ready to make a market in most stocks and often in substantialquantities, thereby maintaining market liquidity.

    Dealers make their living by taking a large part of the spread on each transaction - they normallyare not long-term investors. In fact, they work a lot like the local supermarket, raising and loweringprices on their inventory as the market moves, and making a few cents here and there. And whilelettuce eventually spoils, holding a stock that is tailing off with no buyers is analogous.

    Because dealers in a security get to keep much of the spread, they work fairly hard to keep thespread above zero. This is really quite fair: they provide a valuable service (making a market in thestock and keeping the markets liquid), so it's only reasonable for them to get paid for their services.Of course you may not always agree that the price charged (the spread) is appropriate!

    Occasionally you may read that there is no bid-ask spread on the NYSE. This is nonsense. Stockstraded on the New York exchange have bid and ask prices just like any other market. However, theNYSE bars the publishing of bid and ask prices by any delayed quote service. Any decent real-timequote service will show the bid and ask prices for an issue traded on the NYSE.

    Broker

    Only the members of the exchange (brokers) can participate in trading in the listed securities in thestock exchange. There are various types of brokers depending upon the type of job they perform.Commission Brokers: About one half of all the brokers in NYSE are commission brokers. Theirprimary function is to buy or sell on behalf of their clients. They charge commission for this fromthe clients and hence the name. The prominent ones are Merrill Lynch, Pierce, Fenner & Smith,Shearson Lehman Hutton,