Financial Markets
FIN 3600: Chapter 5
Timothy R. Mayes, Ph.D.
Size of Various Financial Markets
Average Daily Trading Volume in Dollars
NYSE Stocks
$
68,500,000,000 (Aug 2006)
Nasdaq Stocks
$
46,538,625,901 (2006 average as of 9/25/06)
AMEX Stocks
$
2,400,000,000 (2005 average)
Municipal Bonds
$
13,030,000,000 (July 2004)
U.S. Treasury Securities
$
481,195,000,000 (June 2004)
U.S. Agency Securities
$
72,957,300,000 (June 2004)
U.S. Corporate Bonds
$
20,600,000,000 (August 2004)
Worldwide Currency Trading
$
Sources:
New York Stock Exchange, Nasdaq Academic Research, Bond Market Association, Bloomberg
1,900,000,000,000 (Sept 2004)
What is a Market?


A market is a public place where products or
services are sold, either directly or through
intermediaries.
Markets are important for a number of reasons:



They provide a place (either physical or virtual) for
the trading of goods or services.
They provide for competition so that the best price
may be found (this is called price discovery).
They provide liquidity.
Money vs. Capital Markets


Money Market – Short-term, high quality debt
securities are traded here. These securities carry
little or no default risk and have very little price
risk due to their short maturities.
Capital Market – Long-term securities trade in
the capital markets. These securities are subject
to significant price risk, default risk, purchasing
power risk, etc. due to their longer maturities.
Primary vs. Secondary Markets




Primary markets are where securities are initially sold. In this
market the issuer receives the proceeds from the sale.
Once securities have been sold into the primary market, they begin
trading in the secondary markets. In the secondary markets the
seller of the securities receives the proceeds, not the issuer.
Primary markets would barely exist were it not for well functioning,
efficient secondary markets. At the least, prices of securities would
be far lower due to much higher required returns. How much would
you pay for a security that you could never sell?
There are also third and fourth markets. The third market is
comprised of trades in listed securities away from the exchange
where they are listed. This is an institutional market. The fourth
market refers to trades directly between buyers and sellers.
Organized vs. OTC Markets


Organized markets are those which have a
physical location where all trading takes place.
For example, the NYSE, Amex, and regional
exchanges are organized markets.
Over the Counter (OTC) markets do not have
physical locations. Instead, they are
characterized by networks of dealers who are
connected by telephone or computer networks.
The Nasdaq is an example of an OTC market.
Investment Bankers


When securities are sold into the primary market,
firms enlist the services of investment bankers.
Investment bankers provide three basic services
to companies:



Advice and counsel (before and after the sale)
Underwriting
Distribution
Investment Banking Functions:
Advice and Counsel

Investment bankers provide important advice on security
issues, such as:






Pricing
Size of the offering
Timing of the offering
Type of security (debt or equity)
Special features (callability, convertibility, coupon rate, etc)
Additionally, investment bankers often consult on issues
of corporate governance, such as mergers.
Investment Banking Functions:
Underwriting


Once the company and investment banker agree as to the
type of security, pricing, etc. the issue is ready to market.
The investment banker may either:



Underwrite the issue – here the investment banker purchases the
issue and hopes to sell it at a higher price to the public (assumes
price risk). This is also known as a “firm commitment.”
Act as an agent – Also known as a “best efforts” offering, the
investment banker does not purchase the securities and merely
markets them to the public.
Typically only small, relatively unknown firms agree to a
best efforts offering.
Investment Banking Functions:
Distribution




The final role of the investment banker is to actually sell
the securities.
Typically, the originating investment banking firm will
form an underwriting group (syndicate) to spread the
price risk.
Next, a selling group consisting of the underwriting
group and, perhaps, other brokerage firms is formed to
sell the security. Each member of the selling group is
given an allocation for which it is responsible.
The selling group then allocates its share of the securities
among interested customers.
Investment Banking Functions:
Distribution (cont.)






Before a new issue may actually be sold to investors, the originating
underwriter must file a registration statement (Form S-1, or other Form S-x)
with the Securities and Exchange Commission (SEC).
This preliminary prospectus (“red herring”) contains information about the
firm, the type of security being offered, and the proposed use of the
proceeds.
While it is being reviewed by the SEC, the preliminary prospectus is
distributed to interested investors.
The exact pricing, and often quantity, of the issue is determined the night
before the actual offering.
It is important to note that the SEC does not judge the quality of the issue
and does not give investment advice. Its approval simply means that the
prospectus meets all requirements concerning disclosure.
For some time after the securities are sold, the investment banker will often
participate in price-stabilizing trades (if the market tries to drive the price
down, the IB will often step in to buy, thereby propping up the price).
Largest Investment Bankers (2001)
Firm
Market Share
Merrill Lynch
12.2%
Citigroup
11.3%
Credit Suisse First Boston
8.9%
JP Morgan Chase
8.1%
Morgan Stanley
7.5%
Goldman Sachs
6.6%
Lehman Brothers
6.2%
UBS Warburg
5.5%
Deutsche Bank
5.1%
Others
28.6%
Source: Thomson Financial Securities Data Corp. in Business Week,
July 30, 2001.
Domestic Stock Markets

In the U.S. we have three major stock exchanges:




We also have several regional stock exchanges:






The New York Stock Exchange (NYSE)
Nasdaq
The American Stock Exchange (Amex)
The Pacific Exchange (known mostly for options trading)
The Boston Stock Exchange
The Cincinnati Stock Exchange (all electronic, located in Chicago)
The Chicago Stock Exchange (formerly the Midwest Stock Exchange)
The Philadelphia Stock Exchange (known mostly for options trading)
Small companies, or those which do not meet listing
requirements may be traded on the OTC Bulletin Board
or in the Pink Sheets.
Domestic Stock Markets (cont.)

Additionally, in the past several years (mostly since
1997) many electronic communications networks (ECNs)
have begun trading stocks, and some are seeking
“exchange” status:







The Island
Archipelago (run by the Pacific Exchange)
Instinet
B-Trade (Bloomberg)
NexTrade
RediBook
ECNs offer such advantages as lower costs, anonymity,
open limit order books, and after-hours trading.
The NYSE History





The New York Stock and Exchange Board began on 17 May 1792
under a buttonwood tree. Originally, 24 brokers signed the
Buttonwood Agreement in which they agreed to trade only among
themselves and at a fixed commission rate (fixed commissions were
the rule until 1975).
In 1817 the exchange was moved into rented rooms at 40 Wall
Street. They also wrote and approved a formal constitution.
In 1863, the name was changed to The New York Stock Exchange.
In 1903 the NYSE moved to its current home.
Today, the NYSE Group is a publicly traded company (NYSE:
NYX).
NYSE Current Statistics
The New York Stock Exchange Selected Facts
January 2004
Listed Companies (common & preferred)
2,750
Number of Common Issues Listed
2581
Number of Preferred Issues Listed
364
Average Daily Share Volume
1,663,100,000
Average Share Price
$30.27
Number of Seats
Seat Price
1366
$
1,500,000
Nasdaq History and Operation





The Nasdaq stock market began operations on 8 February 1971.
Prior to that, the NASD had regulatory authority over a very
fragmented OTC market.
Nasdaq originally, but no longer, stood for National Association of
Securities Dealers Automated Quotation system.
Unlike the NYSE and AMEX, Nasdaq is not an open outcry auction
market, and does not use specialists. Instead, it uses a system of
market makers.
A market maker is a dealer who competes with others to get
customer orders. The market maker posts his bid/ask quote on the
system for all to see.
Today, the Nasdaq is a publicly traded company (Nasdaq: NDAQ).
Differences Between Market Makers
and Specialists


The major difference between a specialist and a
market maker is that a specialist is charged with
maintaining an orderly market and is required to
step in and buy when there are no buyers and sell
when there are no sellers. Market makers may
withdraw from the market at any time, though
there are rules.
There is only one specialist for an NYSE stock,
but there are usually multiple market makers for
Nasdaq stocks.
Nasdaq Statistics
Nasdaq Selected Facts
August 2001
Listed Companies
Total Market Capitalization
Average Daily Share Volume
Average Share Price
3,314 (Jan 2004)
$
3,007,392,971
1,580,716,560
$22.78
AMEX History and Operation




The American Stock Exchange (Amex) was originally
known as the New York Curb Market because it was
based outside the NYSE and traded stocks that were not
traded on the NYSE.
In 1921, the Curb was moved indoors. It was renamed in
1953.
The Amex is something of a poor stepchild to the NYSE
and has struggled somewhat to survive. It has turned to
technology and new products (options, ETFs, etc) to
survive.
In 1998 the Amex was merged with the NASD, and
today operates as an independent entity within the
NASD.
AMEX Statistics
Amex Selected Facts
August 2001
Listed Companies
Total Market Capitalization
Average Daily Share Volume
Average Share Price
700
$
111,352,851
56,034,948
$48.20
Stock Market Indices and Averages


For more than 110 years, people have tracked the
market’s daily ups and downs using various “indexes” of
overall market performance
There are currently thousands of indices calculated by
various information providers. Best known are:





Dow Jones & Co
Standard & Poor’s
Morgan Stanley Capital Markets (MSCI)
Lehman Brothers (bond indices)
Dow Jones alone currently publishes more than 3,000
indices
Stock Market Indices and Averages
(cont.)

A short list of the major indices:










Dow Jones Industrial Average (DJIA)
Dow Jones Transportation Average (DJTA)
Dow Jones Utility Average (DJUA)
Standard & Poor’s 500 Index (S&P 500)
Standard & Poor’s 100 Index (S&P 100, or OEX)
Nasdaq Composite
Nasdaq 100
Value Line Arithmetic Index
Value Line Geometric Index
Wilshire Total Market Index (formerly Wilshire 5000 index)
Types of Indices and Averages

There are essentially four methods of index or
average construction:





Price Weighted
Capitalization Weighted
Equal Weighted Arithmetic
Equal Weighted Geometric
There are also some variations of these
techniques. We will cover the basics.
Example Data for Index Calculation
Stock
Day 1
Day 2
Day 3
ABC
(100 shares)
DEF
(200 shares)
60
62
32*
25
22
23
XYZ
(300 shares)
43
45
46
Split 2-for-1
Index Types:
Price-weighted Average


A price-weighted average is calculated by adding
up the prices of the index constituents and
dividing by a divisor.
The divisor begins as the number of constituents,
but will change over time (to maintain price
continuity) as:



Constituents change
Stocks are split or pay a big stock dividend
Divisions are spun off
Index Types:
Price-weighted Average (cont.)





The DJIA is the best-known price-weighted average.
It was created by Charles Dow on 17 May 1896, and
originally contained only 12 stocks (industrial stocks
were less important at the time than the railroads).
Today, General Electric is the only company left that was
in the original average.
Today, the DJIA contains 30 stocks and the divisor is
about 0.14418073. (17 September 2002)
Each 1 point change in a component therefore adds about
6.94 points to the value of the average.
Index Types:
Price-weighted Average (cont.)




As an example of calculating a price-weighted average,
consider our sample data.
On day 1, we start our average by adding up the prices
and dividing by 3, to get a value of 42.67.
For day 2, we calculate the average the same way, and
get a value of 43.
For day 3, ABC has split 2-for-1 necessitating a change
in the divisor. The new divisor is calculated (using day 2
closing prices adjusted for the split) such that the average
begins day 3 unchanged from day 2.
Index Types:
Price-weighted Average (cont.)

To calculate the divisor:
62  22  45
98
43  2

x
x
98
x
 2.279
43

Now, to calculate the average on day 3:
32  23  43
 44.32
2.279

From now on, until another adjustment is required,
the divisor will be 2.279.
Index Types:
Capitalization-weighted



A capitalization-weighted index is weighted by the total
value of the outstanding shares (price x shares) rather
than stock price.
The best known cap-weighted index is the S&P 500
which contains 500 of the leading stocks in the U.S.
markets (not necessarily the largest, though the S&P 500
is considered a large-cap index).
Currently, the total market value of the 500 stocks is over
$8.23 trillion. The divisor is 9,237,672,206 (on
9/16/2002).
Index Types:
Capitalization-weighted (cont.)

The current (9/25/2006) composition of the S&P 500 is
shown below:
Sector
Energy
Materials
Industrials
Consumer Discretionary
Consumer Staples
Health Care
Financials
Information Technology
Telecommunications Services
Utilities
S&P 500
Data as of 9/25/2006
Source: Standard & Poor’s
# of Companies % of Total
29
5.80%
30
6.00%
52
10.40%
86
17.20%
39
7.80%
56
11.20%
89
17.80%
78
15.60%
10
2.00%
31
6.20%
500
100.00%
Market Capitalization ($
Millions)
1,077,459
341,856
1,292,053
1,218,908
1,148,899
1,518,295
2,671,307
1,826,509
429,064
411,162
11,935,511
% of Total
9.03%
2.86%
10.83%
10.21%
9.63%
12.72%
22.38%
15.30%
3.59%
3.44%
100.00%
Index Types:
Capitalization-weighted (cont.)

A capitalization-weighted index is calculated by
dividing the total market cap of the stocks in the index
by the index divisor.
N
IndexValue 


 P Q
i 1
i
i
Divisor
The divisor is determined at inception by dividing the
total market cap by the desired beginning level of the
index.
The divisor will occasionally be adjusted for splits,
changing constituents, spin-offs, etc.
Index Types:
Capitalization-weighted (cont.)




As an example of calculating
a capitalization-weighted
average, consider our sample
data.
Suppose that we want to set
the initial index value at 100.
First calculate the divisor,
note that it is 239.
Now, calculate the index for
each day.
Note that the split has no
impact on the divisor.
Divisor 
60 100  25  200  43  300  23900  239
100
100
Day1 
60 100  25  200  43  300  23900  100
Day 2 
62 100  22  200  45  300  24100  100.84
Day 3 
32  200  23  200  46  300  24800  103.77
239
239
239
239
239
239
Index Types:
Equal-weighted



Both price-weighted and capitalization-weighted indices
are affected most by certain stocks (either the highest
priced, or the most valuable).
An equally-weighted index gives each stock equal
weight, it is most affected by those that have the biggest
percentage changes.
Value Line calculates two indices using equal
weightings:



Value Line Geometric
Value Line Arithmetic
These indices both include about 1600 to 1700 stocks,
and vary only in the type of averaging they use.
Index Types:
Equal-weighted: Geometric Average


On June 30, 1961 Value Line introduced its Value Line
Composite Index, which is an index of the geometric
average of the percentage changes in its 1600 to 1700
stocks.
An equally-weighted geometric index is calculated
with the following equation:
N
Pj ,t
j 1
Pj ,t 1
Indext  Indext 1  N 

Where Indext-1 is the previous day’s index value, and
Pj,t and Pj,t-1 are today’s price and yesterday’s price for
stock j.
Index Types:
Equal-weighted: Geometric Average




As an example, again consider our sample data.
First, we arbitrarily set the beginning index value to
100 or whatever value seems appropriate.
Next, calculate the percentage changes from the
previous day, and calculate the geometric mean of
these.
Finally, multiply by the previous day’s index value.
Day 2  100  3
Day 3  98.36  3
62 22 45
 
 100  0.9836  98.36
60 25 43
32 23 46
 
 98.36 1.0333  101.63
31 22 45
Index Types:
Equal-weighted: Arithmetic Average



After complaints that the geometric index underestimated
market performance relative to competing indices, on
February 1, 1988 Value Line began calculating an
arithmetic version of their index.
This index is calculated using the same data as the
geometric index, but the method of averaging is different.
To calculate an equally-weighted arithmetic index use the
following formula:
1
Indext  Indext 1 
N
N
Pj ,t
P
j 1
j ,t 1
Index Types:
Equal-weighted: Arithmetic Average

Once again, using the our sample data, and a day 1
index value of 100, the index on days 2 and 3 is:
1  62 22 45 
Day 2  100    
   100  0.9866  98.66
3  60 25 43 
1  32 23 46 
Day 2  98.66    
   98.66 1.033  101.95
3  31 22 45 

Note that we have adjusted for the split within the
calculation of the average return.
Summary of Index Calculations
Stock
ABC*
DEF
XYZ
Day 1
Day 2
Day 3
60
25
43
62
22
45
42.67
100.00
100.00
100.00
43.00
100.84
98.66
98.36
Total Return
32
6.67%
23
-8.00%
46
6.98%
* ABC split 2-for-1 at the close of trading on day 2
Price-weighted
Capitalization-weighted
Equal-weighted Arithmetic
Equal-weighted Geometric
Stock
ABC
DEF
XYZ
* This only applies to the Cap-weighted index
44.32
103.77
101.95
101.63
Shares Outstanding*
Day 1
Day 2
Day 3
100
100
200
200
200
200
300
300
300
3.87%
3.77%
1.95%
1.63%
Summary of Index Calculations (cont.)





Notice that the total returns for each index are different, despite the fact that
they are all measuring the “average” returns of the same group of stocks.
This is not a contrived situation. The different weighting schemes will
always lead to different returns.
Note that the average price change of the three stocks is 1.88%, so it would
seem that the equally-weighted arithmetic average is closest to what really
happened.
However, one could easily argue that stocks with larger market caps are
“more important” in the market, and therefore the cap-weighted index is
better.
The least defensible of the indices is the price-weighted average. There is
no reason to believe that higher priced stocks are any more important than
lower priced stocks (especially because when they split, they are
automatically “less important” even though there is no economic change).
Price weighting was only chosen by Dow simply because it was very easy to
calculate in the days before computers and calculators.