Chapter 5: The Stock Market
I.
Primary Market
Where securities are issued for the first time, either in initial public offerings
(IPO) or seasoned offerings. Regulated under the Securities Act of 1933.
A.
The Functions of Investment Bankers (IB)
1.
Financing:
a.
Underwriting (firm commitment) - IB
buy the entire issue & assume the risk of
failure; compensated in spread and fees.
b.
Best efforts - IB do not finance & firm
retains risk; primarily used for smaller,
regional issues; IB receive fees.
c.
Dutch Auction – method used for US
Treasury securities and Google’s IPO. (Another view!)
2.
Marketing & Distribution:
a.
Syndicate - Team of IB led by one or several IB, each promising to
sell a percentage of issue. A syndicate increases the likelihood of
successful offering.
b.
Tombstone advertisement - Public notice of “intent” to sell; only
prospectus can make an offer or solicitation; includes price, quantity
and list of IB to contact.
c.
Road show - Presentations that IB perform for interested investors
just before the offering (for institutions and wealthy individuals).
3.
Registration:
IBs are experts in the legal requirements of the regulatory process, and in
determining the type and timing of financing. They advise and guide a firm
through the entire process, from deciding what securities to issue to making
changes in the registration forms that are required by the SEC.
4.
After Market Support:
IBs develop and maintain an aftermarket for new issues of stock. The
purpose is to promote a successful issue.
FIN 330: Chapter 5, page
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B.
The Registration Process
1.
-
SEC registration statement is required under 1933 Securities Act
Reviewed and approved by S.E.C. which just looks for proper disclosure.
-
Includes financial statements, terms of new issue, any existing securities,
and information about the company’s management.
2.
-
The prospectus
The official offer following SEC approval
Available to all prospective buyers
Includes offer price & information in the registration statement
A preliminary prospectus (a red herring) is circulated prior to SEC
approval.
3.
Rule 415 (shelf registration)
In 1982 the SEC allowed firms to register securities that they could keep “on
the shelf” for up to 2 years without issuing them.
Rule 415 allows firms to time the sale better and reduce costs.
4.
Registration exemptions:
Federal & municipal government securities
Regulated industries’ securities (banks, insurance companies)
Private placements (Rule 144A)
a) sales to limited number (less than 35);
b) sales to qualified “sophisticated” investors;
c) sales of less than $1.5M per year.
Restrictions on resale of these securities.
C.
Advantages and Disadvantages of Going Public:
Advantages: Access to capital Liquidity Valuation
Raise market value
Changes in capital structure
Diversification
Exit strategy
Disadvantages:
Loss of control
Reporting costs
attachment Disclosure requirements
Emotional
FIN 330: Chapter 5, page
2
II.
The Secondary Market
Where existing financial securities are traded. A healthy primary market
requires a smoothly functioning secondary market. The secondary market is
regulated under the Securities Exchange Act of 1934.
Types of Secondary Markets
A.
Auction market: Where “price discovery” occurs around a central location
with the help of the “auctioneer.”
NYSE (1792): Created when 24 traders signed the “Buttonwood
Agreement”. In 2006 the NYSE transformed from a non-profit corporation
(with 1366 seats) to a publicly traded company (ticker symbol: NYX).
(Membership seats are replaced with annual trading licenses).
In April 2007 NYSE-Euronext is formed, merging NYSE with major
European exchanges.
B.
Negotiated market: The OTC
NASDAQ (National Association of Securities Dealers Automated
Quotation).
Electronic network of dealers (a dealer market ) trading unlisted (not listed
on an exchange) stocks. Prior to 1971 stock data circulated on pink sheets &
required contacting dealers by phone to trade.
C.
Electronic Communications Networks (ECNs)
(2009 Report on ECNs)
NYSE-Archipelago, Bloomberg Tradebook. The original ECN was
INSTINET (1969) which provided direct trading between institutions.
ECNs are computer networks that bypass market makers and directly link
buyers with sellers.
Originally involved large block trades and now expanded to individual
investors.
FIN 330: Chapter 5, page 3
III.
Basic Types of Orders
Market order: The order is executed as soon as possible, at the market price.
Execution is guaranteed, but not the price. Can be a “surprise” when you learn the
price was not what you hoped.
Limit order: The order is executed at the price you specify, or better. The price is
guaranteed, but not the execution (if the price is never reached, you will not get a
trade).
Stop (loss) order: A suspended order on the specialist’s books that becomes a
market order when the stop price is reached. The execution is then guaranteed, but
not the price.
Example: Current price is $70
Stop-sell at $65: When price reaches $65, it becomes a market order to sell.
Used to limit losses (thus the name: stop loss order)
Stop-buy at $75: When price reaches $75, it becomes a market order to buy.
Usually used to limit losses in a short-sale situation.
Stop-limit order: combination stop order & limit order. Stop order becomes a
limit order at a specified price. The stop and the limit prices are both pre-specified.
Example: same example (current price is $70)
Stop at $65, limit $60: When price reaches $65, it becomes a limit order to
sell. The limit price of $60 means don’t sell if price continues to fall below
$60. This type of order is used to limit losses but may result in you holding a
stock worth less than $60.
FIN 330: Chapter 5, page 4
IV.
U.S. Stock Market Indexes
A.
The DJIA - Grandfather of Stock Indexes (1896)
Charles Dow and Edward D. Jones began a 2-page newsletter reporting the average
price for 11 stocks (9 railroads) in 1884.
1896 – Newsletter evolves into the first industrial average (12 industrial stocks)
May 26,1896:
Dow = 40.94
1928 – First year when 30 industrial stocks were included.
The DJIA includes large blue-chip stocks and represents about 20% of the market
value of all publicly owned U.S. stocks.
Dow is an unusual “average” since it uses a divisor other than 30 due to stocks
splits, additions, deletions, & mergers since inception.
DJTA - 20 transportation companies
DJUA - 15 utilities
Dow Composite: Composite of all 65 companies
B.
Standard and Poor’s 500 (1957) - data dates to 1926.
500 large companies, primarily industrial (75%); 90% are listed on NYSE;
represents75-80% of market value of all publicly owned U.S. stocks, thus it
is a broader barometer of the entire market than the DJIA.
C.
NYSE Composite - 3,000+ companies representing about 80% of market
value of all publicly owned U.S. stocks. Over 2/3rds of all companies listed in
last 12 years.
D.
NASDAQ Composite – 5,000+ companies in the NASDAQ composite
including around 3,000 NMS companies and around 1,400 NASDAQ smallcap market companies.
E.
Wilshire 5000 (1974) - Wilshire Associates tracks over 7,000 stocks.
F.
Russell 2000 is the small stock index and includes 2000 smallest of 3000
largest companies in the U.S.
FIN 330: Chapter 5, page
5
Calculating a Price-Weight and Value-Weighted Index
A.
Dow Jones Industrial Average: Price-weighted index
DJIAt =  Pit / N
N = divisor
Simply add up the prices of the 30 stocks in the Dow Jones and divide by the
divisor. (divisor: 0.132129493 on August 2, 2012)
Divisor adjusts for stock splits, additions and deletions, stock buybacks, by
adjusting divisor.
B.
S&P500 Index: Market-value weighted index
i=1
500
S&P500
=
Pit Qit
x(k)
Pib Qib
Numerator = the market value of all stocks at time period t
Denominator = the market value of all stocks during the base period
k = a multiplier
Thus, on first day of index, S&P500 = 10
If the total market value rose by 10% during the first year the index value
will be 11 at the end of one year.
C.
Value Line Index: an equally weighted geometric average
The daily percentage change in each stock (1700) is calculated
The geometric average of these changes is computed.
The Index value is increased (decreased) by this average.
All stocks have the same impact. High priced or high market value stocks
have no more influence than low ones.
FIN 330: Chapter 5, page
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