Investments:
Theory and Applications
Mark Hirschey
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Chapter 3
Overview of the
Equities Markets
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KEY TERMS
Markets
 NYSE
 negotiated market
 agency auction
 market makers
 specialist
 customer order flow
 round lot
 market maker spread
 NASD
 inside market
 AMEX
 Nasdaq SmallCap Market
 public float
 penny stock
 CBOE
 OTCBB
 CBOT
 ADR (American Depositary
 Nasdaq Stock Market
Receipts)
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Major U.S. Securities
Exchanges
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New York
Stock Exchange
 New York Stock Exchange (NYSE): Largest stock
market in terms of market capitalization

founded 1817

Specialist: Employee of a NYSE firm who manages the
market for an individual stock

Roughly 3,700 issues from more than 3,000 companies are
listed on the NYSE

Open for business daily from 9:30 am to 4:00 pm EST,
except on weekends and holidays
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New York
Stock Exchange

The NYSE Is an Agency Auction Market: Market in
which brokers represent buyers and sellers and prices are
determined by supply and demand.

Trading on the NYSE takes place in the form of bids and
offers by exchange members, acting as agents for
institutions or individual investors

Buy and sell orders meet directly on the trading floor, and
prices are determined by the interplay of supply and
demand

By way of contrast, in the over-the-counter (OTC) market stock
prices are determined by a network of dealers who buy and sell out
of inventory
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New York
Stock Exchange


Each listed stock is assigned to a single post, where the
specialist manages the auction process.
NYSE members bring all orders for NYSE-listed stocks to
the exchange floor electronically or by a floor broker.


As a result, the flow of buy and sell orders for each stock is
directed to a “single location”.
This stream of diverse orders is one of the great strengths of
the exchange


It provides “liquidity” – the ease with which securities can be
bought and sold without wide price fluctuations.
When an investor’s transaction is complete, the best price will have
been exposed to a wide range of would-be buyers and sellers.
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New York
Stock Exchange
 The NYSE is the largest U.S. securities market in
terms of the value of companies listed and the dollar
value of trading activity.
 The NYSE is the largest equities marketplace in the
“world”.

There are eight other U.S. regional exchanges. The largest
regional exchanges are:


Midwest Stock Exchange in Chicago
Pacific Stock Exchange in San Francisco and Los Angeles
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New York
Stock Exchange
 To be listed on the NYSE, firms:
 Must be willing to keep the investing public fully informed
 Are expected to meet certain qualifications


Be a going concern or the successor to a going concern
Minimum: firm size and distribution of the company shares within
the U.S.
– Minimum total number of round lot (100 shares) holders



Minimum trading volume
Minimum earnings and operating cash flow
There are “initial” and “continuing” annual fees associated
with a NYSE listing.
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New York
Stock Exchange
 NYSE sponsors an informative Web site.

www.nyse.com

Obtain stock quotes

Get the latest info about listed companies
Learn how the NYSE and the investment community
work.
Price and volume data for the overall market


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QUICK QUIZ
At the NYSE, the auction process for each listed
stock is assigned to a:
a.
b.
c.
d.
Broker
Market Maker
Dealer
Specialist
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American Stock
Exchange
 National Association of Securities Dealers,
Inc. (NASD) – A “self-regulatory” organization
of the securities industry.

Particular responsibility for the regulation of the
Nasdaq (a multiple dealer market system) Stock
Market and the OTC markets
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American Stock
Exchange
 American Stock Exchange (AMEX) – Nation’s
second largest floor-based stock auction exchange
“Specialist” central auction market
 Significant presence in both listed equities and equity
derivative securities
 Financial and Public Float guidelines for listing



Public Float – Common stock held by unaffiliated institutional and
individual investors
Public Float includes shares not held by any officer or director of
the issuer or by any person who is the beneficial owner of more
than 10% of the total outstanding shares.
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OPTIONS
Exchanges
 Chicago Board Options Exchange (CBOE) – Primary
exchange for standardized, listed stock “options”
World’s largest option exchange
 Lists “options” on more than 1,200 widely traded stocks and
broad-based stock indexes


S&P 500 Index (SPX)
 Options are traded on five U.S. exchanges:





CBOE
NYSE
AMEX
Pacific Stock Exchange
Philadelphia Stock Exchange
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Futures
Exchanges
 Trading of futures and options on futures for
commodities, natural resources, and financial
instruments.
 Futures Contract: Financially secured binding
agreement to buy or sell a commodity at a
future time (page 772)
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Futures
Exchanges
 Seven futures exchanges
 The “big three” account for 90% of trading
activity:

Chicago Board of Trade—ag commodities
 Chicago Mercantile Exchange—trading of
financial instruments to hedge foreign currency
risk
 New York Mercantile Exchange—oil products,
precious metals
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Over-the-Counter
Markets
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Nasdaq
National Market Securities
 Nasdaq Stock Market – Largest organized equities
market by “trading volume” and “number of listed
companies”.

World’s first electronic stock market – began in 1971

Features many of the high-tech companies

Lists more than 5,400 domestic and foreign companies,
more than any other stock market in the world.

Share “trading volume” rivals the NYSE

But the “value” of shares traded is still much greater on the
NYSE
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Nasdaq
National Market Securities
 Nasdaq Listing Requirements:

Significant net tangible assets or operating income

Minimum public float of 500,000 shares

At least 400 shareholders

Bid price of at least $5

Nasdaq competes with AMEX and NYSE for
company listings
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Nasdaq
National Market Securities
 Trading is executed through an advanced
computer and telecommunications network

participants meet over the computer rather than
face to face.
 Nasdaq is a Negotiated Market:

price determination through bargaining
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Nasdaq
National Market Securities
 Investors deal directly with Market Makers:

“Member firms” that use their own capital,
research, and/or systems resources to represent a
stock and compete with each other to buy and sell
the stocks they represent


trade and hold an inventory of NASD stocks
There are more than 500 member firms that act as
Nasdaq market makers.
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Nasdaq
National Market Securities
 Each market maker competes for:

Customer Order Flow: customer buy/sell
activity

Display buy and sell quotations for a guaranteed
number of shares.

Once an order is received, the market maker will
immediately purchase for or sell from “its own
inventory” or seek the other side of the trade until
it’s executed.
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Nasdaq
National Market Securities
 Market Maker Spread: The difference
between the price at which a market maker is
willing to buy a security and the price at which
the firm is willing to sell.

This difference between a market maker’s bid
and ask price depends on:


Market supply and demand conditions
The level of the market maker’s own inventory
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Nasdaq
National Market Securities
 On Nasdaq, the typical stock has 10 market makers
actively competing with one another for investor order
flow.
 Inside Market: Highest bid and lowest offer prices
among all competing market makers in a Nasdaq
security.
 There are initial requirements and initial and recurring
annual Nasdaq listing fees.
 Operates 9:30 a.m. to 4:00 p.m. EST but allows
extended and early morning trading.
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Nasdaq
SmallCap Market Securities
 Nasdaq SmallCap Market: Market for smaller
companies that trade prior to full listing on the Nasdaq
national market



Comprises more than 1,400 companies that seek the
sponsorship of Nasdaq market makers
Have applied for listing
Meet specific and financial requirements

Far less strenuous than for any other national market
– Minimum bid price required for common and preferred stock is only
$1
– Provides a safeguard against certain unscrupulous market activity
associated with low-priced Penny Stocks: Equities priced below $1.
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Nasdaq
SmallCap Market Securities

Lower initial listing requirements for tangible
assets, market capitalization, net income, public
float, number of market makers, round lot holders,
etc.

Required to meet minimum corporate governance
requirements for:

Distribution of annual and interim reports

Number of independent directors
Accounting Audit Committee

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Over-the-Counter (OTC)
Bulletin Board
 OTC Bulletin Board (OTCBB) – Regulated
quotation service for “very small” over-the-counter
equity securities.

Displays:




real-time quotes
Last-sale prices
Volume information
Prior-day trading activity
 OTC equity securities – any “publicly traded” equity
that is “not” listed on Nasdaq or a national securities
exchange.
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Over-the-Counter (OTC)
Bulletin Board
 OTCBB provides investors with access to more
than 6,500 securities offered through more than
400 participating market makers.
 OTCBB securities are traded by a “community
of market makers” that:

Enter quotes and trade reports through a highly
sophisticated computer network
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Over-the-Counter (OTC)
Bulletin Board
 OTCBB does not impose listing standards




Nasdaq has no business relationship with the issuers quoted
in the OTCBB.
These companies do not have any filing or reporting
requirements with the Nasdaq Stock Market, Inc. or NASD
Monitored by an online market surveillance system to help
ensure compliance with the existing rules of the SEC and
NASD
However, issuers of securities are subject to periodic filing
requirements with the SEC or other regulatory authorities
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U.S. Large Company
Indexes
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KEY TERMS
Indexes
 DJIA
 Wilshire 4500 Index
 DJIA divisor
 Russell 2000 Index
 S&P 500 Index
 S&P SmallCap 600 Index
 equity benchmark
 FTSE-100
 Russell 3000 Index
 Nikkei 225 Index
 Russell 1000 Index
 TSE-35
 Wilshire 5000 Equity Index
 Hang Seng Index
 Nasdaq Composite Index
 EAFE Index
 Nasdaq 100 Index
 Emerging Markets vs.
 S&P Midcap 400 Index
Developed Markets
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Dow Jones Industrial
Average

Dow Jones Industrial Average (DJIA): is a priceweighted average of 30 large industrial stocks.

DJIA divisor: Adjustment factor used to account for
stock splits

Used to calculate the index average, instead of the number of
stocks, to avoid distortions caused by stock splits or company
substitutions.
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Dow Jones Industrial
Average


These 30 large, frequently traded, stocks in the
DJIA represent roughly 30% of the roughly $15
trillion market capitalization of all U.S. equities.

Each of the stocks are major factors in their
industries

Listed on the NYSE or Nasdaq

Widely held by individuals and institutional investors
DJIA Can be measured with precision on a
minute-by-minute basis during the trading day
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Dow Jones Industrial
Average

Changes in the composition of the DJIA, or any
Dow Jones & Co. indexes, are made solely at the
discretion of the editors of: The Wall Street
Journal

Additions or deletions can be made at any time to
achieve better representation of the broad market
and of American industry
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Dow Jones Industrial
Average
 Indexes provide a convenient benchmark for
comparing:

individual stocks to the course of the market

the market with other economic indicators
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Standard and Poor’s 500
Index
 S&P 500: Popular value-weighted market index

Companies selected for the S&P 500 represent a
broad cross-section from across the spectrum of
the U.S. economy.


Not the 500 largest companies
Chosen according to industry representation, liquidity,
and stability criteria
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Standard and Poor’s 500
Index

Companies in emerging industries and/or industry
groups not fully represented in the index are
candidates for addition

Stocks may be removed from the index:





mergers
bankruptcies
other liquidations
no longer meet current criteria for inclusion
no longer representative of its industry group
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Standard and Poor’s 500
Index

Is preferred as an investment equity benchmark
(performance standard) by many institutional
investors.

http://www.spglobal.com
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Russell 3000 Index
 Russell 3000: Market capitalization index for
the 3,000 largest U.S. companies (98% of U.S.
market cap)

Measures the performance of the 3,000 largest U.S.
companies based on total market capitalization
 Average market capitalization of Russell 3000
companies is approximately $5 billion
 Median: $800 million
 Range: $500 billion (Microsoft) to $180 million
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Russell 1000 Index
 Russell 1000 Index: Market capitalization
index for the 1,000 largest U.S. companies
(90% of U.S. market cap).

Measures the performance of the 1,000 largest
companies in the Russell 3000 index.
 Average market capitalization of Russell 1000
companies is roughly $15 billion
 Median: $5 billion
 Smallest: $1.5 billion
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Wilshire (5000) Equity
Index
 Wilshire (5000) Equity Index: Total dollar value of
the U.S. equity market (in billions of dollars).



Measures the performance of the overall stock market
Designed to track the value of all U.S.-headquartered
equity securities with readily available price data
Included 5,000 stocks when first introduced in 1974




10 times the number of S&P 500 stocks.
# of stocks grows as the # of publicly traded companies in the U.S.
grows
Presently contains more than 7,000 stocks
Market capitalization was $15.8 trillion on 12/31/99
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U.S. Medium-Sized
Company Indexes
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Nasdaq Composite
Index
 Nasdaq Composite Index: Market-value
weighted index of all 5,000-plus stocks listed on
the Nasdaq Stock Market

One of the most widely followed and quoted major
market indexes (active since 1971)

Rapid rate of price appreciation during the 1990’s:

Tech stocks listed on Nasdaq
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Nasdaq 100
Index
 Nasdaq 100 Index: Market capitalization-weighted
index of Nasdaq’s largest companies.

Represents the largest and most active nonfinancial
domestic and international issues listed on the Nasdaq
national market, based on market capitalization, across
major industry groups: computer hardware and software,
telecommunicaitons, retail/wholesale trade, and
biotechnology.

Dominated by large tech stocks (Microsoft, Intell, Dell
Computer)
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Large - Cap
Mid - Cap
 Large-cap stock: total market capitalization in excess
of - $10 billion

The stock price performance of the large-cap segment of
the market is captured by the DJIA and the S&P 500
 Mid-cap stock: total market capitalization generally
between $1.5 and $10 billion

Performance of the mid-cap market segment is captured by
a number of indexes, including the S&P MidCap 400
Index
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Standard & Poor’s
MidCap 400 Index
 S&P MidCap 400 Index: Market cap index for
400 medium-sized domestic stocks.

Captures the performance of the mid-cap market
segment
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Wilshire 4500 Index
 Wilshire 4500 Index: Mid-cap index of Wilshire
5000 Index companies minus the S&P 500

Contains approximately 6,700 stocks

About 2/3’s are mid-sized companies
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U.S. Small Company
Indexes
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SMALL CAP INDEXES
 Small Cap Stocks: publicly traded corporations
with less than $1.5 billion in market
capitalization
 Russell 2000: Small company stock price index
for the 2,000 smallest companies in the Russell
3,000 Index.
 S&P SmallCap 600 Index: Market capweighted index of 600 small domestic stocks.
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Global Stock Indexes
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Major Global Stock
Market Indexes
 The Japanese stock market is the second largest
national stock market in terms of market capitalization.

Nikkei 225 Index: Leading measure of Japanese stock
market
 London is the world’s third largest equity market.

widely followed by using the FTSE 100 - “footsie”:
Capitalization weighted index of the 100 top companies on
the London Stock Exchange.
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Major Global Stock
Market Indexes
 Canada is the second largest national stock market in
“North America”.

Trading on the Toronto Stock Exchange is captured by the
TSE-35: Market basket of 35 blue-chip Canadian
companies
 Hong Kong is one of the most “dynamic” major stock
markets in the world.

This market is measured by the Hang Seng Index: Market
cap-weighted measure of Hong Kong stocks.
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Morgan Stanley Capital
International Indexes
 MSCI is a subsidiary of Morgan Stanley
 MSCI indexes are the most widely used benchmarks
for international portfolio managers.
 Europe, Australasia, Far East (EAFE) Index:
Leading global stock index of stocks from 21 countries

Designed to measure the investment returns of developed
countries outside of North America.
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Emerging Markets
 Emerging Markets: Stock markets in developing
nations. These markets typically:






Display GDP per capita that is substantially below the average
for developed economies
Have lax government regulation
Have irregular trading hours
Have less sophisticated back office operations, including clearing
and settlement capabilities
May have restrictions on repatriation (return to the country of
birth) of initial capital, dividends, interest, and or capital gains.
Involve companies with greater perceived investment risk than
leading firms in developed markets
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Securities Market
Regulation
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KEY TERMS
Regulation
 Securities and Exchange
 Stock Watch
Commission (SEC)
 Self-regulatory
organizations (SROs)
 Intermarket Surveillance

NASD
 NYSE
 AMEX
 CBOE
 Municipal Securities
Rulemaking Board
Group
 Securities arbitration
 Circuit breakers and
trading limits
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Legislative Foundation
 The securities markets in the United States
operates according to laws passed by the
Congress and the state legislatures
 The Securities Act of 1933 and the Securities
Exchange Act of 1934 are the most significant
laws for:

Investors
 Issuers of securities
 Brokers/Dealers.
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Legislative Foundation
 Securities Act of 1933

Primarily concerned with the issuance of new
securities

Requires companies going public to register and
supply financial and other material information
concerning their securities offerings.


Enable investors to make informed decisions
Exempts private placements, small issues, and
intrastate offerings
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Legislative Foundation
 Securities Exchange Act of 1934

Focuses on securities trading

Authorized the creation of the Securities and
Exchange Commission (SEC) as the primary
agency responsible for “administering” federal
securities laws.

Stipulated that the registration of securities
offerings required by the 1933 act was to be done
with the SEC.
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Legislative Foundation
 SEC rules governing brokers/dealers include:
 Mandatory registration with the SEC
 Financial responsibility requirements
 Restrictions on borrowing
 Prohibition of security price manipulation
 No deceptive sales or purchase practices
 SEC rules governing issuers include:
 Ongoing disclosure requirements
 Regulation of the proxy solicitation and tender offer
processes related to shareholder voting
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Legislative Foundation
 State Securities Laws focus on:

Registration of securities

Registration of brokers/dealers and agents

Antifraud provisions
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Self-Regulatory
Organizations (SROs)
 Self-Regulatory Organization (SRO): Industry
group with oversight authority granted by the SEC

NASD
 NYSE


AMEX
CBOE
A number of the regional stock and options exchanges

Municipal Securities Rulemaking Board

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Self-Regulatory
Organizations (SROs)
 Responsibilities of SROs include:







The formulation of rules governing business practices and
markets
Periodic business practice reviews to ensure fair dealing by
members with their customers
Securities firms are examined for compliance with “net capital”
and other “financial” and “operational” requirements
Market surveillance is carried out
Take enforcement actions when members or industry
professionals violate the securities laws or SRO rules
Responsible for the imposition of disciplinary sanctions
Arbitrate disputes between investors and firms and disputes
between firms.
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Self-Regulatory
Organizations (SROs)
 The SEC oversees SROs
 All SRO rules and regulations must be approved
by the SEC before they can take effect
 Fully funded by member and listed company
fees
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Allocation of
Responsibility
 National Association of Securities Dealers (NASD)
 Regulates Nasdaq and OTC securities markets
 Monitors sales practices via field inspection programs
 Administers testing, registration, and licensing of securities
industry professionals.
 Conducts fairness reviews of the level of underwriter
compensation in new offerings
 Ensures that member advertising and sales literature is
accurate and not misleading
 All brokers/dealers registered in the United States that do
business with the public are required to be members of the
NASD and are regulated by it.
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Allocation of
Responsibility
 Municipal Securities Rulemaking Board -
formulates rules governing the origination, sale,
and trading of “Municipal” securities

The NASD enforces these rules.
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MARKET
SURVEILLANCE
 Stock Watch: Computerized system to flag unusual
volume or price changes


guards against manipulation and insider trading
The NYSE launches an investigation, when there’s no
legitimate explanation for any unusual volume or price
changes




Contact the company
Surveillance personnel draw on an electronic audit trail to
reconstruct the details of every trade that takes place
Contact the firm and obtain the names of customers involved in
questionable trades which are matched with names of officers,
directors, and other corporate and non-corporate insiders
Automated Search and Match (ASAM) system – database of
executives, officers, directors of public corporations
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MARKET
SURVEILLANCE
 Intermarket Surveillance Group: Coordinated effort
to detect cross-market manipulative trading

Shares surveillance information and coordinates efforts to
detect cross-market manipulative trading.
 Advanced computer-based surveillance systems are
operated by the NASD to oversee activity on
Nasdaq:

StockWatch Automated Tracking (SWAT)
 Research and Data Analysis Repository (RADAR)
 Through these systems, every bid and offer quotation and
trade in every security on the Nasdaq market is subject to
computerized scrutiny
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MARKET
SURVEILLANCE
 An SRO can take disciplinary action and / or
turn any suspicious trading practice information
over the the SEC.
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Securities Arbitration
 Securities Arbitration: Private form of dispute
resolution within the securities industry

A securities customer always has the right to require a
stockbroker to submit to the arbitration process

Attractive alternative to lengthy and expensive litigation
 Enables a dispute to be resolved quickly and fairly by
impartial arbitrators
 All parties waive the right to pursue the matter through the
courts
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Circuit Breakers
 Circuit Breakers: Rules to halt securities
trading in volatile markets

Circuit Breakers are tripped to restore order when
prices plummet.
 At the end of each calendar quarter, the NYSE
figures the average daily closing value for the
DJIA during the preceding month
 Multiplies that figure by 10%, 20%, and 30%
 The resulting figures become the circuit breakers
for the following quarter.
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Qualifying to Become A
Securities Professional
 Any securities professional associated with a
broker/dealer firm must register with the NASD
and other relevant SROs through the firm and
must provide:

Prior employment and any disciplinary history

Fingerprints - for submission to the FBI for a
criminal record check
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Qualifying to Become A
Securities Professional
 Barred from working in the securities industry
for violation of SEC requirements or conviction
of a felony
 Securities professionals must qualify through
NASD examinations:

Series 7, 24, 27, 63, and 65, etc.
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Chapter 3
Answers to Selected
End of Chapter Questions
 1. (c)
 10. (b)
 2. (b)
 11. (a)
 3. (a)
 20. (d)
 6. (a)
 Note: be sure and read
 7. (b)
 8. (b)
 9. (c)
the chapters, the
chapter summaries
and review the power
point presentations to
do well on exams.
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