Transcript Bonus Slide: Derivatives Terminology

Chapter 1
Web Extension 1C
A Closer Look at the Stock
Markets
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Topics in Web Extension
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Stock indexes
Regulation
Overview of investment banking
Stock trading
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Stock Indexes
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Stock indexes try to measure some
aspect of the market
The differ with respect to:
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Composition (types of stock in the index)
Weighting (how the individual stocks are
aggregated into an index)
(More . .)
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Index Composition
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Replicate a particular exchange
Measure a country’s most important
stocks
Measure a particular business sector
Measure a particular investment “style”
Measure an international region
(More . .)
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Composition by Exchange
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NYSE Composite
Nasdaq Composite
(More . .)
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Composition by Business
Sector
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Many different index providers, such as:
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Dow Jones
Amex
Morgan Stanley
Many different sectors, such as:
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Airlines
Biotechnology
Chemicals
Consumer retailers
Technology
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Composition by “Style”
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Two important investment styles are by the
size of the firm and by its growth prospects.
Growth is measure by high-expected sales
growth and high price-book ratios (value
stocks have lower growth and lower pricebook ratios)
Examples:
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Russell 1000 Growth
Russell Midcap Value
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Composition by International
Region
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Morgan Stanley Capital International
(MSCI)
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EAFE (Europe, Asia, Far East) Index
Emerging Markets Index
Pacific Index
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Stock Weighting in Indexes
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Price weighted
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DJIA
Market-value weighted
S&P500
 Nasdaq Composite
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Equally weighted
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Value Line Index
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Regulation of Securities
Markets
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Government Regulation– such as SEC.
Insider trading oversight (SEC)
Margin oversight (Federal Reserve)
Self-regulation– such as NASD.
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Circuit Breakers– automatic halt in trading
if stock prices have exceptional changes.
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Public vs. Private Offerings
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Public offerings: registered with the SEC and
sale is made to the investing public.
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Shelf registration (Rule 415, since 1982) allows firms to
register an offering and sell parts of the offering over time.
Private offering: Sale to a limited number of
sophisticated investors not requiring the protection of
registration.
- Dominated by institutions.
- Very active market for debt securities.
- Not as active for stock offerings.
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Investment Banking and
Security Offerings
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Underwritten vs. “Best Efforts”
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Underwritten: firm commitment on proceeds to
the issuing firm.
Best Efforts: no firm commitment.
Negotiated vs. Competitive Bid
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Negotiated: issuing firm negotiates terms with
investment banker. Usually a 7% spread.
Competitive bid: issuer structures the offering
and secures bids (more common in bonds than
stocks).
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Initial Public Offerings
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Initial Public Offerings (IPOs)
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Underpricing—Average increase is 14% on
first day.
Performance– Underperforms similar stock
during three years after IPO.
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Costs of Trading
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Commission: fee paid to broker for making
the transaction
Spread: cost of trading with dealer
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Bid: price dealer will buy from you
Ask: price dealer will sell to you
Spread: ask - bid
“Price Impact”– Large sales or purchase
might cause prices to change.
“Payment for Order Flow”– Exchange will pay
brokers to direct orders to them.
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The Specialist at the NYSE
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Handles around 10-20 stocks (one per
specialist)
Stocks trade at the “specialist’s post”
“Makes a market” by matching buyers/seller
and by buying/selling from own inventory
Goal is to “maintain a fair and orderly market”
so that price changes are smooth
Specialist loses money when smoothing the
market, but makes it back during normal
conditions
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Trading Away from Exchanges
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Third Market– trading listed stocks but
not through exchange
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Institutional market: to facilitate trades of
larger blocks of securities.
Involves services of dealers and brokers
Fourth Market– institutions trading with
institutions
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No middleman involved in the transaction
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Margin Trading
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Investor uses only a portion of own
capital for an investment.
Borrows remaining component.
Margin arrangements differ for stocks
and futures.
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Stock Margin Trading
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Maximum initial margin
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Maintenance margin
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Currently 50%
Set by the Fed
Minimum level of equity margin if prices
change
Margin call
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Call for more equity funds
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Short Sales Mechanics
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Opening a short position:
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Borrow stock through a dealer.
Sell it
Deposit proceeds and margin in account.
Closing out the position:
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Buy the stock
Return to the party from which it was
borrowed.
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Short Sales Purposes and
Features
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Purpose: to profit from a decline in the
price of a stock or security.
Must pay the broker the equivalent of
any dividends paid by the stock
“Uptick” restrictions– can only sell short
when the ask price of a stock is higher
than the last transaction
Unlimited loss potential
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