Chapter 5 The Stock Market PDF

Chapter 5 The Stock Market Copyright © 2021 McGraw-Hill Education. All rights reserved.  The Stock Market, I. “One of the funny things about the stock market is that every time one man buys, another sells, and both think they are astute.” –William Feather...

Chapter 5 The Stock Market Copyright © 2021 McGraw-Hill Education. All rights reserved.  The Stock Market, I. “One of the funny things about the stock market is that every time one man buys, another sells, and both think they are astute.” –William Feather “If you don’t know who you are, the stock market is an expensive place to find out.” –Adam Smith (pseud. for George J. W. Goodman) 5-2  Learning Objectives Take stock in yourself. Make sure you have a good understanding of: 1. The differences between private and public equity, and primary and secondary stock markets. 2. The workings of the New York Stock Exchange. 3. How NASDAQ operates. 4. How to calculate index returns. 5-3  The Stock Market, II. Our goal in this chapter is to provide a “big picture” overview of:  Who owns stocks,  How a stock exchange works, and  How to read and understand the stock market information reported in the financial press. 5-4  Types of Private Equity Funds: Middle Market  Many small, regional private equity funds concentrate their investments in “middle market” companies.  ongoing concerns (i.e., not start-ups)  known performance history  typically, small and family owned and operated.  Reasons middle market companies seek more capital:  Expansion beyond their existing region  Founder wants to “cash out”  A private equity fund might purchase a portion of the business so that others can now manage the company. 5-5  Types of Private Equity Funds: Leveraged Buyouts  Suppose a company (or someone else) purchases all the shares of the company held by the public at large?  This process is called “taking the company private.”  The cost of going private is often high.  A manager or investor who wants to take a company private probably needs to borrow a significant amount of money.  Taking a company private is called a leveraged buyout (LBO).  LBO market activity levels depend on credit markets.  Around 2005, the LBO market was quite active.  Activity in the LBO market came to a standstill after the crash of 2008. 5-6  Selling Securities to the Public  The primary market is the market where investors purchase newly issued securities.  Initial public offering (IPO): An IPO occurs when a company offers stock for sale to the public for the first time.  Seasoned equity offering (SEO): If a company already has public shares, an SEO occurs when a company raises more equity.  The secondary market is the market where investors trade previously issued securities. An investor can trade:  Directly with other investors.  Indirectly through a broker who arranges transactions for others.  Directly with a dealer who buys and sells securities from inventory. 5-7 The Primary Market for Common Stock: IPO and SEO Details  The primary market for common stock: How new securities are sold.  Part of this market is known as the initial public offerings (IPOs) market.  An IPO occurs when a company sells stock to the public for the first time.  Typically, small and growing companies needed capital to expand operations.  An IPO is sometimes called an unseasoned equity offering because shares are not available to the public before the IPO.  If a company already has shares owned by the public, it can raise equity with a seasoned equity offering (SEO).  Seasoned equity offerings: general cash offer or a rights offer.  General cash offer: securities sold on a “first-come, first-served” basis.  With a rights offer, securities are initially offered only to existing owners. 5-8  The Primary Market for Common Stock IPO Example: All IPOs are Cash Offers  Your privately held corporation sold 100,000 shares of stock, all for $1 per share.  You bought 50,000 shares and the remaining 50,000 shares were bought by friends and relatives (who are your “venture capitalists”). These investors are NOT the general public.  Your company has prospered, but now needs capital to grow.  You hire an investment banker. After lengthy negotiations and analyses, your investment banker suggests selling 4 million shares of common stock.  Two million shares are given to the original investors in exchange for the old shares.  After much haggling, your investment banker agrees to underwrite the stock issue by purchasing the other 2 million shares from your company for $10 per share.  The net effect: You have sold half the company to the underwriter for $20 million.  The investment banker, the underwriter, will resell shares in the primary market.  The investment banker thinks the stock can sell for $11 per share in an IPO.  The difference between the $11 received by the underwriter and the $10 per share the original investors received is called the underwriter spread, or discount.  The typical underwriter spread ranges from 7 to 10 percent. 5-9  The Primary Market for Common Stock: The Rest of The Story  This IPO (and an SEO) involves several steps.  Company appoints an investment banking firm to arrange financing.  Investment bankers design the stock issue and arrange for either fixed commitment underwriting, best efforts underwriting, or Dutch auction underwriting.  Company prepares a prospectus (usually with outside help) and submits it to the Securities and Exchange Commission (SEC) for approval. Investment banker circulates preliminary prospectus (red herring).  Upon obtaining SEC approval, company finalizes prospectus.  Underwriters place announcements (tombstones) in newspapers and begin selling shares. 5-10  IPO Tombstone 5-11  Crowdfunding: An Alternative Source of Public Funding  Project Crowdfunding and Equity Crowdfunding are different!  The Jumpstart Our Business Startups Act (JOBS) of 2012.  One provision: Crowdfunding  Crowdfunding: Raising small amounts of capital from a large number of people  At first, the JOBS Act allowed only “accredited” investors to participate in equity crowdfunding.  More than $1,000,00 in net worth OR  More than $200,000 income in 2 of last 3 years  In May 2016, Regulation CF of the JOBS Act allowed small investors to get access to new equity crowdfunding “portals.”  Investors with less than $107,000 in income or assets  Invest at least $2,200 but a maximum of $5,350  If a company wants to raise capital through Regulation CF, it must file with the SEC which makes it eligible to raise capital through FINRA-approved portals. 5-12  Initial Coin Offering: An Alternative Source of Public Funding  As of 2015, companies can also raise capital by selling tokens (and issuing debt and equity).  Tokens often grant the holder the right to use the company’s services in the future.  Token sales occur on digital security platforms.  Tokens can be exchanged easily on these platforms.  Tokens can be exchanged for U.S. dollars on specialized token exchanges.  Tokens are purchased by customers and investors.  The initial sale of a token is often called an initial coin offering, or ICO (to sound like IPO).  Ethereum is the most common platform for issuers, but there are many competitors.  In 2017, there were 234 ICOs with a total value of about $3.7 billion.  Token sales are most popular among companies that are building services based on blockchain technology—which lies at the heart of bitcoin and other cryptocurrencies.  A blockchain is a time-stamped ledger of transactions that is kept among a network of users without centralized control.  Blockchains are similar to a traditional database, except that cryptography is used to make it infeasible to change data once they are added to the chain.  Many industries, including finance, are updating recordkeeping systems by using blockchains. 5-13  The Secondary Market for Common Stock  Secondary stock markets match buyers with sellers.  Trading occurs on either an organized stock exchange or a trading network.  Important concepts:  The bid price:  The price dealers pay investors.  The price investors receive from dealers.  The ask price:  The price dealers receive from investors.  The price investors pay dealers.  The difference between the bid and ask prices is called the bid-ask spread, or simply, the spread.  Dealers attempt to “buy low and sell high” when moving shares into and out of their inventory. 5-14  The New York Stock Exchange  The New York Stock Exchange (NYSE), popularly known as the Big Board, celebrated its bicentennial in 1992.  The NYSE has occupied its current building on Wall Street since the early 1900’s.  For 200 years, the NYSE was a not-for-profit New York State corporation.  The NYSE went public in 2006.  NYSE Group, Inc., ticker: NYX  Naturally, NYX stock is listed on the NYSE  In 2007, NYSE Group merged with Euronext to form NYSE Euronext, the world’s largest exchange.  In 2013, the Intercontinental Exchange (ICE) acquired NYSE Euronext. 5-15  NYSE Seats and Trading Licenses  Historically, the NYSE had 1,366 exchange members. These members:  Were said to own “seats” on the exchange.  Collectively owned the exchange, although professionals managed the exchange.  Regularly bought and sold seats (record seat price: $4 million in December 2005)  Could buy and sell securities on the exchange floor without paying commissions.  In 2006, this structure changed when the NYSE went public.  Instead of purchasing seats, exchange members purchase trading licenses:  number limited to 1,366  In 2015, a license would set you back a cool $50,000—per year.  Having a license entitles the holder to buy and sell securities on the floor of the exchange. 5-16  Farewell, Specialists  For a long time, most securities listed at the NYSE were divided among specialists—an exclusive dealer, or intermediary, for a set of securities.  Specialists:  Posted bid prices and ask prices for each security assigned to them.  Were obligated to make and maintain a fair, orderly market.  Stood ready to buy at bid prices and sell at ask prices when outside sell and buy order flows were unequal.  Specialists had an exclusive, advance look at incoming orders flowing to the display book.  Because of this advance look, specialists had an information advantage when they were making quotes and matching orders.  Under this system, however, specialists could “work” orders: that is, try to improve trading prices for customers. 5-17  Hello, Designated Market Makers  In 2009, aiming to stay competitive, the NYSE replaced the role of specialists with two classes of market makers:  designated market makers (DMMs)  and supplemental liquidity providers (SLPs).  What were specialists are now the DMMs.  The DMMs are assigned a set of securities and are obligated to maintain a fair and orderly market in these stocks.  Differences between the Specialist Role and the DMM Role  DDMs can compete against other exchange members for trades.  Specialists had to step back from a trade if a floor broker order had the same price.  Unlike the former specialist system, however, DMMs do not receive an advance look at incoming orders.  DMMs do not have an exclusive right to make markets in their assigned securities. 5-18  DMMs and Supplemental Liquidity Providers (SLP)  A newly created class of market maker is called the supplemental liquidity provider (SLP).  SLPs can trade the same stocks as the DMMs.  SLPs can trade only from offices outside the exchange.  DMMs are located on the floor of the exchange.  Quoting Requirements:  DMMs must quote bid and ask prices for at least 5% of the trading day.  SLPs are required to quote bid or ask prices for at least 5% of the trading day.  Incentives. For 100 shares traded, the NYSE pays:  DMMs by the type of transaction.  SLPs receive less (lower quoting requirements).  Floor brokers receive even less (no quoting requirements). 5-19  Other NYSE Participants  The largest number of NYSE members are registered as commission brokers.  Commission brokers execute customer orders to buy and sell stocks.  When commission brokers are too busy, they may delegate some orders to floor brokers, or “two- dollar brokers,” for execution.  A small number of NYSE members are floor traders, who independently trade for their own accounts. 5-20  The NYSE Hybrid Market  The NYSE rolled out a faster automated execution system called the Hybrid platform beginning in late 2006 and continues to refine the system.  Hybrid trading combines the exchange’s automated technology with the advantages of an auction market.  In the Hybrid market, DMMs, SLPs, and floor brokers have the choice to interact with the market electronically as well as in person.  Hybrid trading has evolved because human judgment is valuable:  in less liquid stocks.  during the opening and closing of trading sessions.  during times of market duress.  In normal times, for the average stock, the automated platform is an efficient trading option. 5-21  NYSE-Listed Stocks  At the beginning of 2019, the 3,100 or so companies listed on the NYSE represented nearly 25 percent of the world’s equity trading.  Initial and annual listing fees are charged based on the number of shares.  To apply for listing, companies have to meet certain minimum requirements with respect to:  the number of shareholders.  trading activity.  the number and value of shares held in public hands.  annual earnings. 5-22  Operation of the New York Stock Exchange  The fundamental business of the NYSE is to attract and process order flow.  In 2007, the average trading volume on the NYSE was over 2 billion shares a day. It’s lower today: NASDAQ and ECNs have increased their trading volume.  Volume breakdown:  About one-third is from individual investors.  Almost half is from institutional investors.  The remainder represents NYSE-member trading, mostly from specialists acting as market makers. 5-23  NYSE Floor Activity  There are a number of DDM posts, each with a roughly figure-eight shape, on the floor of the exchange.  At the telephone booths, commission brokers:  receive customer orders.  walk out to DMM posts where the orders can be executed,  return to confirm order executions and receive new customer orders.  Coat colors indicate the person’s job or position. 5-24  Stock Market Order Types 5-25  The Flash Crash of 2010  Federal regulators blamed automated trading software  Liquidity Crisis: Many sellers, few buyers.  The DJIA plunged about 1,000 points in minutes. 5-26  Circuit Breakers  Sometimes the marketwide order flow is such that regulators have deemed that trading cease for a short time to “calm the market.”  These trading halts are call Circuit Breakers.  In response to the Flash Crash, regulators updated circuit breakers.  Lowered the marketwide circuit breaker level to 7 percent  Implemented individual stock circuit breakers.  Be informed: The SEC is constantly tinkering with circuit breakers and studying what triggers them. 5-27  Trading on the Web 5-28  Types of Orders: Market and Limit Orders  Market orders:  You specify ticker and quantity  Immediate execution at best available price  Market buy will be executed at lowest ask.  Market sell will be executed at highest bid.  Limit orders:  You specify ticker, quantity, and price  The order will be executed only if trade can be made at the limit price or better.  Limit Buy can only be executed at limit price or lower.  Limit Sell can only be executed at limit price or higher. 5-29  Types of Orders: Stop Orders Stop Orders are intended to prevent something bad from happening (like losing a lot of money).  Sell Stop (or stop loss)  Use this order when you have a long position and want to protect yourself from a price decline.  The Stop price will be below the current price of the stock.  The Stop price is the trigger or activation point.  If the stop price is reached or passed (the price goes lower), the order becomes a market order to be executed at the best available price (which may be higher or lower than stop price).  Risk: price suddenly plummets and your position is liquidated at a large loss.  Buy Stop  Use this order when you have a short position and want to protect yourself if the stock price rises.  The Stop price will be above the current price of the stock.  The Stop is the trigger or activation point.  If the stop price is reached or passed (goes higher), the order becomes a market order to be executed at the best available price (which may be higher or lower than stop price).  Risk: price suddenly rockets and you buy at a higher price than your buy stop. 5-30  Types of Orders: Stop Limit Orders Intended to prevent something bad from happening (But, in an active market, the limit can hurt you)  Sell Stop Limit  Use when you have a long position and want to protect yourself from a price decline.  The Stop price will be below the current price of the stock.  The Stop price is the trigger or activation point.  The limit says you will not accept a selling price below the limit.  Risk: The price plummets and you might not get out.  Buy Stop Limit  Use when you have a short position and want to protect yourself if the stock price rises.  The Stop price will be above the current price of the stock.  The Stop price is the trigger or activation point.  The Limit says you will not accept a purchase price above the limit.  Risk: The price rockets and you might not get out. 5-31  Stop Orders versus Stop Limit Orders  Stop orders guarantee execution (if the stock reaches or moves past your stop price), but not the price.  Stop limit orders guarantee price, but not execution.  Stop and limit prices do not have to be the same.  You could use a stop of $45 with a limit of $44. 5-32  NYSE Ends Use of Stop Orders 5-33  NASDAQ, I.  The name “NASDAQ” is derived from the acronym NASDAQ, which stands for National Association of Securities Dealers Automated Quotations system.  NASDAQ is now a proper name in its own right.  Introduced in 1971, the NASDAQ market is a computer network of securities dealers who disseminate timely security price quotes to NASDAQ subscribers.  In early 2016, the NASDAQ listed just over 3,000 companies.  On most days, volume on the NASDAQ exceeds the NYSE volume. 5-34  NASDAQ, II.  NASDAQ trading is almost exclusively done through dealers who buy and sell securities for their own inventories.  NASDAQ dealers use their inventory as a buffer to absorb buy and sell order imbalances.  NASDAQ is actually made up of three separate markets:  The Global Select Market  The Global Market  The Capital Market  In the late 1990s, the NASDAQ system opened to electronic communications networks (ECNs)  ECNs are basically websites that allow investors to trade directly with one another. 5-35  NASDAQ Quotes  The NASDAQ network provides bid and ask prices as well as recent transaction information.  The bid and ask prices for the NASDAQ represent inside quotes.  The highest bid  The lowest ask  For a small fee, you can have access to “Level II” quotes.  Displays all bids and asks  Frequently displays the market maker identity 5-36  NYSE and NASDAQ Competitors  The third market is an off-exchange market for securities listed on an organized exchange.  The fourth market is for exchange-listed securities in which investors trade directly with one another, usually through a computer network.  For dually listed stocks, regional exchanges also attract substantial trading volume. 5-37  Stock Market Information  The most widely followed barometer of day-to-day stock market activity is the Dow Jones Industrial Average (DJIA), or “Dow” for short.  The DJIA is an index of the stock prices of 30 large companies representative of American industry.  https://money.cnn.com/data/dow30/  General Electric (GE) was an original member of the Dow in 1896.  In continuously since 1907  Dropped from Dow June 26th, 2018  Replaced by Walgreen’s (WBA) 5-38  The DJIA Component Stocks 5-39  Stock Market Indexes, I. 5-40  Stock Market Indexes, II.  Indexes can be distinguished in four ways:  the market covered,  the types of stocks included,  how many stocks are included, and  how the index is calculated (price-weighted, e.g. DJIA, versus value-weighted, e.g. S&P 500).  Stocks that do not trade during a time period cause index staleness over that time period.  That is, we do not know the "true" index level if all the stock prices are not updated, i.e., fresh.  The level of index staleness changes during the trading day. 5-41  Stock Market Indexes, III.  For a value-weighted index (i.e., the S&P 500), companies with larger market values have higher weights.  For a price-weighted index (i.e., the DJIA), higher priced stocks receive higher weights.  This means stock splits cause issues.  But, stock splits can be addressed by adjusting the index divisor.  Note: As of January 3, 2019 the DJIA divisor was a nice “round” 0.1474808199! 5-42  Example I: $1,000,000 to Invest, Price-Weighted Portfolio Note: Shares = $1,000,000 / 131.130 = 7,626 5-43 Example II: Changing the Divisor when a New Stock is Added to the Index Day 1 of Index: Company Price Boeing 67.50 Nordstrom 41.93 Lowe's 21.70 Sum: 131.13 Index: 43.71 (Divisor = 3) Before Day 2 starts, you want to replace Lowe's with Home Depot, selling at $32.90. To keep the value of the Index the same, i.e., 43.71: Boeing 67.50 Nordstrom 41.93 Home Depot 32.90 Sum: 142.33 142.33 / Divisor = 43.71, if Divisor is: 3.256234271 5-44  Example III: $1,000,000 to Invest, Value-Weighted Portfolio Back to our original set of stocks and prices. Shares Capitalization Value Shares Company Price (millions) (millions) Weight to Buy Boeing 67.50 732.74 49,460.0 0.5550 8,223 Nordstrom 41.93 219.65 9,210.0 0.1034 2,465 Lowe's 21.70 1,402.76 30,440.0 0.3416 15,742 Total: 131.130 Total: 89,110.0 1.0000 26,430 Note: Shares to Buy = $1,000,000 × Weight / Stock Price 5-45  Example IV: How Does the Value-Weighted Index Change? Using the Portfolio from Previous Slide: Total Shares Market Capitalization Day 1: Company Price (millions) (millions) Boeing 67.50 732.74 49,460 Nordstrom 41.93 219.65 9,210 Lowe's 21.70 1402.76 30,440 Total MV(1): 89,110 Divisor (Picked to Make Index = 1,000): 89.11 Day 1 Index Level: 1,000.00 Total Shares Market Capitalization Day 2: Company Price (millions) (millions) Boeing 69.00 732.74 50,559 Nordstrom 41.93 219.65 9,210 Lowe's 21.70 1402.76 30,440 Total MV(2): 90,209 Day 2 Index Level: 1,012.33 5-46  The Day 3 Index Can be Calculated in Two Ways: Total Shares Market Capitalization Day 3: Company Price (millions) (millions) Boeing 71.10 732.740 52,098 Nordstrom 41.93 219.650 9,210 Lowe's 21.70 1,402.760 30,440 Total MV(3): 91,748 Total MV(2): 90,209 Day 2 Index Level: 1,012.33 Day 3 Index Level: 1,029.60 Total MV(1): 89,110 Day 3 Index Level: 1,029.60 Market Value Day 3 Day 3 Index  Index Level Day 2 Market Value Day 2 or Market Value Day 3 Day 3 Index  Index Level Day 1 Market Value Day 1 5-47  Chapter Review, I.  Private and Public Equity  Private Equity Funds  The Primary and Secondary Stock Markets  The Primary Market for Common Stock  The Secondary Market for Common Stock  Dealers and Brokers  The New York Stock Exchange  Designated Market Makers, DDMs  Types of Members  NYSE-Listed Stocks 5-48  Private Equity  Private Equity is used in the rapidly growing area of equity financing for nonpublic companies.  Banks are generally not interested in making loans to start-up companies, especially ones:  with no assets (other than an idea).  run by fledgling entrepreneurs with no track record.  Start-up companies search for venture capital (VC), an important part of the private equity markets.  Firms other than start-ups might also need financing.  Private equity also includes:  middle-market firms.  large leveraged buyouts. 5-49  The Structure of Private Equity Funds  Two types of investment companies:  Private equity funds  Hedge funds  Both types:  are set up as limited partnerships.  pool money from investors.  invest this money on behalf of these investors.  use, typically, a 2/20 fee structure (i.e., a 2 percent annual management fee and 20 percent of profits).  have built-in constraints to prevent managers from taking excessive compensation.  Private equity funds generally have:  a high-water-mark provision.  a “clawback” provision. 5-50  How a Clawback Provision Works  Suppose the private equity fund is set up to have a two-year life.  In its first year of operation, the private equity fund earns a 25 percent return.  For every $1,000 in the fund, the managers of this private equity fund “receive” a hefty performance fee of $50 (20 percent of the $250 profit).  In its second year, the private equity fund investors suffer a 10 percent loss.  Under the terms of a typical clawback provision, the managers have to “give back” the first year’s performance fee when the fund is liquidated at the end of the second year.  At liquidation, the managers earn a fee of $25 for every $1,000 in the fund (20 percent of the accumulated two-year profit of $125).  Because the fund managers generally do not take any performance fees until the fund is liquidated, the performance fee for private equity firms is known as carried interest. 5-51  Types of Private Equity Funds: Venture Capital  Venture Capital refers to financing new, often high-risk, start- ups.  Individual venture capitalists invest their own money.  Venture capital firms pool funds from various sources.  Individuals  Pension funds  Insurance companies  Large corporations  University endowments  Venture capitalists know that many new companies will fail.  The companies that succeed can provide enormous profits. 5-52  Venture Capital, II  To limit their risk:  Venture capitalists generally provide financing in stages.  Venture capitalists actively help run the company.  At each stage, money is invested to reach the next stage.  Ground-floor financing  Mezzanine-level financing  At each stage of financing, the value of the founder’s stake grows, and the probability of success rises.  Venture capitalists withhold further financing if goals are not met.  If a start-up succeeds:  The big payoff frequently comes when the company is sold to another company, or goes public.  Either way, investment bankers are often involved in the process. 5-53  Chapter Review, II.  Operation of the New York Stock Exchange  NYSE Floor Activity  Special Order Types  NASDAQ  NASDAQ Operations  NASDAQ Participants  The NASDAQ System  NYSE and NASDAQ Competitors 5-54  Chapter Review, III.  Stock Market Information  How to Calculate Index Returns  The Dow Jones Industrial Average  Stock Market Indexes  More on Price-Weighted Indexes  Value-Weighted Indexes 5-55