1. Chapter 18. The Common Stock
Market
• Types of markets
• Trading mechanics
• Stock market indexes
• Pricing efficiency

2. Common stock
• equity security
• ownership
• entitled to distributed earnings
• entitled to share of assets

3. I. Type of Markets
• exchanges
• OTC trading of
• unlisted stocks & listed stocks
• direct trading

4. Exchanges
• physical location for trading
• trading by members
• own a seat on the exchange
• stock traded on exchange are listed
stocks

5. NYSE
• the “Big Board”
• about 2800 listed U.S. companies
• & 450 non-U.S. companies
• $18 trillion market value (2/04)
• 1366 seats (fixed)
• seat price $2 million 2002
• 10/2003 $1.35 million

6. • stocks trade at post on the trading
floor
• 20 posts, trading about 100 stocks
• each stock has one specialist
• 10 specialist firms, 470 specialists
• each specialist has 5-10 stocks
• process trades from floor brokers
(5%) and electronically (95%)

7. role of the specialist
• MUST maintain a fair and orderly market
for stock
• act as buyer or seller as needed (10% of
trades)
• match buyers and sellers
• maintain order priority

8. the future of the specialist
• may be phased on with next 5-10
years
• recent SEC fines for improper
trading for several major firms

9. AMEX
• merged w/ Nasdaq 1998
• specializes in equity derivative
securities and closed-end funds

10. Regional exchanges
• stocks may be listed on both NYSE
and regional exchange
• 5 regional exchanges
• cheaper seat prices

11. OTC markets
• electronic network of dealers all over
the world
• ECNs
• electronic communication
networks
• more than one dealer per stock
• not obligated to make a market

12. Nasdaq
• not the only OTC system, but the
largest
• over 4000 companies listed
• mkt. value $2 trillion (2/28/03)
• leader in daily share volume
• over 500 dealers
• listing requirements

14. II. Trading Mechanics
• types of orders
• short selling
• buying on the margin
• institutional trading

15. Types of orders
• instructions from investors to
brokers
• market order
• buy/sell order to be executed at
best price
-- get lowest price for buy order
-- get highest price for sell order

16. • market order (cont.)
• market orders given priority in
trading
• no guarantee of execution price
-- price could rise/fall from time
order is placed to time it is
executed

17. • limit order
• buy/sell order where investor
specifies price range
• “buy at $50 or less”
• “sell at $52 or more”
• specialist records orders in
limit order book

18. • investor sets reservation price
BUT
• no guarantee that limit order will
be executed

19. • stop order
• order lies dormant
• turns into market order when
certain price (“the stop”) is
reached
• “buy if price rises to $60”
• “sell if price falls to $58”
-- stop loss order

20. • investor does not have to watch
market
• but in a volatile market stop could
be triggered prematurely
-- end up trading unnecessarily

21. • stop limit order
• turns into limit order when stop is
reached
• “buy if price rises to $60, but only
is executed at $65 or less”

22. • market if touched order
• turns into market order if certain
price is reached
• “buy if price falls to $55”
• “sell if price rises to $62”

23. how long is an order good?
• fill or kill order
• executed when reaches trading
floor, or canceled
• good until canceled/open order
• is good indefinitely

24. order size
• round lots
• lots of 100 shares
• odd lots
• less than 100 shares
• more difficult to trade
• block trades
• 10,000 shares or $200,000 value

25. short selling
• sale of borrowed stock
• profit from belief that stock price is
too high will fall soon
• how?
• borrow stock through broker
• sell stock
• buy and return later

26. • short selling could further
destabilize falling prices
• tick test rules on exchange
• short sales allowed if
• uptick or zero uptick in price for
previous trades:
• $20.75, $21 (uptick)
• $20.75, $20.75 (zero upick)
• $20.75, $20 (downtick)

27. • so short sellers
• believe price will fall and SOON
• but price not currently falling
• face unlimited losses if price rises

28. Buying on the margin
• buyer borrows part of purchase price
of stock, using stock as collateral
• borrow at call money rate
• Fed sets initial margin requirement
• minimum cash payment
• 50% since 1975

29. • if stock price falls
• collateral worth less
• if collateral worth only 125% of
loan (maintenance margin)
-- margin call
-- owner must put up more cash or
sell stock
• margin calls can worsen stock
crash

30. example
• 1000 shares, $20 per share
• $20,000 cost
• $10,000 cash, borrow $10,000
• leverage
• gains/losses on $20,000 capital
• but tied up only $10,000 capital

31. • if prices falls to $12,
• value of stock $12,000
• below 125% of $10,000 loan
• get a margin call

32. Institutional trading
• vs. retail trades
• institutional trades are larger
• special execution
• over 50% of NYSE share volume

33. block trades
• large # shares in one stock
• executed in “upstairs” market
• other firms directly take other side
of trade
• remainder executed on trading floor
or Nasdaq (downstairs)

34. program trades
• large # shares, different stocks
• used by mutual funds for asset
allocation
• want
• low commissions
• prevent frontrunning

35. what is frontrunning?
• brokers trade ahead of program
trade
• to benefit from anticipated price
movements
• due to large trade

36. example
• broker buys ahead of large buy order
• broker buys first
• large buy order pushes up price
• broker’s holdings increase in value
• result
• frontrunning starts to push up
price, so firm does not get best
price

37. agency basis
• brokers bid for trade by commission
• low commission, but
• frontrunning likely

38. agency incentive agreement
• set benchmark value for trade
• based on last day’s prices
• if broker does better
• gets commission + bonus
• higher commission, but
• frontrunning less likely

39. III. Stock market indicators
• measure average performance of a
group of stocks
• different indexes are highly
correlated:
• DJIA & S&P 500 .991 (1990s)
• DJIA & NYSE .95

40. indexes differ due to
• stocks included in the index
• weighting of stocks
• equal, price, value
• average
• arithmetic
• geometric

41. stock exchange index
• includes all stocks listed on
exchange
• NYSE Composite
• Nasdaq Composite
• (both value weighted)

42. subjectively selected index
• organization picks group of stocks
to measure
• Dow Jones Industrial average
• S&P 500

43. DJIA
• price weighted
• 30 large blue chip companies
• cross section of industries
• leaders
• large movements in DJIA may halt
trading on NYSE

44. S&P 500
• 500 large blue chip companies
• value weighted
• most popular benchmark for index
funds

45. objectively selected index
• inclusion of stock based on objective
criteria
• market value
• Wilshire 5000
• all publicly traded stocks
• Russell 2000
• largest 3000 companies, then take
smallest 2000 of those

46. IV. Pricing Efficiency of the
Stock Market
• what information is reflected in
current stock prices?
• what implications does this have
for active vs. passive investment
strategies?

47. 3 levels of price efficiency
• what are they?
• implication?
• evidence for U.S. stock markets?

48. Weak form efficiency
• current stock prices reflect
• information about past prices
• and trading history

49. implication
• if markets are weak-form efficient
• using past price/trading pattern to
predict future stock prices will not
work
• so, technical analysis will fail to
beat the market

50. evidence
• U.S. stock market is weak-form
efficient
• technical analysts do not beat the
market
• especially after trading costs

51. Semi strong form efficiency
• current stock prices reflect
• all publicly available information
relevant to stock
-- economic data
-- financial statements

52. implication
• using public info to predict future
stock prices will not work
• fundamental analysis will fail to
beat market

53. evidence
• mixed
• Yes
• most actively managed portfolios
do not outperform randomly
selected portfolios

54. • No.
• certain pricing anomalies persist
for long periods of time
• January effect
• size effect

55. Strong form efficiency
• current stock prices reflect all
information
• public and private

56. implication
• impossible to predict future stock
prices
• stock prices are a random walk

57. evidence
• U.S. stock market is not strong form
efficient
• why?
• corporate insiders consistently
outperform market
• & they have access to private info

58. active strategy
• using fundamental or technical
analysis to select stocks to buy/sell
• growth, sector, value funds
• trading on this info increases
• trading costs
• tax consequences
• odds of working are low

59. passive strategy
• believe market is efficient, just
capture long-run returns of market
• buy-and-hold diversified portfolio
• index funds
• lower expenses, defer taxes
• index funds outperform most
actively managed funds