Global Capital Markets (Module 3)

Chapter 13 and14

Chapter 13

Common Stock Market 1

Overview of Trading Locations in the U.S

• There are two basic types of trading in the secondary market for equities
• Organized exchanges
• over the counter (OTC) trading (The trading mechanism is a negotiated system whereby
buyers negotiate with sellers)

• Electronic communications networks (ECN's) are independently owned and operated and
have recently developed as a platform for trading common stocks

Major national stock exchanges

• New York Stock Exchange (NYSE) (about 2000 listed companies) Big Board

• American Stock Exchange (AMEX) (about 700 listed companies) Curb

• The major OTC market is Nasdaq (more listed companies than NYSE but less market
capitalization)

Practical categorization of traded stocks

• Exchange listed stocks

• Nasdaq listed OTC stocks

• Non-Nasdaq OTC stocks

Four major types of markets on which stocks are traded

• First Market: trading which occurs on organized, physical exchanges

• Second Market: trading in the OTC market of stocks not listed on an exchange

• Third Market: trading of listed stocks in the OTC market

• Fourth Market: institutional transactions which occur without an intermediary or exchange

Stock Exchanges

• listed stocks are those that are traded on exchanges

• The right to trade securities or make markets on an exchange floor is granted to individuals or
firms called a member, who buys a seat on the exchange

• stocks that are listed on regional exchanges are

– stocks that could not qualify for a national exchange
– dual listed stocks, which are listed on both regional and national exchanges

New York Stock Exchange

 • NYSE is a hybrid market and uses both continuous auction and call auction market
structure
• The majority of members are designated commission brokers, and they execute trades on
behalf of clients via the specialist structure
• Commission broker, an employee of one of the nearly 500 securities houses

• Independent floor brokers execute orders for other exchange members who have more
orders than they can handle alone

• Registered traders’ individual members who buy and sell for their own account

• A NYSE specialist is a market maker for each stock and is required to buy and sell those
shares from other members and maintain an orderly market for that stock
• Specialists maintain the limit order book which contains the prearranged quantities and
prices which the specialist receives from brokers

• Specialists have four major functions at the exchange

1. As a dealer, they buy and sell for their own inventory and provide liquidity if there are no
investors on the other side of a new transaction
2. They serve as agents for other exchange members, executing orders on their behalf
3. Given their presence in the exchange, specialists help to act as catalysts (brokers) by
bringing buyers and sellers together

4. They serve as auctioneers, quoting current bid and ask prices that are determined by
market conditions

Specialists must always give precedence to public orders over trading for their own account

Because of the ability to negotiate commissions the discount brokers have become a in increasingly
popular method for executing orders in the market

The OTC Market

 The OTC market trades unlisted stocks

 Dealers make markets in stocks and trade with each other and with retail customers

 Bid-ask spreads are the main source of dealer profits

 The National Association of Securities Dealers (NASD) regulates the market

NASDAQ Stock Market

 The Nasdaq (National Association of Securities Dealers Automated Quotations founded

in 1971) is an ECN (electronic communication network) which links thousands of
geographically dispersed market-making participants and member-dealers across the
country

NASDAQ Stock Market

 The Nasdaq is divided into two tiers

 Nasdaq National Market System (NNM)

approximately 3600 stocks traded on the NNM

 Small Capitalization Market

approximately 800+ stocks traded on the Small Cap Market

NNM dealers must

 Continuously post firm two-sided (bid and ask) quotes for the issues that they maintain in
inventory

 Report trades on a timely basis

 Be subject to immediate execution against their posted quotes

 Integrate the limit orders of customers into their quoted prices

 Give precedence to customer limit orders and not place a quote on any system different
from their Nasdaq quote

Other OTC Markets

 OTC Bulletin Board, owned and operated by the NASD, is where a majority of trades
occur outside of the Nasdaq

 Pink Sheet, a subscription service

Third market is the trading of listed exchange stocks in the OTC market, by dealers (not members of
an exchange)

Dealers that make markets in the third market operate under the regulatory jurisdiction of the NASD

Fourth market is the direct trading of stocks between two customers without the use of a broker

 This is direct trading of securities among institutions, thereby avoiding brokerage and
dealer costs

Electronic Communications Networks

ECN’s are privately owned broker and dealers that operate as market participants within the
Nasdaq system

The largest ECN’s

i. Instinet, NYSE Euronext, Archipelago and Nasdaq Brut

Crossing networks are batch processes that aggregate orders for execution at specified times
 b. Provide anonymity and reduced cost, and are designed to minimize trading
costs

Order Execution

• Brokers have a choice as to which market to execute stock transactions

• Payment for order flow monetary inducement to route orders to regional exchanges and
third market makers

• Alternatively the broker may

• Route the order to an ECN that automatically matches buy and sell orders at
specified prices

• Route the order to another division of the firm to be fulfilled from the firm’s
inventory (a process called internalization)

Other Types

• Offshore Trading

• Broker/dealers may trade exchange listed or Nasdaq equities offshore via foreign
exchanges or trading desks

Such transactions must be reported to the U.S. marketplace the next day

• Rule 144A Securities

– Allows trading of nonfungible unregistered securities among qualified institutional
buyers (QIB) by creating a “safe harbor” from SEC registration requirements
– QIBs are institutions with $100 million invested in securities
• American Depository Receipts

– (ADRs) are negotiable certificates in registered form, issued in the United States by a
U.S. bank, which certify that a specified number of foreign shares have been
deposited with an overseas branch of the bank that acts as a custodian in the country
of origin.

Intermarket Trading System (ITS)

Electronic system that displays quotes posted on all the exchanges where a stock is listed and
provides the intermarket execution
Consolidated Quotation System is a display system providing data on trades of listed stocks in
different market centers
NBBO: National Best Bid Offer Rate

NASDAQ Pricing Controversy

• Decimalization

• In 2001, the NYSE, AMEX and NASDAQ all used actual decimal or "penny" quotes
rather than the older conventions such as sixteenths or eighths

• Regulation FD (Full Disclosure)

• In 2000, corporations were restricted from providing disclosure to only select
groups of market participants
Trading Stocks Outside

• Global Depositary Receipts

– When shares are issued in other markets, banks issue documents which represent
those securities
• American Depositary Receipts
– Sponsored ADR’s

• A foreign corporation seeks to have its stock traded in the United States and
only one depository bank issues the ADRs.

– Non-sponsored ADR’s

• One or more banks or brokerages can assemble a large block of the shares
of a foreign corporation and issue ADRs without the participation of the
foreign corporations

• ADR LEVEL I,II,III

• Difference between ADR/GDR

Chapter 14

Common Stock Market 2

Trading Mechanisms

• Market order an order to buy or sell at the current (best) price

• Buy limit order an order to purchase only at the designed price or lower

• sell limit order an order to sell only at the designated price or higher

Types of Orders and Trading Priority Rules

• buy stop order is triggered only if the price has risen to some level

• sell stop order is triggered only if the market price falls to a predetermined level

Types of Orders and Trading Priority Rules

• Round lot is 100 shares of the listed firm

• Odd lot is a quantity less than a round lot
• block trade a trade for 10,000 shares or those having a market value of $200,000 or greater

BLOCK DEAL IN INDIA NEW NORMS: SIZE INCREASED TO 10 CRORE FROM 5 CRORE AND
EARLIER TIMING OF 35 MINUTES FROM 9:15 TO 9:50 HAS BEEN CHANGED TO 2 15 MINUTES
SLOT IN THE MORNING (8:45 TO 9. PREVIOUS DAY CLOSING PRICE) AND AFTERNOON (2:05
TO 2:20, 1:45 TO 2 VOLUME WEIGHTED AVERAGE PRICE)
 • Investors can purchase securities by borrowing the money from a broker and using the stocks
themselves as collateral

• The margin requirement is 50 percent

Transaction Costs

Explicit Costs

• Commission is the fee charged by broker to execute trade and the rate is now negotiable
• Soft Dollars are paid by brokers to clients in the form of free services and information in
exchange for guarantees of order flow from those clients

Implicit Costs

• Impact costs result from large trades and these trades tend to increase prices for
buy orders and decrease prices for sell orders
• Opportunity costs result from trades that are not executed, or when a delay occurs
in the trade
• The consensus is that implicit trading costs are economically significant relative to
explicit costs

Retail Stock Trading

• Discount brokerages have thrived since commission deregulation in the 1970's

• “full service” brokers have had to offer more and more services and lower prices to compete

Institutional Trading

• Special arrangements for trade execution

• orders requiring the execution of a trade of a large number of shares of a given

stock (block trades)

• orders requiring the execution of trades in a large number of different stocks as

simultaneous as possible (program trades)

The upstairs market is where these transactions take place

The NYSE defines a program trade as any trade involving the purchase or sale of a basket of at
least 15 stocks with a total value of $1 million or more

Price Limits and Collars

Circuit Breaker Rule

• Rule 80B “circuit breakers rule” instituted by the NYSE, applies when the price level of the
Dow Jones Industrial Average drops a certain amount during a trading day
• There are three trigger levels
• Level One

• 1250 point drop in the DJIA halts trading for 1 hour if the decline occurs before
2pm, for 30 minutes if before 2:30pm, and has no effect between 2:30pm and
4pm
 • Level Two

• 2450 point drop halts trading for 2 hours if the decline occurs before 1pm, for 1
hour if before 2pm, and for the rest of the day if after 2pm

• Level Three

• 3700 point drop halts trading for the remainder of the day regardless of when the
decline occurs

Trading Collar Rule

• Trading collar rule restricts index arbitrage trading

• If DJIA moves up or down 2% from the previous closing value, program trade
orders to buy or sell the S&P 500 stocks as part of the index arbitrage strategies
must be entered with directions to have the order executions effected in a manner
that stabilizes share prices

Stock Market Indicators

• Dow-Jones Industrial Average (DJIA)

– The oldest and most widely used average of 30 blue chip heavily traded industrial
stocks
• Standard & Poor’s 500 (S&P 500)
– Exclusively American companies with weighted prices based upon a previously-set
index base of 100
• NYSE Index

– Calculated from the market value index of all stocks traded on the NYSE

• NASDAQ Composite Index

– Issues traded over-the-counter

• Dow Jones Wilshire 5000 Total Market Index

– Essentially the entire stock market

Major International Stock Market Indexes

• Foreign exchanges have developed their own indexes, an example of just a few:

– Japan – Nikkei 225

– U.K. – Financial Times Index 100

– Germany – DAX 30

– France – CAC 40

Price Efficiency

Forms of Efficiency
• Weak form prices incorporate all historical information regarding price. If a market is weak-
form efficient, technical analysts will not be able to earn returns higher than what they
should earn based upon the risk they bear and transactions costs
 • Semi-strong prices reflect all public information, past and present. If a market is semi-strong
form price efficient, fundamental analysts will not be able to find abnormal returns

• Strong form prices are determined by all information, public or private. If the market is
strong form efficient, professional money managers and corporate insiders will be unable
to outperform a passive investment strategy

Implications for Investing in Common Stock

Passive investment strategy (market is efficient)

• Indexing is the most popular followed by institutional investors

• Indexing captures market

Active strategy (market inefficient)

– Timing selection of transactions

– Identify over or under valued stocks based on short lived market anomalies

Global Diversification

• Studies have provided evidence regarding the degree of dissimilarity in the movements of
stock prices on selected national exchanges
• Geographical and political alliances influence correlations in two ways

• Perceived crisis results in a “flight to safety” such as US Treasuries and thus high
correlation

• Companies in global sectors tend to follow the global market for their goods and
services rather than their local economy and consequently are not highly
diversified

• Global sector provides goods and services to the global economy through international trade

• Country sector produces goods and services mainly for the local economy