978-1259720697 Chapter 5 Lecture Note

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Chapter 5

The Stock Market

Slides

5-1. Chapter 5

5-2. The Stock Market

5-3. Learning Objectives

5-4. The Stock Market

5-5. Private Equity

5-6. The Structure of Private Equity Funds

5-7. Types of Private Equity Funds: Venture Capital

5-8. Venture Capital, II

5-9. Types of Private Equity Funds: Middle Market

5-10. Types of Private Equity Funds: Leveraged Buyouts

5-11. Selling Securities to the Public

5-12. The Primary Market for Common Stock IPO and SEO Details

5-13. The Primary Market for Common Stock IPO Example: All IPOs are Cash

Offers

5-14. The Primary Market for Common Stock The Rest of The Story

5-15. IPO Tombstone

5-16. The Secondary Market for Common Stock

5-17. The New York Stock Exchange

5-18. NYSE Seats and Trading Licenses

5-19. Farewell, Specialists

5-20. Hello, Designated Market Makers

5-21. DMMs and Supplemental Liquidity Providers (SLP)

5-22. Other NYSE Participants

5-23. Super Display Book System (SDBK)

5-24. The NYSE Hybrid Market

5-25. NYSE-Listed Stocks

5-26. Operation of the New York Stock Exchange

5-27. NYSE Floor Activity

5-28. Stock Market Order Types

5-29. Circuit Breakers

5-30. Trading on the Web

5-31. Types of Orders: Market and Limit Orders

5-32. Types of Orders: Stop Orders

5-33. Types of Orders: Stop Limit Orders

5-34. Stop Orders versus Stop Limit Orders

5-35. Comparing Stop and Stop Limit Orders, I.

5-36. Comparing Stop and Stop Limit Orders, II.

5-37. Comparing Stop and Stop Limit Orders, III.

5-38. NASDAQ, I.

5-39. NASDAQ, II.

5-40. NASDAQ Quotes

5-41. NYSE and NASDAQ Competitors

5-42. Stock Market Information

5-43. The Dow Jones Industrial Average

5-44. The DJIA Component Stocks

5-45. Stock Market Indexes, I.

5-46. Stock Market Indexes, II.

5-47. Stock Market Indexes, III.

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5-48. Example I: $1,000,000 to Invest, Price-Weighted Portfolio

5-49. Example II: Changing the Divisor when a New Stock is Added to the Index

5-50. Example III: $1,000,000 to Invest, Value-Weighted Portfolio

5-51. Example IV: How Does the Value-Weighted Index Change?

5-52. The Day 3 Index Can be Calculated in Two Ways:

5-53. Useful Internet Sites

5-54. Chapter Review, I.

5-55. Chapter Review, II.

Chapter Organization

5.1 Private Equity versus Selling Securities to the Public

A. Private Equity

B. The Structure of Private Equity

C. Types of Private Equity Funds

D. Selling Securities to the Public

E. The Primary Market for Common Stock

F. The Secondary Market for Common Stock

G. Dealers and Brokers

5.2 The New York Stock Exchange

A. NYSE Membership History

B. Designated Market Makers

C. Other NYSE Participants

D. The NYSE Hybrid Market

E. NYSE-Listed Stocks

5.3 Operation of the New York Stock Exchange

A. NYSE Floor Activity

B. Special Order Types

5.4 NASDAQ

A. NASDAQ Operations

B. NASDAQ Participants

5.5 NYSE and NASDAQ Competitors

5.6Stock Market Information

A. The Dow Jones Industrial Average

B. Stock Market Indexes

C. More on Price-Weighted Indexes

D. The Dow Jones Divisors

E. More on Index Formation: Base-Year Values

5.7 Summary and Conclusions

Selected Web Sites

www.nvca.org (general VC information)

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www.secondmarket.com (trading in stocks yet to go public)

www.hoovers.com (reference for more on Initial Public Offerings, or IPOs)

www.hsx.com (Hollywood Stock Exchange)

www.nyse.com (website for the New York Stock Exchange)

www.nasdaq.com (website for the NASDAQ)

www.otcmarkets.com (reference for microcap trading)

www.djaverages.com (reference for more information on the DJIA)

www.russell.com (reference for the Russell Indexes)

www.msci.com (reference for fivalue” and figrowth” indexes)

www.standardandpoors.com (website for S&P 500)

Indexes.nikkei.co.jp/en/nkave (website for Japan’s Nikkei 225 index)

Annotated Chapter Outline

5.1 Private Equity versus Selling Securities to the Public

A. Private Equity

Private Equity refers to the rapidly growing area of equity financing for nonpublic

companies.

A. The Structure of Private Equity Funds

There are many similarities to hedge funds (high water mark, fee structure,

limited partnership, etc.). The main difference is that a private equity fund invests

in private companies, typically using convertible securities (like preferred stock)

to minimize risk and retain upside potential.

One added feature of performance compensation is a clawback provision, which

means any prior performance fees must be returned if subsequent losses occur.

Thus, most performance fees are retained as ficarried interest” until the fund

matures and is liquidated.

B. Types of Private Equity Funds

Venture Capital: financing for new, often high-risk ventures

Middle Market: smaller, established companies (often family owned)

Leveraged Buyouts: taking firms public

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C. Selling Securities to the Public

In the primary market, companies issue new securities to raise money. In the

secondary market, investors constantly appraise the values of companies by

buying and selling shares previously issued by these companies.

D. The Primary Market for Common Stock

The market in which new securities are originally sold to investors.

Initial public offering (IPO): An initial public offer occurs when a company offers

stock for sale to the public for the first time.

Seasoned equity offering (SEO): The sale of additional shares of stock by a

company whose shares are already publicly traded.

General cash offer: An issue of securities offered for sale to the general public

on a cash basis.

Rights offer: A public issue of securities in which securities are first offered to

shareholders.

Investment banking firm: A firm specializing in arranging financing for

companies.

Underwrite: To assume the risk of buying newly issued securities from a

company and reselling them to investors.

Underwriter spread: Compensation to the underwriter, determined by the

difference between the underwriter’s buying price and offering price.

Syndicate: A group of underwriters formed to share the risk and to help sell an

issue.

Firm commitment underwriting: A type of underwriting in which the

underwriter buys the entire issue, assuming full financial responsibility for any

unsold shares.

Best efforts underwriting: The underwriter sells as much of the issue as

possible, but can return any unsold shares to the issuer without financial

responsibility.

Dutch auction underwriting: The offer price is set based on competitive

bidding by investors.

Securities and Exchange Commission (SEC): Federal agency charged with

enforcing U.S. securities laws and regulations.

Prospectus: Document prepared as part of a security offering detailing a

company’s financial position, operations, and investment plans for the future.

Red herring: A preliminary prospectus not yet approved by the SEC.

Securities are first bought and sold in the primary market, both through IPOs and

as seasoned offerings. The investment banking firm establishes the financing

package, advises on the pricing and number of shares, and arranges distribution

of the shares. The underwriter spread, the “mark-up” on the stock price, is the

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basic part of the underwriter’s compensation. The stock may be distributed as a

fixed commitment (which is the most common), or on a best effort’s basis. The

other form is a Dutch auction.

All issues must be approved by the SEC, with the prospectus being issued to

investors prior to sale of the stock. To advertise the issue, a tombstone

advertisement will usually appear in the Wall Street Journal or another financial

publication.

Lecture Tip: Examples are very helpful when discussing the primary market and

explaining the differences between a fixed commitment and a best efforts

offering. The most current one that would be of interest to students is Facebook.

The Wall Street Journal website has numerous videos detailing the IPO. It is also

good to emphasize that the underwriter takes on the risk of the issue not

completely selling with a fixed commitment offering, whereas the company takes

the risk in a best efforts arrangement.

Lecture Tip: There are many investment terms that are used because of tradition

or historical significance. The red herring statement and the tombstone

advertisement are two of those. The term fired herring” relates to the red stamp

“preliminary” on the front of the preliminary prospectus, but it also relates to the

old saying of “don’t buy a red herring.” The tombstone advertisement is called

such because the advertisement looks like a tombstone in a graveyard. A legal

statement appears on all tombstone advertisements: “This announcement is

neither an offer to sell nor a solicitation of an offer to buy any of these Securities.

The offer is made only by Prospectus.” The wording may vary somewhat, but the

statement meets the SEC requirements of providing the prospectus to investors

before soliciting a purchase.

F. The Secondary Market for Common Stock

In the secondary market investors buy and sell shares with other investors.

Secondary market trading is directed through three channels:

Directly with other investors

Indirectly through a broker who arranges transactions for others

Directly with a dealer who buys and sells securities from inventory

G. Dealers and Brokers

Dealer: A trader who buys and sells securities from inventory.

Broker: An intermediary who arranges security transactions among

investors.

Bid price: The price a dealer is willing to pay.

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Ask price: The price at which a dealer is willing to sell. Also called the

offer or offering price.

Spread: The difference between the bid and ask prices.

A dealer maintains an inventory and stands ready to buy and sell at any time.

The dealer maintains an inventory to accommodate order imbalances. The

dealer is willing to pay the bid price and will sell at the ask price. The difference is

the bid-ask spread. The dealer profits through strategically setting the spread.

The broker brings together buyers and sellers, but does not maintain an

inventory. The broker facilitates trades by others.

The largest secondary market by market capitalization is the NYSE. By number

of companies listed and shares traded it is the Nasdaq.

Lecture Tip: It is useful to point out to students that the bid-ask spread is not

fixed, but changes frequently. Two important factors in determining the spread

are the perceived risk and the volume. Dealers will typically increase the spread

when the perceived risk is higher, and decrease the spread when the risk is

lower.

5.2 The New York Stock Exchange

The NYSE was 200 years old in 1992. For more than 200 years, the NYSE

operated as a not-for-profit corporation owned by its members, the securities

firms and brokerage companies. On March 8, 2006, the NYSE went public

(ticker NYX) and became a publicly traded for-profit corporation. On April 4,

2007, NYSE Holdings merged with Euronext N.V. and launched NYSE Euronext.

NYSE Euronext was, at the time, the world’s largest exchange. In 2013, NYSE

Euronext was acquired by Intercontinental Exchange (ICE).

A. NYSE Membership History

NYSE exchange member: As of 2006, the owner of a trading license on

the NYSE is an exchange member.

Historically, the NYSE had 1,366 members who fiowned” seats on the exchange.

Seat owners could buy and sell securities on the exchange floor with no

commission. Since 1929, the lowest seat price paid was $55,000 (1977). In 2005,

a seat sold for a record price of about $4 million. In 2006, all of this changed

when the NYSE became a publicly owned corporation called NYSE Group, Inc.

Its stock listed on the NYSE. Now, instead of purchasing seats, exchange

members must purchase trading licenses, the number of which is limited to

1,366. In 2012, a license would set you back $50,000 per year. Before the NYSE

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went public, NYSE members collectively owned the exchange. Today, the

shareholders of ICE own the exchange.

B. Designated Market Makers

Specialist: NYSE member acting as a dealer on the exchange floor. They

are often called market makers. The role of a traditional specialist has

been phased out and replaced by two types of market makers:

Designated Market Maker (DMM): assigned a set of securities and

obligated to maintain a fair and orderly market. DMMs, however, face

fewer trading restrictions than specialists did.

Supplemental Liquidity Provider (SLP): located away from the

exchange and have fewer price posting requirements, but are similar in

that they provide market liquidity.

C. Other NYSE Participants

Floor brokers: Agents who execute customer orders to buy and sell stock

transmitted to the exchange floor. Typically they are employees of NYSE

member firms.

SuperDOT system: Electronic NYSE system allowing orders to be

transmitted directly to market makers for immediate execution. Eliminated

and replaced by the Super Display Book system (SDBK).

Floor brokers execute customer orders to buy and sell stocks, and are typically

employees of NYSE member brokerage firms. Their responsibility is to get the

best possible price for their customers.

DMMs act as an assigned dealer for a small set of securities. DMMs are also

called market makers, and they are assigned the responsibility of maintaining a

fair and orderly market in a security. They make a market by standing ready to

buy at bid prices and sell at ask prices, acting as dealers for their own accounts.

They also maintain an inventory in the security, and provide liquidity to the

market.

The Super Display Book (SDBK) system, connected to the Arca, allows orders to

be transmitted electronically and accounts for a substantial percentage of all

trading.

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D. The NYSE Hybrid Market

Hybrid trading combines the exchange’s automated technology with the

advantages of an auction market. In the Hybrid market, DDMs and floor brokers

interact with the market electronically as well as in person.

E. NYSE-Listed Stocks

There is an initial listing fee, and an annual listing fee that must be paid by firms

on the NYSE. Some example minimum requirements by the NYSE in 2016

included:

Total shareholders must be at least 2,200 (400 round lots for IPOs), with

100,000 shares traded a month on average for the most recent six

months.

At least 1.1 million shares must be held by the public.

Publicly held shares must have at least $100 million market value ($40

million for IPOs).

Company must have annual earnings of $10 million before taxes in the

previous three years, and $2 million in each of the preceding two years.

5.3 Operation of the New York Stock Exchange

The business of the NYSE is to attract and process order flow, the flow of

customer orders to buy and sell stock. In 2015, trading volume regularly reached

1.5 billion shares per day. About one-third of the trading volume is attributable to

individual investors, and almost half (or more) is derived from institutional

investors or high frequency traders.

A. NYSE Floor Activity

DDM post: Fixed place on the exchange floor where the DDM operates.

Market order: A customer order to buy or sell securities marked for

immediate execution at the current market price.

Most of the activity on the floor of the exchange takes place around the DDM’s

post. The clerks operate behind the counters, and the commission brokers

receive customer orders and walk to the DDM’s post to execute the orders. When

a customer issues a market order, they want to buy or sell at the current market

price, with the order marked for immediate execution. The broker will try to get

the best price possible.

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B. Special Order Types

Limit order: Customer order to buy or sell securities with a specified

“limit” price. The order can be executed only at the limit price or a better

price.

Stop order: Customer order to buy or sell securities when a preset “stop”

price is reached.

Stop-limit order: Customer order to buy or sell securities when a preset

fistop” price is reached, with an additional restriction that a specified filimit”

price cannot be violated.

Many NYSE orders are limit orders, where a customer specifies a maximum

price to pay (buy order) or minimum price to accept (sell order). The customer is

not willing to accept any price above (buy) or below (sell) the specified price. A

stop order specifies a “stop” price, which is a trigger price for the order to be

converted into a market order. The stop order does not place a maximum or

minimum limit on the trade price. Once converted to a market order, the trade is

executed like any other market order.

Stop-loss orders (selling when price falls to a particular level) are designed to

prevent loss, but when prices fall rapidly, sellers realize a much lower price than

expected. Realizing this risk, the NYSE is eliminating stop orders, but brokers

can still facilitate these, so long as the triggered ordered is converted to a market

order prior to execution.

5.4 NASDAQ

NASDAQ stands for National Association of Securities Dealers Automated

Quotations system. In terms of dollar volume the NYSE is larger, but in terms of

share volume the NASDAQ is larger.

A. NASDAQ Operations

Over-the-counter (OTC) market: Securities market in which trading is

almost exclusively done through dealers who buy and sell for their own

inventories.

The NASDAQ is a network of securities dealers who disseminate timely security

price quotes to NASDAQ subscribers. The dealers post bid prices and ask prices

as well as the number of shares they are willing to trade at the quoted prices.

NASDAQ market makers trade on an inventory basis, but there are multiple

market makers for actively traded stocks. The NASDAQ market is an OTC

market, although they are trying to lose that name.

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The two key differences between the NYSE and NASDAQ are:

NASDAQ is a computer network with no physical location.

NASDAQ has a multiple market maker system, rather than a specialist

system.

NASDAQ is managed by FINRA, the financial industry regulatory authority. In

fact, every broker or dealer in the U.S. that conducts a securities business is

regulated by FINRA.

B. NASDAQ Participants

The NASDAQ has historically been a dealer market, characterized by competing

market makers. In 2015, over 3,000 companies were listed on the NASDAQ

system (across the three platforms – Global Select, Global, and Capital).

In the late 1990s, the NASDAQ system was opened to the so-called electronic

communications networks (ECNs). ECNs are basically websites that allow

investors to trade directly with one another. As a result, individual investors can

enter orders (not just market markers). Hence, ECNs act to increase liquidity and

competition.

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.

That is, they are the highest bid and the lowest ask.

For a small fee, you can have access to fiLevel II” quotes. With Level II quotes,

you can see all bids and asks. Frequently, the identity of the market maker is

also displayed. Level III quotes are reserved for market makers.

Lecture Tip: When discussing the NASDAQ it is interesting to talk about the

firms listed on the NASDAQ. It is no longer every firm’s goal to be eventually

listed on the NYSE—the NASDAQ is now an attractive competitor to the NYSE.

Ask students what firms they know are listed on the NASDAQ. They should be

able to suggest a number of firms, such as Intel, Microsoft, Google, and Apple.

5.5 NYSE and NASDAQ Competitors

Third market: This term refers to trading in exchange-listed securities that

occurs off the exchange on which the security is listed.

Fourth market: This term refers to direct trading of exchange-listed

securities among investors. (A good example is the ECN, Instinet.)

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The NYSE and NASDAQ face competition from the third market, the fourth

market, and regional exchanges. One example is Instinet, an electronic trading

network that facilitates trading among its subscribers. NASDAQ has SelectNet,

which has not been as popular as Instinet. Thousands of stock issues are dually

listed on the NYSE or NASDAQ, and on a regional exchange.

5.6 Stock Market Information

A. The Dow Jones Industrial Average

The Dow Jones Industrial Average (DJIA) or “Dow” is the most widely followed

barometer of daily stock market activity. The DJIA is an index of 30 large “blue-

chip” companies representative of American industry. Two other Dow averages

include the utilities and transportation averages.

B. Stock Market Indexes

Price-weighted index: Stock market index in which stocks are held in

proportion to their share price.

Value-weighted index: Stock market index in which stocks are held in

proportion to the aggregate market value.

Lecture Tip: Stock indices can be calculated as price-weighted indexes or value-

weighted indexes. To compute a price weighted index, take the price of each

stock in the index, add them up, and divide by the number of stocks. It is

basically a simple average. To compute a value-weighted index, multiply the

number of shares of each stock in the index by the corresponding share price,

and sum the products to give the total market value. Then divide this total market

value by the latest index divisor to give the index value. The initial index divisor is

the initial (base period) total market value divided by the desired initial index

value. The divisor changes as stocks are added to or deleted from the index.

C. More on Price-Weighted Indexes

Lecture Tip: It becomes apparent after some observation that the price-weighted

index has some problems. Since it is a simple average of the share prices of the

stocks in the index, the value can be unduly influenced by the price changes of

one high-priced stock. Also, the index must be adjusted for stock splits and stock

dividends. This tends to cause the divisor to change, in fact decrease, over time.

D. The Dow Jones Divisors

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As of October 27, 2015, the DJIA divisor was a nice, round 0.14967727343. A

divisor that is less than one will further magnify any price change effects. This is

one reason we see such large swings in the DJIA.

E. More on Index Formation: Base-Year Values

Index staleness: Condition that occurs when an index does not reflect all

current price information because some of the stocks in the index have not

traded recently.

If there are problems with price-weighted indices, why do we continue to follow

the DJIA? The answer is tradition. The most popular alternative to the DJIA is the

value-weighted S&P 500 index, which provides frequent accurate updates of

market prices. This index accounts for a major portion of overall stock market

value with its representative 500 stocks.

5.7 Summary and Conclusions

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