Francis

Francis & Ibbotson Chapter 6: The Global Stock Market

11

Slides by:

Pamela L. Hall, Western Washington University

The Global Stock MarketThe Global Stock Market

Chapter 6


22

BackgroundBackground

A variety of different stock markets exist– For instance, Germany’s market is over 400 years old

while Tanzania’s began in 1998

– Macedonia has only two companies trading on its stock exchange while India has 5,840

– The market capitalization of the U.S. is $10 trillion while that of Guatemala is only $2 billion (in U.S. dollars)

Many stock markets also trade other financial instruments

Consolidations are merging stock markets and technology is pulling national markets together


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Aggregate market capitalization of equity shares in the world grew from $9.6 trillion in 1990 to over $35 trillion in 2000– An average rate of 14.8% annually

Financial capital is very mobile– In 1990 the Tokyo Stock Exchange was 30.5% of

the global market but only 12.7% in 1999

– North America increased its share of the world equity market from 28.0% (1990) to 50.28% (1999)


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Technological advances are automating experienced stock exchange employees out of jobs

Stock markets are active in every time zone


55

Brokerage ServicesBrokerage Services

Brokers– Sales people (earning a commission) employed

by dealers

– Have no money invested in the dealer’s security inventory

– Help create markets by buying and selling from employer’s inventory

Brokerage firms extend credit (margin accounts) to clients– Enables client to do more securities trading


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Types of stock brokerage services– Full-service

• Take buy and sell orders

• Extend margin credit to customers

• Hold clients’ securities in safe keeping

• Collect cash dividends

• Provide free investment research

• Perform ‘hand-holding’ services– Pleasant telephone conversations

– Investment counseling

– Birthday cards

• All paid for by clients’ trading commissions– Range from $30 - $150 for one common stock transaction

•Examples–Merrill Lynch

–Goldman Sachs

–PaineWebber

–Morgan Stanley Dean Witter

–Salomon Smith Barney


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– Discount Brokers• Simply take orders• Offer little or no investment advice• No ‘hand-holding’ services provided• Little opportunity for churning• Lower commissions

– Range from $20 to $50

• Examples– Charles Schwab & Company– Quick & Reilly– Muriel Siebert– Jack White & Company– Fidelity Investments– Vanguard Brokerage Services


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– Electronic brokers• Take buy and sell orders via Internet• No ‘hand-holding’ services• May provide investment research

– May or may not be free

• Low commissions– Range from almost free to $35 a trade

• Examples– Discover Brokerage– DLJdirect– E*Trade– Archipelago– Bloomberg Tradebook– Accutrade

–Ameritrade–Charles Schwab–SURETRADE–Wall Street Access–CyberCorp.com


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TransactingTransacting

When making a trade, the investor must specify– Type of order– Whether or not margin will be involved


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Types of Trading OrdersTypes of Trading Orders

Market order—order to buy or sell ASAP at the current market price– Simplest, most common order type

– Executed immediately with virtual certainty

Limit order—order to buy or sell with a limit– Limit as to the maximum price paid for a buy order

– Limit as to the minimum price received for a sell order• If order cannot be immediately transacted, it is recorded in

the market-maker’s limit order book and held for possible future execution

– Order may never be executed if limit price is not reached

– May attach a time frame to the limit order


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Stop orders– To buy (sell) are written at prices greater (lower)

than the current market price– Activated when (if) the market price reaches the

stop price• Once activated becomes a market order

– Dangers with stop orders• Execution price cannot be known in advance• Investor may be whip-sawed in volatile market

– Variation on stop order• Stop limit orders

– When stop order is activated it becomes a limit order rather than a market order


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Scale order– Requires buying or selling part of the order at each

price as market prices change• Cumbersome and not all brokers accept them

Fill or kill (FOK) order– Specifies price at which order must be filled or

order is immediately canceled

Good till canceled order– Remains in effect until canceled

• Day order—must be filled on the day order is issued• Market on close order—can only be executed at the

day’s closing price


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Trading on MarginTrading on Margin

When opening a new account with a brokerage firm, can have either– Cash account

• Must pay cash for securities

– Margin account• Offers ability to buy securities on credit• Money put forth by investor serves as a down payment• Amount investors may borrow is controlled by the

Federal Reserve Board of Governors– For example, the Fed may stipulate a 60% margin,

meaning the investor must put forth at least 60% of the purchase price


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Trading on MarginTrading on Margin

Federal Reserve’s margin requirements for stocks– Varied from 10% (1929) to 100% (1940)– In recent years has been 50%

Margin requirements are different for different types of securities


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How Margin WorksHow Margin Works

Example: You wish to purchase 100 shares of XYZ Company for a price of $100 per share. The initial margin requirement is 50%.– Purchase price is $100 x 100 shares = $10,000

• You put forth 50%, or $5,000

• Borrow the remaining $5,000 from your broker– Broker charges you the brokers’ call rate for a margin

loan


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Assume that the market value of the stock rises to $150 a share– Your total profit will be $50 a share times 100

shares, or $5,000, ignoring interest (on margin loan), taxes and commissions

• Your return is 100%: Profit of $5,000 Investment of $5,000

– If you had not used margin, you could have only afforded 50 shares, and your profit would only have been $2,500

» Your return would have been 50%: Profit of $2,500 Investment of $5,000


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Assume that the market value of the stock falls to $50 a share– Current market value of the investment is now only $5,000

(which exactly equals the amount that was borrowed from the broker)

– Your total loss will be $50 a share times 100 shares, or $5,000, ignoring interest (on margin loan), taxes and commissions

• Your return is -100%: Loss of $5,000 Investment of $5,000

– If you had not used margin, you could have only afforded 50 shares, and your loss would only have been $2,500

» Your return would have been -50%: Loss of $2,500 Investment of $5,000


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Maintenance MarginMaintenance Margin

If a margined portfolio decreases sufficiently in value, investor will receive a margin call– Investor must put up more margin money ASAP– Otherwise, broker liquidates enough of the investor’s

securities to bring account up to the required minimum margin• Easy for broker to do because investor with a margined account

must keep securities at the broker’s office as collateral for their loan

The NYSE has a maintenance margin requirement of 25%– Investor’s equity cannot fall below 25% of the account’s

market value– Or, investor’s loan amount cannot exceed 75% of the

account’s market value


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Maintenance MarginMaintenance Margin

Continuing the example, if you had purchased $10,000 of stock with a 50% margin, you would face a margin call when – Market value of stock dropped below $6,666.67

• Because your loan of $5,000 cannot exceed 75% of the market value of portfolio

– 75% × X = $5,000

– X = $6,666.67

Some brokers set a higher maintenance margin than the 25% minimum


2020

Investment Banks Make Primary MarketsInvestment Banks Make Primary Markets

Initial public offerings (IPOs) occur when corporations and governments issue new securities into the primary market

Sometimes corporations and governments with existing securities raise additional capital by issuing a new issue of seasoned securities

Investment bankers find buyers for both IPOs and seasoned new issues


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Investment BanksInvestment Banks

A few thousand investment banking firms exist in the U.S., including– Merrill Lynch & Co.– Morgan Stanley Dean Witter– Lehman Brothers– Credit Suisse First Boston– Goldman, Sachs & Co.– Salomon Smith Barney– Bear Stearns Cos.– Paine Webber


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Investment Bankers’ FunctionsInvestment Bankers’ Functions

Each public offering has four steps– Consulting with the issuer– Carrying out administrative duties– Underwriting the issue– Distributing the securities to investors


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ConsultingConsulting

The investment bank that serves as the IPO’s originator must analyze the client’s needs and suggest a financing plan– What type of security should be issued?– How much financing is needed?– When should the new securities be issued?

The originator will also manage– The underwriting syndicate

• Ranges from 5 to 200 investment banking firms that share the financing and underwriting risk

– The selling group• Investment banks and brokerage firms that sell the securities

to investors


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AdministrationAdministration

Deals with legal issues associated with an IPO

Helps obtain necessary government permissions

Has the prospectus printedMakes public announcements


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UnderwritingUnderwriting

An underwriter guarantees the issuer will receive a pre-specified amount of cash for the new securities– Days or weeks from the time the underwriter buys the

securities from the issuer till they sell the securities to the investors are very risky to underwriter

• Market conditions may fluctuate and underwriter may lose money on the securities because they have to sell them at a lower price

It is important to set the ‘right’ price for an IPO– If price is too high, underwriters may not be able to sell

securities– If price is too low, issuer may find it costly to issue

securities


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DistributionDistribution

Investment banker may sell securities to a wide group of investors– Or may act as intermediary between issuer

and buyer in a private placement

The difference between the investment banker’s cost and the sale price is known as the spread– Ranges from 5 – 16% for stocks– About 4% for bonds


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Electronic Investment BankersElectronic Investment Bankers

There are several investment banking firms offering internet services– DLJdirect– Freidman, Billings, Ramsey Group– E*Offering– OpenIPO– E-InvestmentBank– Wit Capital

Vary in size and sophistication


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Full DisclosureFull Disclosure

In U.S. the SEC requires most primary issues be accompanied by a prospectus– 10 to 20 page document that fully discloses, among other

items• Purpose for which the proceeds of the issue will be spent• Offering price to the public• Offering price for special groups, in any• Underwriter’s fees• Net proceeds to the issuer• Information on the issuer’s products, history and location• Names and remuneration of officers• Detailed statement of capitalization• Detailed financial statements• Details about any pending litigation


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Full DisclosureFull Disclosure

Approval of a prospectus by the SEC does not mean the investment is a good value, but that all the necessary information required by the SEC has been disclosed

Full disclosure allows investors to estimate value of new securities


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Secondary MarketSecondary Market

Once securities are issued in the primary market, they can begin trading in the secondary market

Types of secondary markets– Organized exchange run by dealers

(NYSE)– Electronic market in which dealers

compete with one another (Nasdaq)– Electronic communication networks


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NYSENYSE

New York Stock Exchange (www.nyse.com) lists approximately– 3000 common and preferred stocks issued

by American corporations– 300 foreign stocks– 250 American Depository Receipts

(ADRs)– Also trades bonds


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NYSENYSE

Each stock traded on the NYSE is assigned a specialist who must– Continuously post bid and ask prices for the

stocks in which they make a market– Stand at assigned posts on the trading floor– Act as market-makers (dealer)

• Always ready to buy at their bid price and sell at their ask (or offer) price

– Invest their own capital (risky) but may earn a return

– Execute orders for others (broker)– Earn the bid-ask spread on every transaction


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DecimalizationDecimalization

A tick represents the minimum amount by which a price can change– Prior to 1997 the tick was 1/8 but then

became 1/16• However the tick size is now 1¢ since the

exchanges instituted decimalization– Expected to reduce the bid-ask spread and trading

costs


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NYSE Listing RequirementsNYSE Listing Requirements

To be listed on the NYSE must have– A minimum taxable annual income of $2.5

million

– A minimum net tangible assets of $18 million

– A minimum of 1.1 million shares of publicly held stock with a minimum market value of $18 million

– A minimum number of 2,000 investors owning round-lots (100 shares)

– One specialist


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NYSE OperationsNYSE Operations

Approximately 460 specialists with about 8 stocks assigned to each specialist’s trading post

About 1,500 trading booths with telephones surround the perimeter of the trading floor– Allows for order transmission and confirmation

between brokers’ offices and exchange floor

NYSE has 1,366 members who must own a seat on the exchange– Almost all members are either specialists or floor

brokers


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Floor BrokersFloor Brokers

Buy and sell securities for the clients of brokerage houses or for their own accounts

Order process– Broker receives order via phone from the

brokerage

– Walks to trading floor and executes transaction at the specialist’s post

– Phones brokerage and provides confirmation


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SpecialistsSpecialists

Accepts obligation to make a fair and orderly market by– Selling shares out of their own inventory if there

are more buy orders than sell orders (or by raising the price of the security they control)

– Buying shares for their own inventory if there are more sell orders than buy orders (or by lowering the price of the stock)

Keeps a limit order book (LOB) for each stock in which they make a market


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Limit Order BookLimit Order Book

Today is kept on a computer Records buy and sell orders from potential traders

– Outlines the supply and demand curves that determine market price of security

• Helps specialists earn trading profits

BID: $42 and ?/8

0/8 4 Wentz

9 Mirandi

3 Dalton

1/8 1 Sullivan

4 Jacoby

1/4 3 McGovern

3/8 2 Gabelli


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NYSENYSE

NYSE has lagged behind other organizations in terms of technology

Uses Super Designated Order Turnaround (SuperDOT) system – Routes small market orders and limit

orders directly from member firms to specialists

• Bypasses floor brokers• Specialists usually let PCs execute SuperDOT

transactions automatically


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Block TradesBlock Trades

A single transaction involving 10,000 or more shares Increased steadily throughout the 1960s-1980s but

leveled off in the 1990s Specialists are not involved in block trades that

occur outside the NYSE by block positioners– Special brokers/dealers that line up multiple buyers for a

large block– Some large investment banks have a block positioning

department• Have the capital to carry a large block for a few days and the

connections to distribute it• The upstairs market

– Economies of scale lead to small commissions per share


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Nasdaq MarketNasdaq Market

Electronic, over-the-counter (OTC) market

Lists over 15% of the world’s stock market capitalization– Over 6,400 common and preferred stocks– About 320 foreign stocks– About 140 ADRs


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National Association of Securities Dealers Automated Quotations (Nasdaq) is the communications network that services the OTC market– About 61,000 computer terminals are connected to

Nasdaq’s mainframe via phone lines• Can obtain current bid and ask prices for all Nasdaq stocks

– Updated continuously by about 540 competing Nasdaq market-makers (dealers)

– Investor’s broker can access the system to find the best bid/ask price for a security

• Broker then calls dealer to execute transaction as trades cannot be executed via Nasdaq computer


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Centralizes a geographically dispersed market into a mainframe computer

When a broker or dealer inquires about a security’s price, bid-ask quotes are instantly provided even if the dealers are many miles apart

Designed to handle up to 20,000 stocks– Currently lists about 6,500 actively traded stocks

In 1999 Nasdaq merged with AMEX Nasdaq plans to cross-list stocks with various

international exchanges– Positioning itself to more effectively compete with NYSE


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CQS, ITS and Law of One PriceCQS, ITS and Law of One Price

SEC requires that the Consolidated Quotation System (CQS) report current transactions for NYSE, OTC, AMEX, regional U.S. stock exchanges and the third market– Helps investors find the best prices– CQS cannot perform executions

• SEC urged NYSE to create the Intermarket Trading System (ITS)

– Electronic trading network linking various U.S. markets

• Nasdaq supplemented ITS with an electronic communications network called Primex

– Gives faster access to NYSE-listed stocks

• Combining CQS with ITS and Primex allows arbitrageurs to enforce the law of one price


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Non-Nasdaq National Quotation Bureau (NQB)Non-Nasdaq National Quotation Bureau (NQB)

To be included in Nasdaq’s national daily list, a stock must have– At least two market makers– A minimum of 1,500 stockholders– Significant investor interest

A stock not meeting these requirements are listed with the National Quotation Bureau (NQB)– NQB lists 3,600 stocks, some of which are not actively traded

• Includes– Domestic U.S. micro-cap stocks– Shares in foreign corporations that cannot be listed on an organized

exchange– ADRS and GDRs for stocks that do not meet the accounting

standards for listing on an organized exchange


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Third U.S. MarketThird U.S. Market

Third market—subset of OTC market where exchange-listed stocks are traded– Competes with organized exchanges

• Offers cost savings in the form of better bid-ask prices

– Nasdaq and regional stock exchanges are the core of the third market

• For instance, in 1999 Chicago Stock Exchange (CHX) traded over 90% of the NYSE-listed stocks

– Majority of CHX’s trading volume is from dual listings– CHX pays for order flow

» Specialists take a penny or so (per share) from their bid-ask spread and give it to brokers to encourage brokers to execute their orders on the CHX rather than NYSE


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Fourth U.S. MarketFourth U.S. Market

Fourth market—a network of market-makers, block traders and institutions– Bypass normal dealer services and negotiate

directly with each other

– Instinet (short for Institutional Network) has operated in the fourth market since 1970

• Has computer terminals in over 5,000 subscribers’ offices

– Millions of shares are traded in secrecy daily via Instinet

– Commissions range from 2¢ to 8¢ a share


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Order Crossing NetworksOrder Crossing Networks An electronic communication network that tries to match buy

and sell orders– The price may be

• The last reported price from an organized exchange• Midway between the current bid-ask prices on an organized exchange

Traders may pay a fixed annual fee to use alternative market systems– Variable trading costs are zero

Rapid executions are possible if the other half of the transaction is already present in network

Offers anonymity Sometimes the network is not operating when it is needed Or the other half of the transaction is unavailable


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Order Crossing NetworksOrder Crossing Networks

Instinet operates the Crossing Network and competes with Investment Technology Group’s (ITG) Portfolio System for Institutiional Trading (POSIT)

Bloomberg runs Tradebook—a continuous matching system mainly for Nasdaq stocks– In 1999 Bloomberg & ITG created SuperECN

• Offers a crossing network with a larger order flow

Other crossing networks include– Investor’s Liquidity Network by Fidelity Investors

– E-Crossnet is for European stocks


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Electronic Order Working SystemsElectronic Order Working Systems

Electronic order working systems– Screen telecommunication networks, capture

current market information and use it to make ongoing transactions

– Needs the following information• Securities that are to be traded

• Limit order prices

• Quantities available at different prices

• Binding time limits

• Markets where the securities are traded

• Any additional information


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Electronic Order Working SystemsElectronic Order Working Systems

Various EOWS include– QuantEX by Investment Technology

Group– Order Management System by Instinet– Lattice Trading System by Credit Suisse

First Boston– REDIBook– Archipelago Exchange


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Electronic Stock ExchangesElectronic Stock Exchanges Arizona Stock Exchange (AZX)

– Formed in 1990 in Phoenix– Periodic call market

• Automated auction process that attempts to equate the supply and demand for a broad list of common stocks at a few specified times each trading day

– Client submits order as if it were a limit order– The limit order book is open to all participants, but anonymity of

participants is maintained

– Each time an auction occurs, the AZX computer calculates supply and demand curves for each security being auctioned

• The intersection of the curve determines the security’s market clearing price

– All sell (buy) orders below (above) the market clearing price are matched

– On a daily basis, about two dozen institutional investors used the AZX system, trading several hundred thousand shares


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Electronic Stock ExchangesElectronic Stock Exchanges

European Association of Securities Dealers Automated Quotations (EASDAQ)– Based in Brussels– Nasdaq acquired EASDAQ in 2001– Lists and trades about 50 technology stocks

Primex– Patterned after NYSE– Takes a customer’s buy or sell order to the NYSE

and other competing exchanges in search of best available price

– Allows users to haggle for the best prices


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Tradepoint– Conducts auctions for U.K. equities

– Operates with a transparent order book

Jiway– Stockbrokers can transact with each other in over

6,000 European and American stocks

– Auctions off the right to be the designated market-maker for each stock in its system to member firms

– Provides custody services, etc.


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European Alliance– Informal alliance of eight stock exchanges, including

• London Stock Exchange

• Amsterdam Stock Exchange

• Brussels Stock Exchange

Reg ATS Exchanges– SEC rule that allows alternative trading systems in the U.S.

to register as stock exchanges

– Exchanges must • report their prices via the Consolidated Quotation System

• Operate as a self-regulating organization

• Participate in the intermarket trading system


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The Twenty-First CenturyThe Twenty-First Century

In 1999 NYSE and Nasdaq announced that they are interested in reorganizing as for-profit corporations– Would allow them to raise outside capital in order to obtain

better technology

In 2000 Merrill Lynch started an electronic brokerage subsidiary—the last full-service brokerage in U.S. to do so

In 2000 several companies submitted a joint proposal to SEC to establish a central limit order book– Would reduce market fragmentation and increase

transparency within U.S.


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The Twenty-First CenturyThe Twenty-First Century

Electronic technology will continue to accelerate change– Trading volume will increase as transaction costs

fall

– There will be pressure on stock exchanges and ECNs to consolidate

A global market will eventually emerge


5858

LiquidityLiquidity

Perfectly liquid assets are highly marketable– Do not suffer from a decline in price if

they are liquidated quickly• For example, the U.S. dollar is perfectly

liquid whereas most real estate is not because– To quickly sell a house, seller must offer a price

discount

– Real estate brokers commonly have commissions of 6% of the property value


5959

Liquidity ContinuumLiquidity Continuum

Assets categorized from most liquid to least liquid– U.S. dollar bills– U.S. Treasury bonds– NYSE-listed stocks and large Nasdaq stocks

(such as Microsoft)– Nasdaq stocks– Corporate bonds– Most municipal bonds– Most real estate– Art objects and collectibles

Investors pay a liquidity premium

for the convenience of owning liquid

assets.


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Liquidity in Securities MarketsLiquidity in Securities Markets

A liquid securities market possesses the following qualities– Depth—buy-sell orders exists both above and

below the price at which the security is transacting

• A market lacking depth is shallow

– Breadth—when a large amount of buy-sell orders as described above exist

• Markets lacking breadth are called thin markets

– Resiliency—if new orders occur in response to price changes due to temporary order imbalances


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Transaction CostsTransaction Costs

Direct transaction costs– Brokers’ commissions– Income taxes– Transfer fees– Custodial fees– Outlays for research information

Indirect transaction costs– Bid-ask spread—determined by the cost of market-making

expenses such as • Interest expense for financing inventory of securities• Risk premium for investing capital• Administrative costs


6262


Indirect transaction costs– Market impact

• Buying (selling) tends to bid up (down) the price of a security

– Large transactions tend to move prices more than smaller transactions

– Opportunity cost (implicit)• Decay of information value of a trade incurred when

market moves against a trader waiting to trade– Tends to increase with time between decision to trade

and the actual execution of the trade


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Total transactions costs can range from less than 1% of the value to much of the investor’s return (in countries with high capital gains taxes)– The cost of transaction varies inversely with the market’s

liquidity• Large cap stocks are usually more actively traded than small

cap– Thus, small cap stocks generally have a higher transaction cost

• Large industrialized nations generally have lower transaction costs because

– The stock markets are more active

– More political stability

– More efficient legal systems


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The Bottom LineThe Bottom Line

Small and large stock markets provide varying degrees of liquidity

Institutional investors may use block positioners to execute large trades

Full-service brokers charge high commissions

Discount brokers, electronic brokers or ECNs offer less costly services

Most trades are market orders, however other order types exist


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The Bottom LineThe Bottom Line

Investors may buy on margin—effectively borrowing money from their brokerage– Margin trading enhances gains and losses

Investment bankers assist their clients in raising money in the primary market– Organizing distribution syndicates– Underwriting the issue– Distributing the securities


6666

The Bottom LineThe Bottom Line NYSE is the largest stock market in the world

– Continuous auction market– Specialists

NASDAQ is a large electronic market ECNs involve several different categories of market

technology Technology is

– Increasing the array of brokerage services– Increasing the competition between brokerage– Reducing transaction costs– Speeding executions– Creating new types of stock exchanges– Altering the IPO process– Integrating the world’s stock markets into a global one

Business

Francis