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Chapter 6Chapter 6

The Stock The Stock MarketMarket

The primary and secondary The primary and secondary stock marketsstock markets

The New York Stock ExchangeThe New York Stock Exchange The Toronto Stock Exchange The Toronto Stock Exchange

and TSX Venture Exchangeand TSX Venture Exchange NasdaqNasdaq Third and Fourth MarketThird and Fourth Market Stock Market InformationStock Market Information

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The Stock MarketThe Stock Market

Our goal in this chapter is to get a “big Our goal in this chapter is to get a “big picture” overview of:picture” overview of: Who owns stocksWho owns stocks How a stock exchange works, andHow a stock exchange works, and How to read and understand the stock market How to read and understand the stock market

information reported in the financial press.information reported in the financial press.

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The Primary Stock MarketsThe Primary Stock Markets TheThe Primary marketPrimary market is the market where investors purchase is the market where investors purchase

newly issued securities.newly issued securities. Initial public offering (IPO):Initial public offering (IPO): An initial public offer occurs An initial public offer occurs

when a company offers stock for sale to the public for the when a company offers stock for sale to the public for the first time.first time.

The Secondary Stock MarketsThe Secondary Stock Markets TheThe Secondary marketSecondary market is the market where investors trade is the market where investors trade

previously issued securities. An investor can trade:previously issued securities. An investor can trade: Directly with other investors.Directly with other investors. Indirectly through a broker who arranges transactions for Indirectly through a broker who arranges transactions for

others.others. Directly with a dealer who buys and sells securities from Directly with a dealer who buys and sells securities from

inventory.inventory.

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The Primary Market for Common StockThe Primary Market for Common Stock

An IPO involves several steps.An IPO involves several steps.Company appoints Company appoints investment banking firminvestment banking firm to arrange financing. to arrange financing.

Investment banker designs the stock issue and arranges for Investment banker designs the stock issue and arranges for fixed fixed commitmentcommitment or or best effort underwritingbest effort underwriting..

Company prepares a Company prepares a prospectusprospectus (usually with outside help) and submits it (usually with outside help) and submits it to sto securities and exchange commissionsecurities and exchange commissions for approval. for approval.

Investment banker circulates preliminary prospectus (Investment banker circulates preliminary prospectus (red red herringherring).).

Upon obtaining approval, company finalizes prospectus. Upon obtaining approval, company finalizes prospectus.

Underwriters place announcements (Underwriters place announcements (tombstonestombstones) in newspapers ) in newspapers and begin selling shares.and begin selling shares.

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Short Form ProspectusShort Form Prospectus

Figure 6.1

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The Secondary MarketThe Secondary Market The The bid price:bid price:

The price dealers pay investors.The price dealers pay investors. The The ask price:ask price:

The price dealers receive from investors.The price dealers receive from investors. The difference between the bid and ask prices is The difference between the bid and ask prices is

called the called the bid-ask spreadbid-ask spread, , or simply or simply spreadspread.. Most common stock trading is directed through an Most common stock trading is directed through an

organized stock exchange or trading network.organized stock exchange or trading network. Whether a stock exchange or trading network, the Whether a stock exchange or trading network, the

goal is to match investors wishing to buy stocks with goal is to match investors wishing to buy stocks with investors wishing to sell stocks. investors wishing to sell stocks.

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The New York Stock ExchangeThe New York Stock Exchange

The New York Stock Exchange (NYSE), popularly known The New York Stock Exchange (NYSE), popularly known as the as the Big BoardBig Board, celebrated its bicentennial in 1992., celebrated its bicentennial in 1992.

The NYSE has occupied its current building on Wall Street The NYSE has occupied its current building on Wall Street since the turn of the centurysince the turn of the century

The NYSE has 1,366 exchange members.The NYSE has 1,366 exchange members. In 2003, stocks from about 2,800 companies were listed, In 2003, stocks from about 2,800 companies were listed,

with a collective market value of about $15 trillion.with a collective market value of about $15 trillion. An initial listing fee, as well as annual listing fees, is An initial listing fee, as well as annual listing fees, is

charged based on the number of shares.charged based on the number of shares. In 2003, the average stock trading volume on the NYSE was In 2003, the average stock trading volume on the NYSE was

just over 1 billion shares a day.just over 1 billion shares a day.

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The Toronto Stock ExchangeThe Toronto Stock Exchange The Toronto Stock Exchange started its operations in 1861 The Toronto Stock Exchange started its operations in 1861

with 18 securities and 14 member firms.with 18 securities and 14 member firms. The initial members paid $250 to purchase a seat at that time. The initial members paid $250 to purchase a seat at that time.

In 1901, the price of a membership rose to $12,000 and In 1901, the price of a membership rose to $12,000 and trading volume became approximately 1 million shares per trading volume became approximately 1 million shares per year.year.

To be listed on the Toronto Stock Exchange, technology To be listed on the Toronto Stock Exchange, technology companies must have at least one million free shares with total companies must have at least one million free shares with total market value of $4 million or $10 million. These shares must market value of $4 million or $10 million. These shares must be held by at least 300 public shareholders.be held by at least 300 public shareholders.

In 1999, the Canadian exchanges were restructured and the In 1999, the Canadian exchanges were restructured and the Toronto Stock Exchange became the major stock exchange for Toronto Stock Exchange became the major stock exchange for trading senior equities. trading senior equities.

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TSX Venture ExchangeTSX Venture Exchange

Small and emerging Canadian companies are listed at the TSX Small and emerging Canadian companies are listed at the TSX Venture Exchange. Majority of the listed companies are Venture Exchange. Majority of the listed companies are mining, oil and technology companies. mining, oil and technology companies.

New companies seeking access to venture capital marketplace New companies seeking access to venture capital marketplace prefer TSX Venture Exchange. As companies get bigger they prefer TSX Venture Exchange. As companies get bigger they apply to be listed on senior exchanges. apply to be listed on senior exchanges.

Companies are listed in three different tiers at TSX Venture Companies are listed in three different tiers at TSX Venture Exchange. Each tier has different listing requirements. Exchange. Each tier has different listing requirements.

Firms can use the following ways to be listed on TSX Venture Firms can use the following ways to be listed on TSX Venture Exchange: 1- initial public offering, 2- reverse takeover and 3- Exchange: 1- initial public offering, 2- reverse takeover and 3- the Capital Pool Company Program. Currently, there are more the Capital Pool Company Program. Currently, there are more than 2500 companies listed at TSX Venture Exchange. than 2500 companies listed at TSX Venture Exchange.

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NasdaqNasdaq The name “Nasdaq” is derived from the acronym NASDAQ, which The name “Nasdaq” is derived from the acronym NASDAQ, which

stands for National Association of Securities Dealers Automated stands for National Association of Securities Dealers Automated Quotations system.Quotations system.

Introduced in 1971, the Nasdaq market is a computer network of Introduced in 1971, the Nasdaq market is a computer network of securities dealers who disseminate timely security price quotes to securities dealers who disseminate timely security price quotes to Nasdaq subscribersNasdaq subscribers

There are two key differences between the NYSE and Nasdaq:There are two key differences between the NYSE and Nasdaq:• Nasdaq is a computer network and has no physical location Nasdaq is a computer network and has no physical location

where trading takes place.where trading takes place.• Nasdaq has a multiple market maker system rather than a Nasdaq has a multiple market maker system rather than a

specialist system.specialist system.• Like NYSE specialists, Nasdaq market makers use their inventory Like NYSE specialists, Nasdaq market makers use their inventory

as a buffer to absorb buy and sell order imbalances.as a buffer to absorb buy and sell order imbalances.

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NasdaqNasdaq

Nasdaq is often referred to as an an Nasdaq is often referred to as an an Over-the-counter (OTC) Over-the-counter (OTC) market : market : securities market in which trading is almost exclusively securities market in which trading is almost exclusively done through dealers who buy and sell for their own inventories.done through dealers who buy and sell for their own inventories.

Nasdaq is actually made up of two separate markets, the Nasdaq Nasdaq is actually made up of two separate markets, the Nasdaq National Market (NNM) and the Nasdaq SmallCap Market.National Market (NNM) and the Nasdaq SmallCap Market.

In 2010,Market value of Nasdaq firms was $3.9 trillion, In 2010,Market value of Nasdaq firms was $3.9 trillion, compared to $13.4 trillion for the NYSE.compared to $13.4 trillion for the NYSE.

In 2010, there were about 1000 competing Nasdaq dealers In 2010, there were about 1000 competing Nasdaq dealers (market makers), which amounts to about 35 or so per stock.(market makers), which amounts to about 35 or so per stock.

In the late 1990s, the Nasdaq system was opened to the In the late 1990s, the Nasdaq system was opened to the electronic electronic communications networkscommunications networks ( (ECNsECNs).). ECNs are websites that allow individual investors to trade directly with ECNs are websites that allow individual investors to trade directly with

one another.one another. ECN orders are transmitted to the Nasdaq and displayed along with market ECN orders are transmitted to the Nasdaq and displayed along with market

maker prices.maker prices.

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Third and Fourth MarketThird and Fourth Market

The The third market third market is an off-exchange market for is an off-exchange market for securities listed on an organized exchange.securities listed on an organized exchange.

The The fourth market fourth market is for exchange-listed securities is for exchange-listed securities in which investors trade directly with one another, in which investors trade directly with one another, usually through a computer network.usually through a computer network.

For For dually listed dually listed stocks, regional exchanges also stocks, regional exchanges also attract substantial trading volume.attract substantial trading volume.

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Stock Market InformationStock Market Information

The most widely followed barometer of day-to-day The most widely followed barometer of day-to-day stock market activity is the stock market activity is the Dow Jones Industrial Dow Jones Industrial AverageAverage ( (DJIADJIA), or “), or “DowDow” for short.” for short.

The DJIA is an index of the stock prices of 30 large The DJIA is an index of the stock prices of 30 large companies representative of American industry.companies representative of American industry.

The S&P/TSX is a capitalization weighted index of The S&P/TSX is a capitalization weighted index of 220 Canadian companies.220 Canadian companies.

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S&P/TSX CompositeS&P/TSX CompositeFigure 6.3

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Stock Market IndexesStock Market Indexes

Indexes can be distinguished in four ways:Indexes can be distinguished in four ways: The market covered,The market covered, The types of stocks included,The types of stocks included, How many stocks are included, andHow many stocks are included, and How the index is calculated (How the index is calculated (price-weightedprice-weighted, e.g. , e.g.

DJIA, versus DJIA, versus value-weightedvalue-weighted, e.g. S&P 500), e.g. S&P 500)

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Stock Market IndexesStock Market Indexes For a For a value-weightedvalue-weighted index (i.e., the S&P 500), index (i.e., the S&P 500),

companies with larger market values have higher companies with larger market values have higher weights.weights.

For a For a price-weightedprice-weighted index (i.e., the DJIA), higher index (i.e., the DJIA), higher priced stocks receive higher weights.priced stocks receive higher weights. This means stock splits cause issues.This means stock splits cause issues. But, stock splits can be addressed by adjusting the index But, stock splits can be addressed by adjusting the index

divisor. divisor.

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Stock Market Major IndexesStock Market Major Indexes

Figure 6.4Figure 6.4

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Example I: $1,000,000 to Invest, Example I: $1,000,000 to Invest, Price-Weighted PortfolioPrice-Weighted Portfolio

Price SharesCompany Price Weight to Buy

GM 40.56 0.3376 8,323

Nordstrom 25.91 0.2156 8,323

Lowe's 53.68 0.4468 8,323

120.150 1.000 8,323

Note: Shares = $1,000,000 / 99.370 = 10,063

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Example II: Changing the DivisorExample II: Changing the Divisor

Day 1 of Index: Company Price

GM 40.56Nordstrom 25.91Lowe's 53.68Sum: 120.15

Index: 40.05 (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., 40.05:

GM 40.560Nordstrom 25.910Home Depot 32.90Sum: 99.370

Sum / Divisor = 40.05, if Divisor is: 2.481148564

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Example III: $1,000,000 to Invest, Example III: $1,000,000 to Invest, Value-Weighted PortfolioValue-Weighted Portfolio

Shares Capitalization Value Shares

Company Price (millions) (millions) Weight to Buy

GM 40.56 560.72 22,742.8 0.3323 8,192

Nordstrom 25.91 136.07 3,525.6 0.0515 1,988

Lowe's 53.68 785.75 42,179.1 0.6162 11,480

Total: 120.150 Total: 68,447.4 1.0000 21,660

Note: Shares to Buy = $1,000,000*Weight / Price

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

Total Shares Market CapitalizationDay 1: Company Price (millions) (millions)

GM 40.56 560.72 22,743Nordstrom 25.91 136.07 3,526Home Depot 32.90 2370.00 77,973

Total MV(1): 104,241

Divisor (Set by Vendor): 104.2413769

Day 1 Index Level: 1000.00

Total Shares Market CapitalizationDay 2: Company Price (millions) (millions)

GM 44.21 560.72 24,789Nordstrom 27.25 136.07 3,708Home Depot 33.50 2370.00 79,395

Total MV(2): 107,892

Day 2 Index Level: 1035.02

(Use Index Example II.)

Using the Index from Example II:

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The Day 3 Index Can be Calculated in Two The Day 3 Index Can be Calculated in Two Ways: Ways:

Total Shares Market Capitalization

Day 3: Company Price (millions) (millions)

GM 43.250 560.720 24,251.1Nordstrom 23.210 136.070 3,158.2Home Depot 34.100 2,370.000 80,817.0

Total MV(3): 108,226.3

Total MV(2): 107,892.0

Day 2 Index Level: 1035.02

Day 3 Index Level: 1038.23

Total MV(1): 104,241.0

Day 3 Index Level: 1038.23

1Day LevelIndex 1Day ValueMarket

3Day ValueMarketIndex 3Day

or

2Day LevelIndex 2Day ValueMarket

3Day ValueMarketIndex 3Day

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Useful Internet SitesUseful Internet Sites www.hoovers.com (reference for more on Initial (reference for more on Initial

Public Offerings, IPOs)Public Offerings, IPOs) www.nyse.com (website for the New York Stock (website for the New York Stock

Exchange)Exchange) www.tsx.com (website for the Toronto Stock (website for the Toronto Stock

Exchange)Exchange) www.nasdaq.com (website for the Nasdaq) (website for the Nasdaq) averages.dowjones.com (reference for more (reference for more

information on the DJIA)information on the DJIA)