Chapter Two

Securities MarketSlides Prepared

ByMohd. Mohsin,

Assistant Professor of Finance, IIUC

Investment and Risk Analysis

Three interrelated reasons for constructing global investment portfolios

1. When investors compare the absolute and relative sizes of domestic and foreign markets for stocks and bonds, they see that ignoring foreign markets reduces their choices to less than 50 percent of available investment opportunities.

2. The rates of return available on global securities often have substantially exceeded those for domestic securities.

3. One of the major tenets of investment theory is that investors should diversify their portfolios.

WHAT IS A MARKET?

A market is the means through which buyers and sellers are brought together to aid in the transfer of goods and/or services.

Several Aspects of Market Definition1) A market need not have a physical location. It is only

necessary that the buyers and seller can communicate

1) The market does not necessarily own the goods and services involved; the important criterion is the smooth ,cheap transfer of goods and services.

1) A market can deal any variety of goods and services

Characteristics of Good Market1. Timely and accurate information is available

on the price and volume of past transactions and the prevailing bid and ask prices.

2. It is liquid, meaning an asset can be bought or sold quickly at a price close to the prices for previous transactions (has price continuity), assuming no new information has been received. In turn, price continuity requires depth.

3. Transactions entail low costs, including the cost of reaching the market, the actual brokerage costs, and the cost of transferring the asset.

4. Prices rapidly adjust to new information; thus, the prevailing price is fair because it reflects all available information regarding the asset.

Organization of Securities MarketPRIMARY CAPITAL MARKETSThe primary market is where new issues of

bonds, preferred stock, or common stock are sold by government units, municipalities, or companies to acquire new capital.

Three Methods of Stock/ Bond Issues1. Competitive bid sales typically involve sealed bids.

The bond issue is sold to the bidding syndicate of underwriters that submits the bid with the lowest interest cost

2. Negotiated sales involve contractual arrangements between underwriters and issuers wherein the underwriter helps the issuer prepare the bond issue and set the price and has the exclusive right to sell the issue.

3. Private placements involve the sale of a bond issue by the issuer directly to an investor or a small group of investors usually institutions). The firm enjoys lower issuing costs because it does not need to prepare the extensive registration statement required for a public offering. return. In fact, the institution should require a higher return because of the absence of any secondary market for these securities,

4. Best Effort :Investment banker acts as broker

Underwriting Function The underwriting function can involve three

services: origination, risk bearing, and distribution.

1.Origination involves the design of the bond issue and initial planning.

2.The risk bearing function involves the underwriter acquires the total issue at a price dictated by the competitive bid or through negotiation and accepts the responsibility and risk of reselling it for more than the purchase price.

3.Distribution means selling it to investors, typically with the help of a selling syndicate that includes other investment banking firms and or commercial banks.

Underwriting Continued-------

Corporate Stock Issues

For corporations, new stock issues are typically divided into two groups:

(1)seasoned equity issues : Seasoned equity issues are new shares offered by firms that already have stock outstanding.

(2) Initial public offerings (IPOs) : Initial public offerings (IPOs) involve a firm selling its common stock to the public for the first time.

SECONDARY FINANCIAL MARKETS

Secondary markets permit trading in outstanding issues; that is, stocks or bonds already sold to the public are traded between current and potential owners.

The proceeds from a sale in the secondary market do not go to the issuing unit (the government, municipality, or company) but, rather, to the current owner of the security.

Three major segments Of Secondary Equity Markets:(1) the major national stock exchanges,

including the New York, the Tokyo, and the London stock exchanges;

(2) regional stock exchanges in such cities as Chicago, San Francisco, Boston, Osaka and Nagoya in Japan, and Dublin in Ireland; and

(3) the over-the-counter (OTC) market, which

involves trading in stocks not listed on an organized exchange.

Third Market & Fourth Market

Third market describes OTC trading of shares listed on an exchange. Although most transactions in listed stocks take place on an exchange, an investment firm that is not a member of an exchange can make a market in a listed stock.

Fourth market describes direct trading of securities between two parties with no broker intermediary. In almost all cases, both parties involved are institutions.

Listing Requirements in DSEi. Application for listing as per Form I;(ii) Memorandum & Articles of Association;(iii) Copy of the Certificate of incorporation;(iv) Copy of the Certificate of Commencement of Business;(v) Copy of the Feasibility Report, in case of a new project;(vi) Copy of the certificate of registration of the industrial Units

issued by theCouncil of Investment or any other competent authority;(vii) Copies of all material contracts and agreements entered into or

exchangedwith foreign participants, machinery suppliers and any other

financial institutions;(viii) Copies of Letter (s) of Credit established in favour of MachinerySuppliers, if linked with the public issue;(ix) Copy of Consent order issued by the Commission;(x) Names of Directors along with directorship of other companies

listed onthe Exchange;

Continued--------------------------(xi) Draft prospectus/Offer for sale;(xii) Auditors Certificate for the amount subscribed by the

promoters/directors/subsidiaries/associates;(xiii) Copies of the agreements relation to issue to securities for

consideration other than cash, if any;(xiv) Copy of underwriting agreement (if any);(xv) Statement of audited accounts for the last 5 years or for a shorter

number of years if the company is in operation only for such shorter period;

(xvi) Statement showing the cost of project and means of finance;(xvii) Copies of the approval of tax-holiday application under Ordinance,

1984;(xviii) Copies of the consent Letters from Bankers or Financial Institution

to the Issues;(xix) Application for submission of Under of Undertaking and payment of

fees as per Form II;(xx) Copy of approval of prospectus/offer for sale from Commission; and(xxi) Any other documents/material contract and such other particulars

as may be required by the Exchange or by the Council and/or by the Commission;

Exchange Membership

Securities exchanges typically offer four major categories of membership:

(1) Specialist,(2) Commission broker : are employees of a

member firm who buy or sell for the customers of the firm.

(3) Floor broker : Floor brokers are independent members of an exchange who act as brokers for other members.

(4) Registered traders are allowed to use their memberships to buy and sell for their own accounts.

Types of Orders

Market Orders : The most frequent type of order is a market order, an order to buy or sell a stock at the best current price. Market orders provide immediate liquidity for someone willing to accept the prevailing market price.

Example of Market OrderAssume you are interested in General Electric (GE)

and you call your broker to find out the current “market” on the stock. The quotation machine indicates that the prevailing market is 45 bid—45.25 ask. This means that the highest current bid on the books of the specialist is 45; that is, $45 is the most that anyone has offered to pay for GE.

The lowest offer is 45.25, that is, the lowest price anyone is willing to accept to sell the stock.

If you placed a market buy order for 100 shares, you would buy 100 shares at $45.25 a share (the lowest ask price) for a total cost of $4,525 plus commission.

If you submitted a market sell order for 100 shares, you would sell the shares at $45 each and receive $4,500 less commission.

Limit Order-------------------Limit order specifies the buy or sell

price. You might submit a bid to purchase 100 shares of

Coca-Cola stock at $50 a share when the current market is 60 bid–60.25 ask, with the expectation that the stock will decline to $50 in the near future.

A limit order can be instantaneous (“fill or kill,” meaning fill the order instantly or cancel it).

Stop loss orderA stop loss order is a conditional market order

whereby the investor directs the sale of a stock if it drops to a given price.

Example: Assume you buy a stock at 50 and expect it to

go up. If you are wrong, you want to limit your losses. To protect yourself, you could put in a stop loss order at 45.

In this case, if the stock dropped to 45, your stop loss order would become a market sell order, and the stock would be sold at the prevailing market price.

Short Sales

A short sale is the sale of stock that you do not own with the intent of purchasing it back later at a lower price. Specifically, you would borrow the stock from another investor through your broker, sell it in the market, and subsequently replace it at (you hope) a price lower than the price at which you sold it.

Margin Transactions

Margin transaction means leveraging the transaction.

means the investor pays for the stock with some cash and borrows the rest through the broker, putting up the stock for collateral.

Initial Margin: That part of transaction's value that a customer must pay to initiate the transaction

Examples of Margin TransactionAssume you acquired 200 shares of a $50

stock for a total cost of $10,000. A 50 percent initial margin requirement allowed you to borrow $5,000, making your initial equity $5,000. If the stock price increases / decreases by 20 percent to $60 / $40 a share

Required:i. Find the return on your investment if the share

price increases / decreases by 20 %.ii.What would be the answer of requirement 1 if

you have to pay 6% interest on your borrowed fund and $1000 commission on your transaction?

Solution--------------------------

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Maintenance margin,It is the required proportion of your equity

to the total value of the stock; the maintenance margin protects the broker if the stock price declines.

Margin call

Call for more equity funds or additional cash from the broker as a result of the actual margin declining below the maintenance margin

Examples of Margin Call

SECURITY MARKET (Indicator Series)INDEXES

It gives the answer to the question “What happened to the market today?” to investors

Supply investors with a composite report on market performance

USES OF SECURITY MARKET INDEXES

Security market indexes are used: As benchmarks to evaluate the performance

of professional money managers. To create and monitor an index fund. To measure market rates of return in

economic studies. For predicting future market movements by

technicians. As a proxy for the market portfolio of risky

assets when calculating the systematic risk of an asset

STOCK MARKET INDICATOR SERIESThree principal weighting series are used: (1) a price-weighted series, (2) a market-value-weighted series, and(3) an un weighted series, or what would be

described as an equally weighted series.

Price-Weighted Series A price-weighted series is an arithmetic

average of current prices, which means that index movements are influenced by the differential prices of the components.

Dow Jones Industrial Average(DJIA) is a price-weighted average of 30 large, well-known industrial stocks of US

The DJIA is computed by totaling the current prices of the 30 stocks and dividing the sum by a divisor that has been adjusted to take account of stock splits and changes in the sample over time.

Example of Price Weighted Series

Market –Value-Weighted SeriesA market-value-weighted series is generated

by deriving the initial total market value of all stocks used in the series (Market Value = Number of Shares Outstanding × Current Market Price).

This initial figure is typically established as the base and assigned an index value (the most popular beginning index value is 100, but it can vary—say, 10, 50).

Subsequently, a new market value is computed for all securities in the index, and the current market value is compared to the initial “base” value to determine the percentage of change, which in turn is applied to the beginning index value.

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where:Index t = index value on day tPt = ending prices for stocks on day tQt = number of outstanding shares on day tPb = ending price for stocks on base dayQb = number of outstanding shares on base day

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