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Chapter 5The Stock Market

Slides

Fundamentals of InvestmentsThe Stock MarketThe Primary & Secondary Stock MarketsThe Primary Market for Common StockThe Primary Market for Common StockThe Primary Market for Common StockThe Primary Market for Common StockWork the Web

The Secondary Market for Common StockThe Secondary Market for Common StockThe New York Stock ExchangeNYSE MembershipTypes of MembersTypes of MembersNYSE-Listed StocksWork the WebOperation of the New York Stock ExchangeNYSE Floor ActivityStock Market Order Types

Stock Market Order TypesNasdaqNasdaqNasdaqNasdaq ParticipantsWork the WebThe Nasdaq SystemNYSE and Nasdaq CompetitorsStock Market InformationStock Market InformationWork the Web

Stock Market IndexesStock Market IndexesStock Market IndexesChapter ReviewChapter Review

5-1 Chapter Review


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Chapter Organization

5.1 The Primary and Secondary Stock MarketsA. The Primary Market for Common StockB. The Secondary Market for Common Stock

C. Dealers and Brokers5.2 The New York Stock Exchange

A. NYSE MembershipB. Types of MembersC. NYSE-Listed Stocks

5.3 Operation of the New York Stock ExchangeA. NYSE Floor ActivityB. Special Order Types

5.4 NasdaqA. Nasdaq OperationsB. Nasdaq Participants

C. The Nasdaq System5.5 NYSE and Nasdaq Competitors5.6 Stock Market Information

A. The Dow Jones Industrial AverageB. Stock Market IndexesC. More on Price-Weighted IndexesD. The Dow Jones Divisors

5.7 Summary and Conclusions

Selected Web Sites

http://www.hoovers.comhttp://www.nyse.comhttp://www.island.comhttp://averages.dowjones.com
http://www.hoovers.com/http://www.nyse.com/http://www.island.com/http://averages.dowjones.com/http://www.nyse.com/http://www.island.com/http://averages.dowjones.com/http://www.hoovers.com/


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The Stock Market A-37

Annotated Chapter Outline

5.1 The Primary and Secondary Stock Markets

Primary market: The market in which new securities are originally sold to

investors.

Secondary market: The market in which previously issued securitiestrade among investors.

In the primary market, companies issue new securities to raise money, whereasin the secondary market, investors buy and sell previously issued securities forspeculation and investment.

A. The Primary Market for Common Stock

Initial public offering (IPO): An initial public offer occurs when acompany offers stock for sale to the public for the first time.Investment banking firm: A firm specializing in arranging financing forcompanies.Underwrite: To assume the risk of buying newly issued securities from acompany and reselling them to investors.Fixed commitment: Underwriting arrangement in which the investmentbanker guarantees the firm a fixed amount for its securities.Best effort: Arrangement in which the investment banker does notguarantee the firm a fixed amount for its securities.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 acompany's financial position, operations, and investment plans for thefuture.Red herring: A preliminary prospectus not yet approved by the SEC.

Securities are first bought and sold in the primary market, both through IPOs, andas seasoned security offerings. The investment banking firm establishes thefinancing package, advises on the pricing and number of shares, and arrangesdistribution of the shares. The underwriter spread, the "mark-up" on the stockprice, is the basic part of the underwriter's compensation. The stock may be

distributed as a fixed commitment, or on a best effort's basis. All issues must beapproved by the SEC, with the prospectus being issued to investors prior to saleof the stock. To advertise the issue, a tombstone advertisement will usuallyappear in the Wall Street Journal or another financial publication.

Lecture Tip: Examples are very helpful when discussing the primary market andexplaining the differences between a fixed commitment and a best effortsoffering. It is also good to emphasize that the underwriter takes on the risk of the


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issue not completely selling with a fixed commitment offering, whereas thecompany takes the risk in a best efforts arrangement.

Lecture Tip: There are many investment terms that are used because oftradition or historical significance. The red herring statement and the tombstone

advertisement are two of those. The term red herring relates to the red stamp"preliminary" on the front of the preliminary prospectus, but it also relates to theold saying of "don't buy a red herring." The tombstone advertisement is calledsuch because the advertisement looks like a tombstone in a graveyard. A legalstatement appears on all tombstone advertisements: "This announcement isneither an offer to sell or a solicitation of an offer to buy any of these Securities.The offer is made only by Prospectus." The wording may vary somewhat, but thestatement meets the SEC requirements of providing the prospectus to investorsbefore soliciting a purchase.

Current Topics: "Paper Chase: SEC is Tough Grader, Push for Clarity Slows

Offerings," by Bridget O'Brian, The Wall Street Journal, July 6, 1999. The SEChas been reviewing, grading and returning filings from hundreds of companiessince the "plain English" rule took effect in October 1998. The agency's "zealousexecution" of this ruling has slowed down how long it takes to navigate the SEC'sapproval process necessary to raise money for stock and bond offerings. Beforethe decree became effective, it took an average of 30 days for the SEC to issuecomments on companies proposed offerings. In March 1999, it took close to 45days, according to bankers and lawyers. The SEC says it is now back to 30days, but the SEC is providing comments aplenty. One recent IPO was returnedwith 70 SEC comments, of which 40 concerned plain English. Another IPO wentthrough four revisions before its IPO became official. The intent of the ruling wasto make prospectus' more readable for the typical investor. Some expertsindicate that the readability of these documents may not actually be improving.

B. 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

C. Dealers and Brokers

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

Broker: An intermediary who arranges security transactions amonginvestors.

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 theoffer 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. Thedealer is willing to pay the bid price and will sell at the ask price. The difference isthe bid-ask spread. The dealer profits through strategically setting the spread.The broker brings together buyers and sellers, but does not maintain aninventory. The broker facilitates trades by others.

The largest secondary market is the NYSE, with the Chicago Stock Exchangeand the American Stock Exchange as 2nd and 3rd. The major competitor to theseorganized exchanges is the Nasdaq. The Nasdaq merged with the American

Stock Exchange in 1998.

Lecture Tip: It is useful to point out to students that the bid-ask spread is notfixed, but changes frequently. Two important factors in determining the spreadare the perceived risk and the volume. Dealers will typically increase the spreadwhen the perceived risk is higher, and decrease the spread when the risk islower.

5.2 The New York Stock Exchange

The NYSE was 100 years old in 1992. It is a not-for-profit corporation owned byits members, the securities firms and brokerage companies.

A. NYSE Membership

NYSE member: The owner of a seat on the NYSE

The NYSE has 1,366 members who own seats on the exchange. Seat ownerscan buy and sell securities on the exchange floor with no commission. The seatcan be bought and sold, as with any other commodity. Since 1929, the lowestseat price paid was $55,000 (1977). In 2000, seats were going for $2 million,down from a record $2.65 million paid in 1999. Seats can also be leased to tradeon the exchange, with about one-half the seats being leased. Exchangemembers elect 24 of the 27 members of the board of directors. The board setsexchange policy, and the NYSE professional staff manages the exchange.


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B. Types of Members

Commission brokers: Agents who execute customer orders to buy andsell stock transmitted to the exchange floor. Typically they are employeesof NYSE member firms.

Specialist: NYSE member acting as a dealer on the exchange floor.Often called a market maker.

Floor brokers: NYSE members who execute orders for commissionbrokers on a fee basis. Sometimes called two-dollar brokers.

SuperDOT system: Electronic NYSE system allowing orders to betransmitted directly to specialists for immediate execution.

Floor traders: NYSE members who trade for their own accounts, trying to

anticipate and profit from temporary price fluctuations.

Commission brokers execute customer orders to buy and sell stocks, and aretypically employees of NYSE member brokerage firms. Their responsibility is toget the best possible price for their customers. There are more than 500 NYSEcommission brokers.

Specialists act as an assigned dealer for a small set of securities, with eachsecurity assigned to a single specialist. Specialists are also called marketmakers, and are assigned the responsibility of maintaining a fair and orderlymarket in a security. They make a market by standing ready to buy at bid pricesand sell at ask prices, acting as dealers for their own accounts. They alsomaintain an inventory in the security, and provide liquidity to the market.Specialists wear two hats, acting as both brokers and dealers at times. There areabout 400 NYSE specialists belonging to 30 specialist firms, although about halfof all NYSE trading is concentrated in the three largest specialist firms.

Floor brokers are often used by commission brokers when they are too busy tohandle the orders themselves. Floor brokers are also called "two-dollar" brokersbecause many years ago their fee was two dollars. The SuperDOT systemallows orders to be transmitted electronically directly to the specialist, andaccounts for a substantial percentage of all trading. DOT stands for designatedorder turnaround. Floor traders independently trade for their own account and tryto profit from short-term price fluctuations. The number of floor traders hasdeclined in recent years.

Current Topics: "Floor-Broker Probe Could Yield More Changes," by Ann Davis,The Wall Street Journal, May 12, 1999. "Brokers on the Big Board have longbeen prohibited from trading for their 'own account.'" Since "they have access tohighly sensitive information the exchange prohibits them from trading for


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themselves or putting their trading interests ahead of their clients'." Securitiesregulators are investigating the trading practices of 64 brokers on the floor of theNYSE who may have illegally shared profits with customers. Investigatorsindicate that the brokers initiated trades and then falsified trading tickets to makeit appear that the orders came from a brokerage firm. The brokers then may have

split the profits with the firm. The brokers were charged with: trading in their ownaccounts, trading in accounts in which they had an interest, falsifying records,and "front-running." Front-running occurs when brokers trade ahead of theircustomers' orders. Several brokers have pleaded guilty or are in pleanegotiations and the investigation is continuing. This investigation suggests thatthese improprieties on the floor of the exchange may be more common thanpreviously thought.

C. NYSE-Listed Stocks

In late 2000, there were 3,025 companies representing 281 billion shares and

$16 trillion in market value listed on the NYSE. There is an initial listing fee andan annual listing fee that must be paid by firms on the NYSE. The NYSEminimum requirements for listing are:

Total shareholders must be at least 2,200, with 100,000 shares traded amonth on average.

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

Publicly held shares must have at least $40 million market value.

Company must have annual earnings of $2.5 million before taxes in the mostrecent year, and $2 million in each of the preceding two years.

The company must have net tangible assets of $40 million.

5.3 Operation of the New York Stock Exchange

The business of the NYSE is to attract and process order flow, the flow ofcustomer orders to buy and sell stock. In 2000, the average stock trading volumewas just over 1 billion shares per day. About one-third of the trading volume isattributable to individual investors, and almost half is derived from institutionalinvestors.

A. NYSE Floor Activity

Specialist's post: Fixed place on the exchange floor where the specialistoperates.Market order: A customer order to buy or sell securities marked forimmediate execution at the current market price.

Most of the activity on the floor of the exchange takes place around thespecialist's post. The clerks operate behind the counters, and the commissionbrokers receive customer orders and walk to the specialist's post to execute the


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orders. When a customer issues a market order, they want to buy or sell at thecurrent market price, with the order marked for immediate execution. The brokerwill try to get the best price possible.

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 betterprice.Stop order: Customer order to buy or sell securities when a preset "stop"price is reached.NYSE uptick rule: Rule for short sales requiring that before a short salecan be executed, the last price change must be an uptick.

Many NYSE orders are limit orders, where a customer specifies a maximumprice 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. Astop order specifies a "stop" price, which is a trigger price for the order to beconverted into a market order. The stop order does not place a maximum orminimum limit on the trade price. Once converted to a market order, the trade isexecuted like any other market order. Specific variations of these orders include:

Stop-gain order: order to sell when the price rises to reach the stop price.

Stop-loss order: order to sell when the price decreases to reach the stopprice.

Start-gain order: order to buy when the price rises to reach the stop price.

Start-loss order: order to buy when the price decreases to reach the stop

price. Stop-limit order: when the stock reaches a preset stop price, the order is

converted into a limit order.

Short-sale order: when shares are sold as part of a short-sale transaction,they must be marked as short-sale order.

Short sales are subject to the NYSE uptick rule. A short sale can only beexecuted if the last trade was an uptick. This makes it more difficult forspeculators to drive down a stock's price by repeated short sales. The Nasdaqhas also instituted a similar rule.

5.4 Nasdaq

Nasdaq stands for National Association of Securities Dealers AutomatedQuotations system. In terms of dollar volume the NYSE is larger, but in terms ofshare volume the Nasdaq is larger.


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A. Nasdaq Operations

Over-the-counter (OTC) market: Securities market in which trading isalmost exclusively done through dealers who buy and sell for their owninventories.

The Nasdaq is a network of securities dealers who disseminate timely securityprice quotes to Nasdaq subscribers. The dealers post bid and ask prices and thenumber of shares they are willing to trade at the quoted prices. Nasdaq marketmakers trade on an inventory basis, but there are multiple market makers foractively traded stocks. The Nasdaq market is an OTC market, although they aretrying to lose that name. The two key differences between the NYSE andNasdaq are:

Nasdaq is a computer network with no physical location.

Nasdaq has a multiple market maker system, rather than a specialist system.

By 2000, there were more than 6,000 securities listed on the Nasdaq, with about12 market makers for each security. Nasdaq is managed by the NASD. Everybroker or dealer in the U.S. that conducts a securities business must be amember of the NASD.

B. Nasdaq Participants

Nasdaq has historically been a dealer market, characterized by competingmarket markers. Then, in the late 1990s, the Nasdaq system was opened to theso-called electronic communications networks (ECNs). ECNs are basicallywebsites that allow investors to trade directly with one another. As a result,

individual investors can enter orders (not just market markers). Hence, ECNs actto increase liquidity and competition.

C. The Nasdaq System

Inside quotes: highest bid quotes and the lowest asked quotes offered bydealers for a security.

The Nasdaq operates with three levels of information access:

Level 1: provides median bid and ask quotes for registered representatives.

Level 2: provides the highest bid and lowest asked quotes to market makers,

brokers, and dealers. Level 3: allow market makers to enter or change their price quote information.

The Nasdaq National Market (NNM) was introduced in 1982 as the NationalMarket System (NMS).

Lecture Tip: When discussing the Nasdaq it is interesting to talk about the firmslisted on the Nasdaq. It is no longer every firm's goal to be eventually listed on


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the NYSEthe Nasdaq is now an attractive competitor to the NYSE. Askstudents what firms they know are listed on the Nasdaq. They should be able tosuggest a number of firms, such as Intel, Microsoft, Yahoo!, and MCI Worldcom.

5.5 NYSE and Nasdaq Competitors

Third market: Off-exchange market for securities listed on an organizedexchange.

Fourth market: Market for exchange-listed securities in which investorstrade directly with other investors, usually through a computer network.

The NYSE and Nasdaq face competition from the third market, the fourth market,and regional exchanges. The third market refers to trading in exchange-listedsecurities that occurs off the exchange in which the security is listed. The fourthmarket refers to direct trading of exchange-listed securities among investors.

One example is Instinet, an electronic trading network that facilitates tradingamong its subscribers. Nasdaq has SelectNet, which has not been as popular asInstinet. Thousands of stock issues are dually listed on the NYSE or Nasdaq, anda regional exchange.

Current Topics: "Structure Problems: Fragmented Nasdaq May BecomeVulnerable to Competition," by Greg Ip, The Wall Street Journal, June 10, 1999.The 1997 reforms that followed an investigation into dealer's fixing of stockprices, coupled with advances in electronic trading, are fragmenting Nasdaq intomany submarkets, making it harder to ensure investors are getting the best price.The NASD thought they had a solution, a central limit order book. This proposalwas killed when some member firms thought the NASD was trying to competewith its own members. But if the situation is not addressed, competition awaits inthe form of "10 quasi-stock exchanges called electronic communicationsnetworks," the largest of which is operated by Instinet. These ECNs are seen ascompetition since they display a book of investors' buy and sell orders. In May1999, Instinet had 20% of Nasdaq's volume, and Island ECN had 6% ofNasdaq's volume. Several solutions include: allowing dealers to separatelydisplay their own and their customers' order in Nasdaq, speeding up SelectNet,and compelling ECNs to display previously hidden orders. Finally, the proposalfor the central limit order book has been quietly resurrected.

5.6 Stock Market Information

A. The Dow Jones Industrial Average

The Dow Jones Industrial Average (DJIA) or "Dow" is the most widely followedbarometer of daily stock market activity. The DJIA is an index of 30 large "blue-chip" companies representative of American industry. Two other Dow averagesinclude the utilities and transportation averages.


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B. Stock Market Indexes

Price-weighted index: Stock market index in which stocks are held inproportion to their share price.

Value-weighted index: Stock market index in which stocks are held inproportion to their total company market value.

Lecture Tip: Stock indices can be calculated as price-weighted indices or value-weighted indices. To compute a price weighted index, take the price of eachstock in the index, add them up, and divide by the number of stocks. It isbasically a simple average. To compute a value-weighted index, multiply thenumber 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 marketvalue 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 indexvalue. 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-weightedindex has some problems. Since it is a simple average of the share prices of thestocks in the index, the value can be unduly influenced by the price changes ofone high-priced stock. Also, the index must be adjusted for stock splits and stockdividends. This tends to cause the divisor to change, in fact decrease, over time.In August 2000, the divisor was 0.16894073. A divisor that is less than one willfurther magnify any price change effects. This is one reason we see such largeswings in the DJIA.

D. The Dow Jones Divisors

Index staleness: Condition that occurs when an index does not reflect allcurrent price information because some of the stocks in the index have nottraded recently.

If there are problems with price-weighted indices, why do we continue to followthe DJIA? The answer is tradition. The most popular alternative to the DJIA is thevalue-weighted S&P 500 index, which provides frequent accurate updates ofmarket prices. This index accounts for the major portion of overall stock marketvalue with its representative 500 stocks.

5.7 Summary and Conclusions

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