Investment analysis and portfolio management 8th reilly and brown chapter 04

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Lecture Presentation Software to accompany Investment Analysis and Portfolio Management Eighth Edition by Frank K Reilly & Keith C Brown Chapter Organization and Functioning of Securities Markets Questions to be answered: • What is the purpose and function of a market? • What are the characteristics that determine the quality of a market? • What is the difference between a primary and secondary capital market and how these markets support each other? Organization and Functioning of Securities Markets • What is Rule 415 and Rule 144A and how they affect corporate security underwriting? • What are call markets and when are they typically used? • What is the third market? • What are Electronic Communication Networks (ECNs) and alternative trading systems (ATSs) and how they differ from the primary listing markets? • What are the major types of orders available to investors and market makers? What is a market? • Brings buyers and sellers together to aid in the exchange of goods and services • Does not require a physical location • Both buyers and sellers benefit – Reduces search & screening costs – Price discovery Characteristics of a Good Market • Availability of past transaction information – must be timely and accurate • Liquidity – marketability – price continuity – depth • Low transaction costs • Rapid adjustment of prices to new information Decimal Pricing • The Canadian equity market switched to decimal pricing in April, 1996 • The US equity market switched to decimal pricing in early 2001 • All North American equity markets now price in dollars & cents rather than 1/8ths and 1/16ths • Reasons for decimal pricing:  Easier for investors to understand prices  Reduces the size of the bid-ask spread  Markets more competitive on a global basis Organization of the Securities Market • Primary markets – Market where new securities are sold by the firms/entities issuing securities – The funds raised go to the issuer • Secondary markets – Market where already issued securities are bought and sold by investors The issuer does not receive any funds in a secondary market transaction Government Bond Issues • Treasury Bills – negotiable, non-interest bearing securities with original maturities of one year or less • Government of Canada Bonds – original maturities of more than 1year • The Bank of Canada publishes detailed information on the auction process on its website; http://www.bankofcanada.ca/en/markets/markets_auct.html Canadian Treasury Bills • Prior to November 1995 Treasury bills were issued in bearer form and were available in denominations ranging from $1,000 to $1,000,000 • Effective November 1995 all new issues of Treasury bills are issued in global certificate form only whereby a global certificate for the full amount of the Treasury bill is issued in fully registered form in the name of CDS & Co., a nominee of CDS • Treasury bills are sold via auction every two weeks by the Bank of Canada on behalf of the Government of Canada • Treasury bills must be purchased, transferred or sold, directly or indirectly, through a participant of the Debt Clearing Service, which is operated by CDS, and only in integral multiples of $1,000 (face value) • The Government of Canada also periodically issues cash management bills (CMBs) • CMBs are Treasury bills with maturities of less than three months (they can be as short as one day) used as a source of short-term financing for the Government CMB auctions can take place on any business day, typically for next-day delivery, but on some occasions for same-day delivery Why Secondary Financial Markets Are Important • Provides liquidity to investors who acquire securities in the primary market • Results in lower required returns than if issuers had to compensate for lower liquidity • Helps determine market pricing for new issues Secondary Equity Markets Primary listing markets – New York, American, Tokyo, and London stock exchanges Regional markets – Toronto, Chicago, San Francisco, Boston, Osaka, Nagoya, Dublin, Cincinnati OTC markets - Nasdaq Third-market dealers/brokers – Madoff Investment Securities, Knight Trading Group, Jefferies Group, ITG Fourth Market – alternative trading systems Alternative Trading Systems (ATSs), • Electronic Communications Networks (ECNs) – Archipelago, BRUT, Instinet, Island, REDIBook – Are electronic trading systems that automatically match buy and sell orders at specified prices • Electronic Crossing Systems (ECSs) – POSIT, Global Instinet Crossing, Arizona Stock Exchange – provide greater anonymity for participants Basic Trading Systems • Pure auction market (also known as orderdriven market) – Toronto Stock Exchange – Market price determined by buy & sell orders placed by investors • Dealer market (also known as quote-driven market) – NASDAQ – Bid & ask prices posted by dealers who “make a market” in the stock Call Versus Continuous Markets • Call markets trade individual stocks at specified times All orders are gathered and then a single price is determined which satisfies most orders – Used for opening prices on TSX if orders build up overnight or after trading is suspended • In a continuous market, trades occur at any time the market is open – During regular trading hours, the TSX is a continuous market Global Stock Exchanges • Trend toward consolidations or affiliations that will provide more liquidity and greater economies of scale to support the technology required by investors • Many of the larger companies in countries such as Canada, the U.K., Germany, and Japan that can qualify for listing on a U.S exchange become dual-listed • The existence of strong international exchanges has made possible a global equity market wherein stocks that have a global constituency can be traded around the world 24 hours a day Major Types of Orders • Market orders – Buy or sell at the best current price – Provides immediate liquidity • Limit orders – Order specifies the buy or sell price – Time specifications for order may vary • Instantaneous - “fill or kill”, part of a day, a full day, several days, a week, a month, or good until canceled (GTC) Major Types of Orders • Short sales – Sell overpriced stock that you don’t own and purchase it back later (at a lower price) – Borrow the stock from another investor (through your broker) – Can only be made on an up-tick – Short seller must pay any dividends to the lender of the stock – Margin requirements apply (must maintain margin of 150% of current market price) – Subject to “close-outs” during a short squeeze – Lender loses the right to vote the stock Major Types of Orders • Special Orders – Stop loss • Conditional order to sell stock if it drops to a given price • Market order is triggered once the market price touches the stop loss price • Does not guarantee price you will get upon sale – Stop buy order • Investor who sold short may want to limit loss if stock increases in price Margin Transactions • Is available on any type of order but not to all investors (depends on the nature of the account you establish) • Borrow a portion (usually up to 50%) of the purchase price using the stock as collateral • Interest rate on margin credit may be below prime rate • Regulations limit proportion borrowed • The use of margin leverages or magnifies both gains and losses Margin: Canadian Stocks Long Positions • Margin requirements can be found on the IDA (Investment Dealers Association) website (www.ida.ca) – See Section 100 of their Rule Book Common stocks are in Subsection (f), reproduced below • On securities (other than bonds and debentures) including rights and warrants listed on any recognized stock exchange in Canada or the United States, on the Tokyo Stock Exchange First Section or on the stock list of the London Stock Exchange: – Securities selling at $2.00 or more - 50% of market value – Securities selling at $1.75 to $1.99 - 60% of market value – Securities selling at $1.50 to $1.74 - 80% of market value Margin: Canadian Stocks Short Positions • • • • Securities selling at $2.00 or more - 150% of market value Securities selling at $1.50 to $1.99 - $3.00 per share Securities selling at $0.25 to $1.49 - 200% of market value Securities selling at less than $0.25 - market value plus $0.25 per share Margin: Interesting facts • The lowest margin requirement is for Treasury bills, which is equal to 1% of market value multiplied by maturity over 365 Thus the most equity you would have to post to buy a one year Treasury bill would be 1% of its current market value • Securities selling under $1.50, securities of companies designated as Capital Pool Companies on the TSX Venture Exchange and securities of companies classified as Tier or Inactive Tier issuers on the TSX Venture Exchange may not be carried on margin Margin Transactions Buy 200 shares at $50 = $10,000 position Borrow 50%, investment of $5,000 If price increases to $60, position – – – – Value is $12,000 Less - $5,000 borrowed Leaves $7,000 equity for a $7,000/$12,000 = 58% equity position • If the minimum margin is 50%, then have excess margin in your account Margin Transactions Buy 200 shares at $50 = $10,000 position Borrow 50%, investment of $5,000 If price decreases to $40, position – – – – Value is $8,000 Less - $5,000 borrowed Leaves $3,000 equity for a $3,000/$8,000 = 37.5% equity position • If the minimum margin is 50%, then are short margin in the account (will have to add $2,000) ... between a primary and secondary capital market and how these markets support each other? Organization and Functioning of Securities Markets • What is Rule 415 and Rule 144A and how they affect... investors and market makers? What is a market? • Brings buyers and sellers together to aid in the exchange of goods and services • Does not require a physical location • Both buyers and sellers... What are call markets and when are they typically used? • What is the third market? • What are Electronic Communication Networks (ECNs) and alternative trading systems (ATSs) and how they differ
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