Chapter 1:

Overview of
Stock market
The Stock Market 1

• “One of the funny things about the stock market is that

every time one man buys, another sells, and both think
they are astute.”
• –William Feather

• “If you don’t know who you are, the stock market is an
expensive place to find out.”

• –Adam Smith (pseud. for George J. W. Goodman)

Learning Objectives
1. Asset Classes

Fixed Income

Asset Classes Equity

Derivatives
1.1 Fixed Income: Money Markets

Money Markets
Fixed Income
Capital Markets
Asset Classes Equity

Derivatives
1.1 The Money Market
1.1 The Money Market: Treasury Bills
Treasury Bills
Issuer: Federal Government
Denomination: Commonly $10,000; $1,000
Maturity: 4, 13, 26 or 52 Weeks
Liquidity: High
Default Risk: None
Interest Type: Discount
Taxation: Owed: Federal; Exempt: State, Local
1.1 The Money Market: Treasury Bills
1.1 The Money Market: Treasury Bills

r = $10,000 − P x 360 $10,000 = Par

BD $10,000 n
rBD = bank discount rate
P = market price of the T-bill
n = number of days to maturity

$10,000 - $9,875 360

r BD = × = 5%
$10,000 90
1.1 The Money Market: Certificates of Deposit (CDs)

Certificates of Deposit
Issuer: Depository Institutions
Denomination: Any, $100,000 or more marketable
Maturity: Varies, Typically 14-day Minimum
Liquidity: High for CDs <3 months, if marketable
Default Risk: First $250,000 FDIC insured
Interest Type: Add on
Taxation: Owed: Federal, State, Local
Figure 1.1 Spreads on CDs and Treasury Bills
5.0
OPEC I

4.5

4.0
Financial crisis

3.5
OPEC II
Percentage points

3.0
Penn Square

2.5

Market crash
2.0

1.5
LTCM

1.0

0.5

0.0
1970

1972

1974

1976

1978

1980

1982

1984

1986

1988

1990

1992

1994

1996

1998

2000

2002

2004

2006

2008

2010

2012

2014
1.1 The Money Market: Commercial Paper
Certificates of Deposit
Issuer: Large creditworthy corps.; financial
institutions
Denomination: Minimum $100,000

Maturity: Maximum 270 days, usually 1-2 months

Liquidity: CP < 3 months liquid if marketable
Default Risk: Unsecured, rated, mostly high quality
Interest Type: Discount
Taxation: Owed: Federal, State, Local
1.1 The Money Market: Instruments
1.1 The Money Market: Instruments

* Depository institutions must maintain deposits with Federal Reserve

Bank
1.1 The Money Market: Repurchase Agreements
1.1 The Money Market: Brokers’ Calls
1.1 The Money Market: Credit Crisis
1.1 The Money Market: Instrument Yields
1.1 The Money Market: Bond Equivalent Yield
1.1 The Money Market: Bond Equivalent Yield
P = price of the T-bill rBD = 5%
n = number of days to maturity

10,000 − P 365
r = ×
BEY P n

r = 10,000 − 9,875 365

×
BEY 90
9,875

rBEY = .0127 × 4.0556 = .0513 = 5.13%

1.1 The Money Market: Effective Annual Yield

365 Compare:
 $10, 000 − P  n
rEAY = 1 +  −1 rBD = 5%
 P  rBEY = 5.13%
P = price of the T-bill rEAY = 5.23%
n = number of days to maturity

365
 $10, 000 − $9,875  90
rEAY = 1 +  −1
 $9,875 
rEAY = 5.23%
1.1 The Money Market: Instrument Yield
Money Market Instrument Instrument Yield
Treasury Bills Discount
Certificates of Deposit Bond Equivalent Yield
Commercial Paper Discount
Bankers’ Acceptances Discount
Eurodollars Bond Equivalent Yield
Federal Funds Bond Equivalent Yield
Repurchase Agreements Discount
Reverse RPs Discount
1.2 Fixed Income: Capital (Bond) Markets

Money Markets
Fixed Income
Capital Markets
Asset Classes Equity

Derivatives
1.2 The Bond Market
Figure 1.3 Listing of Treasury Issues
1.2 The Bond Market: Agency Issues
1.2 The Bond Market: Municipal Bonds

rtax exempt = rtaxable x (1 – Tax rate)

r = Interest rate
Table 1.2 Equivalent Taxable Yields
Tax-Exempt Yield
Marginal Tax Rate 1% 2% 3% 4% 5%
20% 1.25% 2.50% 3.75% 5.00% 6.25%
30 1.43 2.86 4.29 5.71 7.14
40 1.67 3.33 5.00 6.67 8.33
50 2.00 4.00 6.00 8.00 10.00

rtax exempt = rtaxable x (1 – Tax rate)

Figure 1.5 Yield Ratio: Tax-Exempt to Taxable Bonds
1.2 The Bond Market: Private Issue
Figure 1.6 Mortgage-Backed Securities Outstanding
Figure 1.7 Asset-Backed Securities Outstanding
Figure 1.9 The U.S. Fixed-Income Market
1.3 Equity

Money Markets
Fixed Income
Capital Markets
Asset Classes Equity

Derivatives
1.3 Equity Securities: Instruments
1.3 Equity Securities: Instruments
1.3 Equity Securities: Instruments
1.3 Equity Securities: Returns

PSell − PBuy + Div $54 − 50 + 1

Total Return = = = 10%
PBuy $50
Div $1
Dividend Yield = = = 2%
PBuy $50
PSell − PBuy $54 − 50
Capital Gains Yield = = = 8%
PBuy $50
Figure 1.8 Listing of stocks traded on NYSE
The Stock Market 2
1.4 Stock and Bond Market Indexes
1.4 Stock and Bond Market Indexes
1.4 Stock and Bond Market Indexes
1.4 Stock and Bond Market Indexes
1.5 Derivative Markets
Figure 1.10 Stock Options on Apple
1.5 Derivative Markets: Call Option

Cost Call = 100  $7.63=$763

1.5 Derivative Markets: Put Option

Cost Put = 100  $1.17=$117

1.5 Derivative Markets
Figure 1.11 Futures Contracts
1.5 Derivative Markets
Private Equity

• Private equity

• With no assets (other than an idea).

• Run by fledgling entrepreneurs with no track record.

• Middle-market firms.
• Large leveraged buyouts.
The Structure of Private Equity Funds

• Private equity funds.

• Hedge funds.

• Are set up as limited partnerships.

• Pool money from investors.
• Invest this money on behalf of these investors.
• Use, typically, a 2/20 fee structure (that is, a 2% annual management
fee and 20% of profits).
• Have built-in constraints to prevent managers from taking excessive
compensation.

• A high-water mark provision.

• A “clawback” provision.
How a Clawback Provision Works

• In its first year of operation, the private equity fund earns a 25%
return.
• For every $1,000 in the fund, the managers of this private equity fund
“receive” a hefty performance fee of $50 (20% of the $250 profit).
• In its second year, the private equity fund investors suffer a 10% loss.

carried interest.
Types of Private Equity Funds: Venture Capital

• Venture Capital start-ups

• Individual venture capitalists

• Venture capital firms

• Individuals.
• Pension funds.
• Insurance companies.
• Large corporations.
• University endowments.
Venture Capital

• Venture capitalists generally provide financing in stages.

• Venture capitalists actively help run the company.

• Ground-floor financing
• Mezzanine-level financing

• The big payoff frequently comes when the company is sold to

another company or goes public.
• Either way, investment bankers are often involved in the process.
Types of Private Equity Funds: Middle Market

middle market”
• Ongoing concerns (that is, not start-ups).
• Known performance history.
• Typically, small and family owned and operated.

• Expansion beyond their existing region.

• Founder wants to “cash out”.
Types of Private Equity Funds: Leveraged Buyouts

taking the company private.

• A manager or investor who wants to take a company private

probably needs to borrow a significant amount of money.
• Taking a company private is called a leveraged buyout (LBO).

• Around 2005, the LBO market was quite active.

• Activity in the LBO market came to a standstill after the crash
of 2008.
Selling Securities to the Public

primary market

• Initial public offering (IPO): An IPO occurs when a company offers

stock for sale to the public for the first time.
• Seasoned equity offering (SEO): If a company already has public
shares, an S E O occurs when a company raises more equity.

secondary market

• Directly with other investors.

• Indirectly through a broker who arranges transactions for others.
• Directly with a dealer who buys and sells securities from inventory.
The Primary Market for Common Stock: IPO and SEO Details

• An I P O occurs when a company sells stock to the public for the first time.
• Typically, small and growing companies need capital to expand operations.

• General cash offer: securities sold on a “first-come, first-served” basis.

• With a rights offer, securities are initially offered only to existing owners.
The Primary Market for Common Stock IPO Example: All IPOs Are Cash
Offers

• You bought 50,000 shares and the remaining 50,000 shares were bought by friends and relatives (who
are your “venture capitalists”). These investors are NOT the general public.
• Your company has prospered but now needs capital to grow.
• You hire an investment banker. After lengthy negotiations and analyses, your investment banker suggests
selling 4 million shares of common stock.
• Two million shares are given to the original investors in exchange for the old shares.
• After much haggling, your investment banker agrees to underwrite the stock issue by purchasing the
other 2 million shares from your company for $10 per share.

• The investment banker, the underwriter, will resell shares in the primary market.
• The investment banker thinks the stock can sell for $11 per share in an I P O.
• The difference between the $11 received by the underwriter and the $10 per share the original investors
received is called the underwriter spread, or discount.
• The typical underwriter spread ranges from 7‒10%.
The Primary Market for Common Stock: The Rest of the Story

• Company appoints an investment banking firm to arrange

financing.
• Investment bankers design the stock issue and arrange for either
fixed commitment underwriting, best efforts underwriting, or
Dutch auction underwriting.
• Company prepares a prospectus (usually with outside help) and
submits it to the Securities and Exchange Commission (SEC) for
approval. Investment banker circulates preliminary prospectus (red
herring).
IPO Tombstone

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Crowdfunding: An Alternative Source of Public Funding

• Project Crowdfunding and Equity Crowdfunding

• One provision: Crowdfunding.

• Crowdfunding: Raising small amounts of capital from a large number of people.

• At first, the JOBS Act allowed only “accredited” investors to participate in equity crowdfunding.

• More than $1,000,00 in net worth or

• More than $200,000 income in two of last three years.

• Investors with less than $107,000 in income or assets.

• Invest at least $2,200 but a maximum of $5,350.

Initial Coin Offering: An Alternative Source of
Public Funding
• As of 2015, companies can also raise capital by selling tokens (and issuing debt and equity).
• Tokens often grant the holder the right to use the company’s services in the future.
• Token sales occur on digital security platforms.

• The initial sale of a token is often called an initial coin offering, or ICO (to sound like IPO).
• Ethereum is the most common platform for issuers, but there are many competitors.
• In 2017, there were 234 ICOs with a total value of about $3.7 billion.

• A blockchain is a time-stamped ledger of transactions that is kept among a network of users without
centralized control.
• Blockchains are similar to a traditional database, except that cryptography is used to make it
infeasible to change data once they are added to the chain.
• Many industries, including finance, are updating record-keeping systems by using blockchains.
The Secondary Market for Common Stock

• The bid price:

• The ask price:

• The difference between the bid and ask prices is called the bid-ask spread, or
simply, the spread.

• Dealers attempt to “buy low and sell high” when moving shares into and out of
their inventory.
The New York Stock Exchange

Big Board

• NYSE Group, Inc., ticker: NYX.

• Naturally, NYX stock is listed on the NYSE.
NYSE Seats and Trading Licenses

• Were said to own “seats” on the exchange.

• Collectively owned the exchange, although professionals managed the
exchange.
• Regularly bought and sold seats (record seat price: $4 million in December
2005).
• Could buy and sell securities on the exchange floor without paying commissions.

• Instead of purchasing seats, exchange members purchase trading licenses:

• Having a license entitles the holder to buy and sell securities on the floor of the
exchange.
Farewell, Specialists

• Posted bid prices and ask prices for each security assigned to them.
• Were obligated to make and maintain a fair, orderly market.
• Stood ready to buy at bid prices and sell at ask prices when outside sell
and buy order flows were unequal.

• Because of this advance look, specialists had an information advantage

when they were making quotes and matching orders.
• Under this system, however, specialists could “work” orders (that is, try
to improve trading prices) for customers.
Hello, Designated Market Makers

• Designated market makers (DMMs)

• Supplemental liquidity providers (SLPs)

• The DMMs are assigned a set of securities and are obligated to maintain a fair
and orderly market in these stocks.

• DDMs can compete against other exchange members for trades.

• Specialists had to step back from a trade if a floor broker order had the same
price.
• Unlike the former specialist system, however, DMMs do not receive an advance
look at incoming orders.
DMMs and Supplemental Liquidity Providers (SLP)

• SLPs can trade only from offices outside the exchange.

• DMMs are located on the floor of the exchange.

• DMMs must quote bid and ask prices for at least 5% of the trading day.
• SLPs are required to quote bid or ask prices for at least 5% of the
trading day.

• DMMs by the type of transaction.

• SLPs receive less (lower quoting requirements).
• Floor brokers receive even less (no quoting requirements).
Other NYSE Participants

commission brokers.

floor brokers two-dollar

brokers,”

floor traders
Super Display Book System (SDBK)

• How fast is this trading?

• For comparison, when your favorite race driver is running at 200
miles per hour, the car covers only about 1.5 feet in 5 milliseconds.
The NYSE Hybrid Market

• In less liquid stocks.

• During the opening and closing of trading sessions.
• During times of market duress.
NYSE-Listed Stocks

• The number of shareholders.

• Trading activity.
• The number and value of shares held in public hands.
• Annual earnings.
Operation of the New York Stock Exchange

order flow.

• About one-third is from individual investors.

• Almost half is from institutional investors.
• The remainder represents NYSE-member trading, mostly from specialists
acting as market makers.
NYSE Floor Activity

• Receive customer orders.

• Walk out to DMM posts where the orders can be executed.
• Return to confirm order executions and receive new customer orders.
 Stock Market Order Types

Order Type Buy Sell

Market order Buy at best price available for immediate Sell at best price available for immediate
execution. execution.

Limit order Buy at best price available, but not more than Sell at best price available, but not less than
the preset limit price. Forgo purchase if limit is the preset limit price. Forgo sale if limit is not
not met. met.

Stop order Convert to a market order to buy when Convert to a market order to sell when
the stock price crosses the stop price from the stock price crosses the stop price
below. from above. Also known as a “stop-loss."

Stop-limit Convert to a limit order to buy when the Convert to a limit order to sell when the
stock price crosses the stop price from stock price crosses the stop price from
order below. above.
The Flash Crash of 2010

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• Source: Ben Rooney, “Trading Program Sparked May ‘Flash Crash,’” CNN Money, October 1, 2010.
Circuit Breakers

circuit breakers

• Lowered the marketwide circuit breaker level to 7%.

• Implemented individual stock circuit breakers.

• Be informed: The SEC is constantly tinkering with circuit breakers and

studying what triggers them.
Trading on the Web

Access the text alternative for slide images.

• Source: www.schwab.com.
Types of Orders: Market and Limit Orders

• You specify ticker and quantity.

• Immediate execution at best available price.

• You specify ticker, quantity, and price.

• The order will be executed only if trade can be made at the limit price or
better.
Types of Orders: Stop Orders
• Stop orders are intended to prevent something bad from happening (like losing a lot of
money).
• Sell Stop
• Use this order when you have a long position and want to protect yourself from a price decline.
• The stop price will be below the current price of the stock.
• The stop price is the trigger or activation point.

• Buy Stop
• Use this order when you have a short position and want to protect yourself if the stock price rises.
• The stop price will be above the current price of the stock.
• The stop is the trigger or activation point.
• If the stop price is reached or passed (goes higher), the
Types of Orders: Stop Limit Orders
• Intended to prevent something bad from happening (in an active market, the
limit can hurt you).
• Sell Stop Limit
• Use when you have a long position and want to protect yourself from a
price decline.
• The stop price will be below the current price of the stock.

• Buy Stop Limit

• Use when you have a short position and want to protect yourself if the stock
price rises.
• The stop price will be above the current price of the stock.
Stop Orders versus Stop Limit Orders

• Stop and limit prices do not have to be the same.

• You could use a stop of $45 with a limit of $44.
NYSE Ends Use of Stop Orders
• In 2015, the New York Stock Exchange eliminated stop orders. Why restrict the type of transactions that investors can
make? Because other investors, including BlackRock, blame stop orders for escalating extreme share-price swings.
• What are stop orders? Stop orders are instructions to immediately trade once a stock hits a certain price, even if the
price is far worse than the one specified in the order.
• How do stop orders work? Say an investor requests that 1,000 shares of Alpha X get sold once the price falls to $15. If
the stock plunges from $20 to $10, without hitting any intermediate prices first, the stop order will be executed at that
first stopping point . . . even though it’s much lower than the specified $15 target.
• Was there a key incident that led investors to call for this ban? You know there was! On August 24, 2015, hundreds of
normally stable securities (including blue chips like General Electric and JPMorgan Chase) posted unusual moves,
plunging as much as 21% before quickly recovering. BlackRock, the world’s biggest asset manager, took a close look at
these swings and decided that stop orders were part of the problem.
• At least some academics agreed. Annie Massa at Bloomberg quoted James Angel, a Georgetown University professor,
as saying that “Stop orders are like land mines; they blow up in ways that are unanticipated by the people who plant
them.”
• Brokerage firms can still program their systems to execute orders achieving the same results as a stop order for their
clients. The ban on stop orders, though, should raise awareness of the risks that investors take in making these types of
trades.
• Source: Annie Massa, “NYSE Kills ‘Land Mine’ Order Type Some Blame for August Mayhem,” Bloomberg, November 19, 2015.
NASDAQ 1

National Association of Securities Dealers Automated Quotations

system
NASDAQ 2

• The Global Select Market.

• The Global Market.
• The Capital Market.
NASDAQ Quotes

inside quotes.
• The highest bid.
• The lowest ask.

• Displays all bids and asks.

• Frequently displays the market maker identity.
NYSE and NASDAQ Competitors

third market

fourth market

dually listed
 Stock Market Information

• https://money.cnn.com/data/dow30/

• In continuously since 1907.

• Dropped from Dow June 26, 2018.
• Replaced by Walgreens (WBA).
The DJIA Component Stocks

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• Source: CNN Money, (2019).

The Dow Jones Industrial Average

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• Source: finance.yahoo.com, accessed January 3, 2019.

Stock Market Indexes 1

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Stock Market Indexes 2

• The market covered,

• The types of stocks included,
• How many stocks are included, and
• How the index is calculated (price-weighted―for example, DJIA versus
value-weighted―for example, S and P 500).

• We do not know the “true” index level if all the stock prices are not updated
(that is, fresh).
• The level of index staleness changes during the trading day.
Stock Market Indexes 3

value-weighted

price-weighted

• This means stock splits cause issues.

• Stock splits can be addressed by adjusting the index divisor.
• Note: As of January 3, 2019, the DJIA divisor was a nice “round”
0.1474808199!
Example I: $1,000,000 to Invest, Price to Weighted Portfolio

Company Price Price Weight Shares to Buy

Boeing 67.50 0.5148 7,626

Nordstrom 41.93 0.3198 7,626
Lowe's 21.70 0.1655 7,626
Total: 131.130 1.0000

Note: Shares = $1,000,000 / 131.130 = 7,626

Example II: Changing the Divisor When a New Stock Is Added to the Index

Day 1 of Index: Company Price

Boeing 67.50
Nordstrom 41.93
Lowe's 21.70
Sum: 131.13
Index: 43.71 (Divisor = 3)

• Before Day 2 starts, you want to replace Lowe's with Home Depot, selling at
$32.90.

Boeing 67.50
Nordstrom 41.93
Home 32.90
Depot
Sum 142.33

142.33 Divisor = 43.71, if Divisor is: 3.256234271

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

Shares Capitalization Value Shares to

Company Price (millions) (millions) Weight Buy
Boeing 67.50 732.74 49,460.0 0.5550 8,223

Nordstrom 41.93 219.65 9,210.0 0.1034 2,465

Lowe's 21.70 1,402.76 30,440.0 0.3416 15,742

Total: 131.130 Total: 89,110.0 1.0000 26,430

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

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

• Using the Portfolio from Previous Slide

Total Shares Market Capitalization
Day 1: Company Price (millions) (millions)
Boeing 67.50 732.74 49,460
Nordstrom 41.93 219.65 9,210
Lowe's 21.70 1402.76 30,440
Total MV(1): 89,110
89.11
Day 1 Index Level: 1,000.00
Total Shares Market Capitalization
Day 2: Company Price (millions) (millions)
Boeing 69.00 732.74 50,559
Nordstrom 41.93 219.65 9,210
Lowe's 21.70 1402.76 30,440
Total MV(2): 90,209
Day 2 Index Level: 1,012.33
The Day 3 Index Can Be Calculated in Two Ways
Total Shares Market Capitalization
Day 3: Company Price (millions) (millions)
Boeing 71.10 732.740 52,098
Nordstrom 41.93 219.650 9,210
Lowe's 21.70 1,402.760 30,440
Total MV(3): 91,748
Total MV(2): 90,209

Day 2 Index 1,012.33

Level:

Day 3 Index Level: 1,029.60

Total MV(1): 89,110

Day 3 Index 1,029.60

Level:
Market Value Day 3
Day 3 Index =  Index Level Day 2
Market Value Day 2
or
Market Value Day 3
Day 3 Index =  Index Level Day 1
Market Value Day 1
Useful Internet Sites

• www.nvca.org
• www.hoovers.com
• www.hsx.com
• www.nyse.com
• www.nasdaq.com
• https://en.wikipedia.org/wiki/Dow_Jones_Industrial_Average

• www.russell.com
• www.msci.com
• jmdinvestments.blogspot.com
Vietnam stock market
Discussion
Chapter Review 1

• Private Equity Funds.

• The Primary Market for Common Stock.

• The Secondary Market for Common Stock.
• Dealers and Brokers.

• Designated Market Makers (DDMs).

• Types of Members.
• NYSE-Listed Stocks.
Chapter Review 2

• NYSE Floor Activity.

• Special Order Types.

• NASDAQ Operations.
• NASDAQ Participants.
• The NASDAQ System.
Chapter Review 3

• The Dow Jones Industrial Average.

• Stock Market Indexes.
• More on Price-Weighted Indexes.
• Value-Weighted Indexes.
Thank you and see you next
lecture