Understanding Markets by Jimmy Gentry

Understanding Markets Strictly Financials Jan. 2, 2012

Donald W. Reynolds National Center For Business Journalism At Arizona State University Strictly Financials

James K. Gentry, Ph.D. Clyde M. Reed Teaching Professor School of Journalism and Mass Communications University of Kansas [email_address] Strictly Financials

Risk-Return Relationship Strictly Financials

Basic Types of Risk Systematic or market Unsystematic or nonmarket. Also called “business risk.” Can be diversified away.

Specific Types of Risk Financial risk, credit risk, default risk Market risk Interest rate risk Purchasing power or inflation risk Event risk Exchange-rate or foreign exchange risk Liquidity risk Political or sovereign risk Tax risk

Types of Businesses Sole proprietorship Partnership Corporation Limited liability Greater access to capital Permanency Flexibility Double taxation

Types of Structures Private corporations Public corporations Non-profits Strictly Financials

Types of Investments Stocks Bonds Other Options, futures, commodities, real estate, collectibles, currencies Strictly Financials

Types of Markets Equity: Stocks Credit: Bonds, debt or fixed income Others Derivatives (such as options and futures), commodities, real estate, collectibles, currencies Historically, the amount of long-term debt financing issued in the U.S. greatly exceeds the volume of equity financing

Stock Stockholders want: Stock price to increase Dependable dividend stream Increase in size of dividend Strictly Financials

Types of Stock Common stock Preferred stock Strictly Financials

Common Stock Risk: Lose your money if company falters Reward: Owners share in success when company does well Appreciation Dividends Strictly Financials

Dividends Represent a return on capital invested by shareholders. Board must declare dividend for it to be paid. Dividend payment is not a business expense. It is an after-tax expense. Usually relationship between company’s age and size, and the dividends it pays. Strictly Financials

Preferred Stock Reduced risk but reward may be limited Dividend amount is stated and is paid before dividends on common If company is liquidated, holders are preferred over common holders. Dividends don’t necessarily increase if company prospers. Strictly Financials

Bond Bond is debt a company owes Individual or company “loans” money to the company by buying a bond Bond pays interest over a fixed period of time Principal is repaid to the lender or holder of the bond at end of the term Interest rate is typically fixed when the bond is sold (i.e., fixed income security) Interest rate is comparable to what other bonds, with that rating, are paying Strictly Financials

Bond Terminology Interest rate: Fixed percentage of the bond’s purchase price that is paid annually to the bond holder Yield: Return on investment if bond is held to maturity. Equals interest rate. If bond is traded before maturity date, yield could change although interest rate stays the same. Par value: Dollar amount paid for bond at time of issue Maturity date: When bond comes due Strictly Financials

Issuers Prefer Bonds When companies need to raise money, they can issue stock or sell bonds They often prefer bonds, in part because issuing more stock can dilute the value of shares investors already own Bonds also may have income tax advantages Strictly Financials

A Quasi-Bond? Is preferred stock debt (i.e., a bond) in disguise? Preferred holders have a “guaranteed” dividend. Is that like the fixed interest rate of a bond? Why do investors pick common, preferred or bonds? Strictly Financials

Risk and Reward Strictly Financials

Yield Curve Yield Maturity Strictly Financials

Equity or Securities Markets Primary market Go public Private placement Secondary market Strictly Financials

Going Public Entrepreneurs have an idea. Company grows with an investment from the private equity market (venture capital). Owners decide to “go public.” Register with SEC to make an initial public offering (IPO). Investment bankers typically underwrite the offering through a syndicate. Strictly Financials

Going Public (cont.) Company prepares a prospectus, which is a detailed analysis of the company’s financial history, its products and services, as well as management’s background and experience. Prospectus should identify and assess risk factors the company faces. Strictly Financials

IPO Terms Prospectus Road show Quiet period Lockup period Strictly Financials

Shelf Registration Firm can file one registration statement for a relatively large block of stock and sell parts over a two-year period This can reduce red tape and costs, and because stock can be sold directly to institutional investors, can eliminate the underwriting fee Strictly Financials

Private Placement New issues can be sold in large lots to a small group of buyers. Allows start-up firms to show appeal by raising capital on their own. Additional shares later can be offered through an underwriter. Many debt issues are placed privately, usually to large buyers such as insurance companies . Strictly Financials

Secondary Offering If company already is public, it can sell more stock through a secondary offering. Causes dilution Major owners sell their shares. They get the funds so no dilution. Strictly Financials

Wall Street Got its name from a wall of brush and mud built by early settlers to protect the city of New York from attacks (1609) Site of New York’s first organized stock trading Strictly Financials

New York Stock Exchange In March 1792, Wall Street leaders met to establish an improved auction market In May 1792, 24 men signed an agreement to trade securities only among themselves, maintain fixed commission rates and avoid other auctions Considered the origination of NYSE Strictly Financials

NYSE (cont.) Until March 2006, was owned by 1,366 seat-holding members Highest price ever paid for a seat was $4 million Price was determined by auction. Strictly Financials

NYSE Members Floor brokers House brokers Independent brokers Specialists Manage auction process Execute orders for brokers Serve as catalysts Provide capital Stabilize prices Strictly Financials

In The Day, Buy or Sell Order Tell your broker or “registered representative” to buy or sell a stock at the current price, or market price. Called a market order. If you name the price to buy or sell, you’re making a limit order. Tell your broker to buy or sell once the price hits a specific price, you’re placing a stop order at a stop price. Strictly Financials

Trading on the NYSE Floor Trading occurs in the “Big Room” Numerous stations, each with a roughly figure-eight shape, with counters and screens above. Called “trading posts.” Each counter is a “specialist’s” post Strictly Financials

NYSE Floor (cont.) Order comes to the booth that is rented by a brokerage house Floor broker takes order to appropriate specialist’s post Specialist keeps a list of unfilled orders. Processes orders as prices move. Specialist’s job is to maintain an orderly market in the stock (match buyers/sellers) Strictly Financials

NYSE Floor (cont.) Stocks or groups of stocks are traded at trading posts near the specialists’ positions. Floor brokers can use a specialist or trade between themselves, called trading in the “crowd” Terminals display the stock’s activity. After every trade, a reporter records the stock symbol, price and initiating broker. Successful trades are confirmed. Strictly Financials

NYSE Floor (Then & Now) Strictly Financials

Round or Odd Lots Round lots: Buying or selling stock in multiples of 100 shares Odd lots: Buying or selling stock in other quantities Strictly Financials

Who Holds Your Stock? Virtually all investors leave shares in their brokerage account in what’s called the street name . Investor retains beneficial ownership , though. This offers safe storage. You can get tangible certificates if you want them. Typically, you must pay for them. Strictly Financials

Super DOT System Designated Order Turnaround Allows orders to be transmitted electronically to specialist. Now makes up a substantial percentage of NYSE trading, particularly smaller orders Strictly Financials

American Stock Exchange Non-members of NYSE couldn’t afford office space so traded in the street 1842: New York Curb Exchange By late 1870s known as “curbstone brokers” and their market was known as the Curb. Merged with NASDAQ in 1998 Acquired by NYSE Euronext in 2009 Strictly Financials

NASDAQ National Association of Securities Dealers Automated Quotations system NASDAQ is a computer network with no physical location for trading Uses a multiple market maker system, not the specialist system About 4,000-plus companies Strictly Financials

Trading on the NASDAQ Trading is through an open market, multiple dealer system, with many market makers competing to handle each transaction. The computer network checks for matches, which can be handled instantly. Strictly Financials

In Which Market? In general, but with exceptions: NYSE: Oldest, largest, best known AMEX: Smaller, younger NASDAQ: Youngest, least experienced Some of NYSE’s most actively traded stocks are also quoted on the NASDAQ Strictly Financials

ECNs Electronic Communications Networks Are basically Web sites that allow investors to trade directly with one another Archipelago and Instinet were best known BATS Trading Strictly Financials

NYSE - Archipelago Marriage Merged in March 2006 to create NYSE Group, Inc., a publicly-held company. Largest merger ever between securities exchanges. Combined leading equities market with most successful electronic exchange. Archipelago: low fees, user-friendly technology Strictly Financials

NYSE Euronext Merged April 2007 Operates world’s largest, most liquid exchange with diverse products and services Six equities exchanges in five countries and six derivatives exchanges Strictly Financials

Deutsche Borse Seeks To Buy NYSE Euronext Been working on a deal since early 2011. Would create world’s largest trading entity. European regulators are forcing the companies to sell assets because of competitive concerns. Strictly Financials

NYSE ‘Hybrid Market’ Floor trading and automated trading Specialists or Archipelago strengths Why? Customers’ desire for faster access to liquidity and greater anonymity Strictly Financials

NASDAQ Response NASDAQ acquired Instinet Group Inc., another ECN Strictly Financials

Exchanges v. OTC Market Stocks in almost 10,000 companies aren’t listed on any exchanges. They are traded “over the counter” (OTC) Typically handled by phone or computer Generally, comparatively inexpensive and infrequently, or “thinly,” traded Strictly Financials

BATS Global Markets Newer exchange, founded in 2005 Located in Kansas City Competes on technology and cost Developed its own software platform Also offers an options trading platform An ECN Strictly Financials

U.S Equities Market Share NYSE 27.5% Arca, 14% Floor, 13.5% NASDAQ, 21.5% BATS, 12% September 2011 Strictly Financials

Stock Market Participants and the Role of an Exchange

Direct Edge Another ECN Has exchange status Strictly Financials

Dark Pools Also “Dark Liquidity” or “Dark Pool Liquidity” Lightly regulated trading not open to the public. Mostly involves block trades by institutions away from public exchanges so trades are anonymous. Main advantage to institutional investors: Can buy or sell in large blocks without other investors knowing since neither size of trade or trader’s identity are revealed. Prices are reported after trades completed. Also means some market participants are disadvantaged since they can’t see trades executed and prices paid so this market is not transparent. Strictly Financials

High-Frequency Trading Also known as “high-speed trading.’ Electronic trading strategies driven by statistics and algorithms. WSJ reported in October that by some measures, such firms make up 5 of every 10 stock trades in the U.S. each day. Strictly Financials

High-Frequency Trading Research has shown that algorithmic trading broadly makes prices less volatile and reduces the overall cost of trading. These firms’ ability to buy and sell large blocks of securities in fractions of a second has raised fears that ordinary investors are being left behind. Is drawing criticism. Strictly Financials

Cyclical, Income, Growth Cyclical: Highly dependent on the state of the economy. When things slow, earnings and stock price fall. When economy recovers, earnings and stock prices rise. Income: Stocks that pay dividends regularly. Growth: Pay little or no dividend while profits are reinvested. Strictly Financials

Stock Ownership Strictly Financials

Institutional Investors Organizations that invest their own assets or pool those it holds in trust for others. Examples: Investment companies (including mutual funds), pension systems, insurance companies, universities and banks. Trade regularly and in tremendous volume. Must buy or sell at least 10,000 shares for a transaction to be an “institutional trade.” Strictly Financials

Changing Attitudes Institutional investors who own large blocks of stock are increasingly demanding a say in corporate management. Socially or environmentally conscious individual shareholders also are becoming more involved. Strictly Financials

Stock Market Averages Dow Jones Industrial Average: Best known and most widely reported market indicator Made up of 30 industrial companies Dow Jones Transportation Average: 20 airlines, railroads and trucking companies Dow Jones Utility Average: 15 gas, electric and power companies Dow Jones 65 Composite Average: all 65 companies in the other three averages Strictly Financials

Stock Market Indexes NYSE Composite Index: All stocks traded on the NYSE. Standard & Poor’s 500 Index: Broad base of 500 stocks. Considered benchmark for large-stock investors. NASDAQ Stock Market Composite Index: Stocks traded through its electronic system. Often more volatile because of types of companies it covers. Strictly Financials

Market Indexes (cont.) AMEX Composite: Companies on the AMEX. Russell 2000: Follows smallest two-thirds of the 3,000 largest U.S. companies. Includes many IPOs of past few years. Benchmark for small-company stocks. Value-Line: 1,700 common stocks. Wilshire 5000: Broadest index, including nearly all stocks traded in U.S. markets. Strictly Financials

Reg FD, Disclosure and Guidance Regulation Fair Disclosure, October 2000 Bars public issuers from selectively revealing material nonpublic information to securities analysts, broker-dealers, investment advisers, and institutional investors, before disclosing it to the public. Tension: Guidance vs. disclosure Strictly Financials

Blue-Chip Stock Company with national reputation for quality, reliability and ability to be profitable in good or bad times Strictly Financials

Bulls and Bears Bulls: Persons who think prices or values will rise. In general, being optimistic. Bears: Persons with a pessimistic market outlook. Strictly Financials

Selling Short Selling a security not owned by seller Investor borrows stock and sells it for later delivery. Seller hopes to buy the stock later at a lower price, thereby making a profit, which comes from difference between price at sale and price at later purchase. Strictly Financials

Margin Buying on margin: Borrowing money from broker to buy securities. Federal Reserve regulates margin. Today investor can borrow up to 50 percent of the price of the stock. Broker requires a minimum balance and can issue a “margin call” if stock’s value declines. Strictly Financials

Classes of Stock Some firms have more than one class Primarily done to assure control of the firm by one group, such as Ford Motor Company’s Class B, which isn’t publicly traded (held by family) but has 40 percent of voting power, although it represents less than 10 percent of total shares outstanding. Strictly Financials

Stock Split If stock price increases significantly, a company might do a split to lower the price, which it expects to stimulate trading. In a split, more shares are available but total market value is still the same. Price may move up after split, therefore increasing the value of your stock. Reverse split: Exchange more shares for fewer, say 10 for five. To boost share price. Strictly Financials

Arbitrage Simultaneous purchase and sale of an asset to profit from a differential in the price. Usually takes place on different exchanges or marketplaces. Ex: Buy stock in company on one exchange at one price and sell stock in the same company on another exchange at a different price. Strictly Financials

Insider Trading Buying and selling of company stock by officers, directors, employees, family members, etc. Person or trust owning 10 percent or more of a company's stock also considered an "insider." SEC calls them "insiders" because of access to early and potentially key company events. Strictly Financials

Option On an organized exchange, the right to buy or sell securities, commodities, etc. at some point for an agreed upon amount. In a company, stock options are granted to corporate executives and others as part of their compensation packages. Strictly Financials

Warrant Type of security, usually issued with a bond or preferred stock, that entitles holder to buy a proportionate amount of common stock at a specified price, usually higher than the market price at time of issuance, for a period of time. Also called a Subscription Warrant Strictly Financials

Global Marketplace Stocks are traded around the clock, around the world. There’s a market open somewhere, 24 hours a day, Monday through Friday. Growing number of multinational companies on several exchanges. Tendency of investors to buy in many markets, not just their own. Strictly Financials

American Depositary Receipts A bank buys and deposits actual foreign securities with another bank (called a depositary), which then issues certificates in the U.S. that represent (and are backed) by the deposited securities. Depositary handles day-to-day interactions with ADR holders. Advantages: As U.S. securities, ADRs are subject to U.S. regulations and protections. Strictly Financials

ADRs (cont.) Priced in dollars and dividends paid in U.S. dollars. ADR prices follow closely (but not necessarily 1:1) the underlying foreign security, based on supply and demand. Very few U.S. banks are depositaries. Bank of New York is largest with more than 50 percent of all ADR issues. Strictly Financials

Tracking Global Markets Wall Street Journal tracks 24 national stock markets outside the U.S. with 32 indexes. Worldwide market performance is compared by looking at percentage change. Strictly Financials

Why International Rewards Diversification, capital gains, dividends, country’s currency rises against dollar Risks Tax treatments differ by country, accounting and trading rules can be different, converting dividends can add expenses, distance and language barriers Strictly Financials

Credit or Debt Markets Historically, the amount of long-term debt financing issued in the U.S. greatly exceeds the volume of equity financing Short-term or “money market” Bond market Strictly Financials

Money Market Commercial paper Bankers’ acceptance Repurchase agreements Certificates of deposit Municipal notes Treasury bills Money market mutual funds Strictly Financials

Terminology Bills – Maturity dates up to one year Notes – Maturity dates of two to 10 years Bonds – 10 years or longer Strictly Financials

Who Issues Bonds Issued by U.S. companies Issued by the U.S. Treasury Issued by federal, state and local government agencies Issued by overseas companies and governments. When sold in dollars, are sometimes called Yankee Bonds. Strictly Financials

Issuers Prefer Bonds When companies need to raise money, they can issue stock or sell bonds They often prefer bonds, in part because issuing more stock tends to dilute the value of shares investors already own Bonds also may have income tax advantages Strictly Financials

Treasury Issues Life, or term, is fixed at time of issue Treasury bill: One year or less Treasury note: One to 10 years Treasury bond: 10 years or more Generally, the longer the term the higher the interest rate Strictly Financials

Uses of Bonds Corporations use bonds: To raise capital to pay for expansion or modernization To cover operating expenses To finance corporate takeovers or other changes in management structure Strictly Financials

Uses of Bonds (cont.) U.S. Treasury uses bonds: To finance a wide range of government activities To pay off (actually refinance) the national debt Strictly Financials

Uses of Bonds (cont.) States, cities, counties and towns issue bonds: To pay for a wide variety of public projects To supplement their operating budgets Strictly Financials

How Bonds Are Sold Issuing bonds has similarities to an IPO Bonds are sold at par, or face value, in units of $1,000 After issue, bonds trade in secondary market and are bought and sold through brokers Government bonds are directly available through a Federal Reserve Bank program called Treasury Direct or through a broker Most municipals are sold through a broker Strictly Financials

How Bonds Are Traded Most already-issued bonds are traded over the counter Bonds also can be purchased from the inventory of a brokerage firm that might make a market in the bonds Commissions and markups Strictly Financials

Bonds Then and Today Until 1983, all bondholders received certificates Some of these Bearer Bonds had coupons attached to the certificate To collect interest, investor detached the coupon and exchanged it for cash. Hence, the bond interest rate is called the Coupon Rate. Today most new bonds are called Book Entry bonds and are registered electronically Strictly Financials

Rating Bonds Standard & Poor’s, Moody’s Investors Services and Fitch are best known Corporate, international and municipal bonds are rated Credit ratings influence interest rates If a company’s rating is downgraded, investors demand a higher yield Strictly Financials

Bond Rating Code Aaa/AAA: Best quality Aa/AA: High quality A/A: High-medium quality Baa/BBB: Medium quality Ba/BB: Some speculative element B/B: Future default risk Caa/CCC: Poor quality, default danger Ca/CC: Highly speculative C/C: Lowest rated, poor prospects Strictly Financials

Understanding Markets by Jimmy Gentry

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