Securities Markets - Investment Management by Charles P Jones

Chapter 4-Securities Markets

Q 4-1: Discuss the importance of the financial markets to the economy. Can primary markets exist without secondary markets?

Business organisation, in order to finance or expand their operations, need capital in large amounts, which they are incapable of saving in a reasonable period of time. Government organisations also need to generate funds to finance large projects of public interest. The financial markets allow both the business and government organisations to raise funds by issuing securities. Financial markets serve to channel funds from savers (surplus units) to borrowers—those who can make the best use of them.

The existence of the secondary market provides assurance to the investors of the primary market that their investment in securities can be converted into cash. They may sell the securities taking up losses; nevertheless, selling the securities in loss can guarantee some cash recovery. In the event of not being able to sell the securities at all, the money invested will get stuck and the investment would result in a deadlock. In short, secondary markets are indispensable to the proper functioning of the economy and the primary markets would not be lucrative for investors in the absence of the secondary markets.

Q 4-2: Discuss the functions of an investment banker?

Besides performing activities such as helping companies in mergers and acquisitions, investment banker is a firm specialising in sales of new securities to the public, typically by underwriting the issue. Underwriting is the process by which investment bankers purchase an issue of securities from a firm and resell it to the public.

Investment bankers also act as an advisor to the firm in providing information about the type of security to be sold; the features to be offered with the security; the price and timing of the sale. They usually purchase securities from the issuer at a discount rate (less than par value) before offering them to the public at par value, or premium. Investment bankers can protect themselves by forming a syndicate—a group of investment bankers. This allows them to diversify their risk. A prospectus is also prepared by investment bankers, which provides information about initial public offering of securities to potential buyers. Global investment banking has emerged recently with the technological tools to facilitate the process and investment banks can form international syndicates to raise capital from more than one country.

Q 4-3: Outline the process for a primary offering of securities involving investment banker.

To make a primary offering of securities through investment banker, the issuer (seller) of the securities works with the originating investment banker in designating the specific details of the sale. A prospectus, which summarizes this information, offers the security for sale officially. The underwriter forms a syndicate of underwriters who are willing to undertake the sale of these securities once the legal requirements are met. The selling group may consist of the syndicate members or other firms affiliated with the syndicate. The issue may be fully subscribed (sold out) quickly or it may take several days (or longer) to sell it.

Q 4-4: Outline the structure of equity market in the United States. Distinguish between auction markets and negotiated markets?

 The buying and selling of common stocks, preferred stocks and warrants are traded in the equity markets. Some secondary equity markets are auction markets, involving an auction (bidding) process in a specific physical location. The US auction markets include the New York Stock Exchange (NYSE), the American Stock Exchange, and the regional exchanges. In auction markets brokers represent the investors. They work on commission and have no vested interest in whether the customer places a buy order or sell order.

The negotiated markets involve over-the-counter market, which is a network of dealers, who make a market by standing ready to buy and sell securities at specified prices. Unlike brokers, dealers trade on their own account rather than the customer’s account and have a vested interest in the transaction because the securities are bought from them and sold to them. They earn a profit in these trades by the spread, or difference, between the buying and selling prices.

Q 4-5: In what way is an investment banker similar to a commission broker?

Investment bankers are similar to brokers in acting as a financial intermediary to buy and sell securities. Investment bankers play the same role in the primary markets as brokers in secondary markets.

Q 4-6: Explain the role of the specialists, describing the two major roles that they perform. How do they act to maintain an orderly market?

The role of a specialist is critical in an auction market. Specialists are expected to maintain a fair and orderly market in the stocks assigned to them. They act as brokers as well as dealers. As brokers they maintain the limit books, which record limit orders. The commission brokers leave the limit orders with the specialists to be filled when possible. The specialists receive a part of the brokers’ fee for executing these orders.

As dealers specialists buy and sell shares of the assigned stock to maintain an orderly market. Since the orders do not arrive at the same time so that they could be matched, the specialist will buy from the commission brokers with orders to sell, and sell to those with orders to buy, hoping to profit from a favourable spread between the two transactions.

Since specialists are charged by the stock exchange to maintain a continuous orderly market in their assigned stocks, they often must go against the market, which requires adequate capital. However, these ‘stabilisation trades’ constitutes only a small part of the total trading[1].

Q 4-7: Do you think that the specialists should be closely monitored and regulated because of their limit books?

The role of a specialist is critical in buying and selling of shares. One of the many important roles of a specialist is to maintain the limit books, which records limit orders. The specialists are also supposed to maintain an orderly market for the share and establish a fair price. With the help of the limit books they can gauge the total demand and supply for the share and thus it is not difficult for them to establish a fair price. Owing to this reason specialists need to be closely monitored and regulated to ensure an efficient market.

Q 4-8: Is there any similarity between an over-the-counter dealer and a specialist on the stock exchange?

Over the counter market is a negotiated market in which dealers represent investors. It consists of a network of securities dealers linked together to make markets in securities. Unlike brokers, dealers have a vested interest in the transaction since the securities are bought from them and sold to them, and they earn profit in these transactions by the spread—the difference between the two prices. One of the many roles of specialists is to work as a dealer. As dealers, specialists buy and sell shares of the assigned stocks to maintain an orderly market. Since the orders do not arrive at the same time so that they could be matched, the specialist will buy from the commission brokers with orders to sell, and sell to those with orders to buy, hoping to profit from a favourable spread between the two sides.

Q 4-9: Explain the difference between NASD and NASDAQ?

National Association of Securities Dealers (NASD) is a self-regulating body of dealers that oversees the OTC practices. The NASD has the following requirements.

1. Issue license to brokers when they successfully complete a qualification examination.
2. Provide for onsite compliance examination for member firms. Violation of fair practice can result in censure, fine, suspension or expulsion of member firms. This self-regulating role of NASD serves to protect the interest of its members and investors.
3. Provide automated market surveillance.
4. Review member advertising and underwriting arrangements.
5. Provide a mechanism for the arbitration of disputes between member firms and investors.

National Association of Securities Dealers Automated Quotation (NASDAQ) is a national and international stock market, in which a network of dealers, who make a market by standing ready to buy or sell securities as specified prices. This market is a wholly owned subsidiary of NASD.

Q 4-10: Distinguish between a third market and a fourth market?

The third market is an OTC market for exchange listed securities. All off-exchange transaction in securities listed on the organised exchange takes place in the so-called third market. Today a few third market brokers provide investors with the flexibility to trade when the NYSE is closed.

The fourth market refers to transactions made directly between large institutions and wealthy individuals, bypassing brokers and dealers. Essentially, the fourth market is a communications network among investors interested in trading large blocks of stock. Several privately owned automated systems exist to provide current information on specific securities that the participants are willing to buy or sell. Through such automated systems the secrecy of the deals is somewhat ensured as anonymous trading is allowed.

Q 4-11: What are the two primary factors accounting for the rapid changes in the US securities markets?

For the last 15 to 20 years, the securities markets have been changing rapidly. There are two primary factors, which provide some explanation about these rapid changes.

1)      Institutional investors have requirements and views often different from individual investors. Large block activity on the NYSE is an indication of the institutional participation that has increased more than three times in the last 15 years.

2)      Development of a fully competitive national system of securities trading called National Market System, which provides the best price to the buyers and sellers of the securities.

Q 4-12: Why do you think the New York Stock Exchange favours the inter-market trading system (ITS)?

Inter-market trading system (ITS), is a form of central routing system, consisting of a network of terminals, linking together several stock exchanges. NYSE favours this system as it allows the brokers—as well as specialists and market makers trading for their own account—on anyone of the linked markets to interact with their counterparts on any of the other exchanges. Those trading in ITS system can use a nation-wide composite quotation system to check for a better price. However, the ITS does not guarantee that the orders would be routed, since the NYSE brokers can ignore better quotes on other exchanges.

Q 4-13: Outline recent international developments that relate to the US financial markets?

The most recent international development that has significantly affected the US financial markets is the globalisation of securities markets. Since 1990, new horizons of investment have been explored with the opportunity of investing around the world, around the clock. Where other stock exchanges have also benefited from international investing, the US has been the prime beneficiary since NYSE is considered as a benchmark stock exchange among the exchanges all over the world.

Q 4-14: How does NASDAQ/NMS differ from the conventional OTC market?

The conventional over the counter market has been known as a market for small and less known companies. However, now as many as 5,000 companies are traded on NASDAQ/NMS, which amount to $1.6 million for a year.

Q 4-15: What is the Dow Jones Industrial Average? How does it differ from S&P500 composite index?

The Dow Jones Industrial Average (DJIA) is a price-weighted series of 30 leading industrial stocks, used as a measure of stock market activity. It is the oldest market measure, which originated in 1896. This average is said to be comprising of blue-chip stocks. Although the index gives equal weight to equal dollar changes, high priced stocks carry more weight than the low cost stocks. This means that one-dollar change in the price of A stock, which is being traded at $200 would have a different impact on the index than that of a similar change in B stock, which is being traded at $20. This also means that as high-priced stock splits and the price of the stock declines, the stock may lose its relative importance in the calculation of the average, whereas as non-split stock increases in relative importance[2]. The DJIA is basically a blue-chip measure, which is price weighted rather than value weighted.

Standard & Poor’s 500 composite index is the market value weighted index of stock market activity covering 500 stocks. The composite index is carried in the popular press and is referred to as a good measure of overall market performance. All stock splits and dividends are automatically accounted for in calculating the value of the index since the number of shares currently outstanding and the new prices are used in the calculation. Each stock’s performance is based on relative total market value instead of relative price per share. This index primarily consists of NYSE stocks and is dominated by the large corporations.

Q 4-16: What is meant by blue-chip stocks? Cite three examples.

Blue-chips are those stocks with long records of earnings and dividends issued by well-known, stable and mature companies. An investor is willing to pay high price for such stocks. Coca Cola, General Electric and Microsoft are three examples for blue-chips from the US market, whereas Uni-lever, PSO and Nestle are the blue-chips in Pakistan.

Q 4-17: What is an EAFE index?

EAFE index, Europe Asia & Far East Index, is a value weighted index of the equity performance of the major foreign markets.

Q 4-18: What is meant by block activity on the NYSE? How important is it on the NYSE?

Institutional investors often trade in large blocks. Blocks can be defined as transactions involving at least 10,000 shares. Block trading is increasing day by day and a record of 5.5 million block transactions were traded in year 2000, which accounted for 136 billion shares, or 51 percent of NYSE volume.

Q 4-19: What is the NYSE’s current situation in terms of global trading?

The globalisation of securities markets has influenced the trading practices of the NYSE. In mid 1991, the NYSE began two after-hour ‘crossing sections’, which last from 4:15pm to 5:30pm. One session is for individual stocks and the other is for programme trading (basket of stocks).

Q 4-20: What is an Instinet? How does it effect over-the-counter market?

Instinet, owned by Reuters, is the original electronic trading network, started in 1969. it is a system offering equity transactions and research services to date only for brokers, dealers, exchange specialists, institutional funds managers and plan sponsors who pay commissions of about one cent a share. Instinet is always open for trading stocks on any of the exchanges world wide to which Instinet belongs. Instinet offers anonymous trading allowing large traders to by-pass brokers.

The result of the global trading in bonds that are primarily traded in OTC, the dealers have to adapt to the new market demands that allows fairer prices and investment opportunity around the clock.

Q 4-21: What does in-house trading mean? Who is likely to benefit from this activity?

The internal trading or in-house trading refers to buying and selling of securities without the use of a broker or an exchange. At a large institution with several funds or accounts, traders agree to buy and sell in-house, at the next closing price. This activity benefits the investors who wish to save brokerage commissions on their trading. Although the investors would have to pay service charges to the institutions, the cost would be lesser than what investors might have incurred if they had transacted through a broker.

Q 4-22: What is meant by the statement ‘the bond market is primarily an OTC market?

The secondary market for bonds is primarily an OTC market, since the brokerage firms act as dealers to quote a net price. This implies that the bonds are not traded on commission. There are no discount brokerage houses for bonds, but some of the discount brokerage houses may carry bond inventories. They collect a fee for bond transaction, but in actuality, they are also collecting a spread between what they paid for the bond and what they sell them for.

Q 4-23: How is the DJIA biased against growth stocks?

The DJIA is basically a blue-chip measure, which is price weighted index rather than value-weighted. Blue-chips stocks have a long records of earnings and dividends—usually well known, stable and mature companies. Although, index gives equal weight to equal dollar changes, high price stocks carry more weight than the low priced stocks.  As high priced stock split and its price declines, they lose their relative importance in calculation of the average, whereas non-split stocks increase in relative importance. These companies, which have a strong growth potential announce stock spilt, but after the split, the company may not remain in the DJIA index.

Q 4-24: How has the role of the institutional investors as participants in the NASDAQ market changed?

Institutional investors have now become dominant players in the OTC markets. Since 1982, institutional investors have assumed a larger role on total trading. Institutions currently own more than 40 percent of the total shares being traded on NASDAQ.

Q 4-25: What does it mean to say that an IPO has been underwritten by Merrill Lynch?

In order to make an initial public offering, companies have the services of investment bankers. Investment bankers underwrite new issues by purchasing the securities and assuming the risk of reselling them to the investors. Merrill Lynch, which originally was a brokerage house at the Wall Street, has started offering investment banking services to its clients. As an underwriting arrangement it can purchase the securities from the issuer to sell them to the public. Underwriting by a company as professional as Merrill Lynch would boost the confidence of the investor in the company.

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[1] According to one estimate the stabilisation trade does not exceed 10 percent

[2] Companies which pay their dividends in additional stock would also lose their relative importance in the DJIA. Some companies might prefer to remain in the index so that their stock may be considered a blue-chip in the market, but then these companies would have to avoid giving stock dividends to be among the top 30 companies.