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How Securities Are Traded • Process of Securities Issue – New securities issued in How Securities Are Traded • Process of Securities Issue – New securities issued in a primary market such as NYSE – Initial Public Offer (IPO)/Seasoned Issues – IPOs are typically smaller firms, no public history – Bond issue: (1) public offer is sold to public and later traded; (2) private placement - sold to few institutional investor and then held until maturity

 • Underwriting –lead bank forms underwriting syndicate to share with other banks share • Underwriting –lead bank forms underwriting syndicate to share with other banks share the commitment, which can be firm commitment or best-efforts basis • Shelf Registration –in 1982, SEC passed Rule 415 that allows firms to register securities for a 2 -year period and market them when needed • Underpricing – New issues are often underpriced – conflict of interest: a guarantee of issue success, less proceeds to issuing firm.

Trading Places • Secondary Market – trading of existing securities – adds liquidity to Trading Places • Secondary Market – trading of existing securities – adds liquidity to primary market – all exchanges are in the secondary market – most US stocks are traded on the exchanges; most bonds are traded over-the-counter (OTC) market • OTC Market – a loosely organized network of dealers linked by a computer quotation system • Third Market – exchange-listed securities traded in OTC • Fourth Market – market where traders trade exchange-listed securities directly between themselves

Trading Systems • Specialist System – A person in charge of 8 -10 stocks Trading Systems • Specialist System – A person in charge of 8 -10 stocks and smoothes out the supply and demand of the stocks – specialist sometimes provides liquidity by buying/selling on his/her account – performs broker and dealer function – specialist system exists in NYSE • Market Maker System – a market maker quotes a bid-ask price for a stock in the market for other investors to buy/sell stock; – market maker takes risk – OTC market/FX market

Trading on Exchanges • Trading Methods – Continuous Auction – Call Method • Settlement Trading on Exchanges • Trading Methods – Continuous Auction – Call Method • Settlement Method – exchange order must be settled within five business days; – often stock certificates are left with the brokerage firm, in street name. • Participants – commission broker (large retail brokerage firms’ employees) owns the largest seats, executes their clients’ orders – floor broker: independent broker and act for commission broker in trades

– registered traders, execute their own portfolios and few in number – specialists • – registered traders, execute their own portfolios and few in number – specialists • Types of Orders – market order: order to buy/sell at prevailing price – limit order: a order to buy/sell at a certain price or within a certain time period – stop-loss order: stop-loss order is an order to sell if the price falls below a certain level; a stop-buy order to buy if price is above a certain level --- these orders are accompanied by short sales. Buy <$40 Limit Buy >$50 Stop-buy order sell Stop-loss limit sell order

Regulations of Stock Market • Securities Act of 1933 requires disclosure of new issues Regulations of Stock Market • Securities Act of 1933 requires disclosure of new issues • Securities Act of 1934 established the SEC to enforce the 1933 act • Circuit Breakers: if DIJA falls below 250 pts from previous day close, trading halts for 1 -hr and if 400 pts, trading halts for 2 -hrs (also individual stock trading halts • Insider Trading Insiders are major shareholders, officers and directors. They must disclose their trades to the SEC, and cannot profit from insider information when trade

 • Margin Requirement Initial margin is the percentage (50%) of fund acquired from • Margin Requirement Initial margin is the percentage (50%) of fund acquired from investor; the balance is borrowed from broker. It is set by Federal Reserve System. Maintenance margin (MM): the amount below which there will be margin call from brokers. It is set by NYSE and the brokerage firm. – Below MM: investor must either send in cash or sell the shares – Above MM: investor can (1) do nothing, (2) buy additional shares without paying, or (3) increase loan. No Margin buy: buy 100 shares @$50; sell them for $70 1 -yr later Profit = $2000 (i. e. , $20 x 100) Return = profit/initial investment = 2000/5000 = 40%

Margin Buy: Purchase 200 shares @$50 (borrow $5000 @ 9%) Interest cost = $450 Margin Buy: Purchase 200 shares @$50 (borrow $5000 @ 9%) Interest cost = $450 (i. e. , 5000 x 9%) sell shares @$70 in 1 -yr profit = $3, 550 (i. e. , ($70 -50)x 200 - $450) Return = profit/initial investment = 3550/5000 = 71%

 • Short Sales – allows investor to profit from stock price decline – • Short Sales – allows investor to profit from stock price decline – uptick rule – Illustration: (1) You go short 100 Shares @$50, (2) MM =30%, (3) 50% IM (which means $2, 500 cash deposited with broker). Your initial account at broker will be: Assets Proceed $5, 000 Cash $2, 500 $7, 500 Liab & Equity Short $5, 000 Equity $2, 500 $7, 500 IM = Equity/stock value = 2500/5000=0. 5 MM= 0. 3 = (Asset- liabilities)/liability = (7, 500 -100 P)/100 P P = $57. 69

Mutual Funds • Mutual funds pool the funds of many investors and purchase securities Mutual Funds • Mutual funds pool the funds of many investors and purchase securities in large blocks • Open-End Funds – Open-end funds are continuously issuing new shares, which sell at net asset value (NAV) plus commission (load), if any: NAV = MKT value of securities/#shares – load funds are purchased from a broker; no-load are purchased directly from the investment company and involve no commissions • Closed-End Funds – Do NOT issue new shares and trade at prices differing from NAV

Cost/benefit of Mutual funds Advantage • • • Diversification Professional management Small investment Switching Cost/benefit of Mutual funds Advantage • • • Diversification Professional management Small investment Switching privileges reinvestment of dividends and realized capital gains Disadvantage • commission may be high (including front-end load about 4 -8. 5%, a back-end load and operating expenses about 0. 22% per year) • may not receive funds immediately upon selling of mutual funds

Other Investment Cos • Unit investment Trusts pools of funds invested in portfolio that Other Investment Cos • Unit investment Trusts pools of funds invested in portfolio that is fixed for the life of the fund • Commingled Funds These funds are managed by banks or insurance companies and pool retirement and trust accounts that are too small to be managed individually • Real Estate Investment Trust (REITs) similar to closed mutual funds, except that they invest in real estate (equity trusts) or in real estate mortgages (mortgage trusts) • Index Fund replicates broad market index

Investment Concepts • Real vs Nominal Return (rate) 1 + R = (1+r)(1+inf) where Investment Concepts • Real vs Nominal Return (rate) 1 + R = (1+r)(1+inf) where R = Nominal rate (or interest rate) r = real rate inf= inflation rate R = r + inf + r*inf or R = r + inf (Fisher equation)

Interest Rate vs Inflation • To test if Treasury bill is a good proxy Interest Rate vs Inflation • To test if Treasury bill is a good proxy for inflation, i. e, it is tested against the Fisher effect, (i. e. , one-to-one relationship with inflation rate) • R = a + b(inflation) + e where R is the nominal Tbill rate a is the intercept e is the residual (error) term Ho : b =1 (null hypothesis)

Stock Return vs Inflation • R = (P 1 - P 0 + cash Stock Return vs Inflation • R = (P 1 - P 0 + cash dividend)/P 0 where P 1 is the ending period price P 0 is the beginning price R = return (or HPR) Suppose the price of share is currently $100, in one-year, you received $4 dividend and the year-end price is $110, then: R = (110 - 100 + 4)/100 = 14% • In hypothesis testing for equity return, the null hypothesis (one-one relationship between return and inflation) is generally rejected, i. e. , R = a + b(inf) + e

Some basic concepts • Risk premium= expected return - riskfree rate • Excess return Some basic concepts • Risk premium= expected return - riskfree rate • Excess return = actual return - riskfree rate • Hedging is investing in an asset that can reduce the overall risk of the portfolio • Statistical definition of return and risk

Mean and Variances • Expected return E(R) = p 1 R 1 +. . Mean and Variances • Expected return E(R) = p 1 R 1 +. . . + pn. Rn where p is the probability at state i R is the return • Variance (var): pi(Ri-E(R))2+. . . + pn(Rn-E(R))2 • Sample statistics (mean and var) R = (R 1+. . . +Rn)/n s 2 = [(R 1 -R)2+. . . +(Rn-R)]2/n

Covariance (i. e. , cov(x, y)) = [(Rx, 1 -Rx)(Ry, 1 -Ry)+. . . Covariance (i. e. , cov(x, y)) = [(Rx, 1 -Rx)(Ry, 1 -Ry)+. . . (Rx, n-Rx)(Ry, n-Ry)]/(n-1) Correlation coefficient = cov(x, y)/sxsy where correlation coefficient is between -1 and +1, a standardized measure of relationship between two variables, x and y. Return x y time

Risk vs Return Intuition tells us that higher risk means higher return Risk (s Risk vs Return Intuition tells us that higher risk means higher return Risk (s 2 or s)