Chapter 5

The Stock Market

Slides
Fundamentals of Investments
The Stock Market
The Primary & Secondary Stock Markets
The Primary Market for Common Stock
The Primary Market for Common Stock
The Primary Market for Common Stock
The Primary Market for Common Stock
Work the Web
The Secondary Market for Common Stock
The Secondary Market for Common Stock
The New York Stock Exchange
NYSE Membership
Types of Members
Types of Members
NYSE-Listed Stocks
Work the Web
Operation of the New York Stock Exchange
NYSE Floor Activity
Stock Market Order Types
Stock Market Order Types
Nasdaq
Nasdaq
Nasdaq
Nasdaq Participants
Work the Web
The Nasdaq System
NYSE and Nasdaq Competitors
Stock Market Information
Stock Market Information
Work the Web
Stock Market Indexes
Stock Market Indexes
Stock Market Indexes
Chapter Review
Chapter Review
5-1 Chapter Review
A-36 Chapter 5

Chapter Organization
5.1 The Primary and Secondary Stock Markets
A. The Primary Market for Common Stock
B. The Secondary Market for Common Stock
C. Dealers and Brokers
5.2 The New York Stock Exchange
A. NYSE Membership
B. Types of Members
C. NYSE-Listed Stocks
5.3 Operation of the New York Stock Exchange
A. NYSE Floor Activity
B. Special Order Types
5.4 Nasdaq
A. Nasdaq Operations
B. Nasdaq Participants
C. The Nasdaq System
5.5 NYSE and Nasdaq Competitors
5.6 Stock Market Information
A. The Dow Jones Industrial Average
B. Stock Market Indexes
C. More on Price-Weighted Indexes
D. The Dow Jones Divisors
5.7 Summary and Conclusions

Selected Web Sites

http://www.hoovers.com
http://www.nyse.com
http://www.island.com
http://averages.dowjones.com
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Annotated Chapter Outline

5.1 The Primary and Secondary Stock Markets

Primary market: The market in which new securities are originally sold to
investors.

Secondary market: The market in which previously issued securities

trade among investors.

In the primary market, companies issue new securities to raise money, whereas
in the secondary market, investors buy and sell previously issued securities for
speculation and investment.

A. The Primary Market for Common Stock

Initial public offering (IPO): An initial public offer occurs when a

company offers stock for sale to the public for the first time.
Investment banking firm: A firm specializing in arranging financing for
companies.
Underwrite: To assume the risk of buying newly issued securities from a
company and reselling them to investors.
Fixed commitment: Underwriting arrangement in which the investment
banker guarantees the firm a fixed amount for its securities.
Best effort: Arrangement in which the investment banker does not
guarantee the firm a fixed amount for its securities.
Securities and Exchange Commission (SEC): Federal agency charged
with enforcing U.S. securities laws and regulations.
Prospectus: Document prepared as part of a security offering detailing a
company's financial position, operations, and investment plans for the
future.
Red herring: A preliminary prospectus not yet approved by the SEC.

Securities are first bought and sold in the primary market, both through IPOs, and
as seasoned security offerings. The investment banking firm establishes the
financing package, advises on the pricing and number of shares, and arranges
distribution of the shares. The underwriter spread, the "mark-up" on the stock
price, is the basic part of the underwriter's compensation. The stock may be
distributed as a fixed commitment, or on a best effort's basis. All issues must be
approved by the SEC, with the prospectus being issued to investors prior to sale
of the stock. To advertise the issue, a tombstone advertisement will usually
appear in the Wall Street Journal or another financial publication.

Lecture Tip: Examples are very helpful when discussing the primary market and
explaining the differences between a fixed commitment and a best efforts
offering. It is also good to emphasize that the underwriter takes on the risk of the
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issue not completely selling with a fixed commitment offering, whereas the
company takes the risk in a best efforts arrangement.

Lecture Tip: There are many investment terms that are used because of
tradition or historical significance. The red herring statement and the tombstone
advertisement are two of those. The term “red herring” relates to the red stamp
"preliminary" on the front of the preliminary prospectus, but it also relates to the
old saying of "don't buy a red herring." The tombstone advertisement is called
such because the advertisement looks like a tombstone in a graveyard. A legal
statement appears on all tombstone advertisements: "This announcement is
neither an offer to sell or a solicitation of an offer to buy any of these Securities.
The offer is made only by Prospectus." The wording may vary somewhat, but the
statement meets the SEC requirements of providing the prospectus to investors
before soliciting a purchase.

Current Topics: "Paper Chase: SEC is Tough Grader, Push for Clarity Slows
Offerings," by Bridget O'Brian, The Wall Street Journal, July 6, 1999. The SEC
has been reviewing, grading and returning filings from hundreds of companies
since the "plain English" rule took effect in October 1998. The agency's "zealous
execution" of this ruling has slowed down how long it takes to navigate the SEC's
approval process necessary to raise money for stock and bond offerings. Before
the decree became effective, it took an average of 30 days for the SEC to issue
comments on companies’ proposed offerings. In March 1999, it took close to 45
days, according to bankers and lawyers. The SEC says it is now back to 30
days, but the SEC is providing comments aplenty. One recent IPO was returned
with 70 SEC comments, of which 40 concerned plain English. Another IPO went
through four revisions before its IPO became official. The intent of the ruling was
to make prospectus' more readable for the typical investor. Some experts
indicate that the readability of these documents may not actually be improving.

B. The Secondary Market for Common Stock

In the secondary market investors buy and sell shares with other investors.
Secondary market trading is directed through three channels:
• Directly with other investors
• Indirectly through a broker who arranges transactions for others
• Directly with a dealer who buys and sells securities from inventory

C. Dealers and Brokers

Dealer: A trader who buys and sells securities from inventory.

Broker: An intermediary who arranges security transactions among

investors.

Bid price: The price a dealer is willing to pay.

 The Stock Market A-39

Ask price: The price at which a dealer is willing to sell. Also called the
offer or offering price.

Spread: The difference between the bid and ask prices.

A dealer maintains an inventory and stands ready to buy and sell at any time.
The dealer maintains an inventory to accommodate order imbalances. The
dealer is willing to pay the bid price and will sell at the ask price. The difference is
the bid-ask spread. The dealer profits through strategically setting the spread.
The broker brings together buyers and sellers, but does not maintain an
inventory. The broker facilitates trades by others.

The largest secondary market is the NYSE, with the Chicago Stock Exchange
and the American Stock Exchange as 2nd and 3rd. The major competitor to these
organized exchanges is the Nasdaq. The Nasdaq merged with the American
Stock Exchange in 1998.

Lecture Tip: It is useful to point out to students that the bid-ask spread is not
fixed, but changes frequently. Two important factors in determining the spread
are the perceived risk and the volume. Dealers will typically increase the spread
when the perceived risk is higher, and decrease the spread when the risk is
lower.

5.2 The New York Stock Exchange

The NYSE was 100 years old in 1992. It is a not-for-profit corporation owned by
its members, the securities firms and brokerage companies.

A. NYSE Membership

NYSE member: The owner of a seat on the NYSE

The NYSE has 1,366 members who own seats on the exchange. Seat owners
can buy and sell securities on the exchange floor with no commission. The seat
can be bought and sold, as with any other commodity. Since 1929, the lowest
seat price paid was $55,000 (1977). In 2000, seats were going for $2 million,
down from a record $2.65 million paid in 1999. Seats can also be leased to trade
on the exchange, with about one-half the seats being leased. Exchange
members elect 24 of the 27 members of the board of directors. The board sets
exchange policy, and the NYSE professional staff manages the exchange.
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B. Types of Members

Commission brokers: Agents who execute customer orders to buy and

sell stock transmitted to the exchange floor. Typically they are employees
of NYSE member firms.

Specialist: NYSE member acting as a dealer on the exchange floor.

Often called a market maker.

Floor brokers: NYSE members who execute orders for commission

brokers on a fee basis. Sometimes called two-dollar brokers.

SuperDOT system: Electronic NYSE system allowing orders to be

transmitted directly to specialists for immediate execution.

Floor traders: NYSE members who trade for their own accounts, trying to
anticipate and profit from temporary price fluctuations.

Commission brokers execute customer orders to buy and sell stocks, and are
typically employees of NYSE member brokerage firms. Their responsibility is to
get the best possible price for their customers. There are more than 500 NYSE
commission brokers.

Specialists act as an assigned dealer for a small set of securities, with each
security assigned to a single specialist. Specialists are also called market
makers, and are assigned the responsibility of maintaining a fair and orderly
market in a security. They make a market by standing ready to buy at bid prices
and sell at ask prices, acting as dealers for their own accounts. They also
maintain an inventory in the security, and provide liquidity to the market.
Specialists wear two hats, acting as both brokers and dealers at times. There are
about 400 NYSE specialists belonging to 30 specialist firms, although about half
of all NYSE trading is concentrated in the three largest specialist firms.

Floor brokers are often used by commission brokers when they are too busy to
handle the orders themselves. Floor brokers are also called "two-dollar" brokers
because many years ago their fee was two dollars. The SuperDOT system
allows orders to be transmitted electronically directly to the specialist, and
accounts for a substantial percentage of all trading. DOT stands for designated
order turnaround. Floor traders independently trade for their own account and try
to profit from short-term price fluctuations. The number of floor traders has
declined in recent years.

Current Topics: "Floor-Broker Probe Could Yield More Changes," by Ann Davis,
The Wall Street Journal, May 12, 1999. "Brokers on the Big Board have long
been prohibited from trading for their 'own account.'" Since "they have access to
highly sensitive information the exchange prohibits them from trading for
 The Stock Market A-41

themselves or putting their trading interests ahead of their clients'." Securities

regulators are investigating the trading practices of 64 brokers on the floor of the
NYSE who may have illegally shared profits with customers. Investigators
indicate that the brokers initiated trades and then falsified trading tickets to make
it appear that the orders came from a brokerage firm. The brokers then may have
split the profits with the firm. The brokers were charged with: trading in their own
accounts, trading in accounts in which they had an interest, falsifying records,
and "front-running." Front-running occurs when brokers trade ahead of their
customers' orders. Several brokers have pleaded guilty or are in plea
negotiations and the investigation is continuing. This investigation suggests that
these improprieties on the floor of the exchange may be more common than
previously thought.

C. NYSE-Listed Stocks

In late 2000, there were 3,025 companies representing 281 billion shares and
$16 trillion in market value listed on the NYSE. There is an initial listing fee and
an annual listing fee that must be paid by firms on the NYSE. The NYSE
minimum requirements for listing are:

• Total shareholders must be at least 2,200, with 100,000 shares traded a

month on average.
• At least 1.1 million shares must be held by the public.
• Publicly held shares must have at least $40 million market value.
• Company must have annual earnings of $2.5 million before taxes in the most
recent year, and $2 million in each of the preceding two years.
• The company must have net tangible assets of $40 million.

5.3 Operation of the New York Stock Exchange

The business of the NYSE is to attract and process order flow, the flow of
customer orders to buy and sell stock. In 2000, the average stock trading volume
was just over 1 billion shares per day. About one-third of the trading volume is
attributable to individual investors, and almost half is derived from institutional
investors.

A. NYSE Floor Activity

Specialist's post: Fixed place on the exchange floor where the specialist
operates.
Market order: A customer order to buy or sell securities marked for
immediate execution at the current market price.

Most of the activity on the floor of the exchange takes place around the
specialist's post. The clerks operate behind the counters, and the commission
brokers receive customer orders and walk to the specialist's post to execute the
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orders. When a customer issues a market order, they want to buy or sell at the
current market price, with the order marked for immediate execution. The broker
will try to get the best price possible.

B. Special Order Types

Limit order: Customer order to buy or sell securities with a specified

"limit" price. The order can be executed only at the limit price or a better
price.
Stop order: Customer order to buy or sell securities when a preset "stop"
price is reached.
NYSE uptick rule: Rule for short sales requiring that before a short sale
can be executed, the last price change must be an uptick.

Many NYSE orders are limit orders, where a customer specifies a maximum
price to pay (buy order) or minimum price to accept (sell order). The customer is
not willing to accept any price above (buy) or below (sell) the specified price. A
stop order specifies a "stop" price, which is a trigger price for the order to be
converted into a market order. The stop order does not place a maximum or
minimum limit on the trade price. Once converted to a market order, the trade is
executed like any other market order. Specific variations of these orders include:

• Stop-gain order: order to sell when the price rises to reach the stop price.
• Stop-loss order: order to sell when the price decreases to reach the stop
price.
• Start-gain order: order to buy when the price rises to reach the stop price.
• Start-loss order: order to buy when the price decreases to reach the stop
price.
• Stop-limit order: when the stock reaches a preset stop price, the order is
converted into a limit order.
• Short-sale order: when shares are sold as part of a short-sale transaction,
they must be marked as short-sale order.

Short sales are subject to the NYSE uptick rule. A short sale can only be
executed if the last trade was an uptick. This makes it more difficult for
speculators to drive down a stock's price by repeated short sales. The Nasdaq
has also instituted a similar rule.

5.4 Nasdaq

Nasdaq stands for National Association of Securities Dealers Automated

Quotations system. In terms of dollar volume the NYSE is larger, but in terms of
share volume the Nasdaq is larger.
 The Stock Market A-43

A. Nasdaq Operations

Over-the-counter (OTC) market: Securities market in which trading is

almost exclusively done through dealers who buy and sell for their own
inventories.

The Nasdaq is a network of securities dealers who disseminate timely security

price quotes to Nasdaq subscribers. The dealers post bid and ask prices and the
number of shares they are willing to trade at the quoted prices. Nasdaq market
makers trade on an inventory basis, but there are multiple market makers for
actively traded stocks. The Nasdaq market is an OTC market, although they are
trying to lose that name. The two key differences between the NYSE and
Nasdaq are:
• Nasdaq is a computer network with no physical location.
• Nasdaq has a multiple market maker system, rather than a specialist system.

By 2000, there were more than 6,000 securities listed on the Nasdaq, with about
12 market makers for each security. Nasdaq is managed by the NASD. Every
broker or dealer in the U.S. that conducts a securities business must be a
member of the NASD.

B. Nasdaq Participants

Nasdaq has historically been a dealer market, characterized by competing

market markers. Then, in the late 1990s, the Nasdaq system was opened to the
so-called electronic communications networks (ECNs). ECNs are basically
websites that allow investors to trade directly with one another. As a result,
individual investors can enter orders (not just market markers). Hence, ECNs act
to increase liquidity and competition.

C. The Nasdaq System

Inside quotes: highest bid quotes and the lowest asked quotes offered by
dealers for a security.

The Nasdaq operates with three levels of information access:

• Level 1: provides median bid and ask quotes for registered representatives.
• Level 2: provides the highest bid and lowest asked quotes to market makers,
brokers, and dealers.
• Level 3: allow market makers to enter or change their price quote information.

The Nasdaq National Market (NNM) was introduced in 1982 as the National
Market System (NMS).

Lecture Tip: When discussing the Nasdaq it is interesting to talk about the firms
listed on the Nasdaq. It is no longer every firm's goal to be eventually listed on
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the NYSE—the Nasdaq is now an attractive competitor to the NYSE. Ask

students what firms they know are listed on the Nasdaq. They should be able to
suggest a number of firms, such as Intel, Microsoft, Yahoo!, and MCI Worldcom.

5.5 NYSE and Nasdaq Competitors

Third market: Off-exchange market for securities listed on an organized

exchange.

Fourth market: Market for exchange-listed securities in which investors

trade directly with other investors, usually through a computer network.

The NYSE and Nasdaq face competition from the third market, the fourth market,
and regional exchanges. The third market refers to trading in exchange-listed
securities that occurs off the exchange in which the security is listed. The fourth
market refers to direct trading of exchange-listed securities among investors.
One example is Instinet, an electronic trading network that facilitates trading
among its subscribers. Nasdaq has SelectNet, which has not been as popular as
Instinet. Thousands of stock issues are dually listed on the NYSE or Nasdaq, and
a regional exchange.

Current Topics: "Structure Problems: Fragmented Nasdaq May Become

Vulnerable to Competition," by Greg Ip, The Wall Street Journal, June 10, 1999.
The 1997 reforms that followed an investigation into dealer's fixing of stock
prices, coupled with advances in electronic trading, are fragmenting Nasdaq into
many submarkets, making it harder to ensure investors are getting the best price.
The NASD thought they had a solution, a central limit order book. This proposal
was killed when some member firms thought the NASD was trying to compete
with its own members. But if the situation is not addressed, competition awaits in
the form of "10 quasi-stock exchanges called electronic communications
networks," the largest of which is operated by Instinet. These ECNs are seen as
competition since they display a book of investors' buy and sell orders. In May
1999, Instinet had 20% of Nasdaq's volume, and Island ECN had 6% of
Nasdaq's volume. Several solutions include: allowing dealers to separately
display their own and their customers' order in Nasdaq, speeding up SelectNet,
and compelling ECNs to display previously hidden orders. Finally, the proposal
for the central limit order book has been quietly resurrected.

5.6 Stock Market Information

A. The Dow Jones Industrial Average

The Dow Jones Industrial Average (DJIA) or "Dow" is the most widely followed
barometer of daily stock market activity. The DJIA is an index of 30 large "blue-
chip" companies representative of American industry. Two other Dow averages
include the utilities and transportation averages.
 The Stock Market A-45

B. Stock Market Indexes

Price-weighted index: Stock market index in which stocks are held in

proportion to their share price.

Value-weighted index: Stock market index in which stocks are held in

proportion to their total company market value.

Lecture Tip: Stock indices can be calculated as price-weighted indices or value-

weighted indices. To compute a price weighted index, take the price of each
stock in the index, add them up, and divide by the number of stocks. It is
basically a simple average. To compute a value-weighted index, multiply the
number of shares of each stock in the index by the corresponding share price,
and sum the products to give the total market value. Then divide this total market
value by the latest index divisor to give the index value. The initial index divisor is
the initial (base period) total market value divided by the desired initial index
value. The divisor changes as stocks are added to or deleted from the index.

C. More on Price-Weighted Indexes

Lecture Tip: It becomes apparent after some observation that the price-weighted
index has some problems. Since it is a simple average of the share prices of the
stocks in the index, the value can be unduly influenced by the price changes of
one high-priced stock. Also, the index must be adjusted for stock splits and stock
dividends. This tends to cause the divisor to change, in fact decrease, over time.
In August 2000, the divisor was 0.16894073. A divisor that is less than one will
further magnify any price change effects. This is one reason we see such large
swings in the DJIA.

D. The Dow Jones Divisors

Index staleness: Condition that occurs when an index does not reflect all
current price information because some of the stocks in the index have not
traded recently.

If there are problems with price-weighted indices, why do we continue to follow

the DJIA? The answer is tradition. The most popular alternative to the DJIA is the
value-weighted S&P 500 index, which provides frequent accurate updates of
market prices. This index accounts for the major portion of overall stock market
value with its representative 500 stocks.

5.7 Summary and Conclusions