Chapter

5
The Stock Market

Fundamentals
of Investments
Valuation & Management
second edition
Charles J. Corrado Bradford D. Jordan

McGraw Hill / Irwin Slides by Yee-Tien (Ted) Fu

 The Stock Market
Our goal in this chapter is to get a “big picture”
overview of who owns stocks, how a stock
Goal exchange works, and how to read and understand
the stock market information reported in the
financial press.
The Primary & 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.
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.

S a le
F or
The Primary Market for Common Stock
Several steps are involved in an IPO.
 Company appoints investment banking firm to
arrange financing.
 Investment banker designs the stock issue and
arranges for fixed commitment or best effort
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).
The Primary Market for Common Stock

 Upon obtaining SEC approval, company finalizes

prospectus. Underwriters place announcements
(tombstones) in newspapers and begin selling shares.
 5-7
The Primary Market for Common Stock

McGraw Hill / Irwin  2002 by The McGraw-Hill Companies, Inc. All rights reserved.
 Work the Web

 For more on IPOs, check out IPO

Central at:
http://www.hoovers.com
The Secondary Market for Common Stock
 An investor may trade:
 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 price a dealer is willing to pay is called the
bid price, while the price at which a dealer will
sell is called the ask price. The difference
between the prices is called the spread.
The Secondary Market for Common Stock
 Most common stock trading is directed
through an organized stock exchange or
trading network.
 Whether a stock exchange or trading network,
the goal is to match investors wishing to buy
stocks with investors wishing to sell stocks.
 The New York Stock Exchange
 The New York Stock Exchange (NYSE),
popularly known as the Big Board, celebrated
its bicentennial in 1992.
 It has occupied its current building on Wall
Street since the turn of the century, and today
it is a not-for-profit New York State
corporation.

New York
 NYSE Membership
 The NYSE has 1,366 exchange members, who
are said to own “seats” on the exchange.
Collectively, they own the exchange, although
it is managed by a professional staff.
 The seats are regularly bought and sold. In
2000, seats were selling for $2 million. They
can be leased too. Both prospective buyers and
leaseholders are first closely scrutinized.
 Seat holders can buy and sell securities on the
exchange floor without paying commissions.
 Types of Members
 Over 500 NYSE members are commission
brokers. They execute customer orders to buy
and sell stocks.
 Almost 500 NYSE members are specialists, or
market makers. They are obligated to maintain
a fair and orderly market for the securities
assigned to them.
 Types of Members
 When commission brokers are too busy, they
may delegate some orders to floor brokers, or
two-dollar brokers, for execution.
 Floor brokers have become less important because
of the efficient SuperDOT system (designated
order turnaround), which allows orders to be
transmitted electronically directly to the specialist.
 A small number of NYSE members are floor
traders, who independently trade for their own
accounts.
 NYSE-Listed Stocks
 In late 2000, stocks from 3,025 companies
were listed, representing 281 billion shares
with a market value of $16 trillion.
 An initial listing fee, as well as annual listing
fees, is charged based on the number of shares.
 To apply for listing, companies have to meet
certain minimum requirements with respect to
the number of shareholders, trading activity,
the number and value of shares held in public
hands, annual earnings, etc.
 Work the Web

 For up-to-date information on the

NYSE, hit:
http://www.nyse.com
Operation of the New York Stock Exchange
 The fundamental business of the NYSE is to
attract and process order flow.
 In 2000, the average stock trading volume on
the NYSE was just over 1 billion shares a day.
 About one-third of the volume is due to
individual investors, while almost half is from
institutional investors. The remainder
represents NYSE-member trading, especially
specialists acting as market makers.
 NYSE Floor Activity
 There are a number of specialist’s posts, each
with a roughly figure-eight shape, on the floor
of the exchange.
 At the telephone booths, commission brokers
receive relayed customer orders, walk out to
specialist’s posts where the orders can be
executed, and return to confirm order
executions and receive new customer orders.
 The color of the coats worn indicate the
person’s job or position.
 Stock Market Order Types
Type Buy Sell
Market Buy at best price available Sell at best price available
order for immediate execution. for immediate execution.
Limit Buy at best price available, Sell at best price available,
order but not more than the but not less than the preset
preset limit price. Forgo limit price. Forgo sale if
purchase if limit is not met. limit is not met.
Stop Start gain: convert to a Stop gain: convert to a
orders market order to buy when market order to sell when
the stock price crosses the the stock price crosses the
stop price from below. stop price from below.
Start loss: convert to a Stop loss: convert to a
market order to buy when market order to sell when
the stock price crosses the the stock price crosses the
stop price from above. stop price from above.
 Stock Market Order Types
Type Buy Sell
Stop- Start-limit gain: convert to Stop-limit gain: convert to
limit a limit order to buy when a limit order to sell when
orders the stock price crosses the the stock price crosses the
stop price from below. stop price from below.
Start-limit loss: convert to Stop-limit loss: convert to
a limit order to buy when a limit order to sell when
the stock price crosses the the stock price crosses the
stop price from above. stop price from above.
Short- Borrow stock shares and then sell the borrowed shares
sale with the hope of buying them back later at a lower price.
order According to the NYSE uptick rule, a short sale can only
be executed if the last price change was an uptick.
 Nasdaq
 Introduced in 1971, the Nasdaq market is a
computer network of securities dealers who
disseminate timely security price quotes to
Nasdaq subscribers.
 It is the second largest stock market in the U.S.
in terms of total dollar volume of trading.
 The name “Nasdaq” is derived from the
acronym NASDAQ, which stands for National
Association of Securities Dealers Automated
Quotations system.
 Nasdaq
 There are two key differences between the
NYSE and Nasdaq:
 Nasdaq is a computer network and has no
physical location where trading takes place.
 Nasdaq has a multiple market maker system
rather than a specialist system.
 Like NYSE specialists though, Nasdaq market
makers use their inventory as a buffer to absorb
buy and sell order imbalances.
 Nasdaq
Over-the-counter (OTC) market
Securities market in which trading is almost
exclusively done through dealers who buy
and sell for their own inventories.
 Nasdaq is often referred to as an OTC market.
 Note that the Nasdaq is actually made up of
two separate markets, the Nasdaq National
Market (NNM) and the Nasdaq SmallCap
Market.
 Nasdaq Participants
 In 2000, there were about 500 competing
Nasdaq dealers (market makers), which
amounts to about a dozen or so per stock.
 In the late 1990s, the Nasdaq system was
opened to the electronic communications
networks (ECNs).
 ECNs are websites that allow individual investors to
trade directly with one another.
 ECN orders are transmitted to the Nasdaq and

displayed along with market maker prices.

 Work the Web

 You can actually watch trading take

place on the web by visiting Island,
one of the biggest ECNs:
http://www.island.com
 The Nasdaq System
 The Nasdaq network operates with three levels
of information access.
 Level 1 terminals display median quotes from
all registered market markers for a particular
security.
 Level 2 terminals display price quotes, in
particular, inside quotes.
 Level 3 terminals allow Nasdaq dealers to
enter or change their price quote information.
 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 one
another, usually through a computer
network.
 For dually listed stocks, regional exchanges
also attract substantial trading volume.
 Stock Market Information
 The most widely followed barometer of day-
to-day stock market activity is the Dow Jones
Industrial Average (DJIA), or “Dow” for short.
 The DJIA is an index of the stock prices of 30
large companies representative of American
industry.
 5 - 29

Stock Market Information

McGraw Hill / Irwin  2002 by The McGraw-Hill Companies, Inc. All rights reserved.
 Work the Web

 For more on the Dow, visit :

http://averages.dowjones.com
Look for “About the Averages.”
 5 - 31

Stock
Market
Indexes

McGraw Hill / Irwin

 Stock Market Indexes
 Indexes can be distinguished in four ways:
 the market covered,
 the types of stocks included,
 how many stocks are included, and
 how the index is calculated (price-weighted, e.g.
DJIA, versus value-weighted, e.g. S&P 500)
 Stocks that do not trade every day can cause
index staleness.
 Stock Index
Suppose there are only two stocks in the market and the
following information is given:
Price per share
o/s shares Beg.of year End of year
abc co. 100M 60 66
xyz co. 400M 120 100
Construct price and value weighted indexes and calculate
percentage changes in each.
 Stock Index
Suppose there are only two stocks in the market and the
following information is given:
Price per share
o/s shares Beg.of year End of year
Black co. 200M 40 60
Sho. co. 400M 100 140
Construct price and value weighted indexes and
calculate percentage changes in each.
 Stock Index
Suppose there are only two stocks in the market and the
following information is given:
Price per share
o/s shares Beg.of year End of year
Diamond Inc. 1000 42 47
Gold co. 2000 120 128
Construct price and value weighted indexes and
calculate percentage changes in each.
 Stock Index
Suppose there are only three stocks in the market and
the following information is given:
Price per share
o/s shares Beg.of year End of year
Red Inc. 1000 42 47
Yellow co. 2000 120 128
Green Co. 900 96 103
Construct price and value weighted indexes and
calculate percentage changes in each.
 Stock Market Indexes
 Note that for a price-weighted index, the
problem of stock splits can be addressed by
adjusting the index divisor.
Index level = Sum of stock prices
Index divisor
 As of August 28, 2000, the DJIA divisor was .
16894073!
 Chapter Review
 The Primary and Secondary Stock Markets
 The Primary Market for Common Stock
 The Secondary Market for Common Stock

 Dealers and Brokers

 The New York Stock Exchange

 NYSE Membership
 Types of Members

 NYSE-Listed Stocks
 Chapter Review
 Operation of the New York Stock Exchange
 NYSE Floor Activity
 Special Order Types

 Nasdaq
 Nasdaq Operations
 Nasdaq Participants

 The Nasdaq System

 NYSE and Nasdaq Competitors

 Chapter Review
 Stock Market Information
 The Dow Jones Industrial Average
 Stock Market Indexes

 More on Price-Weighted Indexes

 The Dow Jones Divisors