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Investment Analysis and Portfolio Management

Investment Analysis & Portfolio Management (FIN630)
Lesson # 2
Capital markets are the hallmark of the capitalized system. With the collapse of the Soviet
Union, hundreds of delegations from the former communist bloc countries have visited the
United States to learn about out markets and to facilitate the development of markets in
Eastern Europe. Stock markets are one of humankind's greatest inventions; they raise
everyone`s standard of living,. Capital growth promotes job creation, increases disposable
income, and increases charitable giving. The capital markets enable better use of the
resources we have, allowing us to alter our consumption pattern over time.
Despite these benefits, many Americans are ignorant of how markets work. For them, the
nightly newscast is largely incomprehensible when the talk turns to the day's activity on
Wall Street. This chapter serves as a primer on our markets, how they work, and why we
have them. More detail follows in subsequent chapters.
This chapter also introduces the Association for Investment Management and Research
(AIMR), and the Chartered Financial Analyst (CFA) program. The CFA is a prestigious
credential for those involved in the investment business. Many firms require participation in
the CFA program as a condition of employment. Sections of this book and end-of-chapter
problems related to the CFA program are marked with the symbol shown in the margin.
Why is there a New York stock Exchange, or a Chicago Board of Trade, or a Chicago
Board option Exchange? An exchange serves three principal functions: an economic
function, a continuous pricing function, and a fair pricing function. Although exchange
function is a topic in macroeconomics, the concept is sufficiently important to warrant
discussion in an investments text.
The most important function is the economic function. This mechanism facilitates the
transfer of money from savers to borrowers. As an example, consider the secondary market
for home mortgages. Many small communities in the United States contain middle-class
residents with modest savings. Still, the houses they buy are expensive, and virtually
everyone needs to borrow money to buy a house. A town's residents usually have a bank
relationship because of the convenience checking and savings accounts offer. People also
look to banks for home mortgages suppose one person goes to the local bank and is able to
get a $100000 loan. Three other families do the same thing shortly thereafter. Very quickly,
the entire saving of the town is loaned out. The bank cannot loan money it does not have.
Does this mean that no one else in the town can buy a house? Fortunately, it does not.
Elsewhere in the United States, individual investors want to lend money rather than borrow
it. The key is to match up the would-be borrowers with the available savers. THE local
banks holding the mortgage certificates can sell these mortgages to someone else, and
routinely do so. Government agencies like the Government National Mortgage Association
and the Federal National Mortgage Association help facilitate these sales. Once the local
bank sells a mortgage, it receives an inflow of money that can be used to finance someone
else's home mortgage. These mortgages can be sold, too, and the cycle goes on.
Similarly, corporations periodically need to raise money and often sells stocks and bonds to
the public. The U.S government never has enough money, it seems, and sells treasury bonds
to buyers all over the world. Investors with surplus cash buy these securities. Individual
Investment Analysis & Portfolio Management (FIN630)
who already own stock and suddenly need to raise cash con sell their shares to someone
These are all the examples of the economic function of the capital markets: Facilitating the
flow of capital from those who have it and wish to invest it to those who need it and want to
borrow it. When a firm sells securities to the public for the first time, it does so in the
primary market. The firm receives cash in the exchange for the creditor position. After their
initial sale, securities trade in the secondary market, also known as the used of securities
After selling shares in the primary market, the issuing firm receives cash. Concurrently, the
shareholders equity portion of the corporate balance sheets changes. Trading in the
secondary market, however, does not affect the firm's financial statements. If X buys 100
shares of the Intel common stock for $ 64, he pays $ 6400 to the seller of the shares. Intel
receives nothing from the trade. Similarly, if y sells her Saturn automobile, the sale has not
impact on the automobile company's financial statements. When people talk about what
happened on the stock market, they usually mean the secondary market.
The economic functions of the capital markets: facilitating the flow of capital from savers
to borrowers.
Continuous Price Function:
A second function of the capital markets is the continuous pricing function. It means
precisely what the name indicates ­ prices are available moment by moment ­ and provides
a tremendous advantage to the security investors. Consider the case of alternative
investments: How much is an antique grandfather's clock worth? How about Chinese
porcelain, or 50 acres of southern pine timberland? Determining the value of these items is
not always cays, nor can the task always be accomplished quickly. First, an appraiser checks
authenticity and condition. Having established this, we may need to check recent sales of
comparable items. This could involve researching catalogs and auction reports or making
numerous telephone calls. The necessary activities in this process can be time consuming
and even nuisance
These problems are not an issue with financial assets as sticks and bonds. In most cases,
anyone can discover the prices of the various financial assets instantly during the business
day. People routinely call their broker and ask, "How's IBM? How about Texaco?" they
fully expect and have come to take for granted an instant reply. Alternatively, one can
always check the wall street journal or other newspaper with a business section or pull
prices off the internet.
Some securities seldom trade, and we would be less confident in our ability to get a quick
notation of a firm that is too small to be carried in the electronic price reporting system.
Still, we could probably get a good estimate more quickly than we could for an attic full of
uncategorized art or shoebox full of old coins.
The continuous price function enables market participants to get accurate, up-to-date
price information.
Fair Pricing Function:
Fair pricing is the third function of the capital markets. Some people consider it the most
important because it means that we can trust the system. You can tell you broker to sell your
stock at the going price and be assured of getting a fair price.
Investment Analysis & Portfolio Management (FIN630)
This assistance is not there with most things that sell outside an organized trading ground.
You would not, for instance, go to the automobile classified advertisements in the
newspaper and automatically pay what someone wanted for a car that interested you if you
did; you would likely pay considerably more than necessary.
A main reason capital markets prices are fair is the high number of players in the game.
Many people are competing for the same business, in a sense. If you have stock to sell,
thousands of people are willing to bid on it. The market ensures that you sell it to the
highest bidder. Conversely, buyers confronted with numerous potential sellers can rely on
the system to match their order with the best price, which from the buyer's perspective is
the lowest price. The greater number of participants and the more formal the marketplace,
the more assurance you have, that you are getting a good price.
Consider a well established local grocery store that is part of a national chain. Are you
comfortable shopping there, or do you worry about not getting a good deal? Changes are the
prevailing prices are competitive, because so many people pass through the store (and
through others in the area) that stores with unreasonably high prices will simply not survive.
As another example, you might own an old coin you know to be valuable. One way to sell
the coin would be to go a regional coin show, taking it to various dealers' tables and getting
individual offers on it. An alternative is to offer it for sale at a coin auction. The latter
choice will almost certainly result in a higher price. When many dealers look
simultaneously look at a particular coin, the market is much more efficient than when the
dealers individually look at the coin.
An old joke among academic people describes a business professor who was asked what is
daily consulting fee was. He replied, "$2500 per day". When asked how much consulting he
did, he replied, "none, but that is my rate". You can set any price you like, but when
comparable services are available, the highest price is not likely to get any action from the
The fair price function removes the fear of buying or selling at rip off price. The greater
number of participants and the more formal the marketplace, the greater is the likelihood
that you are getting a fair price.
Exchanges are not a new invention. The oldest stock market is probably the Amsterdam
bourse, where shares of the East Indies trading company changed hands. Future contracts
traded at the Osaka rice exchange as far back as 1754. What makes the US exchanges to
respected are the member of securities traded, the quality of the trading and the oversight of
the trading mechanism.
National Exchanges:
The two national exchanges in the United States were historically the New York stock
exchange on Wall Street and the American stock exchange on trinity place, one block from
the NYSE. In early 1999 the AMEX merged with the NASDAQ stock market. The NYSE
dates back to 1792, when 24 merchants began gathering daily to exchange shares of stock.
Legend has it that these people met under a buttonwood tree where they traded shares
among themselves. The NYSE recognizes the bank of New York as the first corporate stock
to have traded on the exchange.
Investment Analysis & Portfolio Management (FIN630)
The NYSE officially opened in 1817 in tontine's coffeehouse. A membership cost $25. In
1825 only 70 stocks were listed. As the capital markets grew, the need to limit the number
of exchange members became obvious. Trading continued outside near the buttonwood tree,
however, in the area knows as the curb exchange. The curb exchange moved indoors in
1921. It adopted the name AMEX in 1950s.
Only exchange members may trade on the floor of an exchange. A membership is
commonly called a seat. Most people are not members and, in order to buy securities, must
normally hire someone who is a member to make a desired trade. That person is a broker.
The broker is paid commission for his or her efforts. In early 2000, discussions were
underway regarding the feasibility of taking NYSE public. Instead of buying or selling seats
like any other asset, the current owners of the seats would receive common stock shares. In
theory, anyone could then own a piece of the NYSE simply by acquiring one or more
Today, during an average day, over $40 billion worth of stock trades at the NYSE. The
NYSE is colloquially called the big board. NYSE employees still sometimes refer to the
AMEX as the curb exchange.
Regional Exchanges:
The NYSE is not the oldest US exchange; that distinction belongs to the Philadelphia stock
exchange, organized two years before the star of NYSE. Investors call the Philly and 13
other smaller exchanges regional exchanges. Many securities are dual listed, which means
they trade on both a national exchange and on one or more of the regional exchanges. Coca
cola for instance, trades on the New York, Boston, Cincinnati, Chicago, pacific, and Philly
stock exchanges. It also trades on the Frankfurt, Germany, and Zurich, Switzerland
exchanges. Worldwide, there are approximately 150 stock exchanges throughout more than
50 countries. The oldest continuously running exchange is the London stock exchange, in
business since 1773.
People buy and sell securities through different mechanisms via the specialist system, via
the matchmaker system or electronically.
The Specialist System:
The specialist system is a distinctive feature of the NYSE and the AMEX. At the exchanges,
trades in a particular security are subject to the oversight of an exchange member called the
specialist. The specialist is charges with making a fair and orderly market in one or more
assigned securities. There are about 460 specialties, most of who handle between 5 and 10
stocks. A specialist is one of the more active stocks will likely handle only that security. A
specialist is one of the more active stocks will likely handle only that security.
Suppose an individual investor has a brokerage account with Paine Webber and places an
order to buy 100 share of IBM common stock. The individual's stock-broker wires the order
to the floor of the NYSE, where Paine Webber employee receives it and tasks it to the
specialist's post. The post is the specific location on the exchange floor where IBM stock
trades. By exchange rules, IBM may only trade at the IBM trading post. The NYSE has 17
trading posts.
Investment Analysis & Portfolio Management (FIN630)
At the specialist's post, three prices for IBM are shown on the computer screen: the bid
price, the offer price, and the price at which the last trade occurred. The bid price is the
highest price anyone has expressed a willingness to pay for IBM stock. The offer price is
the lowest price at which anyone is willing to sell. The computer screen might show IBM
bid at 55, offered at 55¼, with the last trade at 55 1/8. The specialist's is job to keep the
difference between the bid price and the offer price small. This difference is the bid spread.
At the NYSE, 90% of all trades take place within 1/16th of the previous price, and 98% take
place within 1/8th. The specialist also ensures that sellers will always find a buyer for their
shares, and that buyers will always find shares for sale.
The specialist can get fined for failure to perform his or her duties properly. In 1999 the
NYSE fined one specialist firm $200,000 for allegedly failing to maintain a fair and orderly
market in six assigned stocks on eight occasions from October 1996 to September 1998. In
one instance, on October 27, 1991, the Dow Jones industrial average was down 554.20
points because of the Asian crisis. The following day city corporation opened at $113, down
more than $10 from the previous day's close. The stock then rallied to $127.50 by the end
of the day. Some market participants felt the specialist failed to set the opening price
properly and then failed to deal with its rapid rise. The NYSE alleged that the specialist
failed to participate adequately as a dealer against a market trend doing certain periods of
significant price movement.
The specialist is charged with making a fair and orderly market in one or more assigned
SuperDot is an electronic system enabling NYSE member firms to send certain orders
directly to the specialists' posts on the floor of the exchange without using a human runner
to deliver the order. Specialists, in turn, use SuperDot to confirm trades back to the member
firms. The NYSE reports that on a given day more than 75% of its trading volume is via
Any NYSE security may be traded via this system, prior to the opening of the trading day;
investors may place orders for immediate execution of up to 30000 shares. Once the day's
trading begins, the maximum order size drops to 2100 shares. Orders to buyer sell at a set
price or better for up to 100000 shares may be placed at any time. About 85% of all orders
reach the specialists via the SuperDot system. These orders comprise about 38% of total
The market maker system differs from the specialist system in that a group of competing
individuals (rather than a single person) maintains the fair and orderly market. Futures
exchanges and the Chicago board options exchange use the market maker system
The visitor to a market maker exchange will be impressed with the activity on the trading
floor. Rather than a post, the market maker system uses trading pits. In these sunken areas
on the exchange floor, groups of market makers trade by open outcry, calling out theirs
offers to buy and sell and eliminating any standing in line or computerized order entry. The
collection of market makers in any trading pit is called the crowd.