Organized exchanges
Colombo Stock Exchange, NSE
The listing of securities
Over-the-counter markets
Nasdaq stock market
“Third” and “fourth” markets
OTC for listed securities (block trades off the exchange)
Trade via computerized systems on subscription basis
Offer to buy (the bid) and sell (the ask) for their own accounts
Spread
Difference between the bid and ask prices
Market makers
Do not set the level of prices
Market forces set the prices
Facilitate securities transactions
Financial analysis Construct earnings estimates
Buy side Analysts who provide recommendations for institutional
clients (non brokerage) such as mutual funds
Sell side Analysts who provide recommendations for the use by
brokers These recommendations will be used to “generate sales”
for the broker Potential conflict of interest
Broker – An agent who handles buy and sell order for an investor.
Dealer/Market Makers – Buys and sell for the own account
Broker dealers – Two separate divisions
Registered representative – A person who trades for a client/investor (should maintain trust and confidence and understand the client)
The long (bullish) position
Anticipating prices to rise
Investor will purchase the security
The short (bearish) position
Anticipating prices to fall
Investor will sell the security
Sell Short (discussed later)
Market orders
– Buy or sell certain quantity at current market price
– Execution is ensured but not the price
Limit orders
– Buy or sell certain quantity at a specified price or better
– Execution not assured but price is assured if executed
Good till cancelled order
– Order that remains until executed or cancelled by the investor
Stop (loss) orders
Sell when market hits specified lower price
Buy when market hits specified higher price
When market hits specified price, stop order becomes a market order
No assurance of the price
Execution may not occur
Not to confuse limit order and stop order
Once the specified price is reached stop order ensures execution not the price where as limit order ensures the price not execution
Confirmation statements
T+3: settlement date (three business days after the trade date)
Cash account
No borrowing
Margin account
Can borrow/leverage
Regulation and broker may limit borrowing
Increases the risk
Magnifies the potential profit or loss
ROE will increase so long as the cost of borrowing is less than the return on investment
Initial margin requirement
The minimum percentage of the cost of an investment the individual must put to buy securities
Maintenance margin
Minimum equity required in a margin account at all times
Margin call
A call by the broker to deposit additional cash when maintenance margin is breached
Regulatory Fees to CSE, CDS and SEC
Commissions
Fees charge by brokers for execution of trades
Large deals on negotiated commissions
The spread
Impact on price
Applicable for large orders and illiquid securities
Sale of borrowed securities in anticipation of a price decline Bearish strategy Process Broker to borrow the stock on behalf of the investor and sell
Sales proceeds to be kept with the broker
Investor to keep a margin with the broker
Investor must subsequently buy the stock and return to the lender (covering the short sale)
Short seller has to make a payment to the lender equal to the dividends received
Gain = Selling Price – Purchase Price – Interest Paid
Companies Act No 7 of 2007
Securities and Exchange Commission Laws
SEC Act
Takeover and Mergers Code
Directives
Listing Rules of the CSE and circulars
Corporate Code of Best Practices
Purpose – Protect the investors by ensuring honest and fair
practices
Annual reports
Quarterly financials
Periodic announcements - Change in the firm that
may affect the value
Immediate disclosure
An investor who buys 10% and 30% of a company
Inside Information – Material corporate information which is likely to impact the share price which has not been made public
The directors and employees are prohibited from trading using inside information
Criminal offence
Directors and officers are required to report their holdings and changes in their holdings
Private Placement
Public Offer
Direct sale of securities to institutional/private investors
Eliminates selling costs Less disclosure requirement Terms of the issue and features can be tailor made
for both parties More appropriate for smaller and emerging firms
who are not yet ready to tap the public market
IPO - First sale of common stock to the public Increase public interest towards the company By pass restrictive covenants of financial intermediaries Securities are sold to the public via an investment banker Extensive disclosures in the prospectus Needs to have higher level of corporate governance Investment Banker – A firm that manages the public issue SEC approval is not for the worth of the firm but to confirm
that information has been provided and the prospectus is complete in the format and content
Prices change quickly to new information
Current price embodies all known information
By the time most investors know the information, the price change has already occurred
New information must be random
Successive price changes are independent
Today’s price does not forecast tomorrow’s price
A large number of competing participants
Information is readily available virtually costless
Transaction costs are small May not hold for individual investors
Cannot expect to beat the market consistently on a risk-adjusted basis Future earnings and dividends are correctly reflected in the prices
Earning a higher return is not necessarily outperforming the market Could at a higher level of risk
Considering risk is also important Risk adjusted returns
The forms of the efficient market hypothesis:
The weak form
The semi-strong form
The strong form
Studying past price and volume data will not lead to superior investment results.
All historical information is reflected in the price
While the weak form suggests that using price data will not produce superior results, using financial analysis may produce superior return.
Prices reflect all public information (past and present)
Studying economic and accounting data and historical prices will not lead to superior investment returns.
Studying inside information may lead to superior returns.
Illegal
Prices reflect all public and inside information.
Even having access to inside information will not lead to superior investment returns.
Empirical results generally support:
The weak form
The semi-strong form
Possible exceptions to the efficient market hypothesis, called anomalies, appear to exist.
Low P/E stocks The small firm effect The January effect The neglected firm effect The day-of-the-week effect The overreaction effect
Empirical evidence of the existence of an anomaly does not mean the individual can take advantage of the anomaly.
The anomaly can still exist and the market be effectively efficient from the individual investor’s perspective.
Securities prices embody known information.
The playing field is level.
Specifying financial goals may be more important than seeking undervalued stocks.