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HANDBOOK OF FINANCIAL MARKETS

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HANDBOOK OF FINANCIAL MARKETS

The financial system exists for the sake of  funneling purchasing power from  Surplus Spending  Units (SSU) to Deficit Spending Units (DSU)  (p. 6).  Such transfer is accomplished through an IOU, formally called financial claims.  These include bonds, mortgages, Treasury bills, certificate of deposit, and commercial paper.  Financing may proceed directly between parties or indirectly through an intermediary such as a savings bank, pension plan, mutual fund, and like.  Direct transactions occur, for example, when a DSU such as General Motors Acceptance Corporate issues commercial paper which is purchased by an SSU.  A broker can execute such a transaction.  

FINANCIAL INTERMEDIARIES:                                                                                                                                   1.  Depository financial institutions;   2.  Commercial banks;  3.  Savings and loan associations;  4.  Mutual savings banks (similar to S&Ls);  5.  Credit unions (owned by their members);  6.  Contractual savings institutions (obtain funds under long-term contractual arrangements and invest these funds in the capital markets);  7.  Life insurance companies;  8.  Casualty insurance companies;  9.  Pension funds;  10.  Finance companies;  11.  Mutual funds;  12.  Money market mutual funds.

MONEY MARKET INSTRUMENTS are traded in large denominations, have a low default risk, and are highly liquid.  Major issuers include the U.S. Treasury, federally sponsored agencies (TVA, Federal Land Bank, Small Business Administration, etc.), state and local governments, large industrial firms, etc.

CAPITAL MARKET INSTRUMENTS  (compared to money-market instruments) vary widely in default risk, terms of default, maturity, and marketability.  DSU use these funds in productive assets (expected to produce an income).  Capital market instruments include common stock, corporate bonds, mortgages, and municipal bonds.

OPTIONS AND FUTURES MARKETS come in many forms such as interest-rate futures, options on individual stocks, options on stock-market indexes, options on debt securities, options on financial futures, commodity futures.

An efficient capital market will channel liquid capital quickly and accurately to where it will do the most good; fulfill the investors expectations of return and risk.  Efficiency of a market is determined by how well the market prices reflect relevant information about the economy, industries, companies, and past behavior of the stock market.   On an efficient market the price at any point in time would represent the best estimate of the securitys intrinsic value.  The random walk model holds that the future price change is independent of past price changes.  A martingale  return is zero; submartingale return is a loss.   A market price which is determined by information about price changes, volume, and like is said to be weakly efficient.  Semistrongly efficient if the price reflects not just information about past market behavior, but also about economy, industries, and companies.  And strongly efficient if price reflects ALL information, whether or not it is publicly available. 

A market that is operationally efficient permits buyers and sellers of securities to obtain transactions services as cheaply as possible (24). 

In a weakly efficient market charting cannot be a means of systematically improving investment performance ... [it] may be a good way to  while away ones evening and weekends, but it isnt going to make you rich  in a market that prices securities efficiently at the weak form level....  In other words, the results of a myriad of empirical tests indicate that studying past price and volume statistics is a complete waste of time when it comes to improving investment performance and that analyzing all other forms of public information is not a much better use of time. (28). [I suggest that a statistical analysis should be applied by obtaining percentages.  For example in a 25% rise in 12 months, to see what percentage of stocks that have outperformed the market at a given percentages, such as 10, 20, 30 ... will in the subsequent month out perform the market, what percentage will under perform the market.  Secondly, to see if any factors about each company is relevant in predicting the performance of  each stock, such as P/E, industrys performance, news, etc.  A similar approach can be used to predict the performance of the market itself by seeing what relationships exist between past performance (week, month, 3 months, year) and future performance (5, 10, 15, and 20 work days).  Such analysis would be like those found in Winning on Wall street of  the markets performance in election years, following changes in the prime interest rate, and so on.]   Those who possess nonpublic information can systematically improve their investment results (29).  [Zweig, whoever, combines the public information into 2 blocks, fundamentals and sentiment, and by econometric model is able to systematically improve results.]    Investors can outperform the market only if they have access to information that is not yet fully reflected in prices (30), [the analysis performed by Zweig is such information].   One way of increasing return (and losses) is to increase risk (32).

Diversification reduces unsystemic risk; i.e., increases the probability that the stock portfolio will mirror the market (43).  Sir John Maynard Keynes ... argued that myopic speculation, not long-run expectations about earnings and dividends, is the key to predicting stock prices (51-2). 

[Chapter 4, Psychology and Markets has a number of interesting stories to illustrate herd behavior].  Social reality refers to how a group of people perceive reality (86).  On Wall Street there are a gaggle of folk heroes.  Many of them are, such as Fred Carafe Enterprise Fund, who in one quarter traded 200 companies (93).  Substantial gains were made by buying large blocks of thinly traded companies, pushing them higher.  Legions of admirers usually followed in the wake of the go-go stars, making the price rise:  a self-fulfilling prophecy for a while.  Because of the commissions made by brokerage houses dealing with these folk heroes, they were able to obtain large blocks of hot new stocks at issue price, which immediately went to substantial premiums, generating instant profits on their books (94).   Often buy letter stock--stock not authorized to be traded in public markets--at a substantial discount, then they would reevaluate the stock at above their discount price--instant profit.  Almost no attention was paid to how real the earnings actually were.... Companies in technology were bid up to astronomical prices as investors envisioned futures of limitless growth (95).  At the height of  bull markets, money managers state that valuation standards of the past no longer apply.  Speculators go upon the greater fool theory (97). 

Taxation of  Security Transactions, Chapt. 6.    INTERNAL REVENUE CODE DEFINITIONS:  Gross income is all income that is subject to income tax;  adjusted income is gross income minus certain business and other deductions;  taxable income is the amount on which the tax liability is determined. 

Regulation of the Securities Markets, Chapt. 7.  For a stock to be publicly traded on an exchange it must file a registration application with the particular exchange and with the SEC  if the company has more that $1 million in assets and their shareholders number 500 or more.  Also regulated is proxy solicitations, disclosure of sought control of a company through cash tender offer, stock acquisitions involving changes in ownership or control,  corporate repurchase of stock, insider trading, security exchange, securities associations of brokers and dealers, brokers and dealers, municipal securities dealers, margin trading, and assorted regulations such as of investment companies, public utilities, investment advisers,   A consolidated transaction reporting system is required for security exchanges. 

The New Issues Market, Chapter 8.  Issue of primary shares (also known as new issue or new money issue) is sold by the corporation which receives the proceeds of the sale.  In most cases these sales were previously authorized by the stockholders of the company--often such issues are used to purchase another company, they are also used in the exercise of stock option plans, and in stock dividends.  Often they are held in reserve.  Issues of secondary shares are stock offerings that in the past had been authorized by stockholders and actually issued and distributed by the company.  Such stock might have been issued in lieu of cash payment to acquire a patent or process, issued in a merger or acquisition (such stock exchanges in general do not create a tax liability).  The most usual source of non-underwritten offerings is for the startup company, whose stock is sold by its founder and/or promoter (140).  While new issues may be promoted directly by the corporation, must seek to have it underwritten; i.e., to negotiate a price with an  investment bank which will bank will be the buyer (underwriter) at an agreed upon price.     

 

Secondary Markets, Chapt. 9   Such markets are the means through which buyers and sellers are brought together, for a price.   The characteristics of a good market:  1, timely &n accurate information on the price and volume of past transactions and on current supply and demand; 2,  liquidity, the ability to buy & sell assets quickly at a price which is close to that of the previous transaction; 3, low transaction cost (internal efficiency); 4, rapid adjustment of prices to new information (external efficiency) (151-2).  The NYSE is the major secondary market for bonds.  In 1984 3,700 bonds were there listed with a volume of trade about $30 million, for the AMEX about $2 million (154).  The NYSE listed in 1984 1,534 companies and 2,319 issues with a total market value of $1,586 billion.  The volume has gone from less than 3 million share traded daily in the late 50s to over 91 million by 1984.  In 1984 the NYSE accounted for 82%, AMEX for 5%, and 12% for regional exchanges; converted to value of shares 85, 2.2, & 12% respectively.    In 1984 the price for membership on the NYSE went for between $400 and $290,000; the AMEX  for 1983 between $325 and $261,000.  As for local exchanges, the Midwest, Pacific, and Philadelphia-Baltimore-Washington account for between  90% of the volume.  A number of large companies listed on NYSE are also listed on the local exchanges, so as to permit small brokerage houses not members of NYSE to avoid the cost of going through a house that is a member.   In 1984 between 75 and 90% of the volume of regional exchanges were attributed to trading in dual listed issues (160).  In 1984 there were about 3,500 active issues traded over-the-counter (OTC, also called NASDAQ its quotation system--National Association of  Securities Dealers Automatic Quotations), and another 3-4,000 traded fairly actively, but are not on NASDAQ.  Besides small companies traded on OTC market, the vast majority of bank stocks and insurance stock are traded, and all U.S. government bonds.  Finally, in 1984 there were 150 stock listed on the OTC which were on the NYSE, including AT&T, GM, IBM, Xerox.  On the OTC, rather than the specialist, the dealer can buy and sell for his own account.  The secondary market denotes stocks that have already been sold to the public and are being traded on an exchange (i.e., not OTC).   The third market  denotes over-the-counter trading of shares listed on an exchange.  The  fourth market denotes direct trading of securities. between two parties.  The nature of sales has changed:  in 1961 the average sales was 197 share; in 1984 it was 1,781 on NYSE.   In 1961 the public bought 66.7% and institutions 39.3% of the shares sold on NYSE. (170-171); in 1980, first quarter the figures reversed, 35.1% public and 64.9% institutions.  Correspondingly, the number of block trades (10,000  or more shares) has gone from 47,632 in 1976 to 433,427 in 1984,  The intuitional role  changes the makeup of the market and thus reduces the predictive value of  modeling of the trends that incorporate from both periods.

Exchange Membership:    1, specialist; 2. odd-lot dealer; 3, commission broker; 4, floor broker; and 5, registered trader (165). 

Specialists constitute about 25% of the total membership on exchanges.  Typically they handle about 12 to 14 stocks and must possess enough capital to purchase 5,000 shares of the stock or $500,000, whichever is greater.  He handles the stop limit orders for the broker and  also orders placed with member brokers.  When there is insufficient public supply to provide a continuous liquid market, the specialist is expected to buy and sell from his own account.  This is especially done when the gap between buy-and-sell is great (say 40 to 41).  He would enter and bid 4o.5 or 40.75 or ask (sell) at 40.25 or 40.5 (166).   Whether he buys or sells depends upon both the size of his stock holding and the direction of  the market., often going against the markets direction.  Buy having the only list of all the limit orders for his stock he has insider information which gives the more probable short-term direction for that stock.  His profits from trading his own stocks are over the year substantial, and he makes a broker fee in all transactions.  His return (as percentage of dollars in market,  figured annually) is 80% for high activity issue,  110% for medium activity issues, and  190% for low activity issues.  The service [providing an orderly and fluid market] is useful, but the returns are excessive (168). 

Odd-Lot Dealer is one who buys and sells from his own inventory to fill odd lots.  In most other exchanges the specialist fills odd lots; and some large brokerage firms act as odd-lot dealers for their customers.

Commission  Broker is a registered with the SEC representative of a brokerage firm who also is a member of  an exchange.  He will on that exchanges floor  buy-and -sells stocks as directed by his firm

Floor Broker  is similar to a common broker only he will act as a broker for other members of the exchange.  Typically he owns his own seat; that is, not  connected with a member firm.  When, for example, when the commissioned broker for Merrill Lynch becomes too busy to handle all of  his orders, he will ask one of the floor brokers to help him. 

Registered trader is a member of the exchange who buys-and-sells for his (brokerages) account.  Becasue they are on the floor they can react quickly to new information. 

Block Houses are brokerage firms that stand ready to help buy or sell blocks for institutions.  A good blockhouse functions like a specialist:  capital required to position a large block,  actually take a position to facilitate the sale and reduce the spread between offer and bid, and contacts among other institutions to move the block.  Thus they would offer, after lining up buyers, the mutual fund seeking to sell a price a bit lower than the those buyers would pay; moreover they would pick up that portion of the block which went unsold--this they might offer on the NYSE. 

 

THE MONEY MARKET  Participants trade hundred of billion of dollars every day.... affects how U.S. government finances its debt [as well as state and municipal governments], how business finances its expansion, how consumers choose to spend or save....  The money market is a wholesale market for low risk, highly liquid, short term IOUs....  [The money market] trades includes a large chunk if the U.S. Treasurys debt and billions of dollars worth of federal agency securities, negotiable bank certificates of deposit, bankers acceptances, and commercial paper (183).  Also included within the market are trades in foreign currency and those of secure loan (called the repo market).  The heart of the activity occurs in trading rooms of dealers and brokers.  The money market (MM) shifts funds between banks as needed, to corporations and institutions as needed, funnel surplus funds of cash-rich banks, corporation and institutions, and provides the fed with arena ... to influence interest rates and the growth of the money supply (184 185).  Commissions run about one dollars per million. 

THE INSTRUMENTS:  U.S. Treasury securities, financial futures market, federal agency securities, federal funds, eurodollars, certificates of deposit, variable rate CDs, discount CDs, eurodollar CDs (issued by foreign banks issued in London), Yankee CDs (issued outside of London), commercial paper (unsecured promissory note maturing on a specific day--less than 271 days by regulation of the SEC) issued by a industrial firm and nearly always secured by a banks line of credit to that firm; bankers acceptance issued to secure payment of imports, it is a letter of credit whereby the exporter receives payment from the U.S. bank according to terms; repos and reserves, where the dealer acts as market maker by taking a  position; municipal notes, notes issued which nature in 1 month to 1 year or more. 

MARKET MAKERS:  DEALERS  He buys or sells from his own account (199), and brokering.  Brokering includes advising clients on market conditions, providing lowest possible borrowing, and highest selling rates. 

 

HANDBOOK OF FINANCIAL MARKETS, SECURITIES, OPTIONS AND FUTURES, SECOND EDITION, Frank J. Fabozzi & Frank G. Zarb, editors, Dow Jones-Irwin, Homewood, IL, 1986.

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