Stock Markets

1. Market Actors

The individual actors in financial markets can be classified into three main categories:

1. Investors: Investors can take on many forms. Essentially, an investor is someone who provides capital with the assumption of a financial return on that capital. There are many different types of investments that can be made. In the sections to come, we will discuss the various roles that are necessitated by the practice of investing.
2. Issuers: Issuers are legal entities that register and create securities so that they can be sold. The issuer can also sell these instruments. Common examples of issuers include investment trusts, foreign governments, and corporations.
3. Intermediaries: Financial institutions (intermediaries) perform the vital role of bringing together those economic agents with surplus funds that want to lend and those with a shortage of funds that want to borrow. A classic example of a financial intermediary is a commercial bank. Commercial banks receive bank deposits from their customers and use those funds to underwrite loans for other customers. Other classes of intermediaries include credit unions, financial advisers or brokers, collective investment schemes, and pension funds.

Specifically, market actors include individual retail investors; institutional investors such as mutual funds, banks, insurance companies, and hedge funds; and publicly traded corporations trading in their own shares.

• Pension funds: A pension fund, as the name implies, is any financial plan whose purpose is to provide some type of retirement income. In this type of investment, large institutional investors make up the majority of the market. It is commonly one of the largest categories of investments.
• Mutual funds: A mutual fund is a collection of diversified investments that are professionally managed. Typically, these investments seek to pool funds from a variety of investors with the purpose of purchasing additional securities. While there is no legal definition for the term “mutual fund,” it is most commonly applied only to those collective investment vehicles that are regulated, available to the general public, and open-ended in nature. Hedge funds are not considered to be a type of mutual fund. There are three types of mutual funds in the United States: open-end, unit investment trust, and closed-end mutual funds. The most common type—the open-end mutual fund—must be willing to buy back its shares from its investors at the end of every business day.
• Index fund: An index fund or index tracker is a collective investment scheme (usually a mutual fund or an exchange-traded fund) that aims to replicate the movements of the index of a specific financial market or a set of rules of ownership that is held constant, regardless of market conditions. As of 2007, index funds comprised over 11% of all equity mutual fund assets in the United States.
• Exchange-traded fund (ETF): An exchange-traded fund (ETF) is composed of a mixture of stocks, bonds, and other commodities. The majority of ETFs track an existing stock index, such as the S&P 500. These are desirable for many investors as they offer a low-cost, tax-efficient option that is easy to acquire.
• Hedge fund: A hedge fund is a fund that can undertake a wider range of investment and trading activities than other funds. It is generally only open to certain types of investors, specified by regulators. These investors are typically institutions—such as pension funds, university endowments, and foundations—or high-net-worth individuals who are considered to have the knowledge or resources to understand the nature of the funds. As a class, hedge funds invest in a diverse range of assets, but they most commonly trade liquid securities on public markets. They also employ a wide variety of investment strategies and make use of techniques such as short sales and leverage.

hint

ETFs are open-end funds or unit investment trusts that trade on an exchange. Open-end funds are more common, but ETFs have been gaining in popularity.

big idea

The value of a stock is derived from the buying and selling decisions of these actors. Some studies have suggested that institutional investors and corporations trading in their own shares generally receive higher risk-adjusted returns than retail investors.

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2. The New York Stock Exchange (NYSE)

The New York Stock Exchange (NYSE) is a stock exchange or a secondary market. With primary issuances of securities or financial instruments in the primary market, investors purchase these securities directly from issuers such as corporations issuing shares in an initial public offering (IPO) or private placement. Alternatively, they purchase them directly from the federal government, as in the case of treasuries.

After the initial issuance, investors can purchase from other investors in secondary markets like the NYSE. If an investor wishes to buy a stock from Apple, for example, the actual company is not directly involved. Secondary markets can be further subdivided into auction or dealer markets, typified by the mode of transactions. The NYSE is an auction market. Buyers and sellers meet at a physical location (in this case, Wall Street) and announce their bids or ask prices.

At the NYSE, traders gather around a specialist broker who acts as an auctioneer in an open-outcry auction market environment to bring buyers and sellers together and to manage the actual auction. The auction market format aims to bring together parties with mutually agreeing prices in an efficient manner. The auction process moved toward automation in 1995 through the use of wireless handheld computers (HHCs). The system enabled traders to receive and execute orders electronically via wireless transmission.

The NYSE represents the largest stock exchange in the world in terms of companies listed and market capitalization. Most of the largest U.S. companies are listed on the NYSE. The NYSE’s biggest competitor is NASDAQ; both are major secondary markets vying for large and profitable companies to list on their exchange.

Secondary markets like the NYSE serve a vital function as settings where companies can raise capital for expansion by selling shares to the investing public. They also gain advertising and a boost in prestige, which likely increases their stock value. To be able to trade a security on the NYSE, it must be listed. To be listed on the NYSE, a company must have issued at least a million shares of stock worth $100 million and must have earned more than $10 million over the last 3 years. They must also disclose certain information to the exchange, providing a measure of transparency that prevents insider manipulation of the stock prices.

term to know

Market Capitalization

The total market value of the equity in a publicly traded entity.

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3. NASDAQ

The NASDAQ stock market, also known simply as the NASDAQ, is an American stock exchange. “NASDAQ” originally stood for “National Association of Securities Dealers Automated Quotations.” Along with the NYSE, it is one of the largest stock exchanges in the world. The NASDAQ is a dealer-based market in which stock dealers sell directly to investors or firms electronically via phones or the Internet. The NYSE conducts its trading in person.

NASDAQ was founded in 1971 by the National Association of Securities Dealers (NASD), which divested itself of the exchange in a series of sales in 2000 and 2001. It is owned and operated by the NASDAQ OMX Group and is regulated by the Financial Industry Regulatory Authority (FINRA), the successor to the NASD.

When the NASDAQ stock exchange began trading on February 8, 1971, it was the world’s first electronic stock market. At first, it was merely a computer bulletin board system and did not actually connect buyers and sellers. The NASDAQ helped lower the spread (the difference between the bid price and the asking price of a stock), but it was paradoxically unpopular among brokerages because they made much of their money from the spread.

Firms, including Microsoft, began doing business through NASDAQ early in their history and remained with this exchange as the technology industry boomed. NASDAQ became known for its concentration of tech and high-growth firms, making it the primary tech market and an indicator of industry trends.

A stock index or stock market index is a method of measuring the value of a section of the stock market. It is computed from the prices of selected stocks, which vary depending on the index. Investors and financial managers can use it as a “snapshot” to describe market conditions and also as a tool to compare the return on specific investments.

NASDAQ’s major indices include the following:

• NASDAQ-100
• NASDAQ Bank
• NASDAQ Biotechnology Index
• NASDAQ Transportation Index
• NASDAQ Composite

hint

The NASDAQ Composite is often referred to as the NASDAQ. It is calculated from weighting common stocks and similar securities listed on the NASDAQ stock market. Thus “NASDAQ” can refer to two things: either the stock exchange itself or the index.

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4. Market Reporting

A stock index provides the ability to measure the particular value of a stock or set of stocks. It is assembled by combining the prices of existing stocks and determining a weighted average. It offers investors and fund managers the ability to evaluate the market and make comparisons on the current return on certain investments.

An index is a mathematical construct, so it may not be invested in indirectly. Many mutual funds and ETFs attempt to “track” an index. The funds that do may not be judged against those that do not.

Stock market indices may be classified in many ways. A “world” or “global” stock market index includes (typically large) companies regardless of where they are domiciled or traded. Two examples are MSCI World and S&P Global 100.

In contrast, a national stock index provides details regarding the stock market performance of an entire nation. This is often used to assess investors’ perceptions of the current state of that nation’s economy.

EXAMPLE

The most commonly referenced national indices include America’s S&P 500, Japan’s Nikkei 225, Britain’s FTSE 100, and India’s SENSEX.

Stock market indices provide invaluable information to investors and accountants. For instance, information regarding the current market price per share, market capitalization, and trading volume is readily available. This information, along with a company’s consolidated financial statements, enables the following ratios and calculations:

• Dividend yield on common stock ratio = Dividend per share of common stock
• Payout ratio on common stock = Dividend per share of common stock
• Earnings per share (EPS)

By comparing these ratios with those of other companies, investors, accountants, and forecasters can determine the position and health of their respective company’s stock.