THE MARKETPLACE

Three principal functions of the capital markets:

1. an economic function
--facilitating the flow of capital from the savers to borrowers
*figure 3.8 The Markets pp 42
2. a continuous pricing function
--enables the market participants to get accurate, up-to-date price information
3. a fair pricing function
--the greater the number of participant and the more formal the marketplace, the greater is the likelihood that you are
getting a fair price

The Exchanges

-- A stock exchange does not own shares. Instead, it acts as a market where stock buyers connect with stock sellers.
Stocks can be traded on one or more of several possible exchanges such as the New York Stock
Exchange (NYSE). Although you will most likely trade stocks through a broker, it is important to understand the
relationship between exchanges and companies, and the ways in which the requirements of different exchanges protect
investors.

The primary function of an exchange is to help provide liquidity; in other words, to give sellers a place to "liquidate" their
shareholdings.

Stocks first become available on an exchange after a company conducts its initial public offering (IPO). In an IPO, a
company sells shares to an initial set of public shareholders (the primary market). After the IPO "floats" shares into the
hands of public shareholders, these shares can be sold and purchased on an exchange (the secondary market).

The exchange tracks the flow of orders for each stock, and this flow of supply and demand sets the stock price. Depending
on the type of brokerage account you have, you may be able to view this flow of price action. For example, if you see that
the "bid price" on a stock is $40, this means somebody is telling the exchange that he or she is willing to buy the stock for
$40. At the same time you might see that the "ask price" is $41, which means somebody else is willing to sell the stock for
$41. The difference between the two is the bid-ask spread.

Trading Systems
1. The specialist system
An specialist is charged with making a fair and orderly market in one or more assigned securities.
2. The marketmaker system
A group of cometing individuals rather than a single person(specialist) maintains the fair and orderly market.
3. SuperDot
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.
Over-the-Counter Market
--no actual place
--a worldwide computerized linkup of brokerage firms, investment houses, and large commercial bank
--bids and offers of individual securities are posted to an electronic bulletin board called the National Market
System(NMS)
--the largest and most established firms in the OTC market are called national market issues. This firms include Intel and
Microsoft
--another type of firms in the otc market are small-cap issues(companies with low levels of capitalization)
--Listed securities can also be traded in the OTC market. Ex:General Electric also trades in the NYSE and in the OTC
market

BOND FUNDAMENTALS
What is a Bond?
A bond is a fixed income investment in which an investor loans money to an entity (typically corporate or governmental)
which borrows the funds for a defined period of time at a variable or fixed interest rate. Bonds are used by companies,
municipalities, states and sovereign governments to raise money and finance a variety of projects and activities. Owners
of bonds are debtholders, or creditors, of the issuer.

How Bonds Work

When companies or other entities need to raise money to finance new projects, maintain ongoing operations, or refinance
existing debts, they may issue bonds directly to investors instead of obtaining loans from a bank. The indebted entity
(issuer) issues a bond that contractually states the interest rate that will be paid and the time at which the loaned funds
(bond principal) must be returned (maturity date).
The interest rate, called the coupon rate or payment, is the return that bondholders earn for loaning their funds to the
issuer.

The issuance price of a bond is typically set at par, usually $100 or $1,000 face value per individual bond. The actual
market price of a bond depends on a number of factors including the credit quality of the issuer, the length of time until
expiration, and the coupon rate compared to the general interest rate environment at the time.
Characteristics of Bonds
Most bonds share some common basic characteristics including:
 Face value is the money amount the bond will be worth at its maturity, and is also the reference amount the bond
issuer uses when calculating interest payments. For example, say an investor purchases a bond at a premium
$1,090 and another purchases the same bond at a discount $980. When the bond matures, both investors will
receive the $1,000 face value of the bond.
 Coupon rate is the rate of interest the bond issuer will pay on the face value of the bond, expressed as a
percentage. For example, a 5% coupon rate means that bondholders will receive 5% x $1000 face value = $50
every year.
 Coupon dates are the dates on which the bond issuer will make interest payments. Typical intervals are annual or
semi-annual coupon payments.
 Maturity date is the date on which the bond will mature and the bond issuer will pay the bond holder the face
value of the bond.
 Issue price is the price at which the bond issuer originally sells the bonds.
Bond Issuers
There are three main categories of bonds.
 Corporate bonds are issued by companies.
 Municipal bonds are issued by states and municipalities. Municipal bonds can offer tax-free coupon income for
residents of those municipalities.
 Treasury bonds (more than 10 years to maturity), notes (1-10 years maturity) and bills (less than one year to
maturity) are collectively referred to as simply "Treasuries."
Varieties of Bonds
 Zero-coupon bonds do not pay out regular coupon payments, and instead are issued at a discount and their market
price eventually converges to face value upon maturity. The discount a zero-coupon bond sells for will be
equivalent to the yield of a similar coupon bond.
 Convertible bonds are debt instruments with an embedded call option that allows bondholders to convert their
debt into stock (equity) at some point if the share price rises to a sufficiently high level to make such a conversion
attractive.
 Some corporate bonds are callable, meaning that the issuer can call back the bonds from debtholders if interest
rates drop sufficiently. These bonds typically trade at a premium to non-callable debt due to the risk of being
called away and also due to their relative scarcity in the bond market. Other bonds are putable, meaning that
creditors can put the bond back to the issuer if interest rates rise sufficiently.

COMMON STOCKS
What is a 'Common Stock'
Common stock is a security that represents ownership in a corporation. Holders of common stock exercise control by
electing a board of directors and voting on corporate policy. Common stockholders are on the bottom of the priority
ladder for ownership structure; in the event of liquidation, common shareholders have rights to a company's assets only
after bondholders, preferred shareholders and other debtholders are paid in full.
The first ever common stock was established in 1602 by the Dutch East India Company and introduced on the Amsterdam
Stock Exchange. In 2016, there are over 4,000 stocks traded on major exchanges and over 15,000 traded over the counter.
Larger U.S.-based stocks are traded on a public exchange such as the New York Stock Exchange or NASDAQ. There are
also several international exchanges for foreign stocks, such as the London Stock Exchange or the Japan Stock Exchange.
Companies that are smaller in size and unable to meet an exchange’s listing requirements are considered unlisted. These
unlisted stocks are traded on the Over-The-Counter Bulletin Board (OTCBB) or pink sheets.
For a company to issue stock, it must begin by having an initial public offering. An IPO is a great way for a company
seeking additional capital to expand. To begin the IPO process, a company must work with an underwriting investment
banking firm, which helps determine both the type and pricing of the stock. After the IPO phase is completed, the general
public is allowed to purchase the new stock on the secondary market
Categories of Stocks
1. Blue Chip Stocks
- A blue-chip stock is the stock of a large, well-established and financially sound company that has operated for many
years. A blue-chip stock typically has a market capitalization in the billions, is generally the market leader or among the
top three companies in its sector, and is more often than not a household name. Some examples of blue-chip stocks are
IBM Corp., Coca-Cola Co. and Boeing Co.
The Safety of Blue-Chip Stocks
While a blue-chip company may have survived several challenges and market cycles, leading to it being perceived as a
safe investment, this may not always be the case. The bankruptcies of General Motors and Lehman Brothers as well as a
number of leading European banks during the global recession of 2008 is proof that even the best companies may struggle
during periods of extreme stress.
Blue Chips as Part of a Larger Portfolio

While blue-chip stocks are appropriate for use as core holdings within a larger portfolio, they generally shouldn't be the
entire portfolio. A diversified portfolio usually contains some allocation to bonds and cash. Within a portfolio's allocation
to stocks, an investor should consider owning mid-caps and small-caps as well. Younger investors can generally tolerate
the risk that comes from having a greater percentage of their portfolios in stocks, including blue chips, while older
investors may choose to focus more on capital preservation through larger investments in bonds and cash.
2. Income Stocks

- An income stock is an equity security that pays regular, often steadily increasing dividends. Income stocks usually offer
a high yield that may generate the majority of the security's overall returns. While there is no specific breakpoint for
classification, most income stocks have lower levels of volatility than the overall stock market, and offer higher-than-
market dividend yields.

Income stocks may have limited future growth options, thereby requiring a lower level of ongoing capital investment.
Any excess cash flow from profits can be directed back to investors on a regular basis.

Income stocks can come from any industry, but investors commonly find them within real estate (through real estate
investment trusts, or REITs), energy sectors, utilities, natural resources and financial institutions.

3. Cyclical Stocks
-One whose fortune is directly tied to the state of the overall national economy. When the economy is booming, these
stocks do well. During a recession, they do poorly.
-Cyclical stocks rise and fall with the business cycle. This seeming predictability in the movement of these stock's prices
leads some investors to attempt to time the market. They buy the stocks at the low point in the business cycle and
sell them at the high point. Examples of companies whose stocks are cyclical include car manufacturers, airlines, furniture
retailers, clothing stores, hotels and restaurants. When the economy is doing well, people can afford to buy new cars,
upgrade their homes, shop and travel. When the economy is doing poorly, these discretionary expenses are some of the
first things consumers cut. If a recession is bad enough, cyclical stocks can become completely worthless as companies go
out of business.

The Role of Cyclical Stocks in a Portfolio

Cyclical stocks are viewed as more volatile than non-cyclical or defensive stocks, which tend to be more stable during
periods of economic weakness. However, they offer greater potential for growth because they tend to outperform the
market during periods of economic strength. Investors seeking long-term growth with reduced volatility tend to balance
their portfolios with a mix of cyclical stocks and non-cyclical stocks.

4. Defensive Stocks
- A defensive stock is a stock that provides a constant dividend and stable earnings regardless of the state of the
overall stock market. Because of the constant demand for their products, defensive stocks tend to remain stable during the
various phases of the business cycle.

Examples of Defensive Stocks

Defensive stocks are also known as "non-cyclical stocks," because they are not highly correlated with the business cycle.
Below are a few types of defensive stocks.

Utilities
Water, gas and electric utilities are an example of defensive stocks because people need them during all phases of the
business cycle. Utility companies also are thought of as benefiting from slower economic environments because interest
rates tend to be lower and their competition to borrow funds is much less.

Consumer Staples
Companies that produce or distribute consumer staples, which are goods people tend to buy out of necessity regardless of
economic conditions, are generally thought to be defensive. They include food, beverages, hygiene products, tobacco and
certain household items. These companies generate steady cash flow and predictable earnings during strong and weak
economies. As such, their stocks tend to outperform non-defensive or consumer cyclical stocks that sell discretionary
products during weak economies, while underperforming them in strong economies.

Health Care Stocks

Shares of major pharmaceutical companies and medical device makers have historically been considered defensive stocks,
as there will always be sick people in need of care. But increased competition from new branded and generic drugs, and
uncertainty surrounding drug price regulation, means they aren't as defensive as they once were.
The Role of Defensive Stocks in a Portfolio

Investors seeking to protect their portfolios during a weakening economy or periods of high volatility may increase their
exposure to defensive stocks. Well-established companies such as Procter & Gamble, Johnson & Johnson, Philip Morris
International and Coca-Cola are considered defensive stocks. In addition to strong cash flows, these companies have
strong operations with the ability to weather weakening economic conditions. They also pay dividends, which can have
the effect of cushioning a stock’s price during a market decline.

5. Growth Stocks

- A growth stock is a share in a company that is anticipated to grow at a rate significantly above the average for the
market. These stocks generally do not pay dividends, as the companies usually want to reinvest any earnings in order to
accelerate growth in the short term. Investors then earn money through capital gains when they eventually sell their
shares.

Investment in growth stocks can be risky. Because of the lack of dividends, the only opportunity an investor has to earn
money on their investment is when they eventually sell their shares. If the company does not do well, investors take a loss
on the stock when it's time to sell.

Today, growth stocks compose a range of technology, biotech and some consumer discretionary companies.

Growth stocks tend to share a few common traits. For example, growth companies tend to have unique product lines.
They may hold patents or access to technologies that put them ahead of others in their industry. In order to stay ahead of
competitors, they reinvest profits to develop even newer technologies and patents as a way to ensure longer term growth.

6. Speculative Stocks

- A speculative stock is a stock with a high degree of risk, such as a penny stock or an emerging market stock. Many
traders are drawn to speculative stocks due to their higher volatility relative to blue-chip stocks, which creates an
opportunity to generate greater returns. Most long-term investors and institutional investors stay away from speculative
stocks unless they are part of a mutual fund or exchange-traded fund (ETF).

Speculative stocks appeal to short-term traders due to their low share price and greater volatility compared to traditional
blue-chip stocks. The greater volatility enables traders to realize windfall profits if the trade works out in their favor.

Often times, speculative stocks are clustered in sectors such as mining, energy, technology, and biotechnology. While
there is significant risk involved in investing in early-stage companies in these sectors, the possibility that a small
company may find a giant mineral deposit, invent the next big app, or discover a cure for a disease offers enough
incentive for speculators to take a chance on them.

Although most speculative stocks tend to be early-stage companies, a blue-chip can occasionally become a speculative
stock if it falls upon hard times and has rapidly deteriorating prospects for the future. Such a stock is known as a fallen
angel and may offer an attractive risk-reward payoff if it can manage to turn its business around and avoid bankruptcy.

7. Penny Stocks
- A penny stock typically trades outside of the major market exchanges at a relatively low price and has a small market
capitalization. These stocks are generally considered highly speculative and high risk because of their lack of liquidity,
large bid-ask spreads, small capitalization and limited following and disclosure. They often trade over-the-counter through
the OTC Bulletin Board (OTCBB) and pink sheets.

MARKET MECHANICS
*Order Information Flow pp.116

Investors can enter various types of orders to buy or sell options. Some orders guarantee that the investor’s order will be
executed immediately. Other types of orders may state a specific price or condition under which the investor wants their
order to be executed. All orders are considered “day” orders unless otherwise specified. All day orders will be canceled at
the end of the trading day if they are not executed. An investor may also specify that their order remain active until
canceled. This type of order is known as “Good Til Cancel” or “GTC”.

Types of Orders:
Market Orders

A market order will guarantee that the investor’s order is executed as soon as the order is presented to the market. A
market order to either buy or sell guarantees the execution but not the price at which the order will be executed. When a
market order is presented for execution, the market for the security may be very different from the market that was
displayed when the order was entered. As a result, the investor does not know the exact price that their order will be
executed at.

Buy Limit Orders

A buy limit order sets the maximum price that the investor will pay for the security. The order may never be executed at a
price higher than the investor’s limit price. While a buy limit order guarantees that the investor will not pay over a certain
price, it does not guarantee them an execution. If the stock continues to trade higher away from the investor’s limit price,
the investor will not purchase the stock and may miss a chance to realize a profit.

Sell Limit Orders

A sell limit order sets the minimum price that the investor will accept for the security. The order may never be executed at
a price lower than the investor’s limit price. While a sell limit order guarantees that the investor will not receive less than
a certain price, it does not guarantee them an execution. If the stock continues to trade lower away from the investor’s
limit price, the investor will not sell the stock and may miss a chance to realize a profit or may realize a loss as a result.

*It’s important to remember that even if an investor sees stock trading at their limit price, it does not mean that their order
was executed because there could have been stock ahead of them at that limit price.

Stop Orders / Stop Loss Orders

A stop order or stop loss order can be used by investors to limit or guard against a loss or to protect a profit. A stop order
will be placed away from the market in case the stock starts to move against the investor. A stop order is not a “live”
order; it has to be elected. A stop order is elected and becomes a live order when the stock trades at or through the stop
price. The stop price is also known as the trigger price. Once the stock has traded at or though the stop price the order
becomes a market order to either buy or sell the stock depending on the type of order that was placed.

Buy Stop Orders

A buy stop order is placed above the market and is used to protect against a loss or to protect a profit on a short sale of
stock. A buy stop order could also be used by a technical analyst to get long the stock after the stock breaks through
resistance.

Settlement Procedures:

Settlement-the activities surrounding the transfer of ownership

Trade date-the date the order was actually executed

Day trade-buying and selling securities on the same day.

Reasons for day trading:
a. many brokerage firms only charge one commission on a day trade
b. the purchase and sale of settle on the same day, technically it is not necessary to pay for the securities being purchased

The specialist- helps maintain a fair and orderly market

The Ticker Tape

-the most widely known symbol of the investment business

- A ticker tape is a device that shows stock symbols and numbers to convey information about trades. The ticker tape is
electronic today, but it gets its name from the ticking sound the original mechanical machine made and from the long,
narrow pieces of paper that stock quotes were printed on.
Each entry on the ticker tape displays the stock symbol (indicating which company’s stock has been traded), volume
(number of shares traded), the price per share at which the trade was executed, an up or down triangle showing whether
that price is above or below the previous trading day’s closing price and another number telling how much higher or lower
that trade’s price was than the last closing price. Electronic ticker tapes also use green to indicate a higher trading price
and red to indicate a lower price, and blue or white to indicate no change. Before 2001, trading prices were displayed in
fractions, but since 2001, all prices are shown in decimals.

Watching the ticker tape, especially one that is color coded, can help investors gauge overall market sentiment at any
moment. Ticker-tape data also helps technical analysts evaluate stock behavior using charts.

Before information could be transmitted electronically, brokers whose offices were closer to the stock exchange had an
advantage because they received the latest trading data sooner than brokers located further away.
Types of Accounts
1. Cash Account
-an investor must have a deposit cash equal to the full value of the securities purchased. Dividends and interest
accumulate in the cash account as they are earned unless the funds are better deployed in a margin account.
2. Margin Account
-permits an investor to borrow part of the cost of the investments from a brokerage firm.

Maintenance Margin
-the exhanges established this margin that determines how badly a position can deteriorate before the investor must
deposit more money into the account portfolio
**in practice, the established rule at most brokerage firms is a requirement of 30percent.

Buying Power
-a measure of how much more can be spent for securities without having to put up any additional cash.

Selling Short
-involves borrowing securities, selling them to someone else, eventually purchasing similar shares from someone else ,
and delivering these substitute shares to the original lender.

Brokers and Commissions

Commissions-occur when a trade is actually executed
*there is no charge to raise the stop price on a stop order or to submit a limit order to buy
**only when a trade occurs is a commission paid.
Full-Service Brokers

A full-service broker is a licensed financial broker-dealer firm that provides a large variety of services to its clients,
including research and advice, retirement planning, tax tips, and much more. Of course, this all comes at a price,
as commissions at full-service brokerages are much higher than those at discount brokers.

Full-service brokers can provide expertise for people who don't have the time to stay up-to-date on complicated issues
such as tax or estate planning; however, for those who just want to execute trades without the extra services, discount
brokers are the way to go.

Full-service brokers offer customized support and interaction in facilitating trades, managing portfolios, financial
planning and wealth management services for clients. Clients are assigned to individual stockbrokers and/or financial
advisors. They are the main point of contact at a full-service brokerage firm.

Discount Brokers

- A discount broker is a stockbroker who carries out buy and sell orders at a reduced commission rate. However, he or she
provides no investment advice, unlike a full-service broker. Before the emergence of technology, only the wealthy could
afford a broker and get access to the stock market. However, the internet has brought an explosion of discountbrokers that
allow individuals with smaller capital to trade, at a smaller fee.