Most publicly traded equities appear on public exchanges through initial public o?erings (IPOs), whereby a privately traded company ?rst sells shares to ordinary investors. IPOs are usually executed by underwriters (investment bankers such as Goldman Sachs or Merrill Lynch), which are familiar with the complex legal and regulatory process and which have easy access to an investor client base to buy the newly issued shares. Shares in IPOs are typically sold at a ?xed price—and for about 10% below the price at which they are likely to trade on the ?rst day of after-market open trading. (Many IPO shares are allocated to the brokerage ?rm’s favorite customers, and can be an important source of pro?t.)
Usually, about a third of the company is sold in the IPO, and the typical IPO o?ers shares worth between $20 million and $100 million, although some are much larger (e.g., privatizations, like British Telecom). About two-thirds of all such IPO companies never amount to much or even die within a couple of years, but the remaining third soon thereafter o?er more shares in seasoned equity o?erings (SEO). These days, however, much expansion in the number of shares in publicly traded companies, especially large companies, comes not from seasoned equity o?erings, but from employee stock option plans, which eventually become unrestricted publicly traded shares.
In 1933/1934, Congress established the SEC through the Securities Exchange Acts. It furtherregulated investment advisors through the Investment Advisors Act of 1940. (The details of these acts can be obtained at the SEC website.) Today, publicly traded companies must regularly report their ?nancials and other information to the SEC, and their executives have ?duciary obligations to their shareholders. Generally, the SEC prohibits insider trading on unreleased speci?c information, although more general trading by insiders is legal (and seems to be done fairly pro?tably by these insiders).
Capital ?ows out of the ?nancial markets in a number of ways—through dividends and share repurchases, or more dramatically, through delistings and bankruptcies. Many companies pay some of their earnings in dividends to investors. Dividends, of course, do not fall like manna from heaven. For example, a ?rm worth $100,000 may pay $1,000, and would therefore be worth $99,000 after the dividend distribution. If you own a share of $100, you would own (roughly) $99 in stock and $1 in dividends after the payment—still $100 in total, no better or worse. (If you have to pay some taxes on dividend receipts, you might come out for the worse.) Alternatively, ?rms may reduce their outstanding shares by paying out earnings in share repurchases. For example, the ?rm may dedicate the $1,000 to share repurchases, and you could ask the ?rm to dedicate $100 thereof to repurchasing your share. But even if you hold onto your share, you have not lost anything. Previously, you owned $100/$100, 000 = 0.1% of a $100,000 company, for a net of $100. Now, you will own $100/$99, 000 = 1.0101% of a
$99,000 company—multiply this to ?nd that your share is still worth $100. In either case, the value of outstanding public equity in the ?rm has shrunk from $100,000 to $99,000.
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Exchanges are centralized trading locations where ?nancial securities are traded. The two mostimportant stock exchanges in the United States are the New York Stock Exchange (NYSE) and Nasdaq (originally an acronym for “National Association of Securities Dealers Automated Quotation” System). The NYSE is an auction market, in which one designated specialist (assigned for each stock) manages the auction process by trading with individual ?oor brokers. The specialist is often a monopolist. In contrast to this human process in one physical location on Wall Street, Nasdaq is a purely electronic exchange without specialists. (For security reasons, its location—well, the location of its computer systems—is secret!) For each Nasdaq stock, there is at least one market-maker, who has agreed to continuously stand by to o?er to buy or sell shares, thereby creating a liquid and immediate market for the general public. Most Nasdaq stocks have multiple market-makers, drawn from a pool of about 500 trading ?rms (such as J.P. Morgan or ETrade), which compete to o?er the best price. Market-makers have one advantage over the general public: they can see the limit order book, which contains as-yet-unexecutedorders from investors to purchase or sell if the stock price changes—giving them a good idea at which price a lot of buying or selling activity will happen. The NYSE is the older exchange, and for historical reasons, controls considerably more trading than Nasdaq, especially when it comes to “blue chip” stocks. (“Blue chip” now means “well established and serious”; ironically, the term itself came from poker, where the highest-denomination chips were blue.) Nasdaq tends to trade smaller and high-technology ?rms.
Continuous trading—trading at any moment an investor wants to execute—relies on the presence of the standby intermediaries (specialists or market-makers), who are willing to absorb shares when no one else is available. This is risky business, and thus any intermediary must earn a good rate of return to be willing to do so. To avoid this cost, some countries have organized their exchanges into non-continuous auction systems, which match buy and sell orders a couple of times each day. The disadvantage is that you cannot execute orders immediately but have to delay until a whole range of buy orders and sell orders have accumulated. The advantage is that this eliminates the risk that an (expensive) intermediary would otherwise have to bear. Thus, auctions generally o?er lower trading costs but slower execution.
Even in the United States, innovation and change are everywhere. For example, electronic communications networks (ECNs) have recently made big inroads into the trading business, replacing exchanges especially for large institutional trades. (They can trade the same stocks that exchanges are trading, and compete with exchanges in terms of cost and speed of execution.) An ECN cuts out the specialist, allowing investors to post price-contingent orders themselves. ECNs may specialize in lower execution costs, more broker kickbacks (see the sidenote below), or faster execution. The biggest ECNs are Archipelago and Instinet. An even more interesting method to buy and trade stocks are crossing systems, such as ITG POSIT. ITG focuses primarily on matching large institutional trades with one another in an auction-like manner. If no match on the other side is found, the order may simply not be executed. But if a match is made, by cutting out the specialist or market-maker, the execution is a lot cheaper than it would have been on an exchange. Recently, even more novel trading places have sprung up. For example, Liquidnet uses peer-to-peer networking—like the original Napster—to match buyers and sellers in real-time. ECNs or electronic limit order books are now the dominant trading systems for equities worldwide, with only the U.S. exchange ?oors as holdouts. Such mechanisms are also used to trade futures, derivatives, currencies, and even some bonds.
There are many other ?nancial markets, too. There are ?nancial exchanges handling stock options, commodities, insurance contracts, etc. A fascinating segment are the over-the-counter (OTC) markets. Over-the-counter means “call around, usually to a set of traders well-known to trade in the asset, until you ?nd someone willing to buy or sell at a price you like.” Though undergoing rapid institutional change, most bond transactions are still OTC. Although OTC markets handle signi?cantly more bond trading in terms of transaction dollar amounts than exchanges, their transaction costs are prohibitively high for retail investors—if you call without knowing the market in great detail, the person on the other end of the line will be happy to quote you a shamelessly high price, hoping that you do not know any better alternatives. The NASD (National Association of Securities Dealers) also operates a semi-OTC market for the stocks of smaller ?rms, the pink sheets. Foreign securities trade on their local national exchanges, but the costs for U.S. retail investors are again often too high to make direct participation worthwhile.
Most individuals place their orders to buy or sell stocks with a retail broker, such as Ameritrade (a “deep-discount broker”), Charles Schwab (a discount broker), or Merrill Lynch (a full service broker). Investors can place either market orders, which ask for execution at the current price, or limit orders, which ask for execution if the price is above or below a limit that the investor can specify. (There are also many other types of orders, e.g., stop-loss orders [which instruct a broker to sell a security if it has lost a certain amount of money], GTC [good-to-cancel orders], and ?ll-or-kill orders.) The ?rst function of retail brokers is to execute these trades. They usually do so by routing investors’ orders to a centralized trading location (e.g., a particular stock exchange), the choice of which is typically at the retail broker’s discretion, as is the particular agent (e.g., ?oor broker) engaged to execute the trade. The second function of retail brokers is to keep track of investors’ holdings, to facilitate purchasing on margin (whereby investors can borrow money to purchase stock, allowing them to purchase more securities than they could a?ord on a purely cash basis), and to facilitate selling securities “short,” which allows investors to speculate that a stock will go down.
Many larger investors break these two functions apart: the investor can employ its own traders, while the broker takes care only of the bookkeeping of the investor’s portfolio, margin provision and the shorting provisions. Such limited brokers are called prime brokers.
Assume that you own one factory among many that is selling a particular type of colored egg to many smart egg traders. It would make sense for you to assume that your egg traders are smart, that they like to buy eggs in colors that have high expected rates of return, but that they also like to buy some eggs that are di?erent and unique. In other words, you should assume that your traders do the same optimal basket stocking calculations that we have just gone through. You can even work out how much smart egg traders would be willing to pay for eggs of your factory’s color. If your egg color is very di?erent from those of the other eggs in traders’ baskets, you can charge more for your eggs than if your eggs are very much like the rest of their eggs. In equilibrium, there should be a relationship—the most unusual-colored eggs should command higher prices and thereby earn egg traders lower expected rates of return, but egg traders still like them because of the insurance such eggs o?er them, within reasonable bounds, of course.
For stocks, this model is called the CAPM. It says that stocks that earn high rates of returns when the (market) portfolio of other stocks does poorly are more desirable, therefore priced higher, and therefore o?er a lower expected rate of return. And this is what we are ultimately really after. As corporate executives, we want to know how our investors are valuing our projects. If our projects earn our investors money when the rests of their portfolio are doing poorly, then our investors will want us to take these projects on their behalves even if our projects have a (reasonably mildly) low expected rate of return. In ?nance-speak, we should use a lowercost of capital for these projects, because they have lower market-betas—market-beta being a measure of the similarities of our projects’ rates of return with those of other investments in the market. The CAPM gives us the precise formula that relates the market beta to the cost of capital, because it presumes that it can work out exactly what smart egg traders (market investors) like and dislike.
One of the most important part of the average real estate purchase is normally the mortgage financing necessary to obtain the property.
The average home buyer does not have the assets to purchase property without some type of mortgage financing. Even those home buyers who can afford to pay for the entire property with cash, it is sometimes not a good idea to use mortgage loans for tax and investment purposes.
Mortgage programs typically set limits on the loan amounts available for purchases. These loan-to-value (LTV) limits are based on the property’s value, type and program.
For example, conforming programs–which normally have the best rates and terms–impose the following LTV limits on purchase loans:
- Single-family home or condominium unit, owner-occupied: 97%
- Two-unit residential property, owner-occupied: 90%
- Three-unit residential property, owner-occupied: 80%
- Four-unit residential property, owner-occupied: 80%
- Single-family, 2nd homes: 90%
- Single-family and two-unit residential, investment (NOO): 80%
- Three-unit & four-unit residential, investment (NOO): 75%
For most Americans, buying a home will probably be the most expensive investment of their lives. For many Americans, it will be their only major investment. Luckily, real estate is still one of the best types of investments available—and today, it is available to more Americans than ever.
The closing or settlement is the culmination of the typical purchase transaction. During the closing, the buyer provides personal finance and mortgage loan funds to the seller. In return, the seller provides the property’s title and necessary keys to the buyer. That’s the simple, easy description.
The closing is actually a hectic event for many home buyers and real estate investors, especially for rookie or novice purchasers. The purchaser must review and sign dozens of legal documents and disclosures, the bulk of which are required for the mortgage financing. The buyer often must also satisfy final documentary, verification or settlement conditions, all of which are meant to satisfy all legal, lender and seller requirements.
With counsel from experienced real estate agents, attorneys and mortgage lenders, home buyers can and should relax. However, the sheer weight of the first home purchase often does not allow much relief for the home buyer.
The purchase mortgage loan is any financing used to finance the purchase transaction of a real estate property. Although the typical community bank will only offer a handful of purchase mortgage programs for their customers, there are actually hundreds of different programs available for the home or real estate investment purchase.
Tax loopholes and benefits make mortgages and real estate properties excellent tax shelters. The interest that homeowners pay on their mortgage loans are tax-deductible, which reduces the borrower’s taxable income. With investment properties, interest is normally not tax-deductible. However, real estate investors can deduct certain expenses–the most profitable of which is depreciation.