We discussed in class the function of financial markets and intermediaries; that these institutions such as brokerage firms, commercial banks, and investment banks exist to make markets flow and function more efficiently.  These firms have specific knowledge of the marketplace and have economies of scale which permits them to bring money to those who need it and provide a place to deposit money for those who do not have a specific use for the money at the time.

(Some) Brokerage firms employ Investment Bankers (Analysts) that follow a group of companies (usually a particular industry).  Following means that an analyst maintains a mathematical model of the company's financial statements that is being followed.  The analyst makes every attempt to accurately predict the earnings per share of that company.  Analyst's opinions on companies that they follow are published for the world to see.  To be a good analyst, is to be accurate.  When we see or hear investment advisors on TV touting a stock, the idea is that they have analyzed the stock, have predicted the earnings per share and are making comments relative to the future performance of the company or the stock.  An analyst may say:  "I have analyzed ABC company's financial statements and predict that they will earn $X next year.  Given those earnings, I think the stock is undervalued and would buy it at this time."

[It is important to know that analysts' follow particular industries.  To understand how a particular company performs, what their earnings should be, what Price/Earnings ratio the firm should have, etc. is to compare the firm's numbers to other firms in that particular industry.  Thus, analysts will study and follow an industry or perhaps several industries if the firm is large enough.  There are investment banks in New Orleans that call themselves 'boutique' firms mainly because they follow a single industry and specialize in that industry.  It is usually the oil industry.  To ask one of these analysts what he or she thinks of IBM, officially, they would tell you that they do not follow IBM nor does anyone in the firm and they do not have an 'official' opinion about IBM.]

The analyst has just predicted the earnings of the firm (the primary determinant of stock prices) to be high next year, relative to where they currently are.  Given that the firm is expected to earn more money in the next year, the increase in earnings will drive up the value of the stock.  The analyst is making a comparison of the current stock price or value of the firm against the price of the stock on the stock exchange at that time.  If the analyst thinks that the stock of the firm is worth $100 per share and it is trading on the exchange for $75, then an investor can look to make money on the purchase of the stock.  A BUY recommendation is issued to the public.

Following company financial statements has another function.  When the firm needs to borrow money, big money, they turn to Wall Street.  Investment bankers will underwrite the sale of securities (stocks or bonds) to get the firm the money that need.  The investment bank will buy all of the securities that the firm wants to sell for a predetermined price.  They advertise these deals in major financial publications such as the Wall Street Journal by placing a tombstone ad.

Underwriting securities is big business for the brokerage firm.  They place the ads to show who is doing business with them in the hope that other firms will see these ads and also turn to this firm when they need financing.

The Investment Bank is working in both Primary and Secondary markets.  Primary Markets:  Involve the sale of new securities, ones that are coming from the issuing corporation to the investment bank.  Secondary markets provide a forum for the trading of securities after their initial sale; a stock exchange.


Investment Bankers provide the liquidity to firms by acting as intermediaries between investors and companies. They are most concerned with the Timing of the Issue and the Pricing of the Issue.  Investment bankers assume the risk of owning the security.  They are paid a Spread; the difference between the purchasing price and the selling price to the public.  Risk is diversified through a syndicate, which is a group of investment bankers helping with the transaction. The lead firm is the syndicate manager.

Types of Underwriting

1.  Un-syndicated Stock Offering: - Direct Placement - Issuing firm sells shares directly to institutional investors bypassing the underwriters.  The firm saves fees and the purchasing institution gets better rates. In a syndicated method, shares are to be sold to individuals.  Un-syndicated means institutions buy for themselves.

2.  Best Effort Underwriting: - Investment Banker provides a best effort at selling the entire issue. The remainder is repurchased by the firm.

3.  Standby: - Underwriters standby as firm does issuing.  Underwriters will assume leftovers.

4.  Secondary Distributors: - Say that a Mutual Fund or wealthy individual wants to unload large number of shares and they need help selling. They would turn to a secondary distributor to place the shares in the market without depressing the price while doing so.

Investment Bankers earn, on average, $335,000 annually.  


Stock Exchanges exist as an efficient mechanism to exchange securities among investors.  Typical market places are auction markets which involve a bidding process in a specific location.  Investors are represented by brokers who execute trades. Their job is to obtain the best possible price for the investor.  The broker holds no vested interest in the security and is paid a transaction fee (commission) for the work.  Remember when you buy 100 shares of XYZ on an exchange, someone else is selling 100 shares of XYZ.


Individuals look to a brokerage firm to provide a financial function much as they do when choosing a bank.  It is another form of a financial institution.  Brokerage firms generally come in two 'flavors,' a full-service firm or a discount firm.

Before the personal computer, for a person to have a broker, was like having a chauffeur or butler.  There were no discount firms, technology was expensive and only the largest firms had access to the financial exchanges.  A brokerage account was basically for the 'rich.'  In the late 1970's, the personal computer and related technology drove down the price of computing power, brought that power into people's homes and a technology boom began.  Stock prices rose quickly, attracting a lot of attention, more individuals wanted to invest, brokerage firms expanded.  [This is when the mutual fund industry absolutely took off!  From about 400 funds, the number swelled to over 8000 today; mutual funds hold trillions of dollars of investor's money.]

The typical full-service firm would charge 3% commission on the value of the trade.  100 shares of $100 stock, a $10,000 trade, would cost $300 in commission.  When discount firms were introduced, they charged 1% commission.  Both full-service and discount-firms began to expand into another areas of traditional banking, capturing checking accounts, savings accounts, offering credit cards, debit cards, monthly statements, etc. and generally being a one-stop-financial-shops for individual investors.  The single biggest difference between these firms is that the full-service firm, by definition, introduces the investor to a broker, a broker that 'knows his client,' has spoken to his client, understands the client's 
account, risk tolerances, etc.  The full-service broker offers ADVICE.  The discount firm offers a commission discount because they do not offer individual advice to the account holder.  In a discount-broker relationship, the account holder is making their own investment decisions.  Not to trivialize the relationship between a broker and their client with this example, but some people want to change the oil on their car themselves, others prefer someone else to do it.

BOTH Full-Service and Discount Firms offer a full line of banking services.  Some are:
Monthly statements
Research departments
Research materials available to customers.
Cash management.
Credit/Debit cards.
Checking Accounts.
24 hour access.
Telephone transactions and quotes.
Personal computer access and trades.
They hold securities for liquidity and safety.

EXAMPLES OF FULL SERVICE FIRMS:     Merrill Lynch, Morgan Stanley
EXAMPLES OF DISCOUNT FIRMS:     Charles Schwab, Fidelity Investments.

To give an example on how successful brokerage firms have been, they were said to hold 75% of the nation's wealth, the other 25% is left to banks, and other financial intermediaries.

On a final note, commissions have been driven down drastically over time.  Fidelity Investments allows trades up to 1000 shares, at any share price for $4.95 per trade.  An account holder could buy 1000 shares of $250 stock (a $250,000 trade) and pay a flat $4.95 in commissions.


More about the broker:

A broker, by definition, is a go-between.  When a client of the firm wants to buy 100 shares of XYZ stock, the broker finds a seller on the Stock Exchange.  The broker is paid a commission for the service.

Brokers have specialized over time, focusing their knowledge and familiarity on sections of the market much like a physician would specialize on certain areas of medicine.  A broker is a licensed professional.  When one is first interested in this as a profession, you must be hired by a firm, then to be registered, you must pass an examination or series of examinations to be licensed.

A Series 6 exam is one that most insurance agents take.  It allows those who hold a Series 6 license to speak to clients about annuities and mutual funds.  The coveted Series 7 license is a 'full' registered representative (a full broker) licensed to speak to clients about individual securities (stocks, bonds, etc.) in addition to mutual funds.

A broker's income is based on commission.  As described above, they are paid when trades are made.  They share the total commissions charged to the client with the brokerage firm.


Opening an Account:

The CASH Account is the most common.  Very simple. Everything is on a "cash" basis - All orders must be paid in full by the settlement date, 3 days after the trade is made.  If you have the cash in the account at the time of the trade, the firm will simply debit your cash position and purchase the securities that you asked them to purchase for you.  In the case of selling securities, they would deposit the sale proceeds into your cash position for a future trade or send the money to you at your request.

Alternatively, an investor can apply for a MARGIN Account.  By regulation, this requires a $2000 minimum account balance.  You may margin (borrow) 50% of the purchase of a security. For a $10,000 trade, you need only $5000 in cash, the brokerage firm will loan you the other $5000.  This ratio of a 50% equity position is watched carefully.  A person using margin to buy securities is leveraging their portfolio, obviously believing that the purchased security will rise in price, more profit could be made if some of that profit was earned using the brokerage firm's money. If, however, the value of the margined security falls in price, at 35% equity, the brokerage will issue a margin call.  This places the investor on notice that the required 50% equity level is not being maintained and requires the investor to deposit cash or other marketable securities to bring the equity in the account back to the 50% level.  If the investor fails to bring in the required capital, the firm can sell the securities to payoff the loan.  If equity falls to 25%, the brokerage firm will SELLOUT the account. At 25% equity, Federal Reserve Regulations are forced on the firm.  The process of watching a margin account and matching the required equity position is called being "marked-to-market."  Go to and look in their dictionary under "margin."

Margin is a difficult subject in investments.  The basics were described above.  Believe it or not, the two biggest reasons that a person will fail the Series 7 exam (to become a broker) is Options and Margin (in that order).  In our lectures, were are scratching the surface but covering the most important part of the subject.

Brokerage firms charge interest on the borrowed money.  Look in the Wall Street Journal under "Money Rates" and find "Call Money."  That is the rate that the firm will charge you.

Remember that Margin is credit, by definition, you can buy ANYTHING with margin, not just securities.  I have know investors to buy cars, vacations, refinance credit cards, etc., using their margin accounts.  It is simply using the equity in your investments to borrow money.


Some lingo first:  If you are LONG a security, means you own it.  When a broker, investor or someone on the business news says that they are 'long' GM, this means simply that they have, at some point, purchased GM stock and they still own it.  If they were to sell the GM stock that they have, they would (1) no longer be long GM, and they would have (2) completed a 'round trip.'  A simple concept.  Example:  You live in New Orleans, go to Miami and return to New Orleans, you have made a round trip.  To execute a "round trip"  you first BUY the security, then when ready, execute a SELL order.   Ideally, you buy LOW and sell HIGH.  Sounds simple enough but not taking the process for granted, you are buying because you believe the security will RISE in price.  You are making money as prices increase.  An investor that buys a security 'signals' that they believe the security is undervalued and they believe it will rise in price.  Remember what was said a few paragraphs ago, when you buy (you think the shares will rise in price), someone else is selling (thinking that the shares will fall in price).

Market Order - The most common order.  Buy or sell at current "market" price.  This order implicitly instructs the broker to purchase the security as quickly as possible.  That you are "not concerned about the price, but the speed of the execution."  The broker will send the order to the exchange where your shares are traded and BUY at the prevailing market price.  Whatever the price is when the trader or computer gets there, is the price that you will get.

Limit Order - Sets sell or buy limits that an investor will accept.  This is somewhat opposite of the Market Order.  The limit order implicitly instructs the broker to buy at a particular price.  That you are "concerned about the purchase price and not the speed of the execution."  A limit order may never be executed. Order can be good for the day (A Day order) or Good Until Cancelled.  Say that IBM is trading at $100 per share.  You contact your broker and ask to buy IBM. "Aat-the-market?" is what you will be asked.  "NO, not at the market, buy with a limit of $95."  The broker will enter the limit order into the computer and there it will sit until IBM's price falls to $95; at that point, it will be released into the trading crowd and become a market order.

Stop Order - Protect a profit or stop a loss (stop loss).  For example, you purchase a stock for $60 per share, you immediately set a stop loss for $57 per share.  The idea being that you allow for some volatility in the stock but want to risk no more than three points.  If the shares fall to $57, the computer will release the order into the trading crowd and it will be a market order.

Short Sales:  See short selling at:
Short selling tends to confuse even though it shouldn't.  It is the opposite of being "Long."  [Review the paragraph above about being "long" a security.]  Wall Street gives us a way to profit from falling securities prices, by executing a round trip (buy and sell), in reverse.  Short Selling is act of selling borrowed securities.  In a short sale, you contact your broker or get onto your computer a sell a security that you do not own.  You borrow the security from your broker and then sell it.  A short seller is hoping that the price of the security will fall.  If it does so, the short seller will then buy back the security at a lower price to return them to their broker.  Short sellers make money as markets are falling.  To short sell, you must have a margin account.

For example, if you think that IBM is overvalued at $100 per share and you think the price will eventually fall, SELL IBM at $100, wait until it falls to (for example $90, then BUY the security back, keeping the difference ($10).  As with going Long, there is a buy (low) and a sell (high), they are just in reverse order.

If the stock pays a dividend, the Short seller has to pay dividends to rightful owner.

Being Short is indefinite but you must have proper margin requirements met.  Proceeds are held in a restricted portion of brokerage account. (No interest paid on proceeds.)

Once monthly, the Wall Street Journal reports the total number of short sales in their Short Interest Report.

Short selling is first looked at as a pessimistic indicator.  Short sellers are believing that the price of the security in question will fall.   The optimistic side of that is short sales eventually have to be covered (a BUY order must be placed). Buy orders are positive for the market and the stock.  As buy orders are placed and the stock starts rising as a result, short sellers are losing money in the process, making them nervous and wanting to close their short positions (more buy orders), the process is called a Short Squeeze - when short sellers are being forced to cover their positions due to mounting losses.

Another interesting trade is going Short Against the Box - is the act of short selling a stock that you already own.  This technique keeps the investor's position static against market movements.  If the price of the stock rises, the money made by the increase will be lost by the short sale a vice-versa.  Investors use this in uncertain times or to keep a position stable right before retirement. (Neat trick)

For example, if you own 200 shares of XYZ and you tell your broker to sell short 200 shares of XYZ, you have shorted against the box.
Go to and look up shorting-against-the-box.