Essentials of Investments, 8th Edition-3

Essentials of Investments, 8th Edition
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Chapter 3: Securities Markets

After Studying This Chapter You Should Be Able To: Describe the role of investment bankers in primary issues. Identify the various security markets. Compare trading practices in stock exchanges with those in dealer markets. Describe the role of brokers. Compare the mechanics and investment implications of buying on margin and short-selling. This chapter will provide you with a broad introduction to the many venues and procedures available for trading securities in the United States and international markets. We will see that trading mechanisms range from direct negotiation among market participants to fully automated computer crossing of trade orders. The first time a security trades is when it is issued to the public. Therefore, we begin with a look at how securities are first marketed to the public by investment bankers, the midwives of securities. We turn next to a broad survey of how already-issued securities may be traded among investors, focusing on the differences between dealer markets, electronic markets, and specialist markets. With this background, we then turn to specific trading arenas such as the New York Stock Exchange, NASDAQ, and several foreign security markets, examining the competition among these markets for the patronage of security traders. We consider the costs of trading in these markets, the quality of trade execution, and the ongoing quest for cross-market integration of trading. We then turn to the essentials of some specific types of transactions, such as buying on margin and short-selling stocks. We close the chapter with a look at some important aspects of the regulations governing security trading, including insider trading laws, circuit breakers, and the role of security markets as self-regulating organizations.
Related Web sites for this chapter are available at www.mhhe.com/bkm.

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3.1: How Firms Issue Securities

When firms need to raise capital they may choose to sell or float securities. These new issues of stocks, bonds, or other securities typically are marketed to the public by investment bankers in what is called the primary market. Trading of already-issued securities among investors occurs in the secondary market.
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Trading in secondary markets does not affect the outstanding amount of securities; ownership is simply transferred from one investor to another. CONCEPT check 3.1 Why does it make primary market sense for shelf registration to be limited in time? Market for new issues Private Placements of securities. Primary offerings also can be sold in a private placement rather than a public offering. In this case, the firm (using an investment banker) sells shares directly to a small group of institutional or wealthy secondary market investors. Private placements can be far cheaper than public offerings. This is because Rule 144A of the SEC allows corporations to make these placements without preparing the extensive and costly registration Market for already-existing securities. statements required of a public offering. On the other hand, because private placements are not made available to types of primary market issues of common stock. Initial public offerings, or IPOs, are stocks There are two the general public, they generally will be less suited for very large offerings. Moreover, private placements do not privately owned company like stock exchanges. This selling reduces the public for the issued by a formerly trade in secondary marketsthat is going public, that is, greatly stock to their liquidity and presumably reduces the offerings investors will pay for the issue. first time. Seasoned equityprices thatare offered by companies that already have floated equity. For example, a sale by IBM of new shares of stock would constitute a seasoned new issue.
private placement initial public offering shares are sold directly to a small group of institutional or Primary offerings in which (IPO)
wealthy investors. First sale of stock by a formerly private company. InInitial of bonds, we also distinguish between two types of primary market issues, a public offering and a the case Public Offerings private placement. The former refers to an issue of bonds sold to the general investing public that can then be Investment bankers manage the issuance of new securities to the public. Once the SEC has commented on traded on the secondary market. The latter refers to an issue that usually is sold to one or a few institutional the registration statement and a preliminary prospectus has been distributed to interested investors, the investors and is generally held to maturity. investment bankers organize road shows in which they travel around the country to publicize the imminent offering. These road shows serve two purposes. First, they generate interest among potential investors and Investment Banking provide information about the offering. Second, they provide information to the issuing firm and its Public offerings of the price at and bonds will be are marketed the securities. bankers who in underwriters about both stocks which theytypicallyable to market by investment Large investors this role are called underwriters. More than one shares of the IPO usually markets the securities. A lead firm communicate their interest in purchasinginvestment banker to the underwriters; these indications of interest forms an a book and the process of polling potential investors share the responsibility for the stock issue. are calledunderwriting syndicate of other investment bankers tois called bookbuilding. These indications of interest provide valuable information to the issuing firm because institutional investors often will have useful insights about both the market demand for the security as well as the prospects of the firm and its underwriters competitors. It is common for investment bankers to revise both their initial estimates of the offering price of a security and the number of shares offered based on feedback from the investing community. Underwriters purchase securities from the issuing company and resell them. Why do investors truthfully reveal their interest in an offering to the investment banker? Might they be Investment bankers little the firm regarding that this on drive down the offering price? Truth is the better off expressingadviseinterest, in the hopethe terms willwhich it should attempt to sell the securities. A preliminary in this case because must be filed with the Securities and Exchange Commission (SEC), better policyregistration statementtruth telling is rewarded. Shares of IPOs are allocated across investors in describing the issue and the each investors expressed interest in the offering. If a is known as a red part based on the strength ofprospects of the company. This preliminary prospectusfirm wishes to get a herring because it includes a statement printed in red, stating that the company is not attempting to large allocation when it is optimistic about the security, it needs to reveal its optimism. In turn, the sell the security before the registration is approved. When price to these investors to induce approved by the SEC, underwriter needs to offer the security at a bargain the statement is in final form, and them to participate in bookbuilding and share their information. Thus, IPOs commonly are underpriced compared to the price at
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it is called could be marketed. Such underpricing at which the securities will be occur on the public is which theythe prospectus. At this point, the price is reflected in price jumps that offered tothe date when announced. the shares are first traded in public security markets. The most dramatic case of underpricing occurred in December 1999 when shares in VA Linux were sold in an IPO at $30 a share and closed on the first day of trading at $239.25, a 698% one-day return.
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prospectus
While the explicit costs of an IPO tend to be around 7% of the funds raised, such underpricing should be viewed asA descriptionof the issue. and the security it is issuing. sold its shares for the $239 that another cost of the firm For example, if VA Linux had investors obviously were willing to pay for them, its IPO would have raised 8 times as much as it actually In a typical underwritingthe table in this case far exceeded thepurchase cost securities from the This degree did. The money left on arrangement, the investment bankers explicit the of the stock issue. issuing company and then far more dramatic public. common, but underpricing seems to to theuniversal of underpricing is resell them to the than is The issuing firm sells the securities be a underwriting syndicate for the public offering price less a spread that serves as compensation to the underwriters. This phenomenon. procedure is called a firm commitment. In addition to the spread, the investment banker also may receive Figure of.2 presentsstock or other securities of the firm. Figure 3.1 depicts world. The results consistently shares 3 common average first-day returns on IPOs of stocks across the the relationships among the firm indicatethe security, the lead underwriter, the underwriting syndicate, and the public. makes them issuing that IPOs are marketed to investors at attractive prices. Underpricing of IPOs appealing to all investors, yet institutional investors are allocated the bulk of a typical new issue. Some view this as unfair discrimination against small investors. issuing securities,suggests that the apparent FIGURE 3.1: Relationship among a firm However, our analysis the underwriters, discounts on IPOs may be in part payments for a valuable service, specifically, the information contributed and the public by the institutional investors. The right to allocate shares in this way may contribute to efficiency by promoting the collection and dissemination of such information.
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FIGURE 3.2: Average initial returns for (A) European and (B) Non-European IPOs
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Shelf Registration
An important innovation in the issuing of securities was introduced in 1982 when the SEC approved Rule 415, which allows firms to register securities and gradually sell them to the public for two years following the initial Source: Provided by Professor J. Ritter already registered,of Florida,be sold This is an updated registration. Because the securities are of the University they can 2008. on short notice, with little additional paperwork. Moreover, they canin T. Loughran, J. Ritter, and K. Rydqvist, Initial version of the information contained be sold in small amounts without incurring substantial flotation costs. The securities are on the shelf, ready to be 2 (1994), pp. 165199. Copyright 1994 shelf Public Offerings, Pacific-Basin Finance Journal issued, which has given rise to the term registration. permission from Elsevier Science. with
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Both views of IPO allocations probably contain some truth. IPO allocations to institutions do serve a valid CONCEPT check 3.1 economic purpose as an information-gathering tool. Nevertheless, the system can beand has been abused. Part of the Wall Street scandals of 20002002 centered on the allocation of shares in IPOs. In a Why does it make sense for shelf bankers used be limited in time? practice known as spinning, some investmentregistration to IPO allocations to corporate insiders to curry favors, in effect as implicit kickback schemes. These underwriters would award generous IPO allocations Private Placements to executives of particular firms in return for the firms future investment banking business. Pricing of IPOs is alsotrivial and not allprivate placement rather than a public offering. In this issue. the Primary offerings not can be sold in a IPOs turn out to be underpriced. Some do poorly after case, The 2006(using an investment a notablesells shares directly tostock lost about 30% of its value wealthy seven firm IPO of Vonage was banker) disappointment. The a small group of institutional or in its first days of trading. Other IPOs cannot even cheaper than public market. Underwriters left with unmarketable investors. Private placements can be far be fully sold to the offerings. This is because Rule 144A of the securities are forced to sell them at a loss on the secondary market. Therefore, the investment banker bears SEC allows corporations to make these placements without preparing the extensive and costly registration the price risk of an underwritten issue. On the other hand, because private placements are not made statements required of a public offering. available to the general public, they generally will be less suited for very large offerings. Moreover, private Interestingly, despite their dramatic initial investment performance, IPOs have been poor long-term placements do not trade in secondary markets like stock exchanges. This greatly reduces their liquidity and investments. Figure 3.3 compares the stock price performance of IPOs with shares of other firms of the presumably reduces the prices that investors will pay for the issue. same size for each of the five years after issue of the IPO. The year-by-year underperformance of the IPOs is dramatic, suggesting that, on average, the investing public may be too optimistic about the prospects of these firms. Such long-lived systematic errors on the part of investors would be surprising. An interesting private placement study by Brav, Geczy, and Gompers (2000), however, suggests that apparent IPO underperformance may be illusory. When they carefully match firms based on size and a small group of institutional or values, they Primary offerings in which shares are sold directly to ratios of book values to market find that IPO returns are actually similar to those of comparison firms. wealthy investors.
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FIGURE 3.3: Long-term Initial Public Offerings relative performance of initial public offerings, 19702006
Investment bankers manage the issuance of new securities to the public. Once the SEC has commented on the registration statement and a preliminary prospectus has been distributed to interested investors, the investment bankers organize road shows in which they travel around the country to publicize the imminent offering. These road shows serve two purposes. First, they generate interest among potential investors and provide information about the offering. Second, they provide information to the issuing firm and its underwriters about the price at which they will be able to market the securities. Large investors communicate their interest in purchasing shares of the IPO to the underwriters; these indications of interest are called a book and the process of polling potential investors is called bookbuilding. These indications of interest provide valuable information to the issuing firm because institutional investors often will have useful insights about both the market demand for the security as well as the prospects of the firm and its competitors. It is common for investment bankers to revise both their initial estimates of the offering price of a security and the number of shares offered based on feedback from the investing community. Why do investors truthfully reveal their interest in an offering to the investment banker? Might they be better off expressing little interest, in the hope that this will drive down the offering price? Truth is the better policy in this case because truth telling is rewarded. Shares of IPOs are allocated across investors in part based on the strength of each investors expressed interest in the offering. If a firm wishes to get a large allocation when it is optimistic about the security, it needs to reveal its optimism. In turn, the underwriter needs to offer the security at a bargain price to these investors to induce them to participate in Source: Prof. Jay R. Ritter, University of Florida, August 2008. Reprinted by permission. bookbuilding and share their information. Thus, IPOs commonly are underpriced compared to the price at
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which they could be marketed. Such underpricing is reflected in price jumps that occur on the date when 3.2: shares are first traded in public security markets. The most dramatic case of underpricing occurred in the How Securities are Traded December 1999 when shares in VA Linux were sold in an IPO at $30 a share and closed on the first day of Financial markets develop to meet the needs of particular traders. Consider what would happen if organized 1 trading at not exist. Any household return. markets did $239.25, a 698% one-daywishing to invest in some type of financial asset would have to find others wishing to sell. Soon, an IPO where interested traders could meet wouldsuch underpricing Eventually, While the explicit costs of venues tend to be around 7% of the funds raised, become popular. should be financial markets would emergeissue. For example, if VA Linux hadpub in old London the $239 that viewed as another cost of the from these meeting places. Thus, a sold its shares for called Lloyds launched the maritimewere willing to pay forManhattan curb on Wall Street became synonymous with the investors obviously insurance industry. A them, its IPO would have raised 8 times as much as it actually financial world. left on the table in this case far exceeded the explicit cost of the stock issue. This degree did. The money of underpricing is far more dramatic than is common, but underpricing seems to be a universal Types of Markets phenomenon. We can differentiate four types of markets: direct search markets, brokered markets, dealer markets, and Figure 3.2 presents average first-day returns on IPOs of stocks across the world. The results consistently auction markets. indicate that IPOs are marketed to investors at attractive prices. Underpricing of IPOs makes them appealing to all investors, yet institutional investors are allocated the bulk of a typical new issue. Some Direct search markets view this as unfair discrimination against small investors. However, our analysis suggests that the apparent discounts on IPOsmarket is the least organized market. Buyers andspecifically, the information contributed A direct search may be in part payments for a valuable service, sellers must seek each other out bydirectly. An example of a transaction to allocate shares is the sale ofmay contribute to efficiency by the institutional investors. The right in such a market in this way a used refrigerator where the seller advertises for buyers on Craigslist. Such of such information.2 promoting the collection and disseminationmarkets are characterized by sporadic participation and low-priced and nonstandard goods. It would not pay for most people or firms to specialize in such markets. FIGURE 3.2: Average initial returns for (A) European and (B)
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Non-European IPOs Brokered markets

The next level of organization is a brokered market. In markets where trading in a good is active, brokers find it profitable to offer search services to buyers and sellers. A good example is the real estate market, where economies of scale in searches for available homes and for prospective buyers make it worthwhile for participants to pay brokers to conduct the searches. Brokers in particular markets develop specialized knowledge on valuing assets traded in that market. An important brokered investment market is the primary market, where new issues of securities are offered to the public. In the primary market, investment bankers who market a firms securities to the public act as brokers; they seek investors to purchase securities directly from the issuing corporation. Another brokered market is that for large block transactions, in which very large blocks of stock are bought or sold. These blocks are so large (technically more than 10,000 shares but usually much larger) that brokers or block houses often are engaged to search directly for other large traders, rather than bring the trade directly to the markets where relatively smaller investors trade.
Dealer markets by Professor J. Ritter of the University of Florida, 2008. This is an updated Source: Provided
version of the information contained in T. Loughran, J. Ritter, and K. Rydqvist, Initial When trading activity in a particular type of asset increases, dealer markets arise. Dealers specialize in Public Offerings, Pacific-Basin Finance Journal 2 (1994), pp. 165199. Copyright 1994 various assets, purchase these assets for their own accounts, and later sell them for a profit from their with permission from Elsevier Science. inventory. The spreads between dealers buy (or bid) prices and sell (or ask) prices are a source of profit. Dealer markets save traders on search costs because market participants can easily look up the prices at which they can buy from or sell to dealers. A fair amount of market activity is required before
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dealing in a market is an attractive source of income. The over-the-counter (OTC) securities market is Both views of IPO allocations probably contain some truth. IPO allocations to institutions do serve a valid one example of a dealer market. economic purpose as an information-gathering tool. Nevertheless, the system can beand has been abused. Part of the Wall Street scandals of 20002002 centered on the allocation of shares in IPOs. In a practice known as spinning, some investment bankers used IPO allocations to corporate insiders to curry dealer markets favors, in effect as implicit kickback schemes. These underwriters would award generous IPO allocations Markets in which traders specializing in particular assets buy banking business. to executives of particular firms in return for the firms future investment and sell for their own accounts. Pricing of IPOs is not trivial and not all IPOs turn out to be underpriced. Some do poorly after issue. The 2006 IPO of Vonage was a notable disappointment. The stock lost about 30% of its value in its first seven Auction markets days of trading. Other IPOs cannot even be fully sold to the market. Underwriters left with unmarketable securities are forced tomarket is an a loss onmarket, in which all traders converge investment banker bears The most integrated sell them at auction the secondary market. Therefore, the at one place (either the price riskor electronically) issue. or sell an asset. The New York Stock Exchange (NYSE) is an physically of an underwritten to buy example of despite their dramatic advantage of auction markets over dealer been poor long-term Interestingly, an auction market. Aninitial investment performance, IPOs have markets is that one need not search across dealers compares best price for good. If all of IPOs with shares of other firms of the investments. Figure 3.3 to find the the stock priceaperformanceparticipants converge, they can arrive at mutually agreeable prices and save the bidask spread. same size for each of the five years after issue of the IPO. The year-by-year underperformance of the IPOs is dramatic, suggesting that, on average, the investing public may be too optimistic about the prospects of these firms. Such long-lived systematic errors on the part of investors would be surprising. An interesting auction market study by Brav, Geczy, and Gompers (2000), however, suggests that apparent IPO underperformance may be illusory. When they carefully match meet at one place to and ratios of book values to market values, they A market where all traders firms based on size buy or sell an asset. find that IPO returns are actually similar to those of comparison firms. Continuous auction markets (as opposed to periodic auctions, such as in the art world) require very FIGURE 3.3: trading to cover the expense of maintaining the market. For this offerings, heavy and frequent Long-term relative performance of initial public reason, the NYSE and other exchanges set up listing requirements, which limit the stocks traded on the exchange to those 19702006 of firms in which sufficient trading interest is likely to exist. The organized stock exchanges are also secondary markets. They are organized for investors to trade existing securities among themselves.
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CONCEPT check 3.2

Many assets trade in more than one type of market. What types of markets do the following trade in? a. Used cars b. Paintings c. Rare coins
Source: Prof. Jay R. Ritter, University of Florida, August 2008. Reprinted by permission.
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Essentials of Investments, 8th Edition 3.2: How Securities are Traded Types of Orders
Financial comparing alternative tradingneeds of particular traders. Consider what would happen ifbegin with Before markets develop to meet the practices and competing security markets, it is helpful to organized markets did not exist.types household wishing tomight wish to have executed in these markets. Broadly an overview of the Any of trades an investor invest in some type of financial asset would have to find others wishing to sell.two types of orders: market orders and orders meet wouldon price. popular. Eventually, speaking, there are Soon, venues where interested traders could contingent become financial markets would emerge from these meeting places. Thus, a pub in old London called Lloyds Market orders launched the maritime insurance industry. A Manhattan curb on Wall Street became synonymous with the financial world. Market orders are buy or sell orders that are to be executed immediately at current market prices. For example, Markets Types ofour investor might call her broker and ask for the market price of IBM. The broker might report back that the best bid price is $90 and the best ask price is $90.05, meaning that the investor We can differentiate four types purchase a share, and could receivebrokered markets, dealer markets,some would need to pay $90.05 to of markets: direct search markets, $90 a share if she wished to sell and auction markets. of her own holdings of IBM. The bidask spread in this case is $.05. So an order to buy 100 shares at market would result in purchase at $90.05, and an order to sell at market would be executed at $90.
Direct search markets
A direct search market is the least organized market. Buyers and sellers must seek each other out bid price directly. An example of a transaction in such a market is the sale of a used refrigerator where the seller advertisesThe buyers on Craigslist. Suchother trader is willing to purchase a security. for price at which a dealer or markets are characterized by sporadic participation and low-priced and nonstandard goods. It would not pay for most people or firms to specialize in such markets.
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ask markets Brokered price

The price at which a dealer or other trader will sell a security. The next level of organization is a brokered market. In markets where trading in a good is active, brokers find it profitable to offer search services to buyers and sellers. A good example is the real estate market, where economies of scale in searches for available homes and for prospective buyers make it worthwhile bidask spread for participants to pay brokers to conduct the searches. Brokers in particular markets develop specialized knowledge on valuing assets traded in that market. The difference between a dealers bid and asked price. An important brokered investment market is the primary market, where new issues of securities are offered to the public. In the primary market, investment bankers who posted price quotes actually This simple scenario is subject to a few potential complications. First,market a firms securities to the public act as brokers; they seek up to a specified number of shares. If the market order is for more than represent commitments to trade investors to purchase securities directly from the issuing corporation. this number of shares, the order may be filled at multiple prices. For example, if the asked price is good Another brokered market is that for large block transactions, in which very large blocks of stock areto for orders up to 1,000 shares, and the investor wishes to purchase 1,500 shares, it may be necessary bought or sold. These blocks are so large (technically more than 10,000 sharesbeat our investor to the pay a slightly higher price for the last 500 shares. Second, another trader may but usually much larger) that brokers or block houseswould are engaged to search worse price.other large traders, rather than quote, meaning that her order often then be executed at a directly for Finally, the best price quote may bring the trade her orderto the markets where relatively smaller investors trade. the one at the moment change before directly arrives, again causing execution at a different price than of the order.
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Dealer markets Price-contingent orders type of asset increases, dealer markets arise. Dealers specialize in When trading activity in a particular
various assets, may placethese assets for their ownat which they are willing to buy or profit security. A Investors also purchase orders specifying prices accounts, and later sell them for a sell a from their inventory. order may instruct the broker to buy some number of shares(or and when IBM maysource of limit buy The spreads between dealers buy (or bid) prices and sell if ask) prices are a be profit. Dealer markets save traders on search costs because market participants can easily look up the obtained at or below a stipulated price. Conversely, a limit sell instructs the broker to sell if and when prices at which they can buy from or sell to dealers. A fair amount of market activity is required before
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dealing in a market above a specified limit. income. The over-the-counter (OTC) be executed is called the stock price rises is an attractive source ofA collection of limit orders waiting to securities market is one example of a dealer market. a limit order book.
dealer markets limit buy (sell) order

Markets specifying a price at which in particular willing to and sell for security. An orderin which traders specializingan investor is assets buy buy or sell atheir own accounts. Figure 3.4 is a portion of the limit order book for shares in Intel taken from the Archipelago exchange (one of several electronic exchanges; more on these shortly) on one day in 2008. Notice that the best Auction markets orders are at the top of the list: the offers to buy at the highest price and to sell at the lowest price. The The most integrated market is an auction market, in which all traders converge at one place (either buy and sell orders at the top of the list$15.95 and $15.96are called the inside quotes; they are the physically or electronically) to buy or sell the inside spread York 1 cent. Note, however, that order highest buy and lowest sell orders. For Intel, an asset. The Newis onlyStock Exchange (NYSE) is an example of an auction market. An fairly small. auction markets over dealer markets is trades face an sizes at the inside quotes are often advantage ofTherefore, investors interested in larger that one need not search across dealers to find best price for a good. If all participants converge, trades at the inside effective spread greater than the nominal one since they cannot execute their entire they can arrive at mutually agreeable prices and save the bidask spread. price quotes.
FIGURE 3.4: The limit order book for Intel on the Archipelago market, auction market October 8, 2008
A market where all traders meet at one place to buy or sell an asset. Continuous auction markets (as opposed to periodic auctions, such as in the art world) require very heavy and frequent trading to cover the expense of maintaining the market. For this reason, the NYSE and other exchanges set up listing requirements, which limit the stocks traded on the exchange to those of firms in which sufficient trading interest is likely to exist. The organized stock exchanges are also secondary markets. They are organized for investors to trade existing securities among themselves.
CONCEPT check 3.2

Many assets trade in more than one type of market. What types of markets do the following trade in? a. Used cars Source: New York Stock Exchange, www.nyse.com b. Paintings c. Rare coins Until 2001, when U.S. markets adopted decimal pricing, the minimum possible spread was one tick, which on the New York Stock Exchange was $ 1 8 until 1997 and $ 1 16 thereafter. With decimal pricing, the spread can be far lower. The average quoted bidask spread on the NYSE is less than 5 cents. Stop orders are similar to limit orders in that the trade is not to be executed unless the stock hits a price limit. For stop-loss orders, the stock is to be sold if its price falls below a stipulated level. As the name
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suggests, the order lets the stock be sold to stop further losses from accumulating. Similarly, stop-buy Types specify that a stock should be bought when its price rises above a limit. These trades often orders of Orders accompany short sales (sales of securities you dont own but have borrowed from your broker) and are Before comparing alternative trading practices and competing security markets, it is helpful to begin with used to limit potential losses from the short position. Short sales are discussed in greater detail later in an overview of the types of trades an investor might wish to have executed in these markets. Broadly this chapter. Figure 3.5 organizes these types of trades in a convenient matrix. speaking, there are two types of orders: market orders and orders contingent on price.
FIGURE 3.5: Market orders Price-contingent orders

Market orders are buy or sell orders that are to be executed immediately at current market prices. For example, our investor might call her broker and ask for the market price of IBM. The broker might report back that the best bid price is $90 and the best ask price is $90.05, meaning that the investor would need to pay $90.05 to purchase a share, and could receive $90 a share if she wished to sell some of her own holdings of IBM. The bidask spread in this case is $.05. So an order to buy 100 shares at market would result in purchase at $90.05, and an order to sell at market would be executed at $90.
bid price
The price at which a dealer or other trader is willing to purchase a security.
ask price
The price at which a dealer or other trader will sell a security.
bidask spread stop order

The difference between a dealers bid and asked price. Trade is not to be executed unless stock hits a price limit. This simple scenario is subject to a few potential complications. First, posted price quotes actually represent commitments to 3.3 up to a specified number of shares. If the market order is for more than CONCEPT check trade this number of shares, the order may be filled at multiple prices. For example, if the asked price is good for orders up to 1,000 shares, and the investor wishes to purchase 1,500 shares, it may be necessary to What type of trading order might you give to your broker in each of the following pay a slightly higher price for the last 500 shares. Second, another trader may beat our investor to the circumstances? quote, meaning that her order would then be executed at a worse price. Finally, the best price quote may change before her order arrives, again causing Intel to diversify your portfolio. You believethe moment a. You want to buy shares of execution at a different price than the one at the share of the order. price is approximately at the fair value, and you want the trade done quickly and cheaply.
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Price-contingent orders
b. You want to buy shares of Intel, but believe that the current stock price is too high Investors also may place orders specifying prices thewhich they are willing to buy or sell5% lower than given the firms prospects. If at shares could be obtained at a price a security. A limit buy order may instruct the broker to buy some to purchaseshares if and when IBM may be the current value, you would like number of shares for your portfolio. obtained at or below a stipulated price. Conversely, a limit sell instructs the broker to sell if and when
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the stock price rises above a specified limit. A collection of limit orders waiting to be executed is called c. a limit order book. You plan to purchase a condominium sometime in the next month or so and will sell your shares of Intel to provide the funds for your down payment. While you believe that Intel share price is going to rise over the next few weeks, if you are wrong and the share limit buy (sell) order price drops suddenly, you will not be able to afford the purchase. Therefore, you want to hold on to the shares for as long as possible, but An order specifying a yourself which an investor is big loss.to buy or sell a security. still protect price at against the risk of a willing Figure 3 is a portion of the Trading.4Mechanisms limit order book for shares in Intel taken from the Archipelago exchange (one of several electronic exchanges; more on these shortly) on one day in 2008. Notice that the best Broadly speaking, there are three the offers to buyemployed in the United States: at the lowest price. The orders are at the top of the list: trading systems at the highest price and to sell over-the-counter dealer markets, electronic communication networks, and formal exchanges.calledbest-knownquotes; they are the buy and sell orders at the top of the list$15.95 and $15.96are The the inside markets such as NASDAQbuy the New York Stock Exchange actually use spread is only 1 cent. Note, however, that delving highest or and lowest sell orders. For Intel, the inside a variety of trading procedures, so before order into these the insideit is useful to understand the basic operation of each type of trading system. face an sizes at markets, quotes are often fairly small. Therefore, investors interested in larger trades effective spread greater than the nominal one since they cannot execute their entire trades at the inside Dealer markets price quotes. Roughly 35,000 securities trade on the over-the-counter or OTC market. Thousands of brokers FIGURE 3.4: as security order book for prices at which Archipelago market, register with the SECThe limit dealers. Dealers quoteIntel on the they are willing to buy or sell securities. A broker then executes8, trade by contacting a dealer listing an attractive quote. October a 2008
over-the-counter (OTC) market

An informal network of brokers and dealers who negotiate sales of securities. Before 1971, all OTC quotations were recorded manually and published daily on so-called pink sheets. In 1971, the National Association of Securities Dealers Automatic Quotations System, or NASDAQ, was developed to link brokers and dealers in a computer network where price quotes could be displayed and revised. Dealers could use the network to display the bid price at which they were willing to purchase a security and the ask price at which they were willing to sell. The difference in these prices, the bidask spread, was the source of the dealers profit. Brokers representing clients could examine quotes over the computer network, contact the dealer with the best quote, and execute a trade. As originally organized, NASDAQ was more of a price quotation system than a trading system. While brokers could survey bid and ask prices across the network of dealers in the search for the best trading opportunity, actual trades required direct negotiationnyse.com the phone) between the investors Source: New York Stock Exchange, www. (often over broker and the dealer in the security. However, as we will see shortly, NASDAQ has progressed far beyond a pure price quotation system. While dealers still post bid and ask prices over the network, NASDAQ now allows for electronic execution of trades at quoted prices without the need for direct Until 2001, when U.S. markets adopted decimal pricing, the minimum possible spread was one tick, negotiation, and the vast Stock Exchange was $executed 1997 and $ 1 16 thereafter. With decimal pricing, which on the New York majority of trades are 1 8 until electronically. the spread can be far lower. The average quoted bidask spread on the NYSE is less than 5 cents.
Electronic communication networks (ECNs)
Stop orders are similar to limit orders in that the trade is not to be executed unless the stock hits a price Electronic communication networks allowsold if its price post marketaand limit orders overthe name limit. For stop-loss orders, the stock is to be participants to falls below stipulated level. As computer networks. The limit order book is available to all participants. An example of such an order book from
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suggests, the one of the leading be sold to stop in Figure 3.4. Orders that can be Similarly, that is, Archipelago, order lets the stockECNs, appearedfurther losses from accumulating. crossed, stop-buy orders specify that a stock should done so automatically without requiring the intervention of a broker. matched against another order, arebe bought when its price rises above a limit. These trades often accompany short sales (sales a securities you of $50 or but have borrowed from your broker) and are For example, an order to buy ofshare at a price dont own lower will be immediately executed if there is used to limit potential losses $50. Therefore, ECNs Short sales are systems, in merely price later in an outstanding asked price offrom the short position. are true trading discussednot greater detail quotation this chapter. Figure 3.5 organizes these types of trades in a convenient matrix. systems.
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FIGURE 3.5: Price-contingent orders ECNs

Computer networks that allow direct trading without the need for market makers. ECNs offer several attractions. Direct crossing of trades without using a broker-dealer system eliminates the bidask spread that otherwise would be incurred. Instead, trades are automatically crossed at a modest cost, typically less than a penny per share. ECNs are attractive as well because of the speed with which a trade can be executed. Finally, these systems offer investors considerable anonymity in their trades.
Specialist markets
In formal exchanges such as the New York Stock Exchange, trading in each security is managed by a specialist assigned responsibility for that security. Brokers who wish to buy or sell shares on behalf of their clients must direct the trade to the specialists post on the floor of the exchange.
specialist
A trader who makes a market in the shares of one or more firms and who maintains a fair and orderly market by dealing personally in the market.
stop order
Each security is assigned to one specialist, but each specialist firmcurrently there are fewer than 10 on Trade is not to be executed unless stock hits a price limit. the NYSEmakes a market in many securities. This task may require the specialist to act as either a broker or a dealer. The specialists role as a broker is simply to execute the orders of other brokers. Specialists also may buy or sell shares of stock for their own portfolios, in this role acting as a dealer in CONCEPT check 3.3 the stock. When no other trader can be found to take the other side of a trade, specialists will do so even if it means they must buy for or sell from their own accounts. Specialist firms earn income both from What type of trading order might you give to your broker in each of the following commissions for managing orders (as implicit brokers) and from the spreads at which they buy and sell circumstances? securities (as implicit dealers). a. You want to buy shares of Intel to diversify your portfolio. You believe the share Part of the specialists job as a broker is simply clerical. The specialist maintains a limit order book of all price is approximately at the fair value, and you want the trade done quickly and outstanding unexecuted limit orders entered by brokers on behalf of clients. When limit orders can be cheaply. executed at market prices, the specialist executes, or crosses, the trade. b. You want to buy shares of Intel, but believe that the current stock price is too high The specialist is required to use the highest outstanding offered purchase price and the lowest given the firms prospects. If the shares could be obtained at a price 5% lower than outstanding offered selling price when matching trades. Therefore, the specialist system results in an the current value, you would like to purchase shares for your portfolio.
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auction market, meaning all buy and all sell orders come to one location, and the best orders win the c. You plan to acts merely as a facilitator. trades. In this role, the specialistpurchase a condominium sometime in the next month or so and will sell your shares of Intel to provide the funds for your down payment. While you The more interesting function of the specialist is is going to rise over theorderly market by acting as a believe that Intel share price to maintain a fair and next few weeks, if you are dealer in the stock. In return for the exclusive right to make the market in a be able to afford the wrong and the share price drops suddenly, you will not specific stock on the exchange, the specialist is required by the exchange to maintain an orderly for as long buying and selling purchase. Therefore, you want to hold on to the shares market by as possible, but shares from inventory. Specialists maintain theirthe risk of a big of stock and quoted bid and ask prices at still protect yourself against own portfolios loss. which they are obligated to meet at least a limited amount of market orders.
Trading Mechanisms
Ordinarily, in an active market, specialists can match buy and sell orders without using their own accounts. That is, the are three trading systems of securities need not be the primary means of dealer Broadly speaking, there specialists own inventoryemployed in the United States: over-the-counterorder execution. Sometimes, however, networks, and bid and ask prices The best-known markets such as markets, electronic communication the specialists formal exchanges. are better than those offered by any other market participant. Therefore, at any actually use a variety of trading procedures, the lower of NASDAQ or the New York Stock Exchange point, the effective ask price in the market isso before delving either the specialists ask price or the lowest of the operation of each type of trading system. into these markets, it is useful to understand the basicunfilled limit-sell orders. Similarly, the effective bid price is the highest of the unfilled limit buy orders or the specialists bid. These procedures ensure that the specialist provides Dealer markets liquidity to the market. In practice, specialists participate in approximately one-quarter of the transactions on the NYSE. Roughly 35,000 securities trade on the over-the-counter or OTC market. Thousands of brokers Specialists strive SEC as security dealers. Dealers quote prices at which they are willing to buy or sell register with the to maintain a narrow bidask spread for at least two reasons. First, one source of the specialistsA brokeris frequent trading at the bid and askaprices, with the spread as a quote. profit. A securities. income then executes a trade by contacting dealer listing an attractive trading too-large spread would make the specialists quotes uncompetitive with the limit orders placed by other traders. If the specialists bid and asked quotes are consistently worse than those of public traders, the specialist will not participate in any trades and will lose the ability to profit from the bidask spread. over-the-counter (OTC) market An equally important reason forof brokers and dealers whois that theysalesobligated to provide price An informal network narrow specialist spreads negotiate are of securities. continuity to the market. To illustrate price continuity, suppose the highest limit buy order for a stock is $30, while the lowest limit sell order isrecorded manually and published daily in, it is matched tosheets. Before 1971, all OTC quotations were $32. When a market buy order comes on so-called pink the best limit sell the$32. A market sell order would be matched Automatic limit buy atSystem, or NASDAQ,and In 1971, at National Association of Securities Dealers to the best Quotations $30. As market buys sells developed tofloor brokers andthe stockin a computerfluctuate between $30 quotes could be displayed was come to the link randomly, dealers price would network where price and $32. The exchange authorities would consider this the network to display the bid price at would they were willing toin with and revised. Dealers could use excessive volatility, and the specialist which be expected to step bid and/or ask prices between these values to reduce the bidask to sell. The difference inlevel, typically purchase a security and the ask price at which they were willing spread to an acceptable these prices, below $.05 for large firms. When aof theis newly listed on an exchange, specialist firms vigorously the bidask spread, was the source firm dealers profit. Brokers representing clients could examine compete to be awarded the rights tocontact the dealer with the best quote,Sinceexecute a trade.evaluated quotes over the computer network, maintain the market in those shares. and specialists are in part on their past performance in maintaining price continuity, they have considerable incentive to As originally organized, NASDAQ was more of a price quotation system than a trading system. While maintain tight spreads. brokers could survey bid and ask prices across the network of dealers in the search for the best trading opportunity, actual trades required direct negotiation (often over the phone) between the investors 3.3: U.S. Securities Markets broker and the dealer in the security. However, as we will see shortly, NASDAQ has progressed far We have briefly sketched the threesystem.trading dealers still post bid and United States: over-the-counter beyond a pure price quotation major While mechanisms used in the ask prices over the network, dealer markets,now allows for electronic execution of trades at quoted prices without the need investors over NASDAQ exchange trading managed by specialists, and direct trading among brokers or for direct electronic networks. Thevast majority of trades are executed the most important dealer market in the United negotiation, and the NASDAQ market historically was electronically. States, and the New York Stock Exchange the most important formal equity exchange. As we will see, however, these markets have evolved in response to new (ECNs) technology and both have dramatically Electronic communication networks information increased their commitment to automated electronic trading. Electronic communication networks allow participants to post market and limit orders over computer networks. The limit order book is available to all participants. An example of such an order book from
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Archipelago, one of the leading ECNs, appeared in Figure 3.4. Orders that can be crossed, that is, NASDAQ matched against another order, are done so automatically without requiring the intervention of a broker. For example, an order to buy a share at a price of $50 or lower will be immediately executed if there is While any security can be traded in the over-the-counter network of security brokers and dealers, not all an outstanding asked price of $50. Therefore, ECNs are true trading systems, not merely price quotation securities were included in the original National Association of Security Dealers Automated Quotations systems. System. That system, now called the NASDAQ Stock Market, lists about 3,200 firms and offers three listing options. The NASDAQ Global Select Market is for the largest, most actively traded firms, the NASDAQ Global Market is for the next tier of firms, and the NASDAQ Capital Market is the third tier of ECNs listed firms. Some of the requirements for initial listing are presented in Table 3.1. For even smaller firms that may not be eligible for listing orallowwish totradingdisclosure requirements associated with listing on Computer networks that that direct avoid without the need for market makers. regulated markets, Pink Sheets LLC offers real-time stock quotes on www.pinksheets.com, as well as Pink Link, an several attractions. Direct trade negotiation service. using a broker-dealer system eliminates ECNs offer electronic messaging and crossing of trades without the bidask spread that otherwise would be incurred. Instead, trades are automatically crossed at a TABLE 3.1: Partial than a penny per share. ECNs are attractive as well because of the speed with modest cost, typically less requirements for initial listing on NASDAQ markets which a trade can be executed. Finally, these systems offer investors considerable anonymity in their trades.
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Specialist markets
In formal exchanges such as the New York Stock Exchange, trading in each security is managed by a specialist assigned responsibility for that security. Brokers who wish to buy or sell shares on behalf of their clients must direct the trade to the specialists post on the floor of the exchange.
specialist
A trader who makes a market in the shares of one or more firms and who maintains a fair and orderly market by dealing personally in the market. Each security is assigned to one specialist, but each specialist firmcurrently there are fewer than 10 on the NYSEmakes a market in many securities. This task may require the specialist to act as either a broker or a dealer. The specialists role as a broker is simply to execute the orders of other brokers. Specialists also may buy or sell shares of stock for their own portfolios, in this role acting as a dealer in the stock. When no other trader can be found to take the other side of a trade, specialists will do so even NASDAQ Stock or sell from if it means they must buy forMarket their own accounts. Specialist firms earn income both from commissions for managing orders (as implicit brokers) and from the spreads at which they buy and sell The computer-linked priced quotation system for the OTC market. securities (as implicit dealers). Part of the specialists job as a broker is simply clerical. The specialist maintains limit order trading Because the NASDAQ system does not use a specialist, OTC trades do not require a centralized book of all outstanding unexecuted limit orders entered be located anywhere they can When limit orders can be floor as do exchange-listed stocks. Dealers canby brokers on behalf of clients.communicate effectively with executed at market prices, the specialist executes, or crosses, the trade. other buyers and sellers. The specialist is required to use the highest highest, level 3 subscribers, price and the lowest NASDAQ has three levels of subscribers. Theoutstanding offered purchase are for firms dealing, or outstanding offered selling price when matching trades. Therefore, inventories of a security and making markets, in OTC securities. These market makers maintain the specialist system results in an constantly stand ready to buy or sell these shares from or to the public at the quoted bid and ask prices.
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They earnmarket, from the spread betweensell orders come prices. Level 3 subscribers may enter the bid auction profits meaning all buy and all the bid and ask to one location, and the best orders win the and ask prices atrole, the specialist acts merely as a facilitator. the computer network and may update trades. In this which they are willing to buy or sell stocks into these quotes as desired. The more interesting function of the specialist is to maintain a fair and orderly market by acting as a Level 2 subscribers receive all for the exclusive right to make the markettheir own quotes. These dealer in the stock. In return bid and ask quotes, but they cannot enter in a specific stock on the subscribers tend specialist is required by the exchange to maintain anbut do not actively buying the stocks exchange, the to be brokerage firms that execute trades for clients orderly market by deal in and selling onsharesown account. Brokers buying or selling shares trade with the stock and quoted level 3 subscriber) at their from inventory. Specialists maintain their own portfolios of market maker (a bid and ask prices displaying theare obligated to meet at least a limited amount of market orders. which they best price quote. Level 1 subscribersactive market, specialists can match the highest bid and lowest ask prices onown Ordinarily, in an receive only the inside quotes (i.e., buy and sell orders without using their each stock). Level 1 subscribers tend to be investors who are not actively buying the primary securities order accounts. That is, the specialists own inventory of securities need not be and selling means of but want information on current prices. execution. Sometimes, however, the specialists bid and ask prices are better than those offered by any other market participant. Therefore, at any point, the effective ask price in the market is the lower of As noted, NASDAQ was originally more a price quotation system than orders. Similarly, But effective bid either the specialists ask price or the lowest of the unfilled limit-sell a trading system. the that has changed. Investors today (through their brokers) typically access bids and offers electronically without price is the highest of the unfilled limit buy orders or the specialists bid. These procedures ensure that human interaction. NASDAQ has to the market. In practice, specialists participate in approximately the specialist provides liquidity steadily introduced ever-more sophisticated electronic trading platforms, which today handle the great majority of its trades. The latest version, called the NASDAQ Market Center, one-quarter of the transactions on the NYSE. was introduced in 2004 and consolidates all of NASDAQs previous electronic markets into one integrated system. Specialists strive to maintain a narrow bidask spread for at least two reasons. First, one source of the specialists income is frequent trading at the bid and ask prices, with the spread as a trading profit. A Market Center is NASDAQs competitive response to uncompetitive with the limit orders placed by other too-large spread would make the specialists quotes the growing popularity of ECNs, which have captured aIf the specialists bid flow.asked quotes are consistently worse than Market Center allows the traders. large share of order and By enabling automatic trade execution, those of public traders, NASDAQ to function much like an ECN. In and will lose the ability to profit from the bidask spread. specialist will not participate in any trades addition, NASDAQ purchased Instinet, which operates the major electronic communications network INET in order to capture a greater share of the electronic trading market. Nevertheless, larger ordersspecialist spreads is that among brokers andto provide price An equally important reason for narrow may still be negotiated they are obligated dealers, so NASDAQ retains some features of a pure dealer market. suppose the highest limit buy order for a stock is continuity to the market. To illustrate price continuity, $30, while the lowest limit sell order is $32. When a market buy order comes in, it is matched to the best The New York Stocksell order would be matched to the best limit buy at $30. As market buys and limit sell at $32. A market Exchange sells come to the floor randomly, the stock price would fluctuate between $30 and $32. The exchange The New York Stock Exchange is by far the largest stock exchange in the United States. Shares of about authorities would consider this excessive volatility, and the specialist would be expected to step in with 2,800 firms trade there, with a combined market capitalization in early 2008 of around $14 trillion. Daily bid and/or ask prices between these values to reduce the bidask spread to an acceptable level, typically trading on the NYSE regularly exceeded 3 billion shares in 2008, with a dollar value of approximately below $.05 for large firms. When a firm is newly listed on an exchange, specialist firms vigorously $150 billion. compete to be awarded the rights to maintain the market in those shares. Since specialists are evaluated in part on their past performance in maintaining price continuity, they have considerable incentive to maintain tight spreads.
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stock exchanges
3.3: U.S.Secondary markets where already-issued securities are bought and sold by members. Securities Markets
We have briefly sketched the three major trading mechanisms used in the United States: over-the-counter An markets, exchange to trade shares on the NYSE places an order with a brokerage firm, which either dealerinvestor who wishestrading managed by specialists, and direct trading among brokers or investors over sends the order to The NASDAQ market historically was the most important its broker on in floor of the electronic networks. the floor of the exchange via computer network or contacts dealer marketthe the United exchange to New York order. Smaller orders are important formal equity exchange. As we will States, and the work the Stock Exchange the most almost always sent electronically for automaticsee, execution, while larger orders that in response to new information technology and both have dramatically however, these markets have evolvedmay require negotiation or judgment are more prone to be sent to a floor broker. A floor broker automated order takes the order increased their commitment to sent a trade electronic trading. to the specialists post. At the post is a monitor called the Display Book that presents current offers from interested traders to buy or sell given numbers of shares at various prices. The specialist can cross the trade with that of another broker if that is
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feasible, or match the trade using its own inventory of shares. Brokers might also seek out traders willing NASDAQ side of a trade at a price better than those currently appearing in the Display Book. If they to take the other can do so, they will bring the agreed-upon trade to the specialist for final execution. While any security can be traded in the over-the-counter network of security brokers and dealers, not all securities were included in right to trade on the floor of the NYSE. Originally, the NYSE was organized as Brokers must purchase the the original National Association of Security Dealers Automated Quotations System. That system, now calledby its members Stock Market, lists about 3,200in 2005 there were 1,366 a not-for-profit company owned the NASDAQ or seat holders. For example, firms and offers three listing options. The NASDAQ Global Select Market is its owner to place a broker ontraded firms, the seat-holding members of the NYSE. Each seat entitled for the largest, most actively the floor of the NASDAQ where he or sheis for the next tier of firms, and firms could charge investors for executingtier of exchange, Global Market could execute trades. Member the NASDAQ Capital Market is the third trades listed firms. Some of the requirements for initial listing are presented in Table 3.1. For even smaller firms on their behalf, which made a seat a valuable asset. The commissions that members might earn by trading that may of be eligible for listing market value avoid which were bought and sold like with listing on on behalfnot clients determined theor that wish toof seat,disclosure requirements associatedany other asset. regulated markets, Pink Sheets LLC offers as low as $4,000 (in 1878) to as high as $4 million well as Seat prices fluctuated widely, ranging fromreal-time stock quotes on www.pinksheets.com, as (in 2005). Pink Link, an electronic messaging and trade negotiation service. More recently, most exchanges have switched from a mutual form of organization, in which seat-holders are joint owners, to publicly traded corporations ownedinitial listingIn 2006, the NYSE markets TABLE 3.1: Partial requirements for by shareholders. on NASDAQ merged with the Archipelago Exchange to form a publicly held company called the NYSE Group. (In 2007, the NYSE Group merged with Euronext to form NYSE-Euronext.) As a publicly traded corporation, its share price rather than the price of a seat on the exchange has become the best indicator of its financial health. Each seat on the exchange has been replaced by an annual license permitting traders to conduct business on the exchange floor. The move toward public listing of exchanges is widespread. Other exchanges that have recently gone public include the Chicago Mercantile Exchange (derivatives trading, 2002), the International Securities Exchange (options, 2005), and the Chicago Board of Trade (derivatives, 2005), which has since merged with the CME. The Chicago Board Options Exchange reportedly also is considering going public. Table 3.2 gives some of the initial listing requirements for the NYSE. These requirements ensure that a firm is of significant trading interest before the NYSE will allocate facilities for it to be traded on the floor of the exchange. If a listed company suffers a decline and fails to meet the criteria in Table 3.2, it may be delisted.
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TABLE 3.2: Some initial listing requirements for the NYSE
NASDAQ Stock Market

The computer-linked priced quotation system for the OTC market. Because the NASDAQ system does not use a specialist, OTC trades do not require a centralized trading floor as do exchange-listed stocks. Dealers can be located anywhere they can communicate effectively with other buyers and sellers. NASDAQ has three levels of subscribers. The highest, level 3 subscribers, are for firms dealing, or making markets, in OTC securities. These market makers maintain inventories of a security and constantly stand ready to buy or sell these shares from or to the public at the quoted bid and ask prices.
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They earn profits from the spread between the bid and ask prices. Level 3 subscribers may enter the bid Regional exchanges also sponsorwilling to buy or firms that are traded on national exchanges. This dual and ask prices at which they are trading of some sell stocks into the computer network and may update listingquotes aslocal brokerage firms to trade in shares of large firms without purchasing a membership on these enables desired. the NYSE. Level 2 subscribers receive all bid and ask quotes, but they cannot enter their own quotes. These About 75% tend toshare volume transacted execute trades for clients but do not actively deal thethe stocks subscribers of the be brokerage firms that in NYSE-listed securities actually is executed on in NYSE. The NYSEs account. Brokers buying ortrades rather than share volume is considerably lower,subscriber) on their own market share measured by selling shares trade with the market maker (a level 3 as smaller retail orders are far price quote. to be executed off the exchange. Nevertheless, the NYSE remains the displaying the best more likely venue of choice for large trades. Level 1 subscribers receive only the inside quotes (i.e., the highest bid and lowest ask prices on each Block sales stock). Level 1 subscribers tend to be investors who are not actively buying and selling securities but want information on current prices. Institutional investors frequently trade tens of thousands of shares of stock. Larger block transactions (technically transactions exceeding 10,000 shares, but often much larger) are often too But that As noted, NASDAQ was originally more a price quotation system than a trading system. large for has specialists to handle, as they do their brokers) typically access bids of offers electronically without changed. Investors today (throughnot wish to hold such large amountsandstock in their inventory. human interaction. NASDAQ has steadily introduced ever-more sophisticated electronic trading platforms, which today handle the great majority of its trades. The latest version, called the NASDAQ Market Center, block transactions was introduced in 2004 and consolidates all of NASDAQs previous electronic markets into one integrated system. Large transactions in which at least 10,000 shares of stock are bought or sold. Market Center is NASDAQs competitive response to the growing popularity of ECNs, which have Block houses have evolved to aid in the placement of larger execution, Market houses are brokerage captured a large share of order flow. By enabling automatic tradeblock trades. Block Center allows firms that specialize in matching ECN. In addition, NASDAQ a buyer and a seller have been matched, NASDAQ to function much like anblock buyers and sellers. Oncepurchased Instinet, which operates the the electronic communications network INET in order execute the trade. If a buyer cannot be found, the majorblock is sent to the exchange floor where specialists to capture a greater share of the electronic block house might purchase all or part of a block be for its own account. The and house so trading market. Nevertheless, larger orders may stillsale negotiated among brokersblockdealers,then can resell the shares to the public. NASDAQ retains some features of a pure dealer market. You can observe in Table 3 Exchange The New York Stock .3 that the share of block trading peaked in the mid-1990s, but has since declined sharply. This reflects changing trading practices since the advent of electronic markets. Large The New York Stock Exchange is by far splitlargest stock exchange trades United States.electronically. trades are now much more likely to be the up into multiple small in the and executed Shares of about 2,800 firmsof depth on the electronic exchanges reinforces this in early 2008 of around $14quote on Daily The lack trade there, with a combined market capitalization pattern: Because the inside trillion. these trading on the NYSEonly for small trades, it generally is preferable to buy or sell a largeapproximately in a exchanges is valid regularly exceeded 3 billion shares in 2008, with a dollar value of stock position $150 billion. series of smaller transactions.
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TABLE 3.3: Block transactions on the New York Stock Exchange stock exchanges
Secondary markets where already-issued securities are bought and sold by members. An investor who wishes to trade shares on the NYSE places an order with a brokerage firm, which either sends the order to the floor of the exchange via computer network or contacts its broker on the floor of the exchange to work the order. Smaller orders are almost always sent electronically for automatic execution, while larger orders that may require negotiation or judgment are more prone to be sent to a floor broker. A floor broker sent a trade order takes the order to the specialists post. At the post is a monitor called the Display Book that presents current offers from interested traders to buy or sell given numbers of shares at various prices. The specialist can cross the trade with that of another broker if that is
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feasible, or match the trade using its own inventory of shares. Brokers might also seek out traders willing to Electronic side of a trade at the NYSE than those currently appearing in the Display Book. If they take the other trading on a price better can do so, they will bring the agreed-upon trade to the specialist for final execution. The NYSE has recently stepped up its commitment to electronic trading. Its SuperDot is an electronic order-routing system that enables brokerage floor of the market and limit orders directly to the Brokers must purchase the right to trade on thefirms to sendNYSE. Originally, the NYSE was organized as specialist over computer lines. SuperDot is especially holders. For example, in 2005 there trade is a a not-for-profit company owned by its members or seatuseful to program traders. A programwere 1,366 coordinated purchase or sale of an Each portfolio of stocks. seat-holding members of the NYSE. entireseat entitled its owner to place a broker on the floor of the exchange, where he or she could execute trades. Member firms could charge investors for executing trades on their behalf, which made a seat a valuable asset. The commissions that members might earn by trading on behalf program trade the market value of seat, which were bought and sold like any other asset. of clients determined Seat prices fluctuated widely, ranging from as low as $4,000 (in 1878) to as high as $4 million (in 2005). Coordinated sale or purchase of a portfolio of stocks. More recently, most exchanges have switched from a mutual form of organization, in which seat-holders While owners, to publicly traded orders to the specialists post electronically, the NYSE also has are joint SuperDot simply transmits corporations owned by shareholders. In 2006, the NYSE merged with instituted a fully automated trade-execution system called called the or Direct+. It (In 2007, the NYSE the Archipelago Exchange to form a publicly held company DirectPlusNYSE Group. matches orders against the inside Euronext price with execution times of small fraction corporation, its share price Group merged with bid or ask to form NYSE-Euronext.) As a publicly tradedof a second. Direct+ has captured the price of a share the exchange has become the the indicator of its financial health. Each rather than an ever-largerseat onof trades on the NYSE. Today,best vast majority of all orders are submitted electronically, but has been to be smaller annual license permitting traders to conduct business on seat on the exchange these tendreplaced by anorders. Larger orders are still more likely to go through a the specialist. exchange floor. The move toward public listing of exchanges is widespread. Other exchanges that have recently gone Settlement public include the Chicago Mercantile Exchange (derivatives trading, 2002), the International Securities Orders (options, 2005), and the must be settled within three working days. which has since is often Exchangeexecuted on the exchangeChicago Board of Trade (derivatives, 2005),This requirement merged called CME. The Chicago plus three days. The purchaser must deliver the cash, and the public. with the T + 3, for trade date Board Options Exchange reportedly also is considering going seller must deliver the stock to the broker, who in turn delivers it to the buyers broker. Frequently, a firms clients Table 3their securitiesof the initial listing requirements for the NYSE. These requirementsin the firmsa keep .2 gives some in street name, which means the broker holds the shares registered ensure that own firm is of significant the client. This conventionNYSE willsecurity transfer. T + 3 settlement has made name on behalf of trading interest before the can speed allocate facilities for it to be traded on the floor ofsuchexchange. If a listed important: It can a declinedifficult for a seller ofcriteria in Table 3.2, it may be the arrangements more company suffers be quite and fails to meet the a security to complete delivery delisted.purchaser within the three-day period if the stock is kept in a safe deposit box. to the Settlement is simplified further by listing requirements for the NYSE exchange members TABLE 3.2: Some initial the existence of a clearinghouse. The trades of all are recorded each day, with members transactions netted out, so that each member need transfer or receive only the net number of shares sold or bought that day. A brokerage firm then settles with the clearinghouse instead of individually with every firm with which it made trades.
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Electronic Communication Networks

ECNs are private computer networks that directly link buyers with sellers. As an order is received, the system determines whether there is a matching order, and if so, the trade is executed immediately. Brokers that have an affiliation with an ECN have computer access and can enter orders in the limit order book. Moreover, these brokers may make their terminals (or Internet access) available directly to individual traders who then can enter their own orders into the system. The two biggest ECNs by far are INET, formed by a merger of Island and Instinet, and Archipelago. As noted, the NYSE and Archipelago merged in 2006. In principle, the merged firm can fill simple orders quickly without human interaction through ArcaEx (the Archipelago Exchange), and large complex orders
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using human traders on the floor of the NYSE. At the same time, NASDAQ purchased the other leading Regional exchanges also sponsor trading of the securities markets appear to be consolidating and it dual ECN, Instinet, which operates INET. Thus, some firms that are traded on national exchanges. This seems listing enables local brokeragefor a time, offer multipleof large firms without purchasingtoward electronic that each market will, at least firms to trade in shares trading platforms. But the trend a membership on the NYSE. trading continues unabated. About 75% of the share volume transacted in NYSE-listed securities actually is executed on the NYSE. The National Market System The NYSEs market share measured by trades rather than share volume is considerably lower, as smaller retail orders are far Amendments of 1975 directed the Securities and Exchange the NYSE remains the The Securities Act more likely to be executed off the exchange. Nevertheless, Commission to implement a venue ofcompetitivelarge trades. national choice for securities market. Such a market would entail centralized reporting of transactions and a centralized quotation system, with the aim of enhanced competition among market makers.
Block sales
In 1975, Consolidated Tape began reporting trades on the NYSE, Amex, and major regional exchanges, as Institutional investors frequently trade In 1977, the Consolidated of stock. Larger block transactions well as trades of NASDAQ-listed stocks.tens of thousands of shares Quotations Service began providing (technically ask quotes exceeding 10,000 shares, but often much other are often too 1978, the online bid and transactionsfor NYSE securities also traded on variouslarger)exchanges. In large for specialists to handle, as they do was implemented. ITS currently links stock in their inventory. Intermarket Trading System (ITS)not wish to hold such large amounts of nine exchanges by computer: NYSE, Amex, Boston, National (formerly Cincinnati), Pacific, Philadelphia, Chicago, NASDAQ, and the Chicago Board Options Exchange. The system allows brokers and market makers to display and view block transactions quotes for all markets and to execute cross-market trades when the Consolidated Quotation System shows better pricesLarge transactions However,at least 10,000 shares of stock are boughtOrders need to be in other markets. in which the ITS has been only a limited success. or sold. directed to alternative markets by participants who might find it inconvenient or unprofitable to do so. Block the growth of automated electronic trading has larger block integration more feasible. The SEC However,houses have evolved to aid in the placement of made market trades. Block houses are brokerage firms that specialize in matching 2005. Its Regulation NMS requires that investors have been matched, reaffirmed its trade-through rule inblock buyers and sellers. Once a buyer and a seller orders be filled at the block is sent to be executed floor where specialists execute the trade. If a a different market. the best price that canthe exchange immediately, even if that price is available in buyer cannot be found, the block house might purchase all or part of a block sale for its own account. The block house then can The trade-through to the public. to improve speed of execution and enhance integration of competing stock resell the shares rule is meant markets. Linking markets electronically through a unified book displaying all limit orders would be a You extension of the ITS, enabling trade execution trading peaked in the mid-1990s, integration has logical can observe in Table 3.3 that the share of blockacross markets. But this degree of but has since not declined sharply. This reflects changing trading practices since the advent of market be publicly Large yet been realized. Regulation NMS requires only that the inside quotes of each electronic markets. shared. trades the inside or best quote is to be split up into only for small trades and executed electronically. Because are now much more likelytypically available multiple a small number of shares, there is still no The lack of an investor electronic the best available prices pattern: Because the inside quote on these guarantee that depth on thewill receiveexchanges reinforces this for an entire trade, especially for larger exchanges is valid only for small trades, it generally is preferable to buy or sell a large stock position in a trades. series of smaller transactions.
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Bond Trading TABLE 3.3: Block transactions on the New York Stock Exchange
In 2006, the NYSE obtained regulatory approval to expand its bond trading system to include the debt issues of any NYSE-listed firm. In the past, each bond needed to be registered before listing; such a requirement was too onerous to justify listing most bonds. In conjunction with these new listings, the NYSE has expanded its electronic bond-trading platform, which is now called NYSE Bonds, and is the largest centralized bond market of any U.S. exchange. Nevertheless, the vast majority of bond trading occurs in the OTC market among bond dealers, even for bonds that are actually listed on the NYSE. This market is a network of bond dealers such as Merrill Lynch (now part of Bank of America), Salomon Smith Barney (a division of Citigroup), or Goldman, Sachs that is linked by a computer quotation system. However, because these dealers do not carry extensive inventories of the wide range of bonds that have been issued to the public, they cannot
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necessarily offer to sell bonds from their inventory to clients or even buy bonds for their own inventory. Electronic work to locate the NYSE They may insteadtrading on an investor who wishes to take the opposite side of a trade. In practice, however, the corporate bond market often is quite thin, in that there may be few investors interested in The NYSE has recently stepped up its commitment to electronic trading. Its SuperDot is an electronic trading a bond at any particular time. As a result, the bond market is subject to a type of liquidity risk, for order-routing system that enables brokerage firms to send market and limit orders directly to the it can be difficult to sell ones holdings quickly if the need arises. specialist over computer lines. SuperDot is especially useful to program traders. A program trade is a coordinated Structure of Other Countries 3.4: Marketpurchase or sale in an entire portfolio of stocks. The structure of security markets varies considerably from one country to another. A full cross-country comparison program trade of this text. Therefore, we will instead briefly review three of the biggest is far beyond the scope non-U.S. stock markets: the London, Euronext, and Tokyo exchanges. Figure 3.6 shows the market Coordinated sale or purchase of a portfolio of stocks. capitalization of firms trading in the major stock markets.
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FIGURE 3.6: Market capitalization of major world stock exchanges, 2008
While SuperDot simply transmits orders to the specialists post electronically, the NYSE also has instituted a fully automated trade-execution system called DirectPlus or Direct+. It matches orders against the inside bid or ask price with execution times of a small fraction of a second. Direct+ has captured an ever-larger share of trades on the NYSE. Today, the vast majority of all orders are submitted electronically, but these tend to be smaller orders. Larger orders are still more likely to go through a specialist.
Settlement
Orders executed on the exchange must be settled within three working days. This requirement is often called T + 3, for trade date plus three days. The purchaser must deliver the cash, and the seller must deliver the stock to the broker, who in turn delivers it to the buyers broker. Frequently, a firms clients keep their securities in street name, which means the broker holds the shares registered in the firms own name on behalf of the client. This convention can speed security transfer. T + 3 settlement has made such arrangements more important: It can be quite difficult for a seller of a security to complete delivery to the purchaser within the three-day period if the stock is kept in a safe deposit box. Settlement is simplified further by the existence of a clearinghouse. The trades of all exchange members are recorded each day, with members transactions netted out, so that each member need transfer or Source: New York Stock Exchange, www.nyse.com, January 20, 2009. receive only the net number of shares sold or bought that day. A brokerage firm then settles with the clearinghouse instead of individually with every firm with which it made trades.
London Electronic Communication Networks

The London Stock Exchange uses an electronic trading system dubbed SETS (Stock Exchange Electronic ECNs are private computer networks that directly link buyers with sellers. As an order is received, the Trading Service). This is an electronic clearing system similar to ECNs in which buy and sell orders are system determines whether there is a matching order, and if so, the trade is executed immediately. Brokers submitted via computer networks and any buy and sell orders that can be crossed are executed that have an affiliation with an ECN have computer access and can enter orders in the limit order book. automatically. However, less liquid shares are traded in a more traditional dealer market called the SEAQ Moreover, these brokers may make their terminals (or Internet access) available directly to individual (Stock Exchange Automated Quotations) system in which market makers enter bid and ask prices at which traders who then can enter their own orders into the system. The two biggest ECNs by far are INET, they are willing to transact. These trades may entail direct communication between brokers and market formed by a merger of Island and Instinet, and Archipelago. makers. The major stock index for London is the FTSE (Financial Times Stock Exchange; pronounced footsie) the NYSE and Archipelago merged in 2006. In principle, the merged firm can fill simple orders As noted, 100 Index. quickly without human interaction through ArcaEx (the Archipelago Exchange), and large complex orders
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using human traders on the floor of the NYSE. At the same time, NASDAQ purchased the other leading Euronext which operates INET. Thus, the securities markets appear to be consolidating and it seems ECN, Instinet, that each market will, at least for a time, offer multiple trading platforms. But the trend toward electronic Euronext was formed in 2000 by a merger of the Paris, Amsterdam, and Brussels exchanges, and itself trading continues unabated. merged with the NYSE Group in 2007. Euronext, like most European exchanges, uses an electronic trading system. Its system, called NSC (for Nouveau Systme de Cotation, or New Quotation System), has The National Market System fully automated order routing and execution. In fact, investors can enter their orders directly without The Securities Act Amendments of 1975 directed the Securities and Exchange Commission to crossed contacting their brokers. An order submitted to the system is executed immediately if it can be implement a national competitive securities market. Such a if it cannot be executed, it is entered into the limit order against an order in the public limit order book;market would entail centralized reporting of transactions and a book. centralized quotation system, with the aim of enhanced competition among market makers. In 1975, has established cross-trading agreements on the NYSE, Amex, and major regional exchanges, as EuronextConsolidated Tape began reporting trades with several other European exchanges such as Helsinki well as trades of NASDAQ-listed stocks. In 1977, the London International Financial began and Options or Luxembourg. In 2002, it also purchased LIFFE,the Consolidated Quotations ServiceFutures providing online bid Exchange. and ask quotes for NYSE securities also traded on various other exchanges. In 1978, the Intermarket Trading System (ITS) was implemented. ITS currently links nine exchanges by computer: Tokyo NYSE, Amex, Boston, National (formerly Cincinnati), Pacific, Philadelphia, Chicago, NASDAQ, and the Chicago Board Options Exchange. The system allows brokers and market makers to display and view The Tokyo Stock Exchange (TSE) is among the largest in the world, measured either by trading volume or quotes for all markets and to execute cross-market trades when the Consolidated Quotation System shows the market capitalization of its roughly 2,400 listed firms. Its exemplifies many of the general trends that better prices in other markets. However, the ITS has been only a limited success. Orders need to be we have seen affecting stock markets throughout the world. In 1999, it closed its trading floor and directed to alternative markets by participants who might find it inconvenient or unprofitable to do so. switched to all-electronic trading. It switched from a membership form of organization to a corporate form in 2001. the growth of automated electronic trading has made market integration more feasible. The SEC However, reaffirmed its trade-through rule in 2005. Its Regulation NMS requires that investors orders be filled at The TSE maintains three sections. The First section is for large companies, the Second is for midsized the best price that can be executed immediately, even if that price is available in a different market. firms, and the Mothers section is for emerging and high-growth stocks. About three-quarters of all listed firms trade on the First is meant and about 200 trade in the Mothers enhance integration of competing stock The trade-through rule section, to improve speed of execution and section. markets. Linking markets electronically through a unified book displaying all limit orders would be a The two major stock market indexes for the TSE are the Nikkei 225 index, which is a price-weighted logical extension of the ITS, enabling trade execution across markets. But this degree of integration has not average of 225 top-tier Japanese firms, and the TOPIX index, which is a value-weighted index of the First yet been realized. Regulation NMS requires only that the inside quotes of each market be publicly shared. 3 section companies. or best quote is typically available only for a small number of shares, there is still no Because the inside guarantee that an investor will receive the best available prices for an entire trade, especially for larger Globalization and Consolidation of Stock Markets trades. All stock markets have come under increasing pressure in recent years to make international alliances or Bond Trading pressure is due to the impact of electronic trading. To a growing extent, traders view mergers. Much of this stock markets as networks that link them to other to expand itsthere are increasingly to include theon the In 2006, the NYSE obtained regulatory approval traders, and bond trading system fewer limits debt securitiesany NYSE-listed firm. they can trade. Againstneeded to be registered before listing; such a for issues of around the world that In the past, each bond this background, it becomes more important exchanges towas too onerous to justify most efficient mechanism by which trades can be executed the requirement provide the cheapest and listing most bonds. In conjunction with these new listings, and cleared. This argues for global alliances that canplatform, which is and bolts of NYSE Bonds, and is and NYSE has expanded its electronic bond-trading facilitate the nuts now called cross-border trading the can benefit from economies of scale. Moreover, in the face of competition from electronic networks, largest centralized bond market of any U.S. exchange. established exchanges feel that they eventually need to offer 24-hour global markets. Finally, companies Nevertheless, the vastbeyond national borders when they wish to raise capital. want to be able to go majority of bond trading occurs in the OTC market among bond dealers, even for bonds that are actually listed on the NYSE. This market is a network of bond dealers such as Merrill These pressures have resulted in a broad trend toward market consolidation. In the last decade, most of the Lynch (now part of Bank of America), Salomon Smith Barney (a division of Citigroup), or Goldman, mergers werelinked bythat is, involving exchanges operating in because these dealers do not carry NYSE Sachs that is local, a computer quotation system. However, the same continent. In the U.S., the merged with the Archipelago ECN in 2006, and in 2008 acquired the American Stock Exchange. extensive inventories of the wide range of bonds that have been issued to the public, they cannot
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necessarily offer to Instinet (which their inventory to major or even buy in 2005 their own inventory. NASDAQ acquired sell bonds from operated the otherclients ECN, INET)bonds forand the Boston Stock They may instead In the locate an market, the wishes Mercantile Exchange acquired the Chicago Exchange in 2007.work toderivativesinvestor whoChicagoto take the opposite side of a trade. In practice, however, the corporate bond market often is was thin, by the merger of the Paris, Brussels, Lisbon, and Board of Trade in 2007. In Europe, Euronextquite formed in that there may be few investors interested in trading a bond at any particular time. As a result, the bond market derivatives exchange based in London. Amsterdam exchanges and shortly thereafter purchased LIFFE, theis subject to a type of liquidity risk, for it can be merged to sell ones Borsa Italiana, which need arises. The LSE difficult in 2007 with holdings quickly if theoperates the Milan exchange. There has also Structure intercontinental consolidation. 3.4: Marketbeen a wave of in Other Countries The NYSE Group and Euronext merged in 2007. The NYSE has purchased 5% of Indias National Stock Exchange and has entered a cooperation The structurewith the Tokyo Stock Exchange. In March 2006, NASDAQ made an offer to acquire the agreement of security markets varies considerably from one country to another. A full cross-country comparison is farExchange, but the LSE rejected that proposal.will insteadNASDAQ finally acquired a London Stock beyond the scope of this text. Therefore, we However, briefly review three of the biggest non-U.S. stock markets: 2007, when itEuronext, and with Brse Dubai to acquire6the Swedish exchange foothold in Europe in the London, joined forces Tokyo exchanges. Figure 3. shows the market capitalization of firms trading in the major stock markets. Exchange Holdings, and ISE announced that it OMX. In 2007, Eurex acquired International Securities would launch a new derivatives market in partnership with the Toronto Stock Exchange.
FIGURE 3.6: Market capitalization of major world stock exchanges, 2008 3.5: Trading Costs
Part of the cost of trading a security is obvious and explicit. Your broker must be paid a commission. Individuals may choose from two kinds of brokers: full-service or discount brokers. Full-service brokers who provide a variety of services often are referred to as account executives or financial consultants. Besides carrying out the basic services of executing orders, holding securities for safekeeping, extending margin loans, and facilitating short sales, brokers routinely provide information and advice relating to investment alternatives. Full-service brokers usually depend on a research staff that prepares analyses and forecasts of general economic as well as industry and company conditions and often makes specific buy or sell recommendations. Some customers take the ultimate leap of faith and allow a full-service broker to make buy and sell decisions for them by establishing a discretionary account. In this account, the broker can buy and sell prespecified securities whenever deemed fit. (The broker cannot withdraw any funds, though.) This action requires an unusual degree of trust on the part of the customer, for an unscrupulous broker can churn an account, that is, trade securities excessively with the sole purpose of generating commissions. Source: on the other hand, provide no-frills services. They 20, 2009. Discount brokers, New York Stock Exchange, www.nyse.com, Januarybuy and sell securities, hold them for safekeeping, offer margin loans, facilitate short sales, and that is all. The only information they provide about the securities they handle is price quotations. Discount brokerage services have become increasingly London available in recent years. Many banks, thrift institutions, and mutual fund management companies now offer such services to the investing public as part of a general trend toward the SETS (Stock Exchange Electronic The London Stock Exchange uses an electronic trading system dubbed creation of one-stop financial supermarkets. Stock trading fees have fallen steadily over the last decade, and discountand sell orders are Trading Service). This is an electronic clearing system similar to ECNs in which buy brokerage firms such as Schwab,computer networks and any buy andcommissions below $15, or even below $10 for submitted via E*Trade, or Ameritrade now offer sell orders that can be crossed are executed preferred customers. automatically. However, less liquid shares are traded in a more traditional dealer market called the SEAQ In(Stock Exchange Automatedof trading coststhein which market makers enter is anand ask prices at which addition to the explicit part Quotations) system brokers commissionthere bid implicit partthe they are willing to transact. These trades may entail direct communication between and charges no dealers bidask spread. Sometimes the broker is a dealer in the security being traded brokers and market makers. The major stock index for London is in FTSE (Financial Times Stock Another implicit cost of commission but instead collects the fee entirely thethe form of the bidask spread. Exchange; pronounced footsie) 100 observers would distinguish is the price concession an investor may be forced to make for trading that someIndex. trading in quantities greater than those associated with the posted bid or asked prices.
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An ongoing controversy between the NYSE and its competitors is the extent to which better execution on the Euronext NYSE offsets the generally lower explicit costs of trading in other markets. The NYSE believes that many Euronext was formed in on the a merger of the Paris, Amsterdam, and Brussels exchanges, may be investors focus too intently2000 bycosts they can see, despite the fact that quality of executionand itselffar merged with to NYSE Group in costs. Part of the quality European exchanges, ability electronic more importantthe their total trading2007. Euronext, like mostexecution refers to the uses an of a large trading like the NYSE to accomodate (for Nouveau Systme de Cotation, or impact on security price. exchange system. Its system, called NSCbig trades without encountering a large New Quotation System), has fully automated size routing and execution. spread. Finally, can enter emphasizes the possibility of Another part is theorderof the effective bidask In fact, investorsthe NYSE their orders directly without contacting their brokers. An order submitted to the system is executed immediately inside the quoted price improvement in a market. This refers to the possibility of trades being crossedif it can be crossed against an order in suppose limit order book; if it cannot be executed, is entered into the limit order spread. To illustrate,the publicIBM is trading at $98.03 bid, $98.07 asked.itA broker who has received a book. market buy order can meet a broker with a market sell order, and agree to a price of $98.05. By meeting in the middle of the quoted spread, both buyer and seller obtain price improvement, that is, transaction prices Euronext has established cross-trading agreements with several other European exchanges such as Helsinki better than the best quoted prices. Such meetings of brokers are more than accidental. Because all trading or Luxembourg. In 2002, it also purchased LIFFE, the London International Financial Futures and Options takes place at the specialists post, floor brokers know where to look for counterparties to a trade. Exchange.
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3.6: Buying on Margin Tokyo

When purchasing securities, investors have easy access to a source of debt financing called brokers call The Tokyo Stock Exchange (TSE) is among the largest in the world, measured either by trading volume or loans. The act of taking advantage of brokers call loans is called buying on margin. the market capitalization of its roughly 2,400 listed firms. Its exemplifies many of the general trends that we have stocks on margin means the investor borrows part In 1999, it closed its of the floor and Purchasingseen affecting stock markets throughout the world. of the purchase price tradingstock from a switched margin in the trading. It switched from a purchase price contributed by the investor; the broker. Theto all-electronicaccount is the portion of the membership form of organization to a corporate form in 2001. remainder is borrowed from the broker. The brokers in turn borrow money from banks at the call money rate to finance these purchases; they then charge their clients that rate (defined in Chapter 2), plus a service The TSE maintains three sections. The First section is for large companies, the Second is for midsized charge for the loan. All securities purchased on margin must be maintained with the brokerage firm in street firms, and the Mothers section is for emerging and high-growth stocks. About three-quarters of all listed name, for the securities are collateral for the loan. firms trade on the First section, and about 200 trade in the Mothers section. The two major stock market indexes for the TSE are the Nikkei 225 index, which is a price-weighted margin average of 225 top-tier Japanese firms, and the TOPIX index, which is a value-weighted index of the First section companies. Describes securities purchased with money borrowed in part from a broker. The margin is the
3
Globalization and Consolidation of Stock Markets

The Board of Governors of the Federal Reserve System limits the extent to make international alliances or All stock markets have come under increasing pressure in recent years to which stock purchases can be financed using margin loans. The is due toinitial margin requirement is 50%, meaning thatextent, traders view mergers. Much of this pressure current the impact of electronic trading. To a growing at least 50% of the purchase price must be paid for in cash, with the rest borrowed. there are increasingly fewer limits on the stock markets as networks that link them to other traders, and securities around the world that they can trade. Against this background, it becomes more important for EXAMPLE 3.1: Margin exchanges to provide the cheapest and most efficient mechanism by which trades can be executed and cleared. This argues for global alliances that can facilitate the nuts and bolts of cross-border trading and The percentage margin is defined as the ratio of the net worth, or the equity value, of the account to can benefit from economies of scale. Moreover, in the face of competition from electronic networks, the market value of the securities. To demonstrate, suppose an investor initially pays $6,000 toward the established exchanges feel that they eventually need to offer 24-hour global markets. Finally, companies purchase of $10,000 worth of stock (100 shares at $100 per share), borrowing the remaining $4,000 want to be able to go beyond national borders when they wish to raise capital. from a broker. The initial balance sheet looks like this: These pressures have resulted in a broad trend toward market consolidation. In the last decade, most of the mergers were local, that is, involving exchanges operating in the same continent. In the U.S., the NYSE merged with the Archipelago ECN in 2006, and in 2008 acquired the American Stock Exchange.
net worth of the investors account.
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NASDAQ acquired Instinet (which operated the other major ECN, INET) in 2005 and the Boston Stock The initial 2007. In the derivatives market, the Chicago Mercantile Exchange acquired the Chicago Exchange inpercentage margin is Board of Trade in 2007. In Europe, Euronext was formed $6, the merger of the Paris, Brussels, Lisbon, and by 000 Equity in account Margin thereafter purchased LIFFE, the = .60, or 60% Amsterdam exchanges and shortly = Value of stock = $10, 000 derivatives exchange based in London. The LSE merged in 2007 with Borsa Italiana, which operates the Milan exchange. If the price declines to $70 per share, the account balance becomes: There has also been a wave of intercontinental consolidation. The NYSE Group and Euronext merged in 2007. The NYSE has purchased 5% of Indias National Stock Exchange and has entered a cooperation agreement with the Tokyo Stock Exchange. In March 2006, NASDAQ made an offer to acquire the London Stock Exchange, but the LSE rejected that proposal. However, NASDAQ finally acquired a foothold in Europe in 2007, when it joined forces with Brse Dubai to acquire the Swedish exchange OMX. In 2007, Eurex acquired International Securities Exchange Holdings, and ISE announced that it would launch a new derivatives market in partnership with the Toronto Stock Exchange. The assets in the account fall by the full decrease in the stock value, as does the equity. The percentage 3.5: Trading Costs margin is now Equity and explicit. Your broker must be paid a commission. Part of the cost of trading a security is obviousin account $3, 000 Margin = = = .43, or 43% Individuals may choose from two kinds of brokers: full-service or discount brokers. Full-service brokers who Value of stock $7, 000 provide a variety of services often are referred to as account executives or financial consultants. If the stock value in Example 3.1 were to fall below $4,000, owners equity would become negative, Besides carrying out the basic services of executing orders, holding securities for from the broker. To guard meaning the value of the stock is no longer sufficient collateral to cover the loan safekeeping, extending margin this possibility, the broker sets a maintenance margin. If theinformation margin fallsrelatingthe against loans, and facilitating short sales, brokers routinely provide percentage and advice below to investment alternatives. maintenance level, the broker will issue a margin call, which requires the investor to add new cash or securities to brokers usually dependthe investor does not act, the broker may sell securities from the account Full-service the margin account. If on a research staff that prepares analyses and forecasts of general to pay off as well as industry and company percentage and often makes specificlevel. sell recommendations. economic enough of the loan to restore the conditions margin to an acceptable buy or Some customers take the ultimate leap of faith and allow a full-service broker to make buy and sell decisions for EXAMPLE 3.2: Maintenance Marginthis account, the broker can buy and sell prespecified them by establishing a discretionary account. In securities whenever deemed fit. (The broker cannot withdraw any funds, though.) This action requires an Suppose the maintenance margin is 30%. How far could the stock price fall before the investor would unusual degree of trust on the part of the customer, for an unscrupulous broker can churn an account, that get a margin call? is, trade securities excessively with the sole purpose of generating commissions. Let P be the price of the stock. The value of the investors 100 shares is then 100P, and the equity in the Discount brokers, on the other hand, provide no-frills services. They buy and sell securities, hold them for account is 100P $4,000. The percentage margin is (100P $4,000)/100P. The price at which the safekeeping, offer margin loans, facilitate short sales, and that is all. The only information they provide percentage margin equals the maintenance margin of .3 is found by solving the equation about the securities they handle is price quotations. Discount brokerage services have become increasingly available in recent years. Many banks, thrift institutions, and mutual fund management companies now offer 100 p 4, 000 = .3 such services to the investing public as part of a general trend toward the creation of one-stop financial 100 p supermarkets. Stock trading fees have fallen steadily over the last decade, and discount brokerage firms which implies that P = or Ameritrade now offer stock were to fall below or even below $10 for such as Schwab, E*Trade, $57.14. If the price of the commissions below $15, $57.14 per share, the investor would get a margin preferred customers. call. In addition to the explicit part of trading coststhe brokers commissionthere is an implicit partthe dealers bidask spread. Sometimes the broker is a dealer in the security being traded and charges no commission but instead collects the fee entirely in the form of the bidask spread. Another implicit cost of trading that some observers would distinguish is the price concession an investor may be forced to make for trading in quantities greater than those associated with the posted bid or asked prices.
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An ongoing controversy between the NYSE and its competitors is the extent to which better execution on the CONCEPT check 3.4 NYSE offsets the generally lower explicit costs of trading in other markets. The NYSE believes that many investors focus too intently on the costs they can see, despite the fact that quality of execution may be far Suppose the maintenance margin of the quality execution refers to the ability of a large more important to their total trading costs. Part in Example 3.2 is 40%. How far can the stock price fall exchange likebefore the investor gets a margin call? the NYSE to accomodate big trades without encountering a large impact on security price. Another part is the size of the effective bidask spread. Finally, the NYSE emphasizes the possibility of Why do investors buyin a market. This refers to the possibilitythey wish being crossed inside the quoted price improvement securities on margin? They do so when of trades to invest an amount greater than their own money allows. Thus,IBM is trading at $98.03 bid, $98.07 asked. A they also exposereceived a to spread. To illustrate, suppose they can achieve greater upside potential, but broker who has themselves greater buy order risk.meet a broker with a market sell order, and agree to a price of $98.05. By meeting in market downside can the middle of the quoted spread, both buyer and seller obtain price improvement, that is, transaction prices To see how, lets suppose an investor is bullish on IBM stock, which is selling for $100 per share. An better than the best quoted prices. Such meetings of brokers are more than accidental. Because all trading investor with $10,000 to invest expects IBM to go up in price by 30% during the next year. Ignoring any takes place at the specialists post, floor brokers know where to look for counterparties to a trade. dividends, the expected rate of return would be 30% if the investor invested $10,000 to buy 100 shares.
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3.6: Buying the investor borrows another $10,000 from the broker and invests it in IBM, too. The total But now assume on Margin
investment in IBM would be $20,000 (for 200 shares). Assuming an interest rate on the margin loan of 9% When purchasing securities, investors have easy access to a source of debt financing called brokers call per year, what will the investors rate of return be now (again ignoring dividends) if IBM stock goes up 30% loans. The act of taking advantage of brokers call loans is called buying on margin. by years end? Purchasing stocks on margin means the investor borrows part of the purchase price of the stock from a The 200 shares will be worth $26,000. Paying off $10,900 of principal and interest on the margin loan leaves broker. The margin in the account is the portion of the purchase price contributed by the investor; the $15,100 (i.e., $26,000 $10,900). The rate of return in this case will be remainder is borrowed from the broker. The brokers in turn borrow money from banks at the call money rate to finance these purchases; they then charge their clients that rate (defined in Chapter 2), plus a service $15, 100 $10, 000 charge for the loan. All securities purchased on margin must be= 51% maintained with the brokerage firm in street $10, 000 name, for the securities are collateral for the loan. The investor has parlayed a 30% rise in the stocks price into a 51% rate of return on the $10,000 investment. Doing so, however, magnifies the downside risk. Suppose that, instead of going up by 30%, the price of IBM margin stock goes down by 30% to $70 per share. In that case, the 200 shares will be worth $14,000, and the investor is left with $3,100 after paying off the $10,900 of principal and interest on the loan. The result is a Describes securities purchased with money borrowed in part from a broker. The margin is the disastrousnet worth of the investors account. return of $3, 100 $10, 000 The Board of Governors of the Federal Reserve System limits the 69% to which stock purchases can be = extent $10, 000 financed using margin loans. The current initial margin requirement is 50%, meaning that at least 50% of the purchase summarizes paid for in results of the rest borrowed. Table 3.4price must bethe possible cash, with these hypothetical transactions. If there is no change in IBMs stock price, the investor loses 9%, the cost of the loan.
EXAMPLE 3.1: Margin TABLE 3.4: Illustration of buying stock on margin

The percentage margin is defined as the ratio of the net worth, or the equity value, of the account to the market value of the securities. To demonstrate, suppose an investor initially pays $6,000 toward the purchase of $10,000 worth of stock (100 shares at $100 per share), borrowing the remaining $4,000 from a broker. The initial balance sheet looks like this:
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The initial percentage margin is
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EXCEL APPLICATIONS: Buying on Margin

Margin = Equity in account $6, 000 = = .60, or 60% Value of stock $10, 000
If the price declines to $70 per.com/bkm account balance becomes: Please visit us at www.mhhe share, the The Excel spreadsheet model below makes it easy to analyze the impacts of different margin levels and the volatility of stock prices. It also allows you to compare return on investment for a margin trade with a trade using no borrowed funds.
The assets in the account fall by the full decrease in the stock value, as does the equity. The percentage margin is now Margin = Equity in account $3, 000 = = .43, or 43% Value of stock $7, 000
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If the stock value in Example 3.1 were to fall below $4,000, owners equity would become negative, meaning the value of the stock is no longer sufficient collateral to cover the loan from the broker. To guard against this possibility, the broker sets a maintenance margin. If the percentage margin falls below the maintenance level, the broker will issue a margin call, which requires the investor to add new cash or securities to the margin account. If the investor does not act, the broker may sell securities from the account to pay off enough of the loan to restore the percentage margin to an acceptable level.
EXAMPLE 3.2: Maintenance Margin

Suppose the maintenance margin is 30%. How far could the stock price fall before the investor would get a margin call?
CONCEPT check 3stock. The value of the investors 100 shares is then 100P, and the equity in the Let P be the price of the .5
account is 100P $4,000. The percentage margin is (100P $4,000)/100P. The price at which the percentageSuppose equals the maintenance margin of .3 investor borrows only $5,000 at the same interest margin that in the IBM example above, the is found by solving the equation rate of 9% per year. What will the rate of return be if the price of IBM goes up by 30%? If it 100 p 4, 000 goes down by 30%? If it remains unchanged? = .3 100 p
3.7: Short SalesP = $57.14. If the price of the stock were to fall below $57.14 per share, the investor which implies that
would get a margin call. Normally, an investor would first buy a stock and later sell it. With a short sale, the order is reversed. First, you sell and then you buy the shares. In both cases, you begin and end with no shares. A short sale allows investors to profit from a decline in a securitys price. An investor borrows a share of stock from a broker and sells it. Later, the short-seller must purchase a share of the same stock in order to
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replace the share that was borrowed. This is called covering the short position. Table 3.5 compares stock CONCEPT sales. purchases to shortcheck 3.4
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TABLE 3.5: Cash maintenance margin in Example 3versus short-sellingstock price of Suppose the flows from purchasing .2 is 40%. How far can the shares fall stock before the investor gets a margin call?
Why do investors buy securities on margin? They do so when they wish to invest an amount greater than their own money allows. Thus, they can achieve greater upside potential, but they also expose themselves to greater downside risk. To see how, lets suppose an investor is bullish on IBM stock, which is selling for $100 per share. An investor with $10,000 to invest expects IBM to go up in price by 30% during the next year. Ignoring any dividends, the expected rate of return would be 30% if the investor invested $10,000 to buy 100 shares. But now assume the investor borrows another $10,000 from the broker and invests it in IBM, too. The total investment in IBM would be $20,000 (for 200 shares). Assuming an interest rate on the margin loan of 9% per year, what will the investors rate of return be now (again ignoring dividends) if IBM stock goes up 30% by years end? The 200 shares will be worth $26,000. Paying off $10,900 of principal and interest on the margin loan leaves $15,100 (i.e., $26,000 $10,900). The rate of return in this case will be $15, 100 $10, 000 = 51% $10, 000 The sale of shares not owned by the investor but borrowed through a broker and later The investor has parlayed a 30% rise in the stocks price into a 51% rate of return on the $10,000 investment. purchased to replace the loan. Doing so, however, magnifies the downside risk. Suppose that, instead of going up by 30%, the price of IBM The short-seller anticipates the stock price will fall, so that the share can be purchased later at a lower price stock goes down by 30% to $70 per share. In that case, the 200 shares will be worth $14,000, and the than it initially sold for; if so, the short-seller will reap a profit. Short-sellers must not only replace the shares investor is left with $3,100 after paying off the $10,900 of principal and interest on the loan. The result is a but also pay the lender of the security any dividends paid during the short sale. disastrous return of In practice, the shares loaned out for a short sale are typically provided by the short-sellers brokerage firm, $3, 100 $10, 000 which holds a wide variety of securities of its other investors = 69% in street name (i.e., the broker holds the shares $10, 000 registered in its own name on behalf of the client). The owner of the shares need not know that the shares have 3.4 lent to the short-seller. If the owner wishes to sell the shares, the If there is no will simply Tablebeen summarizes the possible results of these hypothetical transactions.brokerage firmchange in IBMs borrow shares from another investor. cost of the loan. stock price, the investor loses 9%, theTherefore, the short sale may have an indefinite term. However, if the brokerage firm cannot locate new shares to replace the ones sold, the short-seller will need to repay the loan immediately3.4: Illustrationin the market and turning them over to the brokerage house to close out TABLE by purchasing shares of buying stock on margin the loan. Finally, exchange rules require that proceeds from a short sale must be kept on account with the broker. The short-seller cannot invest these funds to generate income, although large or institutional investors typically will receive some income from the proceeds of a short sale being held with the broker. Short-sellers also are required to post margin (cash or collateral) with the broker to cover losses should the stock price rise during the short sale.
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Essentials of Investments, 8th Edition EXCEL APPLICATIONS: Buying on Margin EXAMPLE 3.3: Short Sales
To illustrate the mechanics of short-selling, suppose you are bearish (pessimistic) on Dot Bomb stock, and its market price is $100 per share. You tell your broker to sell short 1,000 shares. The broker borrows 1,000 shares either from another customers account or from another broker. Please visit us at www.mhhe.com/bkm The $100,000 cash proceeds from the short sale are credited to your account. Suppose the broker has a The Excel spreadsheet model below makes it easy to analyze the impacts of different margin levels and 50% margin requirement on short sales. This means you must have other cash or securities in your the volatility of stock prices. It also allows you to compare return on investment for a margin trade with account worth at least $50,000 that can serve as margin on the short sale. a trade using no borrowed funds. Lets say that you have $50,000 in Treasury bills. Your account with the broker after the short sale will then be:
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Your initial percentage margin is the ratio of the equity in the account, $50,000, to the current value of the shares you have borrowed and eventually must return, $100,000: Percentage margin = Equity $50, 000 = = .50 Value of stock owed $100, 000
Suppose you are right and Dot Bomb falls to $70 per share. You can now close out your position at a profit. To cover the short sale, you buy 1,000 shares to replace the ones you borrowed. Because the shares now sell for $70, the purchase costs only $70,000. Because your account was credited for $100,000 when the shares were borrowed and sold, your profit is $30,000: The profit equals the decline in the share price times the number of shares sold short.
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CONCEPT check 3.5
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Like investors who purchase stock on margin, a short-seller must be concerned about margin calls. If the Suppose that in the IBM example fall; if the investor to the maintenance level, the short-seller stock price rises, the margin in the account will above, margin falls borrows only $5,000 at the same interest will receive a rate of 9% per year. What will the rate of return be if the price of IBM goes up by 30%? If it margin call. goes down by 30%? If it remains unchanged?
EXAMPLE 3.4: Margin Calls on Short Positions 3.7: Short Sales

Suppose the broker has a maintenance margin of 30% on short sales. This means the equity in your Normally, an investor least 30% of theavalue of your short position at short sale, How much can the price of account must be at would first buy stock and later sell it. With a all times. the order is reversed. First, you sellBomb stock rise before you get aboth cases, you begin and end with no shares. Dot and then you buy the shares. In margin call? A short salethe price of Dot Bomb stock. Then the valueaof the shares you An investor borrows a share of Let P be allows investors to profit from a decline in securitys price. must pay back is 1,000P, and the stock from a your account is $150,000 1,000P. Your must purchase margin ratio issame stock in of stock = equity in broker and sells it. Later, the short-seller short position a share of the equity/value order to (150,000 1,000P)/1,000P. The critical value of P is thus
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replace the share that was borrowed. Equity called covering000 short 000 p This is 150, the 1, position. Table 3.5 compares stock = = .3 purchases to short sales. Value of shares owed 1, 000 p
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TABLE 3.5: that P = $115.38 from purchasingstock should rise above $115.38 per share, you which implies Cash flows per share. If Dot Bomb versus short-selling shares of will get a margin call, and you will either have to put up additional cash or cover your short position by stock
buying shares to replace the ones borrowed.
CONCEPT check 3.6

a. Construct the balance sheet if Dot Bomb goes up to $110. b. If the short position maintenance margin in Example 3.4 is 40%, how far can the stock price rise before the investor gets a margin call? You can see now why stop-buy orders often accompany short sales. Imagine that you short-sell Dot Bomb when it is selling at $100 per share. If the share price falls, you will profit from the short sale. On the other hand, if the share price rises, lets say to $130, you will lose $30 per share. But suppose that when you initiate the short sale, you also enter a stop-buy order at $120. The stop-buy will be executed if the share price surpasses $120, thereby limiting your losses to $20 per share. (If the stock price drops, the stop-buy will never be executed.) The stop-buy order thus provides protection to the short-seller if the share price moves up. Short-selling periodically comes under attack, particularly during times of financial stress when share prices fall. The last few years have not owned by the investor rule,borrowed through a broker and later The sale of shares been no exception to this but and the nearby box examines the controversy surrounding short salesreplace thedetail. purchased to in greater loan. The short-seller anticipatesFRONT price will fall, so that the share can be purchased later at a lower price On the MARKET the stock than it initially sold for; if so, the short-seller will reap a profit. Short-sellers must not only replace the shares butSHORT-SELLING the security any dividends paid during the short sale. also pay the lender of COMES UNDER FIREAGAIN Short-selling has long been viewed short sale are typically provided by the England banned short sales In practice, the shares loaned out for a with suspicion, if not outright hostility. short-sellers brokerage firm, for holds a wide variety of securities of its other investors short sellers enemies of the state. In which a good part of the eighteenth century. Napoleon called in street name (i.e., the broker holds the U.S., shares short-selling was name on behalf of the client). to the market crash of 1929, not know that the shares registered in its own widely viewed as contributing The owner of the shares needand in 2008, short sellers were blamed the short-seller. If the owner wishes to Bear Stearns and brokerage firm will simply have been lent tofor the collapse of the investment banks sell the shares, theLehman Brothers. With share prices of other financial investor. Therefore, the short 2008, the SEC instituted a term. However, borrow shares from anotherfirms collapsing in September sale may have an indefinitetemporary ban onif the short-selling about locate those firms. Similarly, the Financial Services Authority, the financial the loan brokerage firm cannot 800 of new shares to replace the ones sold, the short-seller will need to repayregulator in the U.K., purchasing shares in on market and turning them over and Australia banned shorting immediately byprohibited short sales the about 30 financial companies, to the brokerage house to close out the altogether. loan. The exchange for these bans is proceeds sales put downward pressure on account with the broker. Finally,motivationrules require that that short from a short sale must be kepton share prices that in some The cases may be unwarranted: funds abound of income, who first put or institutional investors typically short-seller cannot invest theserumorsto generate investorsalthough largeon a short sale and then spread negative some income from the proceeds of a short sale being held however, shorting is an innocent are will receive rumors about the firm to drive down its price. More often, with the broker. Short-sellers alsobet that a share price is (cash or collateral) with the broker to cover losses market stresses price 2008, the required to post margintoo high and is due to fall. Nevertheless, during the should the stockof late rise during the widespread feeling was that even if short positions were legitimate, regulators should do what they could short sale. to prop up the affected institutions.
short sale
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Hostility to short-selling may well stem from confusion between bad news and the bearer of that news. EXAMPLE 3.3: Short Sales Short-selling allows investors whose analysis indicates a firm is overpriced to take action on that belief andillustrate the mechanics of short-selling, suppose the stock price to fall, shorts may simply bestock, To to profit if they are correct. Rather than causing you are bearish (pessimistic) on Dot Bomb anticipating a decline in the per share. You tellsales simply force the market toshares. The deteriorating and its market price is $100 stock price. Their your broker to sell short 1,000 reflect the broker prospects of troubled firms sooneranother might have account or from another broker. borrows 1,000 shares either from than it customers otherwise. In other words, short-selling is part of the process by which the full range of information and opinionpessimistic as well as optimisticis The $100,000 cash stock prices. the short sale are credited to your account. Suppose the broker has a brought to bear on proceeds from 50% margin requirement on short sales. This means you must have other cash or securities in your For example, short-sellers took that can serve as positions in firms such as WorldCom, Enron, and Tyco account worth at least $50,000 large (negative) margin on the short sale. even before these firms were exposed by regulators. In fact, one might argue that these emerging short Lets say that you have $50,000 in the previously undetected scandals. And in after the short sale will positions helped regulators identifyTreasury bills. Your account with the brokerthe end, Lehman and then Stearns were brought down by their very real losses on their mortgage-related investmentsnot by Bear be: unfounded rumors. Academic research supports the conjecture that short sales contribute to efficient price discovery. For example, the greater the demand for shorting a stock, the lower its future returns tend to be; moreover, firms that attack short-sellers with threats of legal action or bad publicity tend to have especially poor future returns. Short sale bans may in the end be nothing more than an understandable, but nevertheless misguided, impulse to shoot the messenger. Your initial percentage margin is the ratio of the equity in the account, $50,000, to the current value of the shares you have borrowed and eventually must 3.8: Regulation of Securities Markets return, $100,000: Equity $50, 000 Trading in securities markets in the United States is regulated by a myriad of laws. The major governing Percentage margin = = = .50 legislation includes the Securities Act of 1933 Value of stock owed $100, 000 1934. The 1933 Act and the Securities Exchange Act of requires full disclosure of relevant information relating to the issue of new securities. This is the act that Suppose you are right and Dot Bomb falls to $70 per share. You can now close out your position at a requires registration of new securities and issuance of a prospectus that details the financial prospects of the profit. To cover the short sale, you buy 1,000 shares to replace the ones you borrowed. Because the firm. SEC approval of a prospectus or financial report is not an endorsement of the security as a good 5 shares now sell for $70, only that the relevant facts are disclosed; investors must was credited for investment. The SEC cares the purchase costs only $70,000. Because your account make their own $100,000 the securitys value. evaluation ofwhen the shares were borrowed and sold, your profit is $30,000: The profit equals the decline in the share price times the number of shares sold short. The 1934 Act established the Securities and Exchange Commission to administer the provisions of the 1933 Act. It also extended the disclosureon margin, a the 1933 Act by requiring periodic disclosure calls. If the Like investors who purchase stock principle of short-seller must be concerned about margin of relevant financial informationmargin in withaccount will fall; if margin falls to the maintenance level, the short-seller stock price rises, the by firms the already-issued securities on secondary exchanges. will receive a margin call. The 1934 Act also empowers the SEC to register and regulate securities exchanges, OTC trading, brokers, and dealers. While the SEC is the administrative agency responsible for broad oversight of the securities EXAMPLE responsibility with other regulatory Positions markets, it shares 3.4: Margin Calls on Short agencies. The Commodity Futures Trading Commissionthe broker has a maintenance futures markets,on short sales. This means the equity in your Suppose (CFTC) regulates trading in margin of 30% while the Federal Reserve has broad responsibility for account must the at least 30% ofsystem. In of your short position at all times. How much can the and stock the health of be U.S. financial the value this role, the Fed sets margin requirements on stocks price of options Bomb stock rise before you to securities markets participants. Dot and regulates bank lending get a margin call? The Securities Investor Protection Act of 1970 established the Securities Investor Protection 1,000P, and the Let P be the price of Dot Bomb stock. Then the value of the shares you must pay back is Corporation (SIPC) to in your investors from losses 1,000P. Your short positionJust as the Federal Deposit Insurance = equity protect account is $150,000 if their brokerage firms fail. margin ratio is equity/value of stock Corporation provides depositorsThe critical value of P is thus bank failure, the SIPC ensures that investors (150,000 1,000P)/1,000P. with federal protection against will receive securities held for their account in street name by a failed brokerage firm up to a limit of
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$500,000 per customer. The SIPC is financed by levying an insurance premium on its participating, or Equity 150, 000 1, 000 p member, brokerage firms. = = .3 Value of shares owed 1, 000 p
EXCEL APPLICATIONS:per share. Sale Bomb stock should rise above $115.38 per share, you which implies that P = $115.38 Short If Dot
will get a margin call, and you will either have to put up additional cash or cover your short position by buying shares to replace the ones borrowed. Please visit us at www.mhhe.com/bkm
CONCEPT check 3.6
This Excel spreadsheet model was built using the text example for Dot Bomb. The model allows you to a. Construct the balance sheet if Dot Bomb goes levels of initial and maintenance margins. The analyze the effects of returns, margin calls, and different up to $110. modelb. If the short position maintenance margin in Example 3.4 is 40%,on investment. stock price also includes a sensitivity analysis for ending stock price and return how far can the rise before the investor gets a margin call? You can see now why stop-buy orders often accompany short sales. Imagine that you short-sell Dot Bomb when it is selling at $100 per share. If the share price falls, you will profit from the short sale. On the other hand, if the share price rises, lets say to $130, you will lose $30 per share. But suppose that when you initiate the short sale, you also enter a stop-buy order at $120. The stop-buy will be executed if the share price surpasses $120, thereby limiting your losses to $20 per share. (If the stock price drops, the stop-buy will never be executed.) The stop-buy order thus provides protection to the short-seller if the share price moves up. Short-selling periodically comes under attack, particularly during times of financial stress when share prices fall. The last few years have been no exception to this rule, and the nearby box examines the controversy surrounding short sales in greater detail.
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SHORT-SELLING COMES UNDER FIREAGAIN
In addition to federal regulations, security trading is subject to state laws, known generally as blue sky laws Short-selling has long been viewed with suspicion, if not outright hostility. England banned short sales because they are intended to give investors a clearer view of investment prospects. State laws to outlaw fraud for a good part of the eighteenth century. Napoleon called short sellers enemies of the state. In the U.S., in security sales existed before the Securities Act of 1933. Varying state laws were somewhat unified when short-selling was widely viewed as contributing to the market crash of 1929, and in 2008, short sellers many states adopted portions of the Uniform Securities Act, which was enacted in 1956. were blamed for the collapse of the investment banks Bear Stearns and Lehman Brothers. With share prices of other financial Self-Regulation firms collapsing in September 2008, the SEC instituted a temporary ban on short-selling about 800 of those firms. Similarly, the Financial Services Authority, the financial regulator in the U.K., government regulation, about 30 financial companies, and of the securities shorting In addition toprohibited short sales on there is considerable self-regulationAustralia banned market. The altogether. most important overseer in this regard is the Financial Industry Regulatory Authority (FINRA), which is the largest nongovernmental regulator of all securities firms in the United States. FINRA was formed in The motivation for these bans is that short sales put downward pressure on share prices that in some 2007 through the consolidation of the National Association of Securities Dealers (NASD) with the cases may be unwarranted: rumors abound of investors who first put on a short sale and then spread self-regulatory arm of the New York Stock Exchange. It describes its broad mission as the fostering of negative rumors about the firm to drive down its price. More often, however, shorting is an innocent bet investor protection and market integrity. It examines securities firms, writes and enforces rules concerning that a share price is too high and is due to fall. Nevertheless, during the market stresses of late 2008, the trading practices, and administers a dispute resolution forum for investors and registered firms. widespread feeling was that even if short positions were legitimate, regulators should do what they could to prop up the affected institutions.
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There is also short-selling may well stem from confusion between professionals. For bearer of that CFA Hostility to self-regulation among the community of investment bad news and the example, the news. Institute has developed standards of professional conduct that govern the behavior of members with the Short-selling allows investors whose analysis indicates a firm is overpriced to take action on that belief Chartered Financial Analysts designation, commonly the stockto as CFAs. The nearby box presents a brief and to profit if they are correct. Rather than causing referred price to fall, shorts may simply be outline of thosedecline in the stock price. Their sales simply force the market to reflect the deteriorating anticipating a principles. prospects of troubled firms sooner than it might have otherwise. In other words, short-selling is part of the process by which the full range of information and opinionpessimistic as well as optimisticis On the MARKET FRONT brought to bear on stock prices. For example, short-sellers took large (negative) positions in firms such as WorldCom, Enron, and Tyco CONDUCT even before these firms were exposed by regulators. In fact, one might argue that these emerging short positions Professionalism identify the previously undetected scandals. And in the end, Lehman and I. helped regulators Bear Stearns were brought down by their very real losses on their mortgage-related investmentsnot by Knowledge of law. Members must understand knowledge of and comply with all unfounded rumors. applicable laws, rules, and regulations including the Code of Ethics and Standards of Academic research supports Conduct. Professional the conjecture that short sales contribute to efficient price discovery. For example, the greater the demand for shorting a stock, the lower its future returns tend to be; moreover, Independence and threats of legal action or bad publicity tend to have especially poor firms that attack short-sellers with objectivity. Members shall maintain independence and objectivity in 6 their professional activities. future returns. Short sale bans may in the end be nothing more than an understandable, but nevertheless misguided, Misrepresentation. Members must not knowingly misrep-resent investment analysis, impulse to shoot the messenger. recommendations, or other professional activities.
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EXCERPTS FROM CFA INSTITUTE STANDARDS OF PROFESSIONAL
3.8: Regulation of Securities Markets
II. Integrity of Capital Markets Trading in securities markets in the United States is regulated by a myriad of laws. The major governing Non-public information. Members must not exploit material non-public information. legislation includes the Securities Act of 1933 and the Securities Exchange Act of 1934. The 1933 Act requires full disclosure of relevant information relating to the issue of new securities. This is the act that Market manipulation. Members shall not attempt to distort prices or trading volume with requires registration ofintent securities and issuance of a prospectus that details the financial prospects of the the new to mislead market participants. firm. SEC approval of a prospectus or financial report is not an endorsement of the security as a good III. Duties to Clients investment. The SEC cares only that the relevant facts are disclosed; investors must make their own evaluation of the securitys value. Loyalty, prudence, and care. Members must place their clients interests before their own and act with reasonable care on their behalf. The 1934 Act established the Securities and Exchange Commission to administer the provisions of the 1933 Act. It also extended the disclosure principle of the 1933 Act by requiring periodic disclosure of relevant Fair dealing. Members shall deal fairly and objectively with clients when making financial information by firms with already-issued securities on secondary exchanges. investment recommendations or taking actions. The 1934 Act also empowers the SEC to register and regulate securities exchanges, OTC trading, brokers, Suitability. Members shall make a reasonable inquiry into a clients financial situation, and dealers. While the SEC is the administrative agency responsible for broad oversight of the securities investment experience, and investment objectives prior to making appropriate investment markets, it shares responsibility with other regulatory agencies. The Commodity Futures Trading recommendations. Commission (CFTC) regulates trading in futures markets, while the Federal Reserve has broad responsibility for the health of the U.S. financial system. In Members the Fed sets margin requirements on stocks and stock Performance presentation. this role, shall attempt to ensure that investment performance options and regulatespresented fairly, accurately, and completely. is bank lending to securities markets participants. The Securities Investor Protection Act of 1970 established the Securities Investor confidential unless the Confidentiality. Members must keep information about clients Protection Corporation (SIPC) to protect investors from losses if their brokerage firms fail. Just as the Federal Deposit Insurance client permits disclosure. Corporation provides depositors with federal protection against bank failure, the SIPC ensures that investors IV. Duties to held for their will receive securities Employers account in street name by a failed brokerage firm up to a limit of
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$500,000 per customer. The SIPC is financed by levying an insurance premium on its participating, or Loyalty. member, brokerage firms. Members must act for the benefit of their employer.
EXCEL
Compensation. Members must not accept compensation from sources that would create a APPLICATIONS: Short Sale conflict of interest with their employers interests without written consent from all involved parties.
Supervisors. Members must make reasonable efforts to detect and prevent violation of applicable laws and regulations by anyone subject to their supervision. Please visit us at www.mhhe.com/bkm V. Investment Analysis was built using the text This Excel spreadsheet model and Recommendations example for Dot Bomb. The model allows you to analyze the effects of returns, margin calls, and different levels of initial and maintenance margins. The Diligence. Members must exercise diligence and have reasonable basis for investment model also includes a sensitivity analysis for ending stock price and return on investment. analysis, recommendations, or actions. Communication. Members must distinguish fact from opinion in their presentation of analysis and disclose general principles of investment processes used in analysis.
VI. Conflicts of Interest Disclosure of conflicts. Members must disclose all matters that reasonably could be expected to impair their objectivity or interfere with their other duties. Priority of transactions. Transactions for clients and employers must have priority over transactions for the benefit of a member.
VII. Responsibilities as Member of CFA institute Conduct. Members must not engage in conduct that compromises the reputation or integrity of the CFA Institute or CFA designation. SOURCE: Excerpts from the CFA Institute Standards of Professional Conduct.
InRegulatory Responses security trading Scandals state laws, known generally as blue sky laws addition to federal regulations, to Recent is subject to because they are intended to give investors a clearer view of investment prospects. State laws to outlaw fraud in The scandals of 20002002 centered largely on of 1933. Varying state allocations somewhatin initial when security sales existed before the Securities Act three broad practices: laws were of shares unified public offerings, tainted portions research and recommendations put out to enacted in and probably most many states adoptedsecurities of the Uniform Securities Act, which was the public, 1956. important, misleading financial statements and accounting practices. The regulatory response to these issues is still evolving, but some initiatives have been put in place. Many of these are contained in the Self-Regulation Sarbanes-Oxley Act passed by Congress in 2002. Among the key reforms are: In addition to government regulation, there is considerable self-regulation of the securities market. The Creation overseer in this regard is the Financial Industry Regulatory Authority (FINRA), which is most important of a Public Company Accounting Oversight Board to oversee the auditing of public companies. the largest nongovernmental regulator of all securities firms in the United States. FINRA was formed in 2007 through the consolidation of the National Association of Securities Dealers (NASD) with the Rules requiring independent financial experts to serve on audit committees of a firms board of self-regulatory arm of the New York Stock Exchange. It describes its broad mission as the fostering of directors. investor protection and market integrity. It examines securities firms, writes and enforces rules concerning trading practices,CFOs must now personally certify that their for investors andreports fairly represent, in CEOs and and administers a dispute resolution forum firms financial registered firms. all material respects, the operations and financial condition of the company, and are subject to
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personal penalties if those reports turn out to be misleading. Following the letter of GAAP rules may There still be self-regulation it is no longer sufficient accounting practice. is also necessary, but among the community of investment professionals. For example, the CFA Institute has developed standards of professional conduct that govern the behavior of members with the Chartered Financial Analysts designation, commonly referred to as CFAs. The nearby box presents a brief Auditors may no longer provide several other services to their clients. This is intended to prevent outline of thoseprofits on consulting work from influencing the quality of their audit. potential principles. The Board of Directors must be composed of independent directors and hold regular meetings of Directors in which company management is not present (and therefore cannot impede or influence the discussion). EXCERPTS FROM CFA INSTITUTE STANDARDS OF PROFESSIONAL
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On the MARKET FRONT
CONDUCT More recently, there has been a fair amount of push-back on Sarbanes-Oxley. Many observers believe that the compliance costs associated with the law are too onerous, especially for smaller firms, and that I. Professionalism heavy-handed regulatory oversight is giving foreign locales an undue advantage over the United States when firms decide where to listlaw. Members must understandefficacy of single-country regulation is Knowledge of their securities. Moreover, the knowledge of and comply with all being tested in the face of increasing globalization and the ease with which of Ethics and Standards national applicable laws, rules, and regulations including the Code funds can move across of borders. Professional Conduct.
One of the most Independence and in regulation has to doshall maintainversus principles.objectivity in contentious issues objectivity. Members with rules independence and Rules-based regulation attempts to professional activities. practices are or are not allowed. This has generally been their lay out specifically what the American approach, particularly at the SEC. In contrast, principles-based regulation relies on a less Misrepresentation. Members risk not knowingly misrep-resent and the sorts of financial explicitly defined set of understandings about musttaking, the goals of regulation,investment analysis, recommendations, or other professional activities. practices considered allowable. This has been the dominant approach in the U.K., and seems to be the more popular model for regulators throughout the world. II. Integrity of Capital Markets
Insider Trading Non-public information. Members must not exploit material non-public information.
Regulations also Market manipulation. Members shall not attempt to distortin securities to profit from prohibit insider trading. It is illegal for anyone to transact prices or trading volume with inside information,intent toprivate information held by officers, directors, or major stockholders that has the that is, mislead market participants. not yet been divulged to the public. But the definition of insiders can be ambiguous. While it is obvious III. Duties to Clients that the chief financial officer of a firm is an insider, it is less clear whether the firms biggest supplier can be considered anLoyalty, Yet a supplier may deduce themust place their clients interests significant own insider. prudence, and care. Members firms near-term prospects from before their changes in orders. This gives reasonable care on their behalf. and act with the supplier a unique form of private information, yet the supplier is not technically an insider. These ambiguities plague security analysts, whose job is to uncover as much information as possible concerning the firmsdeal fairlyprospects. The distinction between making Fair dealing. Members shall expected and objectively with clients when legal private information and investment recommendations or taking actions. illegal inside information can be fuzzy. Suitability. Members shall make a reasonable inquiry into a clients financial situation, inside investment experience, and investment objectives prior to making appropriate investment information recommendations. Nonpublic knowledge about a corporation possessed by corporate officers, major owners, or Performance with privileged access to informationto ensure that investment performance other individuals presentation. Members shall attempt about the firm. is presented fairly, accurately, and completely. The SEC requires officers, directors, and major stockholders to report allclients confidential unless the Confidentiality. Members must keep information about transactions in their firms stock. A compendium of insider trades is published monthly in the SECs Official Summary of Securities client permits disclosure. Transactions and Holdings. The idea is to inform the public of any implicit vote of confidence or no IV. Duties by insiders. confidence made to Employers
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Insiders do exploit their knowledge.must act for the benefit of support this conclusion. First, there have Loyalty. Members Three forms of evidence their employer. been well-publicized convictions of principals in insider trading schemes. Compensation. Members must not accept compensation from sources that would create a Second, there is considerable evidence of leakage of useful information to some consentbeforeall conflict of interest with their employers interests without written traders from any public announcement of that information. For example, share prices of firms announcing dividend involved parties. increases (which the market interprets as good news concerning the firms prospects) commonly increase Supervisors. public announcement of the increase. Clearly, some prevent violation of in value a few days before theMembers must make reasonable efforts to detect and investors are acting on applicable laws and the public. Share prices still to substantially on the good news before it is released toregulations by anyone subjectrisetheir supervision.the day of the public release of goodAnalysis and Recommendationsinsiders, or their associates, have not fully bid up the V. Investment news, however, indicating that price of the stock to the level commensurate with the news. Diligence. Members must exercise diligence and have reasonable basis for investment A third form of evidence on insider trading has actions. returns earned on trades by insiders. Researchers analysis, recommendations, or to do with have examined the SECs summary of insider trading to measure the performance of insiders. In one of the Communication. (1974) examined the abnormal return of stocks their presentation best known of these studies, Jaffe Members must distinguish fact from opinion in over the months of analysis and disclose general principles of investment processes of a in analysis. following purchases or sales by insiders. For months in which insider purchasers used stock exceeded insider sellers of the stock by three or more, the stock had an abnormal return in the following eight VI. Conflicts of Interest months of about 5%. Moreover, when insider sellers exceeded insider buyers, the stock tended to perform poorly. Disclosure of conflicts. Members must disclose all matters that reasonably could be expected to impair their objectivity or interfere with their other duties.
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SUMMARY
Priority of transactions. Transactions for clients and employers must have priority over transactions for the benefit of a member. Firms issue securities to raise the capital necessary to finance their investments. Investment bankers market these securities to the public on the primary market. Investment bankers VII. Responsibilities as Member of CFA institute generally act as underwriters who purchase the securities from the firm and resell them to the public at a markup. Before must not engage in be sold to thecompromises themust publish an Conduct. Members the securities may conduct that public, the firm reputation or SEC-approved prospectus that provides CFA designation. firms prospects. integrity of the CFA Institute or information on the
SOURCE: Excerpts from the CFA on the secondary of Professional Conduct. Already-issued securities are tradedInstitute Standardsmarket, that is, in organized stock markets; the over-the-counter market; and for large trades, through direct negotiation. Only license holders of exchanges may trade on the exchange. Brokerage firms holding licenses on the Regulatory Responses to Recent Scandals commissions for executing trades on their exchange sell their services to individuals, charging behalf. The scandals of 20002002 centered largely on three broad practices: allocations of shares in initial public offerings,Trading securities place in dealer markets, via electronic communication networks, ormost tainted may take research and recommendations put out to the public, and probably in important, misleading financialdealer markets, security dealers post bid and ask prices at which they are specialist markets. In statements and accounting practices. The regulatory response to these issues is still evolving, butBrokers for individualsbeen put in place. Many ofavailable prices. In electronic willing to trade. some initiatives have execute trades at the best these are contained in the Sarbanes-Oxley Act passed by book of limit2002. Among thethe terms at which trades can be executed. markets, the existing Congress in orders provides key reforms are: Mutually Public Company buy or sell securities Board to oversee the auditing of public Creation of aagreeable offers toAccounting Oversight are automatically crossed by the computer system operating the market. In specialist markets, the specialist acts to maintain an orderly companies. market with price continuity. Specialists maintain a limit order book, but also sell from or buy Rules requiring independent of stock. Thus, liquidity in specialist markets comes from board of for their own inventories financial experts to serve on audit committees of a firms both the directors. limit order book and the specialists inventory.
CEOs and CFOs must now personally certify that which a network of dealers negotiated directly in NASDAQ was traditionally a dealer market in their firms financial reports fairly represent, all material respects, the operations and financial condition of the company, and are years, to over sales of securities. The NYSE was traditionally a specialist market. In recent subject
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personal penalties exchanges dramatically increased their commitment to electronic GAAP rules may however, both if those reports turn out to be misleading. Following the letter of and automated still be necessary,trades today longer sufficient accounting practice. trading. Most but it is no are electronic. Auditors may no includeprovide several other services as the bidask spread. An ongoing prevent Trading costs longer explicit commissions as well to their clients. This is intended to potential profitsamong marketswork fromoverall trading costs including the effect of spreads. The controversy on consulting concerns influencing the quality of their audit. NYSE argues that it is often the cheapest trading venue when quality of execution (including The Board of Directors must be composed of independent is recognized. hold regular meetings of price impact and the possibility of price improvement) directors and Directors in which company management is not present (and therefore cannot impede or influence the Buying on margin means borrowing money from a broker in order to buy more securities than discussion). can be purchased with ones own money alone. By buying securities on a margin, an investor More recently, there has the upside potentialof push-back on Sarbanes-Oxley. Manyaobservers believefalls magnifies both been a fair amount and the downside risk. If the equity in margin account that the compliance costs associated with the law arethe investor will get a margin call from theand that below the required maintenance level, too onerous, especially for smaller firms, broker. heavy-handed regulatory oversight is giving foreign locales an undue advantage over the United States whenfirms decide wherethe list their securities. securities that the seller of single-country regulation is Short-selling is to practice of selling Moreover, the efficacy does not own. The short-seller being tested in thethe securities sold through a broker and may be required to cover the short position at borrows face of increasing globalization and the ease with which funds can move across national borders. any time on demand. The cash proceeds of a short sale are kept in escrow by the broker, and the broker usually requires that the short-seller deposit additional cash or securities to serve as One of the most contentious for thein regulation has to do with rules versus principles. Rules-based margin (collateral) issues short sale. regulation attempts to lay out specifically what practices are or are not allowed. This has generally been the American approach, particularly at the SEC. In contrast, principles-based regulation relies on a less Securities trading is regulated by the Securities and Exchange Commission, by other explicitlygovernment of understandings about risk taking, the goals of regulation, and the sorts of financial defined set agencies, and through self-regulation of the exchanges. Many of the important practices regulations allowable. This has been the dominant approach in the concerning the securities in considered have to do with full disclosure of relevant information U.K., and seems to be the more popular model for regulatorsrules also prohibit traders from attempting to profit from inside question. Insider trading throughout the world. information.
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Insider Trading
KEY TERMS Regulations also prohibit insider trading. It is illegal for anyone to transact in securities to profit from inside information, that is, private information held by officers, directors, or major stockholders that has notask price, divulged to the public. But the definition of insiders can be ambiguous. While it is obvious yet been 57 that the chief financial officer of a firm is an insider, it is less clear whether the firms biggest supplier can auction market, 57 be considered an insider. Yet a supplier may deduce the firms near-term prospects from significant bidask spread, 58 changes in orders. This gives the supplier a unique form of private information, yet the supplier is not technically an insider. These ambiguities plague security analysts, whose job is to uncover as much bid price, 57 information as possible concerning the firms expected prospects. The distinction between legal private information and illegal63 block transactions, inside information can be fuzzy.
dealer markets, 57 electronic communication networks (ECNs), 59 Nonpublic knowledge about a corporation possessed by corporate officers, major owners, initial public offering (IPO), 53 or other individuals with privileged access to information about the firm. inside information, 76 The SEC requires officers, directors, and major stockholders to report all transactions in their firms stock. limit buy (sell) insider trades is published monthly in the SECs Official Summary of Securities A compendium of order, 58 Transactions and Holdings. The idea is to inform the public of any implicit vote of confidence or no margin, 68 confidence made by insiders.
inside information
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Insiders do exploit their knowledge. Three forms of evidence support this conclusion. First, there have NASDAQ Stock Market, 61 been well-publicized convictions of principals in insider trading schemes. over-the-counter (OTC) market, 59 Second, there is considerable evidence of leakage of useful information to some traders before any primary market, 53 public announcement of that information. For example, share prices of firms announcing dividend increases (which the market interprets as good news concerning the firms prospects) commonly increase private placement, 54 in value a few days before the public announcement of the increase. Clearly, some investors are acting on the program trade, 64 it is released to the public. Share prices still rise substantially on the day of the good news before public release of good news, however, indicating that insiders, or their associates, have not fully bid up the prospectus, 53 price of the stock to the level commensurate with the news. secondary market, 53 A third form of evidence on insider trading has to do with returns earned on trades by insiders. Researchers have examined the SECs summary of insider trading to measure the performance of insiders. In one of the short sale, 70 best known of these studies, Jaffe (1974) examined the abnormal return of stocks over the months specialist, 60 following purchases or sales by insiders. For months in which insider purchasers of a stock exceeded insider sellers of the stock by three or more, the stock had an abnormal return in the following eight stock exchanges, 62 months of about 5%. Moreover, when insider sellers exceeded insider buyers, the stock tended to perform poorly. order, 58 stop underwriters, 53
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SUMMARY
Firms issue securities to raise the capital necessary to finance their investments. Investment PROBLEM SETS bankers market these securities to the public on the primary market. Investment bankers generally act as underwriters who purchase the securities from the firm and resell them to the public at a markup. Before the securities may be sold to the public, the firm must publish an SEC-approved prospectus that provides information on the firms prospects. Select problems are available in McGraw-Hill Connect. Please see the packaging options of the Already-issued securities preface for more information.are traded on the secondary market, that is, in organized stock markets; the over-the-counter market; and for large trades, through direct negotiation. Only license Basic holders of exchanges may trade on the exchange. Brokerage firms holding licenses on the exchange sell their servicesbetween an IPOcharging commissions for executing trades on their 1. What is the difference to individuals, (initial public offering) and an SEO (seasoned equity behalf. offering)? Trading may take place in dealer markets,of the effectivecommunication networks, or in of 2. What are some different components via electronic costs of buying or selling shares specialist markets. In dealer markets, security dealers post bid and ask prices at which they are stock? willing to trade. Brokers for individuals execute trades at the best available prices. In electronic 3. What is existing book of limit a primary and the terms market? markets, the the difference betweenorders providessecondary at which trades can be executed. Mutually agreeable offers to buy or sell securities are automatically crossed by the computer 4. How do specialist firms earn their profits? system operating the market. In specialist markets, the specialist acts to maintain an orderly marketwhat circumstances areSpecialists maintain more likely to be used than public offerings? 5. In with price continuity. private placements a limit order book, but also sell from or buy for their own inventories of stock. Thus, liquidity in specialist markets comes from both the 6. What book differences between a stop-loss limit orderare theand the specialists inventory. order, a limit sell order, and a market order? 7. What was traditionally a why market in which a network done in block orders directly NASDAQis a block order, anddealerhas the proportion of trades of dealers negotiated declined in overrecent of securities. The NYSE was traditionally a specialist market. In recent years, sales years?
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however, both exchanges dramatically increased their commitment to electronic and automated 8. What is the role of an are electronic. trading. Most trades today underwriter? A prospectus? 9. How do margin trades magnify both the upside potential and spread. An ongoing Trading costs include explicit commissions as well as the bidaskdownside risk of an investment portfolio? controversy among markets concerns overall trading costs including the effect of spreads. The NYSE Intermediateargues that it is often the cheapest trading venue when quality of execution (including price impact and the possibility of price improvement) is recognized. 10. Suppose you short sell 100 shares of IBM, now selling at $120 per share. Buying on margin means borrowing money from a broker in order to buy more securities than can bea. What iswith ones own money alone. By buying securities on a margin, an investor purchased your maximum possible loss? magnifies both the upside potential and the downside risk. If the equity in a margin account falls b. What happens to the maximum loss if you simultaneously place a stop-buy order at below the required maintenance level, the investor will get a margin call from the broker. $128? Short-selling is the practice of selling securities that the seller does not own. The short-seller 11. Call one full-service broker and one discount broker and find out the transaction costs of borrows the securities sold through a broker and may be required to cover the short position at implementing the following strategies: any time on demand. The cash proceeds of a short sale are kept in escrow by the broker, and the brokera. Buying 100 shares ofshort-sellerand selling them six months from now. serve as usually requires that the IBM now deposit additional cash or securities to margin (collateral) for the short sale. b. Investing an equivalent amount in six-month at-the-money call options on IBM stock Securities now and selling them six months from now. trading is regulated by the Securities and Exchange Commission, by other government agencies, and through self-regulation of the exchanges. Many of the important 12. DRK, have to just sold 100,000 shares relevant information concerning the securities regulationsInc., has do with full disclosure ofin an initial public offering. The underwriters in explicit fees trading rules also prohibit traders from attempting to profit from inside question. Insider were $60,000. The offering price for the shares was $40, but immediately upon issue, the information. share price jumped to $44. a. What is your best guess as to the total cost to DRK of the equity issue?
KEY TERMS
b. Is the entire cost of the underwriting a source of profit to the underwriters?
ask price, 57 13. De Trader opens a brokerage account, and purchases 300 shares of Internet Dreams at $40 per share. auction market, 57 She borrows $4,000 from her broker to help pay for the purchase. The interest rate on the loan is 8%. bidask spread, 58 a. What is the margin in Des account when she first purchases the stock? bid price, 57 b. If the share price falls to $30 per share by the end of the year, what is the remaining block transactions, 63 in her account? If the maintenance margin requirement is 30%, will she margin receive a margin call? dealer markets, 57 c. What is the rate of return on her investment? electronic communication networks (ECNs), 59 14. Old Economy Traders opened an account to short-sell 1,000 shares of Internet Dreams from initial public offering (IPO), 53 the previous question. The initial margin requirement was 50%. (The margin account pays no interest.) inside information, 76 A year later, the price of Internet Dreams has risen from $40 to $50, and the stock has paid a dividend of $2 per share. limit buy (sell) order, 58 a. What is the remaining margin in the account? margin, 68
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NASDAQ StockIf the maintenance margin requirement is 30%, will Old Economy receive a margin b. Market, 61 call? over-the-counter (OTC) market, 59 c. What is the rate of return on the investment? primary market, 53 15. Consider the following limit order book of a specialist. The last trade in the stock occurred private placement, 54 $50. at a price of program trade, 64 prospectus, 53 secondary market, 53 short sale, 70 specialist, 60 stock exchanges, 62 stop order, 58 If a market buy order for 100 shares comes in, at what price will it be filled? a. underwriters, 53 At what price would the next market buy order be filled? b.
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c. If you were the specialist, would you want to increase or decrease your inventory of PROBLEM SETS this stock? 16. You are bullish on Telecom stock. The current market price is $50 per share, and you have $5,000 of your own to invest. You borrow an additional $5,000 from your broker at an interest rate of 8% per year and invest $10,000 in the stock. Select problems are available in McGraw-Hill Connect. Please see the packaging options of the preface for more information. rate of return if the price of Telecom stock goes up by 10% during a. What will be your the next year? (Ignore the expected dividend.) Basic b. How far does the price of Telecom stock have to fall for you to get a margin call if the 1. What is the difference between an IPO (initial public offering) and an SEO (seasoned equity maintenance margin is 30%? Assume the price fall happens immediately. offering)? 2. What are some different components of the effective costs of buying or selling shares of stock? Please visit us at www.mhhe.com/bkm 3. What is the difference between a primary and secondary market? 17. You are bearish on Telecom and decide to sell short 100 shares at the current market price 4. How do specialist firms earn their profits? of $50 per share. 5. Ina. How much in cash or securities must you put likely to be used than public offerings? what circumstances are private placements more into your brokerage account if the brokers initial margin requirement is 50% of the value of the short position? 6. What are the differences between a stop-loss order, a limit sell order, and a market order? b. How high can the price of the stock go before you get a margin call if the 7. What is a block order, and why has the proportion of trades done in block orders declined in maintenance margin is 30% of the value of the short position? recent years?
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8. What is the role of an underwriter? A prospectus? 9. How do margin trades magnify both the upside potential and downside risk of an investment Please visit us at www.mhhe.com/bkm portfolio? 18. Here Intermediate is some price information on Marriott: 10. Suppose you short sell 100 shares of IBM, now selling at $120 per share. a. What is your maximum possible loss? b. What happens to the maximum loss if you simultaneously place a stop-buy order at $128? You have placed a stop-loss order to sell at $20. What are you telling your broker? Given 11. Call one full-service broker and one discount broker and find out the transaction costs of market prices, will your order be executed? implementing the following strategies: 19. Here is some price information on Fincorp stock. Suppose first that Fincorp trades in a a. market. dealer Buying 100 shares of IBM now and selling them six months from now. b. Investing an equivalent amount in six-month at-the-money call options on IBM stock now and selling them six months from now. 12. DRK, Inc., has just sold 100,000 shares in an initial public offering. The underwriters explicit fees were $60,000. The offering price for the shares was $40, but immediately upon issue, the share price jumped to $44. a. Supposeyour haveguess as to an order to your DRK ofto buy at market. At what price a. What is you best submitted the total cost to broker the equity issue? will your trade be executed? b. Is the entire cost of the underwriting a source of profit to the underwriters? b. Suppose you have submitted an order to sell at market. At what price will your trade 13. De Trader opens a brokerage account, and purchases 300 shares of Internet Dreams at $40 be executed? per share. She borrows $4,000 from her broker to help pay for the purchase. The interest c. Suppose is 8%. rate on the loanyou have submitted a limit order to sell at $55.62. What will happen? d. Supposethe marginsubmitted accountorder to buy at $55.37. What stock? a. What is you have in Des a limit when she first purchases the will happen? 20. Now reconsider the previousto $30 perassuming that end of the year, what is the remaining b. If the share price falls problem share by the Fincorp sells in an exchange market like the NYSE. her account? If the maintenance margin requirement is 30%, will she margin in receive a margin call? a. Is there any chance for price improvement in the market orders considered in parts (a) c. and (b)?the rate of return on her investment? What is b. Is there Traders opened immediate trade at $55.37 for the limit buy order in part (d)? 14. Old Economy any chance of anan account to short-sell 1,000 shares of Internet Dreams from the previous question. The initial margin requirement was 50%. (The margin account pays 21. Youve borrowed $20,000 on margin to buy shares in Disney, which is now selling at $40 no interest.) A year later, the price of Internet Dreams has risen from $40 to $50, and the per share. Your account starts at the initial margin requirement of 50%. The maintenance stock has paid a dividend of $2 per share. margin is 35%. Two days later, the stock price falls to $35 per share. a. What is the remaining margin in the account? a. Will you receive a margin call?
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b. How low can the price of Disney sharesis 30%, willyou receive a margin call? If the maintenance margin requirement fall before Old Economy receive a margin call? 22. On January 1, you sold short one round lot (that is, 100 shares) of Lowes stock at $21 per share. What is the1, a dividend of $3 per share was paid. On April 1, you covered the short c. On March rate of return on the investment? sale by buying the stock at a price of $15 per share. You paid 50 cents per share in 15. Consider the following limit order What of the value of your last tradeon April 1? occurred commissions for each transaction. book is a specialist. The account in the stock at a price of $50. Challenge 23. Suppose that Intel currently is selling at $40 per share. You buy 500 shares using $15,000 of your own money, borrowing the remainder of the purchase price from your broker. The rate on the margin loan is 8%. a. What is the percentage increase in the net worth of your brokerage account if the price of Intel immediately changes to: (i) $44; (ii) $40; (iii) $36? What is the relationship between your percentage return and the percentage change in the price of Intel? b. If the maintenance margin is 25%, how low can Intels price fall before you get a margin call? a. If a market buy order for 100 shares comes in, at what price will it be filled? c. How would your answer next market buy you had financed the initial purchase with b. At what price would the to (b) change if order be filled? only $10,000 of your own money? c. If you were the specialist, would you want to increase or decrease your inventory of d. What is the rate of return on your margined position (assuming again that you invest this stock? $15,000 of your own money) if Intel is selling after one year at: (i) $44; (ii) $40; (iii) 16. You are bullish on Telecom stock. The current market price is $50 per share, and you have $36? What is the relationship between your percentage return and the percentage $5,000 of your own price of Intel? Assume an additional $5,000 from your broker at an change in the to invest. You borrow that Intel pays no dividends. interest rate of 8% per year and invest $10,000 in the stock. e. Continue to assume that a year has passed. How low can Intels price fall before you a. Whatmargin call? rate of return if the price of Telecom stock goes up by 10% during get a will be your the next year? (Ignore the expected dividend.) b. How far does the price of Telecom stock have to fall for you to get a margin call if the maintenance margin is 30%? Assume the price fall happens immediately. Please visit us at www.mhhe.com/bkm 24. Suppose that you sell short 500 shares of Intel, currently selling for $40 per share, and give your broker $15,000 to establish your margin account. Please visit us at www.mhhe.com/bkm a. If you earn no interest on the funds in your margin account, what will be your rate of 17. You are bearish on Telecom and decide to selling at:100$44; (ii) $40; current market price return after one year if Intel stock is sell short (i) shares at the (iii) $36? Assume that of $50Intel share.no dividends. per pays a. How much in cash margin is 25%, how high can Intelsbrokerage before youthe a b. If the maintenance or securities must you put into your price rise account if get brokers initial margin requirement is 50% of the value of the short position? margin call? b. How high can the price of the stock go before you get a margin call if the maintenance margin is 30% of the value of the short position?
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c. Redo parts (a) and (b), but now assume that Intel also has paid a year-end dividend of $1 per share. The prices in part (a) should be interpreted as ex-dividend, that is, prices after the dividend has been paid. Please visit us at www.mhhe.com/bkm 18. Here is some price information on Marriott: Please visit us at www.mhhe.com/bkm
CFA Problems
You have placed a stop-loss order to sell at $20. What are you telling your broker? Given 1. If you placeprices, will your order be executed?of stock at $55 when the current price is $62, market a stop-loss order to sell 100 shares how much will you receive for each share if the price drops to $50? 19. Here is some price information on Fincorp stock. Suppose first that Fincorp trades in a a. dealer market. $50. b. $55. c. $54.87. d. Cannot tell from the information given. 2. You wish to sell short 100 shares of XYZ Corporation stock. If the last two transactions were at $34.12 followed byyou haveyou can sell short onto your broker to buyonly at a price what price a. Suppose $34.25, submitted an order the next transaction at market. At of will your trade be executed? a. 34.12 or higher b. Suppose you have submitted an order to sell at market. At what price will your trade b. 34.25 or higher be executed? c. 34.25 or lower c. Suppose you have submitted a limit order to sell at $55.62. What will happen? d. 34.12 or lower d. Suppose you have submitted a limit order to buy at $55.37. What will happen? 3. Specialists on the New York Stock Exchange do all of the following except: 20. Now reconsider the previous problem assuming that Fincorp sells in an exchange market a. like the NYSE. for their own accounts. Act as dealers a. Is there any chance b. Execute limit orders. for price improvement in the market orders considered in parts (a) and (b)? c. Help provide liquidity to the marketplace. b. Is there any chance of an immediate trade at $55.37 for the limit buy order in part (d)? d. Act as odd-lot dealers. 21. Youve borrowed $20,000 on margin to buy shares in Disney, which is now selling at $40 per share. Your account starts at the initial margin requirement of 50%. The maintenance margin is 35%. Two days later, the stock price falls to $35 per share. a. Will you receive a margin call?
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Use data from the Standard & Poorsof DisneyInsight fall before at receive a margin call? b. How low can the price Market shares Database you www.mhhe.com/edumarketinsight to answer the following questions. 22. On January 1, you sold short one round lot (that is, 100 shares) of Lowes stock at $21 per 1. Select the Company tab a dividendticker symbol T and click GO. AT&T should appear.short share. On March 1, and enter of $3 per share was paid. On April 1, you covered the Click on the Compustat Reports section and find theper share. You paid 50 cents perWherein the sale by buying the stock at a price of $15 link for the companys profile. share is companys headquarters located? On what exchange does the companys on April 1? commissions for each transaction. What is the value of your account stock primarily trade? Challenge to the Compustat Reports, click on the Ticker History. Briefly summarize what you find 2. Back out about the companys history with regard to its name and its ticker symbol. 23. Suppose that Intel currently is selling at $40 per share. You buy 500 shares using $15,000 of 3. Link to the Financial Highlights section of the Compustat Reports. Who is your broker.auditor your own money, borrowing the remainder of the purchase price from the primary The rate of the firms financial statements? Is the auditors opinion qualified in any way? on the margin loan is 8%. 4. Repeat this processthe percentage increasethe the net worth of your the two firms. a. What is for GM and compare in Auditors Opinion of brokerage account if the price of Intel immediately changes to: (i) $44; (ii) $40; (iii) $36? What is the relationship between your WEB master: CHOOSINGpercentage return and the percentage change in the price of Intel? A BROKER b. If the maintenance margin is 25%, how low can Intels price fall before you get a There are several factors that should be considered when you are choosing which brokerage firm(s) to margin call? use to execute your trades. There are also a wide range of services that claim to objectively recommend brokeragewould your answer to (b) change if you the brokeragethe initial purchase with c. How firms. Many are actually sponsored by had financed firms themselves. only $10,000 of your own money? Go to the website www.consumersearch.com/online-brokers/reviews and read the information provided under Our Sources. Then follow the link for the Barrons (assuming again that you invest d. What is the rate of return on your margined position ratings. Here you can read the Barrons annual $15,000 of your own money)theIntel is The Brokers one year at: (i) $44; (ii) $40; (iii) broker survey and download if How selling after Stack Up report, which contains a list of fees. Suppose What is the relationship between your percentagein a non-IRA account. $36? that you have $3,000 to invest and want to put it return and the percentage change in the price of Intel? Assume that Intel pays no dividends. 1. Are all of the brokerage firms suitable if you want to open a cash account? Are they all suitable if you e. Continue to assume that a year has passed. How low can Intels price fall before you want a margin account? get a margin call? 2. Choose two of the firms listed. Assume that you want to buy 200 shares of LLY stock using a market order. If the order is filled at $42 per share, how much will the commission be for the two firms if you place an online order? 3. Are Please visit us at wwwfees associated with the account at either brokerage firm? there any maintenance .mhhe.com/bkm 24. Suppose 4. Now assume that you sell short 500 shares of and the balance selling for Calculate the interest have a margin account Intel, currently is $3,000. $40 per share, and give rate yourwould pay if youto establishmoney to buyaccount. you broker $15,000 borrowed your margin stock. a. If you earn no interest on the funds in your margin account, what will be your rate of
SOLUTIONSreturn CONCEPT if Intel stock is selling at: (i) $44; (ii) $40; (iii) $36? Assume that TO after one year checks
Intel pays no dividends. 3.1. Limited-time shelf registration was introduced because of its favorable trade-off of saving b. If the maintenance margin is 25%, how high can Intels price rise before you issue costs versus providing disclosure. Allowing unlimited shelf registration wouldget a margin call? circumvent blue sky laws that ensure proper disclosure as the financial circumstances of the firm change over time. 3.2.
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c. Redo cars trade in dealer markets (used-car lots oralso has paid a year-end dividend of a. Used parts (a) and (b), but now assume that Intel auto dealerships) and in direct $1 per share. The prices in part (a) should be local newspapers or Internet listings. search markets when individuals advertise in interpreted as ex-dividend, that is, prices after the dividend has been paid. b. Paintings trade in broker markets when clients commission brokers to buy or sell art for them, in dealer markets at art galleries, and in auction markets. c. Rare coins trade in dealer markets, for example, in coin shops or shows, but they also Pleasetrade in auctions .mhhe.directbkm markets when individuals advertise they want to visit us at wwwand in com/ search buy or sell coins. 3.3.
CFA Problems
a. You should give your broker a market order. It will be executed immediately and is the stop-loss order to sell in terms of brokerage fees. 1. If you place a cheapest type of order 100 shares of stock at $55 when the current price is $62, how muchYou should give your broker a limit buy order, which will be executed only if the b. will you receive for each share if the price drops to $50? a. $50.shares can be obtained at a price about 5% below the current price. c. b. $55.You should give your broker a stop-loss order, which will be executed if the share price starts falling. The limit or stop price should be close to the current price to avoid c. $54.87. possibility of large losses. the d. Cannot 3.4. Solving tell from the information given. 2. You wish to sell short 100 shares of XYZ Corporation stock. If the last two transactions were at 100 p $4, 000 $34.12 followed by $34.25, you can sell short on p next = .4 transaction only at a price of 100 the a. yields P or higher share. 34.12 $66.67 per b. 34.25 or higher 3.5. The investor will purchase 150 shares, with a rate of return as follows: c. 34.25 or lower d. 34.12 or lower 3. Specialists on the New York Stock Exchange do all of the following except: a. Act as dealers for their own accounts. b. Execute limit orders. 3.6. a. Once Dot Bomb stock goes up to $110, your balance sheet will be: c. Help provide liquidity to the marketplace. d. Act as odd-lot dealers.
80 81
81 82
b. Solving
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Use data from the Standard & Poors Market Insight Database at $150, 000 1, 000 p www.mhhe.com/edumarketinsight to answer the following questions. = .4 1, 000 p 1. Select the Company tab and enter ticker symbol T and click GO. AT&T should appear. Click yields $107.14 per share. on the CompustatPReports section and find the link for the companys profile. Where is the 1 companys headquarters located? On what exchange does the companys stock primarily trade? It is worth noting, however, that by December 2000, shares in VA Linux (now renamed VA 2.Software) were selling forReports, click on the Ticker History. Briefly summarize what youis Back to the Compustat less than $9 a share, and by 2002, for less than $1. This example find extreme, but the companys history with regard long-term investment performance of IPOs. out about consistent with the generally poor to its name and its ticker symbol. 3. Benveniste and Wilhelm (1997) provide an elaboration of this point and a more completeauditor Link to the Financial Highlights section of the Compustat Reports. Who is the primary discussion of the book-building process.the auditors opinion qualified in any way? of the firms financial statements? Is As we noted in Chapter 2, most value-weighted indexes today are based on free float (the value of 4. Repeat this process for GM and compare the Auditors Opinion of the two firms. shares freely tradable among investors) rather than total shares. Free float excludes shares held by founding families or governments. This is true of the TOPIX as well. WEB master: CHOOSING A BROKER 4 Naked short-selling is a variant on conventional short-selling. In a naked short, a trader sells shares that have not factors borrowed, be considered when you can be acquired and delivered firm(s) to There are severalyet beenthat should assuming that the shares are choosing which brokerage whenever use theexecute your trades.be closed out. a wide range of services that claim to objectively to short sale needs to There are also
5 recommendthat when buying Many are actually sponsored byamount of dollars from your broker, so Notice brokerage firms. on margin, you borrow a given the brokerage firms themselves. Go thethe website the loan is independent .of theonline-brokers/contrast, and read the information to amount of www.consumersearch com/ share price. In reviews when short-selling you borrow a given number of shares, which follow returned. Therefore, when the price of the shares changes, provided under Our Sources. Thenmust bethe link for the Barrons ratings. Here you can read the the value of broker also changes. Barrons annualthe loansurvey and download the How The Brokers Stack Up report, which contains 6 of fees. Suppose a listSee, for example, that you haveO. A. Lamont, Shortwant to put it in a and Stock account. Journal C. Jones and $3,000 to invest and Sale Constraints non-IRA Returns, 3 2
of Financial Economics, November 2002, pp. 20739 or O. A. Lamont, Go Down Fighting: Short 1. Are all of the brokerage firms suitable if you want to open a cash account? Are they all suitable Sellers vs. Firms, Yale ICF Working Paper No. 04-20, July 2004. if you want a margin account? 2. Choose two of the firms listed. Assume that you want to buy 200 shares of LLY stock using a market order. If the order is filled at $42 per share, how much will the commission be for the two firms if you place an online order? 3. Are there any maintenance fees associated with the account at either brokerage firm? 4. Now assume that you have a margin account and the balance is $3,000. Calculate the interest rate you would pay if you borrowed money to buy stock.
SOLUTIONS TO CONCEPT checks

3.1. Limited-time shelf registration was introduced because of its favorable trade-off of saving issue costs versus providing disclosure. Allowing unlimited shelf registration would circumvent blue sky laws that ensure proper disclosure as the financial circumstances of the firm change over time. 3.2.
Page 46 of 46 44

a. Used cars trade in dealer markets (used-car lots or auto dealerships) and in direct search markets when individuals advertise in local newspapers or Internet listings. b. Paintings trade in broker markets when clients commission brokers to buy or sell art for them, in dealer markets at art galleries, and in auction markets. c. Rare coins trade in dealer markets, for example, in coin shops or shows, but they also trade in auctions and in direct search markets when individuals advertise they want to buy or sell coins. 3.3. a. You should give your broker a market order. It will be executed immediately and is the cheapest type of order in terms of brokerage fees. b. You should give your broker a limit buy order, which will be executed only if the shares can be obtained at a price about 5% below the current price. c. You should give your broker a stop-loss order, which will be executed if the share price starts falling. The limit or stop price should be close to the current price to avoid the possibility of large losses. 3.4. Solving 100 p $4, 000 = .4 100 p yields P $66.67 per share. 3.5. The investor will purchase 150 shares, with a rate of return as follows:
81 82
3.6. a. Once Dot Bomb stock goes up to $110, your balance sheet will be:
b. Solving
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$150, 000 1, 000 p = .4 1, 000 p yields P $107.14 per share.
1
It is worth noting, however, that by December 2000, shares in VA Linux (now renamed VA Software) were selling for less than $9 a share, and by 2002, for less than $1. This example is extreme, but consistent with the generally poor long-term investment performance of IPOs.
2
Benveniste and Wilhelm (1997) provide an elaboration of this point and a more complete discussion of the book-building process.
3
As we noted in Chapter 2, most value-weighted indexes today are based on free float (the value of shares freely tradable among investors) rather than total shares. Free float excludes shares held by founding families or governments. This is true of the TOPIX as well.
4
Naked short-selling is a variant on conventional short-selling. In a naked short, a trader sells shares that have not yet been borrowed, assuming that the shares can be acquired and delivered whenever the short sale needs to be closed out.
5
Notice that when buying on margin, you borrow a given amount of dollars from your broker, so the amount of the loan is independent of the share price. In contrast, when short-selling you borrow a given number of shares, which must be returned. Therefore, when the price of the shares changes, the value of the loan also changes.
6
See, for example, C. Jones and O. A. Lamont, Short Sale Constraints and Stock Returns, Journal of Financial Economics, November 2002, pp. 20739 or O. A. Lamont, Go Down Fighting: Short Sellers vs. Firms, Yale ICF Working Paper No. 04-20, July 2004.
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Essentials of Investments, 8th Edition-3

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Essentials of Investments, 8th Edition

Chapter 3: Securities Markets

Related Web sites for this chapter are available at www.mhhe.com/bkm.

3.1: How Firms Issue Securities

Chapter 3: Securities Markets