Chapter 3

Securities Markets

McGraw-Hill/Irwin

Copyright 2010 by The McGraw-Hill Companies, Inc. All rights reserved.

3.1 How Firms Issue Securities

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Primary vs. Secondary Market Security Sales

Primary
New issue is created and sold Key factor: issuer receives the proceeds from the sale Public offerings: registered with the SEC and sale is made to the investing public Private offerings: not registered, and sold to only a limited number of investors, with restrictions on resale

Secondary
Existing owner sells to another party Issuing firm doesnt receive proceeds and is not directly involved
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Primary vs. Secondary Security Sales

Equity

Primary

Secondary

IPO

Seasoned

Auction

Dealer

4th

GCO
(Underwritten)

GCO
(Underwritten)

Best Efforts

Rights

NYSE

ASE

Regionals

NASDAQ OTC Pink Sheet

3rd market

Competitive

Negotiated

Standby & Take-up

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Investment Banking Arrangements

Underwritten vs. Best Efforts Underwritten: banker makes a firm commitment on proceeds to the issuing firm Best Efforts: banker(s) helps sell but makes no firm commitment Negotiated vs. Competitive Bid Negotiated: issuing firm negotiates terms with investment banker Competitive bid: issuer structures the offering and secures bids
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Figure 3.1 Relationship Among a Firm Issuing Securities, the Underwriters and the Public

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Shelf Registrations
SEC Rule 415
Security is preregistered and then may be offered at any time within the next two years.
24 hour notice, any part or all of the preregistered amount may be offered

Introduced in 1982 Allows timing of the issues

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Private Placements
Private placement: sale to a limited number of sophisticated investors not requiring the protection of registration
Allowed under SEC Rule 144A Dominated by institutions Very active market for debt securities Not active for stock offerings

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Initial Public Offerings

IPO Process
Issuer and banker put on the Road Show Purpose: Book building and pricing

Underpricing
Post initial sale returns average about 10% or
more, Winners curse problem? Easier to market the issue, but costly to the issuing firm

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Figure 3.2 Average First Day Returns for European and NonEuropean IPOs

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Figure 3.3 Long-term Relative Performance of Initial Public Offerings 1970-2006

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3.2 How Securities are Traded

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Functions of Financial Markets

Overall purpose: facilitate low cost investment
1. Bring together buyers and sellers at low cost 2. Provide adequate liquidity by minimizing time and cost to trade and promoting price continuity. 3. Set & update prices of financial assets Reduces information costs associated with investing

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Types of Markets
Direct Search Markets
Buyers and sellers locate one another on their own

Brokered Markets
3rd party assistance in location buyer or seller

Dealer Markets
3rd party acts as intermediate buyer/seller

Auction Markets
Brokers & dealers trade in one location, trading is more or less continuous
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Types of Orders
Instructions to the brokers on how to complete the order

Market order: execute immediately at the best price Limit order: Order to buy or sell at a specified price or better
On the exchange the limit order is placed in a limit order book kept by an exchange official or computer E.G.: Stock trading at $50, could place a buy $50.25 $49.90 limit at ______ or a sell limit order at ______.
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Limit Order Book for Intel on Archipelago

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Types of Orders Continued

Stop loss order: Becomes a market sell order when the trigger price is encountered.
E.G.: You own stock trading at $40. You could place a stop loss at $38 The stop loss would ___. become a market order to sell if the price of the stock hits $38 ___.

Stop buy order: Becomes a market buy order when the trigger price is encountered.
E.G.: You shorted stock trading at $40. You could place a stop buy at $42 The stop buy would ___. become a market order to buy if the price of the stock hits $42 ___.
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Types of Orders Continued

Discretionary order: gives the broker the power to buy and sell for your account at the broker's discretion. Time dimension on orders (other than market orders):
IOC: immediate or cancel Day: by default GTC: good until canceled (usually 60 days max)
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3.3 U.S. Security Markets

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U.S. Security Markets Overview

Nasdaq Small stock OTC
Pink sheets

Organized Exchanges
New York Stock Exchange American Stock Exchange Regionals

Electronic Communication Networks (ECNs) National Market System

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NASDAQ
Dealer Markets

Dealer market is a market without centralized order flow NASDAQ: largest organized stock market for OTC trading; information system for individuals, brokers and dealers

Securities: stocks, most bonds and some derivatives

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NASDAQ
Nasdaq National Market: Types of securities? Nasdaq SmallCap Market Levels of subscribers to Nasdaq quotation system
Level 1: inside quotes Level 2: receives all quotes but they cant enter quotes Level 3: dealers can see and post quotes SuperMontage: Centralized limit order book for Nasdaq securities that allows automatic trade execution

OTC Bulletin Board Pink Sheet Stocks

www.pinksheets.com

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Table 3.1 Partial Requirements for Listing on NASDAQ Markets

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Organized Exchanges
Auction markets are markets with centralized order flow Dealership function: can be competitive or assigned by the exchange (Specialists) Securities:stock, futures contracts, options, and to a
lesser extent bonds

Examples:

NYSE, ASE, Regionals, CBOE, CME

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Exchanges
Auction Markets

NYSE

ASE and Regionals

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Exchange Markets
Members of the exchange:
Purchase a seat on the exchange, gives the right to trade and a say in the governance of the exchange.

Commission broker:
Employee of a member firm, processes orders for the firm, earns a commission.

Floor broker:
Independent broker who works for various member firms as needed.
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Exchange Participants
Floor trader:
Independent trader who buys and sells securities for his/her own account. Often called speculator or arbitrageur.

Specialist:
Exchange appointed firm in charge of running the
market for a given stock(s). Acts as both a broker and a dealer charged with matching buy and sell orders from customers and/or filling customer's orders by adding to or selling their own inventory of stock.

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Specialists
a) Appointed by exchange to serve as "market maker" for one or more stocks.

b) Specialist acts as a broker:

Facilitating trades for certain types public orders (limit orders)

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Specialists
c) Specialist acts as a dealer: Charged with maintaining a "continuous, orderly market."

Must at times trade against the market Can petition exchange to halt trading Incur inventory costs/risks of holding stock Specialists monitor and limit the bid-ask spread

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 Place a market order to buy 1 round lot of AMD with your broker. Broker electronically submits the order to the floor of the NYSE. Commission broker takes/sends order to specialist post. May trade with another broker or with specialist.
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Placing an order

Trade improvement from trading with another broker:

You place a buy market order when limit inside quotes are Bid $20.00, Ask $20.10 Your buy market order will be executed at ______ against the book. $20.10
$20.00 A sell market order would execute at _______ against the book.

In an auction market, if two brokers arrive at the same time both may get price improvement by $20.05 negotiating a trade at _______.
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Electronic Trading on the NYSE

SuperDot
Electronic order routing system allows brokers to electronically send orders directly to specialist.
Useful for program trading
0

DirectPlus
Fully automated trade execution system Execution time < second

Electronic order placement is growing, large orders still require human intervention.
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 Block Houses

Block Transactions and Block Houses

Trade for 10,000 shares

Specialize in large block trades

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Electronic Computer Networks (ECNs)

ECNs allow institutional investors to post quotes and trade directly with each other. (4th Market) Public limit order book Automatic execution Advantages include Lower transactions costs (usually < 1 per share) Speed even on large trade sizes Anonymity

ECNs

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Market Consolidation Trends

NYSE:
Merged with Archipelago ECN in 2006 Merged with Euronext in 2007 Acquired the ASE in 2008 Entering Indian and Japanese stock markets

NASDAQ
Acquired Instinet/Island in 2005 Acquired Boston Stock Exchange in 2007 Jointly acquired Swedish exchange OMX

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Market Consolidation Trends

Euronext
Formed from merger of Paris, Brussels, Lisbon and Amsterdam exchanges Acquired the Liffe in London Merged with NYSE in 2007

CME acquired CBOT in 2007

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3.4 Market Structures in Other Countries

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Market Structures in Other Countries

Moving to automated electronic trading

Specialist system is largely unique to U.S.

Tokyo Stock Exchange (TSE)
No trading floor, all electronic trading Three sections for different size firms Two major indexes: Nikkei 225 and TOPIX

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Market Capitalization of Major Exchanges

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Dollar Volume of Trading in Major World Markets, 2004

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3.5 Trading Costs

Commission: fee paid to broker for making the transaction Spread: cost of trading with dealer
Bid: price dealer will buy from you Ask: price dealer will sell to you Spread: ask - bid

Combination: on some trades both are paid

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Characteristics of well-functioning markets

a) Low cost transfer of funds (competition among market makers and brokers).

Operational or internal efficiency

b) Adequate trading activity to ensure purchases and sales occur in timely fashion without affecting price. (Trading volume)

Operational or internal efficiency

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Characteristics of well-functioning markets

c) Prices speedily reflect public information Informational efficiency
Informational: Are price changes predictable so that you can earn more than you should for the risk level you are taking?

Allocational efficiency
Allocational: Are prices accurately reflecting the prospects of firm/issuers cash flows?
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Comparing the NYSE and NASDAQ

Which is better in terms of the characteristics, the NYSE or NASDAQ?

Effective spreads for Nasdaq and NYSE:
2004 Effective spread in $ Nasdaq Median $0.038 0.27% 72.3%

NYSE Median
$0.031

Effective spread / Price

Order fill rate on limits

0.19%
83.4%

Adjusted for liquidity differences with matched samples. Differences are statistically significant at the 1% level Source: NYSE, NYSE Execution Quality, 2003-2004

$1.5 million This translates to a cost savings of about __________ per stock per year that trades on the NYSE as 3-44 opposed to Nasdaq

3.6 Margin Trading

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Buying on Margin
Defined: borrowing money to purchase stock. Initial Margin Requirement IMR (minimum set by Federal Reserve under Regulation T), currently 50% for stocks The IMR is the minimum % initial investor equity.
maximum % amount investor can borrow 1-IMR = ________________________
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Buying on Margin
From whom do you borrow? What is a hypothecation agreement? Do you pay interest on the loan? Equity = Position Value - Borrowing + Additional Cash
Maintenance margin requirement (MMR): minimum amount equity can be before additional funds must be put into the account
25% Exchanges mandate minimum _____.

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Margin Call
Margin call: notification from broker you must put up additional funds or have your position liquidated. At what price does the investor receive a margin call? While the position is open the investor's equity = Market Value - Amount borrowed Thus a declining stock price reduces the investor's equity.

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Margin Call
If the Equity / Market Value MMR a margin call occurs. (Market Value - Borrowed) / Market Value MMR ; solve for Market Value

A margin call will occur when: Market Value = Borrowed / (1 MMR)

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Margin Trading
Margin Trading: Initial Conditions X Corp Stock price = $70 50% Initial Margin 40% Maintenance Margin 1000 Shares Purchased
Initial Position Stock $70,000 Borrowed Equity
$35,000 $35,000

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Margin Trading
(MMR = 40%)

Stock price falls to $60 per share (1000 shares)

New Position Stock $60,000 Borrowed $35,000 $25,000

Equity

Margin% =

$25,000 / $60,000 = 41.67%

Margin Trading: Margin Call How far can the stock price fall before a margin call? (MMR = 40%)
Market Value = Borrowed / (1 MMR) Market Value = $35,000 / (1 0.40) = $58,333
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Margin Trading
With 1000 shares, the stock price at which we receive a margin call is $58,333 / 1000 = $58.33
New Position Stock $60,000 Borrowed $35,000 $23,333

Equity

%Margin = $23,333 / $58,333 = 40%

How much cash must you put up?

To restore the IMR you will need equity = x $58,333 = $29,167 have equity = so owe $23,333 $ 5,834
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Margin Trading
Why do people purchase on margin?
Suppose you buy at $70 per share (borrow at a 7% APR interest cost if use margin, use full amt. margin) APRs (365 day year)
Buy at Sell at $72 in 90 Sell at $68 in 90 $70 days days No Margin 11.59% -11.59%
Margin Leverage Factor 16.17% 1.4x -30.17% 2.6x

Do institutions generally purchase on margin?

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3.7 Short Sales

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Short Sales
How is it done?

Mechanics

o Borrow stock from a broker/dealer, must post margin o Broker sells stock and deposits proceeds and margin in a margin account (you are not allowed to withdraw the sale proceeds until you cover) o Covering or closing out the position: Buy the stock and broker returns the stock title to the party from which it was borrowed o Street name?

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The Long & Short of Round Trips

o A Round Trip is a purchase and a sale o Long position
Buy first and then sell later Bullish

o Short position
Sell first and then buy later Bearish
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Short Sales
Required initial margin: usually 50% but more
for low priced stocks Liable for any cash flows: Dividend on stock Zero tick, uptick rule
Zero tick, uptick rule was eliminated by the SEC in July 2007

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Short Sales
Short sale maintenance margin requirements (equity)

Price

MMR

< $ 2.50 $2.50 - $ 5.00 $5.00 $16.75 > $16.75

$2.50 100% market value

$5.00 30% market value

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Short Sales
Example: You sell short 100 shares of stock priced at $60 per share. o The proceeds of $6000 must be pledged to broker. o You must also pledge 50% margin. $9000 $3000 You put up ______. Now you have ______ invested in margin account. Short Sale Equity = Total Margin Account - Market Value
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Short Sales
Maintenance margin for short sale of a stock with price > $16.75 is 30% of market value or
30% x $6,000 = $1,800 ________________________________.

So you have _______in excess margin. (This may be $1,200 withdrawn at your pleasure but assume that it is not.) At what stock price do you get a margin call?

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Short Sales
When: Equity (0.30 * Market Value) Equity = Total Margin Account Market Value When: Market Value = Total Margin Account / (1 + MMR) Market Value = $9,000 / (1 + 0.30) = $6,923 Price at which get a margin call: $6,923 / 100 shares = $69.23

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Short Sales
If this occurs:
Equity = $9,000 - $6,923 = $2,077 Equity as % market value = $2,077 / $6,923 = 30% You get a margin call & You may have to restore the 50% initial margin. If so you must deposit an additional ($6,923 / 2) - $2,077 = $1,384.5

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Short Sales
Naked short sales Should any or all short sales be prohibited? Should the zero tick/uptick rule be utilized?

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3.8 Regulation of Securities Markets

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Market Regulation
Securities Acts of 1933
Requires full disclosure of information by issuers of new securities

Securities Acts of 1934

Established the SEC and require periodic disclosure of relevant financial information for firms with publicly traded securities Gives authority to regulate exchanges and OTC trading/traders to the SEC CFTC retains authority over commodity futures and Federal Reserve sets margin requirements

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Market Regulation
Securities Investor Protection Act of 1970
Protects investors from losses if a brokerage firm fails (up to $500,000 per customer).

Self Regulation
Financial Industry Regulatory Authority (FINRA)
Formed in 2007 by consolidating regulatory arms of the NASD and the NYSE. Examines securities firms, promulgates trading practice rules and administers a dispute resolution forum for investors and firms. 3-66

Insider Trading
Illegal, but what is it? Definition of insiders can be ambiguous SECs Official Summary of Securities Transactions and Holdings

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Response to Scandals
Increased regulation Sarbanes-Oxley Additional regulation will occur as a result of the financial crisis

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Response to the Financial Crisis

Too soon to know the details of what will happen Likely have reform of the SEC

Reform of the ratings agencies approval process and funding model.

Some type of systemic regulator Continued government involvement in the markets
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Selected Problems

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Chapter 3: Problem 1

a. Explicit and Implicit costs. Explicit: Underwriters Fee $70,000

Implicit: Underpricing ($53 -$50) x 100,000 = $300,000 Total Costs = $370,000 b. No. The underwriters did not directly profit from the underpricing of the securities.
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Chapter 3: Problem 2

a. If the price keeps going up your losses are unlimited.

b. The stop-buy order at $128 limits your max loss to about $8 per share.

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Chapter 3: Problem 3

a. The stock is purchased for: 300 $40 = $12,000 The amount borrowed is $4,000. Therefore, the investor put up equity, or margin, of $8,000.

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Chapter 3: Problem 3

b. If the share price falls to $30, then the value of the stock falls to $30 x $300 = $9,000. By the end of the year, the amount of the loan owed to the broker grows to: $4,000 1.08 = $4,320 Therefore, the remaining equity in the investors account is: $9,000 $4,320 = $4,680 The percentage margin is now: __________________________ $4,680 / $9,000 = 0.52 = 52% Therefore the investor will not receive a margin call.
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Chapter 3: Problem 3

c. The rate of return on the investment over the year is:

Beginning Equity = $8,000 End Equity = $4,680

(Ending equity in the account Initial equity) / Initial equity HPR = ($4,680 $8,000) / $8,000 = 0.415 = 41.5%

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Chapter 3: Problem 4

Many exchanges and the ECNs have pretty much eliminated market-making specialists. Here the computer finds the best prices to make the trades.

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Chapter 3: Problem 5

a. $50.25 b. $51.50

c. You should probably increase your position. There is plenty of buying demand at prices just below $50, so downside risk is limited. The limit sell orders are less concentrated.
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Chapter 3: Problem 6

a. You buy $10,000/$50= 200 shares Shares go up 10% $50$55 $55 X 200=$6000 You pay interest .08 X $5000 = $400 Rate of return = 6000 400 5000 = 12% 5000 b. The margin call will occur when Market Value = Amount Borrowed / (1 - MMR) Market Value = $5,000 / (1 0.30) = $7,142.86 Stock price = $7,142.86 / 200 shares = $35.71
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Chapter 3: Problem 7
a. 55.50 b. 55.25 c. The trade will not be executed because the bid price is lower than the price specified in the limit sell order.

d. The trade will not be executed because the ask price is greater than the price specified in the limit buy order.

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Chapter 3: Problem 8
a. In an exchange market, there can be price improvement in the two market orders. Brokers for each of the market orders (i.e., the buy and the sell orders) can agree to execute a trade inside the quoted spread. For example, they can trade at $55.37, thus improving the price for both customers by either $0.12 or $0.13 relative to the quoted bid and asked prices.

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Chapter 3: Problem 8
b. Whereas the limit order to buy at $55.37 would not be

executed in a dealer market (since the asked price is $55.50), it could be executed in an exchange market. A broker for another customer with a market sell order would view the limit buy order as the best bid price; the two brokers could agree to the trade and bring it to the specialist, who would then execute the trade.

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Chapter 3: Problem 9
Note that your profit ($200) equals (100 shares profit per share of $2). Your net proceeds per share was: $14 $ 9 $ 2 $ 1 $ 2 selling price of stock repurchase price of stock dividend per share 2 trades $0.50 commission per share

(Round Trip)

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Chapter 3: Problem 10

d. Cannot tell from the information given. The broker will attempt to sell after the first transaction at $55 or less.

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