3
Securities
Markets
McGraw-Hill/Irwin
3-1
Copyright Chapter 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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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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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.
2.
3.
.
Bring together buyers and sellers at low
cost
Provide adequate liquidity by minimizing
time and cost to trade and promoting price
continuity.
Set & update prices of financial assets
Reduces information costs associated
with investing
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Types of Markets
Direct Search Markets
Brokered Markets
3rd party assistance in location buyer or seller
Dealer Markets
Buyers and sellers locate one another on their own
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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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
Organized Exchanges
Pink sheets
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
3-18
Organized Exchanges
Auction markets are markets with
centralized order flow
Dealership function: can be
competitive or assigned by the
exchange (Specialists)
Securities:
Examples:
stock, futures contracts, options, and to a
lesser extent bonds
NYSE, ASE, Regionals, CBOE, CME
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Exchange Markets
Members of the exchange:
Commission broker:
Purchase a seat on the exchange, gives
the right to trade and a say in the
governance of the exchange.
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 for trades 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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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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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
Margin% =
Borrowed
$35,000
Equity
$60,000
$25,000
$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
Equity
$35,000
$23,333
%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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3.7 Short Sales
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Short Sales
How is it done?
Mechanics
o
o
o
Borrow stock from a broker/dealer, must post margin
Broker sells stock and deposits proceeds and margin in a margin
account (you are not allowed to withdraw the sale proceeds until you
cover)
Covering or closing out the position:
Buy the stock and broker returns the stock title to the party from
which it was borrowed
Street name?
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o
o
The Long & Short of Round
T a purchase and a sale
A Round Trip isrips
Long position
v
v
o
Buy first and then sell later
Bullish
Short position
v
v
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
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.
You put up ______. Now you have ______
$9000
$3000
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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