Slide3 - Chapter
3

 Security
Market


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Unformatted text preview: Chapter
3

 Security
Market
 3.1
How
Firms
Issue
Securi:es
 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
invesAng
public
 –  Private
offerings:
not
registered,
and
sold
to
only
a
 limited
number
of
(insAtuAonal)
investors,
with
 restricAons
on
resale
 •  Secondary
 –  ExisAng
owner
sells
to
another
party
 –  Issuing
firm
doesn’t
receive
proceeds
and
is
not
 directly
involved
 –  Private
placement
of
bond
is
typically
held
unAl
maturity
 Primary
vs.
Secondary
Equity
Sales
 Equity
 Primary
 Secondary
 IPO
 Seasoned
 AucAon
 Dealer
 4th
 (UnderwriMen)
 GCO
 (UnderwriMen)
 GCO
 Best
Efforts
 Rights
 NYSE
 ASE
 Regionals
 NASDAQ
 OTC
 Pink
Sheet
 3rd
market
 CompeAAve
 NegoAated
 Standby
&
 Take‐up
 What
is
the
difference
between
IPO
and
seasoned
equity
offerings?
 Investment
Banking
Arrangements
 •  UnderwriFen
vs.
“Best
Efforts”
 –  UnderwriFen:

banker
makes
a
firm
commitment
on
 proceeds
to
the
issuing
firm
 –  Best
Efforts:

banker(s)
helps
sell
but
makes
no
firm
 commitment
 •  Nego:ated
vs.
Compe::ve
Bid
 –  Nego:ated:

issuing
firm
nego:ates
terms
with
 investment
banker
 –  Compe::ve
bid:

issuer
structures
the
offering
and
 secures
bids
 Figure
3.1
RelaAonship
Among
a
Firm
Issuing
 SecuriAes,
the
Underwriters
and
the
Public
 Shelf
Registra:ons
 •  SEC
Rule
415
 –  Security
is
preregistered

and
then
may
be
 offered
at
any
:me
within
the
next
two
years.
 •  24
hour
no3ce,
any
part
or
all
of
the
preregistered
 amount
may
be
offered,
li;le
addi3onal
paperwork
 •  Can
be
sold
in
small
amount
 •  Introduced
in
1982
 •  Allows
3ming
of
the
issues
 Private
Placements
 •  Private
placement:

sale
to
a
limited
number
 of
sophis:cated
investors
not
requiring
the
 protec:on
of
registra:on
 –  Allowed
under
SEC
Rule
144A
 –  Dominated
by
ins3tu3ons
 –  Very
ac:ve
market
for
debt
securi3es
 –  Not
ac:ve
for
stock
offerings
 –  Lower
price
than
in
public
offerings
 Ini:al
Public
Offerings
 •  IPO
Process

 –  
Issuer
and
banker
put
on
the
“Road
Show”
 –  Purpose:
Book
building
and
pricing
 •  Underpricing

 –  Post
iniAal
sale
returns
average
about
10%
or
 more
 –  Easier
to
market
the
issue
 Figure
3.2
Average
First
Day
Returns
 for
European
and
Non‐European
IPOs
 3.2
How
Securi:es
are
Traded
 Types
of
Markets
 •  Direct
Search
Markets
 •  Brokered
Markets
 •  Dealer
Markets
 –  Buyers
and
sellers
locate
one
another
on
their
own
 –  3rd
party
assistance
in
searching
buyer
or
seller
 –  3rd
party
acts
as
intermediate
buyer/seller
 –  Brokers
&
dealers
trade
in
one
loca:on,
trading
is
more
 or
less
con:nuous
 •  Auc:on
Markets
 Types
of
Orders
 InstrucAons
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
beMer
 –  On
the
exchange
thelimit
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
limit
 at
__50‐____
or
a
sell
limit
order
at
_50+_____.
 Limit
Order
Book
for
Intel

 on
Archipelago
 Types
of
Orders
 •  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
or
below_.
 •  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
or
higher.
 Types
of
Orders

 •  Discre3onary
order:
gives
the
broker
the
 power
to
buy
and
sell
for
your
account
at
the
 broker's
discre:on.

 Time
dimension
on
orders
(other
than
market
 orders):
 –  IOC:
immediate
or
cancel
 –  Day:
by
default
 –  GTC:
good
un3l
canceled
(usually
60
days
max)
 3.3
U.S.
Security
Markets
 U.S.
Security
Markets
Overview
 •  Nasdaq
 •  Small
stock
OTC
 –  Pink
sheets
 •  Organized
Exchanges

 –  New
York
Stock
Exchange
 –  American
Stock
Exchange
 –  Regionals
 •  Electronic
Communica:on
Networks
(ECNs)
 •  Na:onal
Market
System
 NASDAQ
 Dealer
Markets
 •  Dealer
market
is
a
market
without
 centralized
order
flow
 •  NASDAQ:

largest
organized
stock
market
for
 OTC
trading;
informa:on
system
for
 individuals,
brokers
and
dealers
 •  Securi:es:
Stocks,
most
bonds,
some
 deriva:ves
 NASDAQ
 •  Levels
of
subscribers
to
Nasdaq
quota:on
system
 –  Level
1:
inside
quotes
 –  Level
2:
receives
all
quotes
but
they
can’t
enter
 quotes
 –  Level
3:
dealers
can
see
and
post
quotes
 –  SuperMontage:
Centralized
limit
order
book
for
 Nasdaq
securi:es
that
allows
automa:c
trade
 execu:on
 Table
3.1
Par:al
Requirements
for
 Lis:ng
on
NASDAQ
Markets
 Organized
Exchanges
 •  Auc:on
markets
are
markets
with
centralized
 order
flow
 •  Dealership
func:on:
can
be
compe33ve
or
 assigned
by
the
exchange
(Specialists)
 •  Securi:es:
Stock,
futures
contracts,
op:ons,
 and
some
bonds
 •  Examples:
NYSE,
ASE,
Regionals,
CBOE,
CME
 Exchanges
 •  NYSE
 AucAon
Markets
 Some
ini:al
lis:ng
requirements:
 •  ASE
and
Regionals
 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.
 Exchange
Par:cipants
 •  Floor
trader:
 –  Independent
trader
who
buys
and
sells
securi:es
for
 his/her
own
account.

Oien
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.


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


 b) 
Specialist
acts
as
a
broker:
 –  Facilita:ng
trades
for
certain
types
public
orders
 (limit
orders)
 Specialists
 c) 
Specialist
acts
as
a
dealer:
Charged
with
 maintaining
a
"con:nuous,
orderly
market."
 •  
Must
at
:mes
trade
against
the
market
 •  
Can
pe::on
exchange
to
halt
trading
 •  
Incur
inventory
costs/risks
of
holding
stock
 •  
Specialists
monitor
and
limit
the
bid‐ask
spread
 Placing
an
order
 •  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.
 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
$20.10
 against
the
book.


   A
sell
market
order
would
execute
at
$20.00

against
 the
book.


   In
an
aucAon
market,
if
two
brokers
arrive
at
the
same
 Ame
both
may
get
price
improvement
by
negoAaAng
a
 trade
at
$20.05
.


 Electronic
Trading
on
the
NYSE
 •  SuperDot
 •  Electronic
order
rou:ng
system
allows
brokers
to
 electronically
send
orders
directly
to
specialist.

 •  Useful
for
program
trading
 
 0 •  DirectPlus
 •  Fully
automated
trade
execu:on
system
 •  Execu:on
:me
<
½
second
 •  Electronic
order
placement
is
growing,
large
 orders
s:ll
require
human
interven:on.
 Block
Transac:ons
and
Block
Houses
 •  Block
Houses
 –  Specialize
in
large
block
trades

 –  Block
transac:ons
on
NYSE
 Electronic
Communica:on
Networks
 (ECNs)
 ECNs
allow
insAtuAonal
investors
to
post
quotes
and
trade
directly
 with
each
other.

(4th
Market)
 •  Public
limit
order
book
 •  AutomaAc
execuAon
 •  Advantages
include
 –  Lower
transacAons
costs
(usually
<
1¢
per
share)
 –  Speed
even
on
large
trade
sizes
 –  Anonymity
 ECNs
 Market
Consolida:on
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
Ins:net/Island
in
2005
 •  Acquired
Boston
Stock
Exchange
in
2007
 •  Jointly
acquired
Swedish
exchange
OMX
 Market
Consolida:on
Trends
 •  Euronext
 •  Formed
from
merger
of
Paris,
Brussels
and
 Amsterdam
exchanges
in
2000
 •  Acquired
the
Liffe
in
London
in
2001
 •  Merged
with
Portuguese
stock
exchange
in
2002
 •  Merged
with
NYSE
in
2007
 •  CME
acquired
CBOT
in
2007
 3.4
Market
Structures
in
Other
 Countries
 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
secAons
for
different
size
firms
 •  
 Two
major
indexes:
Nikkei
225
and
TOPIX
 Market
CapitalizaAon
of
Major
 Exchanges
in
2008
 3.5
Trading
Costs
 •  Commission:
fee
paid
to
broker
for
making
 the
transac:on
 •  Spread:
cost
of
trading
with
dealer
 –  Bid:
price
dealer
will
buy
from
you
 –  Ask:
price
dealer
will
sell
to
you
 –  Spread:
ask
‐
bid
 •  Combina3on:
on
some
trades
both
are
paid
 Characteris:cs
of
well‐func:oning
 markets
 a)  Low
cost
transfer
of
funds
(compe::on
 among
market
makers
and
brokers).
 b)  Adequate
trading
ac:vity
to
ensure
 purchases
and
sales
occur
in
:mely
fashion
 without
affec:ng
price.

(Trading
volume)
 c)  Prices
speedily
reflect
public
informa:on
 3.6
Margin
Trading
 Buying
on
Margin
 •  Defined:
borrowing
money
to
purchase
stock.
 •  Ini:al
Margin
Requirement
IMR
(minimum
set
 by
Federal
Reserve
under
Regula:on
T),
 currently
50%
for
stocks
 •  The
IMR
is
the
minimum
%
ini:al
investor
 equity.
 
 
1‐IMR
=
maximum
%
amount
investor
can
 borrow
 Buying
on
Margin
 •  From
whom
do
you
borrow?

Do
you
pay
interest
on
 the
loan?
 
Equity
=

Posi:on
Value
‐
Borrowing
+
Addi:onal
Cash
 •  Maintenance
margin
requirement
(MMR):
minimum
 amount
equity
can
be
before
addi:onal
funds
must
 be
put
into
the
account
 
Exchanges
mandate
minimum
25%.

 Margin
Call
 •  Margin
call:
no:fica:on
from
broker
you
must
put
up
 addi:onal
funds
or
have
your
posi:on
liquidated.
 •  At
what
price
does
the
investor
receive
a
margin
call?
 While
the
posi:on
is
open
the
investor's
equity
=
 Market
Value
‐
Amount
borrowed
 
Thus
a
declining
stock
price
reduces
the
investor's
 equity.
 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)
 Margin
Trading
 Margin
Trading:
Ini:al
Condi:ons
 
X
Corp 
 
Stock
price
=
$70
 
50% 
 
Ini:al
Margin
 
40% 
 
Maintenance
Margin
 
1000 
 
Shares
Purchased
 Initial Position Stock $70,000 Borrowed $35,000 Equity $35,000 Margin
Trading
 •  MMR=40%
 •  Stock
price
falls
to
$60
per
share


(1000
shares)
 New Position Stock $60,000 Borrowed Equity $35,000 $25, 000 •  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
 Margin
Trading
 •  With
1000
shares,
the
stock
price
at
which
we
receive
a
margin
 call
is
$58,333
/
1000
=
$58.33
 New Position Stock $58,333 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
=

½
x
$58,333
=
$29,167
 •  
 have
equity
=

$23,333
 










so
owe




$5,834
 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)
 
 Buy at $70 Sell at $72 in Sell at $68 in 90 
 
APRs
(365
day
year)
 No Margin Margin Leverage Factor 90 days 11.59% 16.17% 1.4x days -11.59% -30.17% 2.6x 
 
 

 3.7
Short
Sales
 Short
Sales
 How
is
it
done?
 Mechanics
 •  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
unAl
you
‘cover’)
 •  Covering
or
closing
out
the
posiAon:

 Buy
the
stock
and
broker
returns
the
stock
Atle
to
the
 party
from
which
it
was
borrowed
 •  Street
name?
 The
Long
&
Short
of
“Round
Trips”
 o  A
“Round
Trip”
is
a
purchase
and
a
sale
 o  Long
posi:on
   Buy
first
and
then
sell
later
   Bullish
 o  Short
posi:on
   Sell
first
and
then
buy
later
   Bearish
 Short
Sales
 Required
iniAal
margin:
usually
50%
but
more
 for
low
priced
stocks
 Liable
for
any
cash
flows:

Dividend
on
stock
 Zero‐plus
Ack,
upAck
rule
 –  was
eliminated
by
the
SEC
in
July
2007
 Short
Sales
 •  Short
sale
maintenance
margin
requirements
 (equity)
 Price < $ 2.50 $2.50 - $ 5.00 $5.00 - $16.75 > $16.75 MMR $2.50 100% market value $5.00 30% market value 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
$3000.
Now
you
have
$9000
invested
in
 margin
account.


 Short
Sale
Equity
=
Total
Margin
Account
‐
Market
Value
 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
$1200
in
excess
margin.

 At
what
stock
price
do
you
get
a
margin
call?
 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
 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%
iniAal
margin.


 If
so
you
must
deposit
an
addiAonal

 ($6,923
/
2)
‐
$2,077
=
$1,384.5
 Short
Sales
 •  Naked
short
sales:
short
sell
without
first
 borrowing.
Prohibited
since
2008
 •  Should
any
or
all
short
sales
be
prohibited?
 •  Should
the
zero
:ck/up:ck
rule
be
u:lized?
 3.8
Regula:on
of
Securi:es
Markets
 Market
Regula:on

 •  Securi:es
Acts
of
1933
 •  Securi:es
Acts
of
1934
 •  Requires
full
disclosure
of
informa:on
by
issuers
of
 new
securi:es

 •  Established
the
SEC
and
require
periodic
disclosure
of
 relevant
financial
informa:on
for
firms
with
publicly
 traded
securi:es
 •  Gives
authority
to
regulate
exchanges
and
OTC
 trading/traders
to
the
SEC

 •  CFTC
retains
authority
over
commodity
futures
 and
Federal
Reserve
sets
margin
requirements
 Market
Regula:on
 •  Securi:es
Investor
Protec:on
Act
of
1970
 •  Protects
investors
from
losses
if
a
brokerage
firm
fails
 (up
to
$500,000
per
customer).
 •  Self
Regula:on
 •  Financial
Industry
Regulatory
Authority
(FINRA)

 •  Formed
in
2007
by
consolida:ng
regulatory
arms
of
the
 NASD
and
the
NYSE.
 •  Examines
securi:es
firms,
promulgates
trading
prac:ce
 rules
and
administers
a
dispute
resolu:on
forum
for
 investors
and
firms.
 Insider
Trading
 •  Illegal,
but
what
is
it?
 •  Defini:on
of
insiders
can
be
ambiguous
 •  SEC’s
Official
Summary
of
Securi:es
 Transac:ons
and
Holdings
 Response
to
Scandals
 •  Increased
regula:on
 •  Sarbanes‐Oxley
 •  Addi:onal
regula:on
will
occur
as
a
result
of
 the
financial
crisis
 ...
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