Chapter 6_05.ppt


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Chapter 6_05.ppt

  2. 2. Chapter 6 Questions <ul><li>What is the purpose and function of a market? </li></ul><ul><li>What are the characteristics that determine the quality of a market? </li></ul><ul><li>What is the difference between a primary and secondary capital market and how do these two markets support each other? </li></ul><ul><li>What is the typical underwriting organization structure for corporate stock issues? </li></ul>
  3. 3. Chapter 6 Questions <ul><li>What are Rules 415 and 144A and how do they affect corporate security underwriting? </li></ul><ul><li>For secondary equity markets, what are the two basic trading systems? </li></ul><ul><li>What are the major primary listing markets in the United States and how do they differ? </li></ul><ul><li>What are call markets and when are they typically used in U.S. markets? </li></ul>
  4. 4. Chapter 6 Questions <ul><li>How are national exchanges around the world linked and what is meant by “passing the book”? </li></ul><ul><li>What is Nasdaq and how has its growth and influence impacted the securities market? </li></ul><ul><li>What are the regional exchanges and what securities do they trade? </li></ul><ul><li>What is the third market? </li></ul>
  5. 5. Chapter 6 Questions <ul><li>What are Electronic Communications Networks (ECNs) and alternative trading systems (ATSs) and how do they differ from the primary listing markets? </li></ul><ul><li>What are the major types of orders available to investors and market makers? </li></ul><ul><li>What are the major functions of the specialist on the NYSE? </li></ul>
  6. 6. Chapter 6 Questions <ul><li>What new trading systems on the NYSE and Nasdaq have made it possible to handle the growth in U.S. trading volume? </li></ul><ul><li>What are the three recent innovations that contribute to competition within the U.S. equity market? </li></ul><ul><li>What are Rule 390 and the trade-through rule and what is their effect regarding competition on the U.S. equity market? </li></ul>
  7. 7. What is a market? <ul><li>The means through which buyers and sellers are brought together to aid in the transfer of goods and services </li></ul><ul><li>Does not require a physical location </li></ul><ul><li>“The market” itself does not have to own the goods and services involved </li></ul><ul><li>Buyers and sellers benefit from the market </li></ul>
  8. 8. Characteristics of a Good Market <ul><li>Availability of past transaction information </li></ul><ul><ul><li>must be timely and accurate </li></ul></ul><ul><li>Liquidity: sell quickly at a good price </li></ul><ul><ul><li>marketability </li></ul></ul><ul><ul><li>price continuity </li></ul></ul><ul><ul><li>depth </li></ul></ul><ul><li>Transaction cost are low (Internal efficiency) </li></ul><ul><li>Prevailing market prices reflect all relevant information (External efficiency) </li></ul>
  9. 9. Decimal Pricing <ul><li>The movement to decimal pricing is a case study in making a market better </li></ul><ul><li>Benefits: </li></ul><ul><ul><li>Ease of understanding prices for investors </li></ul></ul><ul><ul><li>Reduction in minimum bid-ask spreads </li></ul></ul><ul><ul><li>Lower transaction costs through enhanced global competition </li></ul></ul>
  10. 10. Organization of the Securities Market <ul><li>Primary markets </li></ul><ul><ul><li>New issues </li></ul></ul><ul><li>Secondary markets </li></ul><ul><ul><li>Outstanding securities are bought and sold </li></ul></ul>
  11. 11. Primary Capital Markets Government Bonds <ul><li>Sold regularly through auctions </li></ul><ul><li>Treasury bills: one year maturity or less </li></ul><ul><li>Treasury notes: maturities of two to ten years </li></ul><ul><li>Treasury bonds: original maturities of more than ten years </li></ul>
  12. 12. Primary Capital Markets Municipal Bonds <ul><li>Sold by three methods </li></ul><ul><ul><li>Competitive bid sales: sealed bids </li></ul></ul><ul><ul><li>Negotiated sale: contractual arrangements, underwriter helps prepare, price, and sell the issue </li></ul></ul><ul><ul><li>Private placements: Issuer sells directly to investors </li></ul></ul><ul><li>Underwriters services </li></ul><ul><ul><li>Origination: design of the issue </li></ul></ul><ul><ul><li>Risk-bearing: purchase the issue, risk reselling </li></ul></ul><ul><ul><li>Distribution: selling the issue </li></ul></ul>
  13. 13. Primary Capital Markets Corporate Bonds <ul><li>Negotiated arrangement with an investment banking firm who maintains a relationship with the issuing firm </li></ul><ul><li>Underwriting firm often organizes a syndicate for distribution </li></ul>
  14. 14. Primary Capital Markets Common Stock <ul><li>New issues are divided into two groups </li></ul><ul><li>Seasoned new issues </li></ul><ul><ul><li>New shares offered by firms that already have stock outstanding </li></ul></ul><ul><li>Initial public offerings (IPOs) </li></ul><ul><ul><li>Firms selling their stock to the public for the first time </li></ul></ul><ul><li>New issues normally underwritten by investment banking firms </li></ul>
  15. 15. Relationships with Investment Bankers <ul><li>1. Negotiated </li></ul><ul><ul><li>Most common </li></ul></ul><ul><ul><li>Full services of underwriter </li></ul></ul><ul><li>2. Competitive bids </li></ul><ul><ul><li>Corporation specifies securities offered, then seeks bids </li></ul></ul><ul><ul><li>Reduced costs but also reduced services of underwriter </li></ul></ul><ul><li>3. Best-efforts </li></ul><ul><ul><li>Investment banker acts as broker, selling all it can at a specified price </li></ul></ul>
  16. 16. Introduction of Rule 415 <ul><li>Shelf registration: </li></ul><ul><li>Allows firms to register securities and sell them piecemeal over the next two years </li></ul><ul><li>Increased flexibility for timing issues </li></ul><ul><li>Reduces registration fees and expenses </li></ul><ul><li>Mostly used for bond sales </li></ul>
  17. 17. Private Placements and Rule 144A <ul><li>Firms sells to a small group of institutional investors, with some assistance of an investment banker </li></ul><ul><li>Lower issuing costs than public offering </li></ul><ul><li>Extensive registration not required </li></ul><ul><li>Issues can trade among large, sophisticated investors </li></ul>
  18. 18. Secondary Markets <ul><li>Involves the trading of issues that are already outstanding </li></ul><ul><li>Provide a means obtaining cash for sellers </li></ul><ul><li>Provide buyers with more investment choices </li></ul>
  19. 19. Why Secondary Markets Are Important <ul><li>Provide liquidity to investors who acquire securities in the primary market </li></ul><ul><ul><li>Helps issuers raise needed funds in the primary market since investors want liquidity </li></ul></ul><ul><li>Help determine market pricing for new issues </li></ul>
  20. 20. Secondary Bond Markets <ul><li>Secondary market for U.S. government and municipal bonds </li></ul><ul><ul><li>U.S. government bonds traded by bond dealers who specialize in these issues </li></ul></ul><ul><ul><li>Banks and investment firms make markets in municipal bond issues </li></ul></ul><ul><li>Secondary corporate bond market </li></ul><ul><ul><li>Traded in an OTC market by bond dealers </li></ul></ul><ul><ul><li>A much more limited market than for stock issues </li></ul></ul>
  21. 21. Financial Futures <ul><li>Bond futures contracts allow the holder to either buy or sell a specific bond issue at a specific price on a future date </li></ul><ul><li>Bond futures are traded in separate markets </li></ul><ul><ul><li>Chicago Board of Trade (CBOT) </li></ul></ul><ul><ul><li>Chicago Mercantile Exchange (CME) </li></ul></ul>
  22. 22. Secondary Equity Markets <ul><li>Basic Trading Systems </li></ul><ul><ul><li>Pure auction market </li></ul></ul><ul><ul><ul><li>Buyers “bid” and sellers “ask” </li></ul></ul></ul><ul><ul><ul><li>Buy and sell orders are matched at a central location </li></ul></ul></ul><ul><ul><ul><li>Price driven market: trades are made by determining the highest bid and the lowest ask </li></ul></ul></ul><ul><ul><li>Dealer market </li></ul></ul><ul><ul><ul><li>Dealers buy shares (at the bid price) and sell shares (at the ask price) from their own inventory </li></ul></ul></ul><ul><ul><ul><li>Dealers compete against each other </li></ul></ul></ul>
  23. 23. Call Versus Continuous Markets <ul><li>Call markets trade individual stocks at specified times to gather all orders and determine a single price to satisfy the most orders </li></ul><ul><ul><li>Used for opening prices on NYSE if orders build up overnight or after trading is suspended </li></ul></ul><ul><li>Continuous markets trade any time the market is open </li></ul>
  24. 24. Classification of U.S. Secondary Equity Markets <ul><li>Primary Market Listings </li></ul><ul><li>Regional Stock Exchanges </li></ul><ul><li>The Third Market </li></ul><ul><li>Alternative Trading Systems </li></ul>
  25. 25. Primary Market Listings <ul><li>Large number of listed securities </li></ul><ul><li>Listing often seen as a sign of prestige </li></ul><ul><li>Wide geographic dispersion of listed firms </li></ul><ul><li>Diverse clientele of buyers and sellers </li></ul><ul><li>Firms wanting to list must meet listing requirements </li></ul>
  26. 26. Primary Market Listings: NYSE <ul><li>Largest organized securities market in United States </li></ul><ul><li>Established in 1817, but dates back to 1792 Buttonwood Agreement by 24 brokers </li></ul><ul><li>About 3,000 companies listed </li></ul><ul><li>Market value over $12 trillion </li></ul><ul><li>Accounts for about 80% of the trading volume for listed stocks </li></ul>
  27. 27. Primary Market Listings: AMEX <ul><li>Started by a group who traded unlisted stocks at the corner of Wall and Hanover Streets in New York as the Outdoor Curb Market </li></ul><ul><li>Emphasis on foreign securities </li></ul><ul><li>Doesn’t trade stocks listed on NYSE </li></ul><ul><li>Merged with Nasdaq in 1998, although operations remain separate </li></ul>
  28. 28. Primary Market Listings: Global Stock Exchanges <ul><li>Tokyo Stock Exchange (TSE) </li></ul><ul><li>London Stock Exchange (LSE) </li></ul><ul><li>Other National Exchanges </li></ul><ul><ul><li>Frankfurt, Toronto, Paris </li></ul></ul><ul><li>New exchanges in emerging countries </li></ul><ul><ul><li>Russia, Poland, China, Hungary, Peru, Sri Lanka </li></ul></ul>
  29. 29. Primary Market Listings: Global Stock Exchanges <ul><li>Trend toward consolidation of exchanges </li></ul><ul><ul><li>Economies of scale, especially in terms of the required technology </li></ul></ul><ul><ul><li>Liquidity is enhanced with more firms trading </li></ul></ul><ul><li>Larger firms dual-listed on a U.S. exchange </li></ul><ul><ul><li>Must meet listing requirements of both </li></ul></ul><ul><li>Strong exchanges abroad enable continuous global trading for firms </li></ul>
  30. 30. The Global Twenty-four Hour Market <ul><li>Investment firms “pass the book” around the world to maintain nearly continuous trading by utilizing markets at Tokyo, London, and New York </li></ul><ul><li>This means that the markets are increasingly interrelated, moving toward a single world market </li></ul>
  31. 31. Primary Market Listings: Nasdaq NMS <ul><li>Historically known as the Over-the-counter (OTC) market </li></ul><ul><li>Not a formal organization or a single location </li></ul><ul><li>Almost 3,500 issues actively traded on Nasdaq’s NMS ( National Market System) </li></ul><ul><li>More issues traded, but less dollar trading in terms of total value than NYSE </li></ul>
  32. 32. Primary Market Listings: Nasdaq NMS <ul><li>Operations </li></ul><ul><ul><li>Any stock may be traded as long as it has a willing market maker to act a dealer </li></ul></ul><ul><ul><li>Nasdaq is a negotiated market with investors potentially dealing directly with dealers </li></ul></ul>
  33. 33. Primary Market Listings: Nasdaq NMS <ul><li>The Nasdaq System </li></ul><ul><li>National Association of Security Dealers Automated Quotation system </li></ul><ul><li>Dealers may elect to make markets in stocks </li></ul><ul><li>Average of about 8 dealers per stock in 2003 </li></ul><ul><li>Three levels of quotations available </li></ul><ul><ul><li>Level 1 shows a median representative quote </li></ul></ul><ul><ul><li>Level 2 shows quotes by all market makers </li></ul></ul><ul><ul><li>Level 3 is for Nasdaq market makers to change their quotes shown </li></ul></ul>
  34. 34. Primary Market Listings: Nasdaq NMS <ul><li>Listing Requirements for Nasdaq </li></ul><ul><li>Two lists </li></ul><ul><ul><li>National Market System (NMS) </li></ul></ul><ul><ul><li>Regular Nasdaq </li></ul></ul><ul><li>Must meet at least one standard for initial and continued listing </li></ul><ul><ul><li>See Exhibit 6.6 </li></ul></ul><ul><li>Making trades </li></ul><ul><li>Broker determines which dealer has the best price (lowest ask price/highest bid price) </li></ul>
  35. 35. Primary Market Listings: Nasdaq <ul><li>Other Nasdaq Market Segments </li></ul><ul><ul><li>The Nasdaq Small-Cap Market (SCM) </li></ul></ul><ul><ul><ul><li>More lenient listing requirements </li></ul></ul></ul><ul><ul><li>The Nasdaq OTC Electronic Bulletin Board </li></ul></ul><ul><ul><ul><li>Report service for smaller stocks </li></ul></ul></ul><ul><ul><li>The National Quotation Bureau (NQB) Pink Sheets </li></ul></ul><ul><ul><ul><li>Price quotation sheets for smaller stocks </li></ul></ul></ul>
  36. 36. Regional Exchanges <ul><li>Provide secondary markets for stocks not listed on a major exchange </li></ul><ul><ul><li>Listing requirements vary </li></ul></ul><ul><li>Some regional exchanges list issues also listed on a national exchange </li></ul><ul><li>Regional Exchanges in United States </li></ul><ul><ul><li>Chicago, Boston, Pacific (San Francisco/Los Angeles), Philadelphia, Cincinnati </li></ul></ul>
  37. 37. Third Market <ul><li>Dealer and broker trading of shares listed on an exchange away from the exchange </li></ul><ul><li>Mostly well known stocks </li></ul><ul><li>May be important to investors particularly when the exchange is closed or when trading is suspended on the exchange </li></ul><ul><li>Success depends on relative costs of transactions compared to the exchange </li></ul>
  38. 38. Alternative Trading Systems (The Fourth Market) <ul><li>Area of great innovation </li></ul><ul><li>Electronic Communication Networks (ECNs) </li></ul><ul><ul><li>Buy and sell orders are matched via computer, mainly for retail and small institutional trading </li></ul></ul><ul><li>Electronic Crossing Systems (ECSs) </li></ul><ul><ul><li>Electronic means for matching larger buy and sell orders </li></ul></ul>
  39. 39. Detailed Analysis of Exchange Markets <ul><li>Listed exchange markets have evolved into rather unique institutions; they can be described with a number of attributes: </li></ul><ul><li>Exchange Membership </li></ul><ul><li>Major Types of Orders </li></ul><ul><li>Exchange Market Makers </li></ul>
  40. 40. Exchange Membership <ul><li>Four categories of membership: </li></ul><ul><li>Specialists </li></ul><ul><ul><li>Maintain an orderly market in a stock </li></ul></ul><ul><li>Commission brokers </li></ul><ul><ul><li>Member firm employees executing orders for clients of the firm </li></ul></ul><ul><li>Floor brokers </li></ul><ul><ul><li>Independent brokers who work for other brokers </li></ul></ul><ul><li>Registered traders </li></ul><ul><ul><li>Members who buy and sell for their own accounts </li></ul></ul>
  41. 41. Major Types of Orders <ul><li>Market orders </li></ul><ul><ul><li>Buy or sell at the best current price </li></ul></ul><ul><li>Limit orders </li></ul><ul><ul><li>Order specifies the buy or sell price </li></ul></ul><ul><ul><li>Time specifications for order may vary </li></ul></ul><ul><ul><ul><li>Instantaneous - “fill or kill”, part of a day, a full day, several days, a week, a month, or good until canceled (GTC) </li></ul></ul></ul>
  42. 42. Major Types of Orders <ul><li>Short sales </li></ul><ul><ul><li>Sell overpriced stock that you don’t own and purchase it back later (at a lower price) </li></ul></ul><ul><ul><li>Borrow the stock from another investor (through your broker) </li></ul></ul><ul><ul><li>Can only be made on an uptick trade </li></ul></ul><ul><ul><li>Must pay any dividends to lender </li></ul></ul><ul><ul><li>Margin requirements apply </li></ul></ul>
  43. 43. Major Types of Orders <ul><li>Special Orders </li></ul><ul><ul><li>Stop loss </li></ul></ul><ul><ul><ul><li>Conditional order to sell stock if it drops to a given price </li></ul></ul></ul><ul><ul><ul><li>Does not guarantee price you will get upon sale </li></ul></ul></ul><ul><ul><ul><li>Market disruptions can cancel such orders </li></ul></ul></ul><ul><ul><li>Stop buy order </li></ul></ul><ul><ul><ul><li>Investor who sold short may want to limit loss if stock increases in price </li></ul></ul></ul>
  44. 44. Major Types of Orders <ul><li>Buying on Margin: </li></ul><ul><li>On any type order, instead of paying 100% cash, borrow a portion of the transaction, using the stock as collateral </li></ul><ul><li>Interest rate is based on the call money rate from a bank </li></ul><ul><li>Regulations limit proportion borrowed and the investor’s equity percentage (margin) </li></ul><ul><ul><li>Margin requirements are from 50% up </li></ul></ul><ul><li>Changes in price affect investor’s equity </li></ul>
  45. 45. Major Types of Orders <ul><li>Margin Example: </li></ul><ul><li>Buy 100 shares at $60 = $6,000 position </li></ul><ul><li>Borrow 50%, investment of $3,000 </li></ul><ul><li>If price increases to $70, position </li></ul><ul><ul><li>Value is $7,000 </li></ul></ul><ul><ul><li>Less - $3,000 borrowed </li></ul></ul><ul><ul><li>Leaves $4,000 equity for a </li></ul></ul><ul><ul><li>$4,000/$7,000 = 57% equity position </li></ul></ul>
  46. 46. Major Types of Orders <ul><li>Margin Example: </li></ul><ul><li>Buy 100 shares at $60 = $6,000 position </li></ul><ul><li>Borrow 50%, investment of $3,000 </li></ul><ul><li>If price decreases to $50, position </li></ul><ul><ul><li>Value is $5,000 </li></ul></ul><ul><ul><li>Less - $3,000 borrowed </li></ul></ul><ul><ul><li>Leaves $2,000 equity for a </li></ul></ul><ul><ul><li>$2,000/$5,000 = 40% equity position </li></ul></ul>
  47. 47. Major Types of Orders <ul><li>Margin Order Details </li></ul><ul><li>Initial margin requirement at least 50% </li></ul><ul><ul><li>Lower margin requirements allow you to buy more </li></ul></ul><ul><li>Maintenance margin </li></ul><ul><ul><li>Required proportion of equity to stock value </li></ul></ul><ul><ul><li>Protects broker if stock price declines </li></ul></ul><ul><ul><li>Minimum requirement is at least 25% </li></ul></ul><ul><ul><li>Margin call on undermargined account to meet margin requirement </li></ul></ul><ul><ul><li>If call not met, stock will be sold to pay off the loan </li></ul></ul>
  48. 48. Exchange Market Makers <ul><li>A NYSE specialist is exchange member assigned to handle particular stocks </li></ul><ul><li>Has two roles: </li></ul><ul><ul><li>Broker: match buy and sell orders and to process any limit orders as prices change </li></ul></ul><ul><ul><li>Dealer: buy and sell from their own account to maintain fair, liquid, and orderly market </li></ul></ul><ul><li>Specialist has two income sources </li></ul><ul><ul><li>Broker commission, without risk </li></ul></ul><ul><ul><li>Dealer trading income from profit, with risk, but also with significant information advantages </li></ul></ul>
  49. 49. New Trading Systems <ul><li>As trading volume has grown, it has become increasingly necessary to seek new technologies to assist the trading process. </li></ul><ul><li>Super DOT </li></ul><ul><ul><li>Electronic order-routing system </li></ul></ul><ul><ul><li>Member firms transmit market and limit orders in NYSE securities to trading posts or member firm’s booth </li></ul></ul><ul><ul><li>Report of execution returned electronically </li></ul></ul><ul><ul><li>85% of NYSE market orders enter through Super DOT system </li></ul></ul>
  50. 50. New Trading Systems <ul><li>Display Book </li></ul><ul><ul><li>Electronic workstation that keeps track of all limit orders and incoming market orders </li></ul></ul><ul><li>Opening Automated Report Service (OARS) </li></ul><ul><ul><li>Pre-opening market orders for Super Dot system </li></ul></ul><ul><ul><li>OARS automatically and continuously pairs buy and sell orders </li></ul></ul><ul><ul><li>Presents imbalance to the specialist prior to the opening of a stock </li></ul></ul><ul><ul><li>Helps determine opening price </li></ul></ul>
  51. 51. New Trading Systems <ul><li>Market Order Processing </li></ul><ul><ul><li>Super Dot’s postopening market order system </li></ul></ul><ul><ul><li>Rapid execution and reporting of market orders </li></ul></ul><ul><ul><li>In 2003, 94.5% of market orders executed in less than thirty seconds </li></ul></ul><ul><li>Limit Order Processing </li></ul><ul><ul><li>Electronically files orders to be executed when and if a specific price is reached </li></ul></ul><ul><ul><li>Updates the Specialist’s Display Book </li></ul></ul><ul><ul><li>Good-until-cancelled orders that are not executed are stored until executed or canceled </li></ul></ul>
  52. 52. New Trading Systems <ul><li>Nasdaq </li></ul><ul><ul><li>Small-Order Execution System (SOES) </li></ul></ul><ul><ul><ul><li>Helps to ensure the execution of smaller orders (up to 1000 shares) </li></ul></ul></ul><ul><ul><li>SelectNet </li></ul></ul><ul><ul><ul><li>A computer order-routing and execution service for institutional investors </li></ul></ul></ul>
  53. 53. Innovations for Competition <ul><li>Two competing models </li></ul><ul><ul><li>Order-driven market (Exchanges) </li></ul></ul><ul><ul><li>Quote-driven market (Nasdaq dealers) </li></ul></ul><ul><li>SEC has encouraged competition </li></ul><ul><ul><li>Consolidated Quotation System (CQS) </li></ul></ul><ul><ul><ul><li>Allows subscribers to see quotations from both exchanges and dealers simultaneously </li></ul></ul></ul><ul><ul><li>Intermarket Trading System (ITS) </li></ul></ul><ul><ul><ul><li>Centralized quotation system between Nasdaq and regional exchanges </li></ul></ul></ul>
  54. 54. Future Developments <ul><li>Continued competition of ECNs with the order-driven and quote-driven markets </li></ul><ul><li>NYSE has sought to protect itself against such competition through regulations </li></ul><ul><ul><li>They argue that they offer many investors the best price even if the other platforms offer better speed of execution </li></ul></ul>