Chapter 3 How Securities Are Traded
Primary vs. Secondary Security Sales New issue - Key factor: issuer receives the proceeds from the sale. Existing owner sells to another party.
Issuing firm doesn’t receive proceeds and is not directly involved.
Investment Banking Arrangements Bringing new securities to market Underwritten vs. Best Efforts Underwritten: firm commitment on proceeds to the issuing firm. Best Efforts: no firm commitment. Negotiated vs. Competitive Bid Negotiated: issuing firm negotiates terms with investment banker.
Competitive bid: issuer structures the offering and secures bids.
Public Offerings Public offerings: registered with the SEC and sale is made to the investing public. Shelf registration (Rule 415, since 1982) Initial Public Offerings (IPOs) Evidence of underpricing (see page 69)
Performance (see page 71)
IPOs slow down in 2006, but deals survive By Steve Gelsi , MarketWatch Last Update: 11:56 AM ET Aug 15, 2006 NEW YORK (MarketWatch) -- With a batch of scuttled IPOs this summer adding to the void, the market for initial public offerings has slowed down this year in the face of rising interest rates, record oil prices and geopolitical jitters. A total of 137 U.S. initial public offerings have priced in 2006 for proceeds of $26.3 billion, according to Dealogic. That's about 10% less in number than the 153 IPOs priced in the year-ago period for proceeds of $28.3 billion. Forty-two IPOs have been withdrawn or postponed so far in 2006, a 17% increase compared to this time in 2005, when 36 deals had been withdrawn or postponed. IPO investors have been particularly cool to the tech sector, once the darling of the IPO market, after the lackluster debut of Vonage ( VG : vonage hldgs corp com
Or it might be a few high-profile IPO letdowns like telephone-broadband company Vonage ( VG : 7.52, +0.44, +6.2%) that are souring some investors. Vonage , which Holmes calls a bold play that turned out to be a disaster, was a venture-backed dud. It priced at $17 on May 24, and subsequently closed down more than 12% on its first day of trading. It's now near $7. (from yahoo.smartmoney
Private Placements Private placement: sale to a limited number of sophisticated investors not requiring the protection of registration. Dominated by institutions. Very active market for debt securities.
Not active for stock offerings.
Organization of Secondary Markets
Organized Exchanges Auction 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 (about 85% of exchange trading in US), AMEX (has ETF’s exchange traded funds), Regionals, CBOE.
Role of the Specialist Role of the specialist is to provide “a fair and orderly market – i.e. “makes a market” The specialist must be willing to buy or sell at all times (post quotes) – provides price continuity Has monopoly on his or her stocks Maintains the “limit order book” May act as a broker (earns commissions) or a dealer (earns spreads)
Participates in about ¼ of trading volume on NYSE
OTC Market Dealer market without centralized order flow. Nasdaq (formerly National Association of Securities Dealers Automated Quotation system) - the largest organized stock market for OTC trading; information system for individuals, brokers and dealers. Similar in Dollar Volume to NYSE Securities: stocks, bonds and some derivatives.
Most secondary bonds transactions
Third Market Trading of listed securities away from the exchange. Institutional market: to facilitate trades of larger blocks of securities.
Involves services of dealers and brokers
Fourth Market Historically was Institutions trading directly with institutions No middleman involved in the transaction Organized information and trading systems
ECN (Electronic Communication Network) – allows individuals to trade directly with others.
International Market Structures Dealer market similar to NASDAQ Stock Exchange Automated Quotation No market making service (No specialist) Sartori provides bookkeeping service Feature a floor and electronic trading Global Market Alliances – Euronext from merger of Paris, Amsterdam & Brussels
Co-listing in the future to allow 24 hour trading?
Costs of Trading 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 Combination: on some trades both are paid
Paying for order flow – paying a broker a rebate for directing trade to dealer (important for “free trading”)
Types of Orders Instructions to the brokers on how to complete the order Market – trade immediately at the best price Limit – place some conditions on the price at which trade Stop loss – sell if the stock fall to a specified price – the order then becomes a market order (protects downside).
Stop buy – buy if the price rises to a specified price (protects short sales)
Buying stocks on margin means taking out a loan so you can buy more stock. Short selling requires a margin deposit to guarantee your position Futures margin (to be discussed later) mean depositing funds as surety for your trade (similar to short selling stocks) Buying stocks on margin leverages the gains or losses! Margin = Equity/(Stock Value) Margin Trading
= (Assets – Liabilities)/(Stock Value)
Currently 50% (set by the Fed) Minimum level the equity margin can fall to. Determined by the exchange and/or the brokerage house Daily marking to market (checking to see you are in compliance) Stock Margin Trading
If you fall short, you must correct the situation or your position will be closed
Initial Position (Balance Sheet) Stock $70,000 Borrowed $35,000 Assets = 70,000 Liabilities = 35,000 Margin Trading - Initial Conditions
Margin = (70,000 – 35,000)/70,000
Margin Trading - Maintenance Margin Stock price falls to $60 per share Stock $60,000 Borrowed $35,000 Margin = (60,000 – 35,000)/60,000
Margin% = $25,000/$60,000 = 41.67%
Margin Trading - Margin Call How far can the stock price fall before a margin call? Note: (1000P - Amount Borrowed) = Equity
(1000P - $35,000) / 1000P = 40%
Return on Margin Purchase P t = $80, i=5% hpr = (V t – V t-1 )/V t-1 V t-1 = Initial Investment = $35,000 V t = Proceeds from closing position = Sale of Stock – Repaying of Loan = 80,000 – 36,750 = 43,250 hpr = (43,250 – 35,000)/35,000 = 23.57% Stock only return = (80-70)/70 = 14.29%
Note: 23.57% = 14.29% + 14.29% - 5%
Return on Margin Purchase P t = $60, i=5% hpr = (V t – V t-1 )/V t-1 V t-1 = Initial Investment = $35,000 V t = Proceeds from closing position = Sale of Stock – Repaying of Loan = 60,000 – 36,750 = 23,250 hpr = (23,250 – 35,000)/35,000 = -33.57% Stock only return = (60-70)/70 = -14.29%
Note: -33.57% = -14.29% - 14.29% - 5%
Short Sales Purpose: to profit from a decline in the price of a stock or security. Borrow stock through a dealer. Sell it and deposit proceeds and margin in an account.
Closing out the position: buy the stock and return to the party from which it was borrowed.
Short Sales News (WSJ) Record Activity In Short Selling Hits the Nasdaq Rise During Latest Month Occurred Despite a Rally In the Technology Sector By PETER A. MCKAY August 25, 2006; Page A12 Short-selling activity hit a record on the Nasdaq Stock Market during the latest monthly period, despite a rally in the technology sector. For the period ended Aug. 15 , the number of short-selling positions not yet closed out at the Nasdaq -- so-called short interest -- rose 1.8% to 7,268,106,428 shares, from 7,139,899,294 shares in mid-July.
Marketwide, the short ratio, or number of days' average volume represented by the outstanding short positions on the market, fell to 4.0 from 4.1.
Short Sale - Initial Conditions Sale Proceeds $10,000 (Asset) Margin & Equity 5,000 (Asset) Stock Owed 10,000 (Liability) (Also is the Stock Value)
Margin = (10,000 + 5000 – 10,000)/10,000
Short Sale - Maintenance Margin Stock Price Rises to $110 Margin: (10,000 + 5000 – 11,000)/11,000
Margin % (4000/11000) 36%
Short Sale - Margin Call How much can the stock price rise before a margin call? ($15,000* - 100P) / (100P) = 30%
* Initial margin plus sale proceeds
Regulation of Securities Markets