CHAPTER 3 How Securities are Traded
How Firms Issue Securities <ul><li>Primary </li></ul><ul><ul><li>New issue </li></ul></ul><ul><ul><li>Key factor: issuer r...
How Firms Issue Securities Continued <ul><li>Investment Banking </li></ul><ul><li>Shelf Registration </li></ul><ul><li>Pri...
Investment Banking <ul><li>Underwritten:  firm commitment on proceeds to the issuing firm </li></ul><ul><li>Red herring </...
Figure 3.1 Relationship Among a Firm Issuing Securities, the Underwriters and the Public
Shelf Registrations <ul><li>SEC Rule 415 </li></ul><ul><li>Introduced in 1982 </li></ul><ul><li>Ready to be issued – on th...
<ul><li>Sale to a limited number of sophisticated investors not requiring the protection of registration </li></ul><ul><li...
Initial Public Offerings <ul><li>Process  </li></ul><ul><ul><li>Road shows </li></ul></ul><ul><ul><li>Bookbuilding </li></...
Figure 3.2 Average Initial Returns for IPOs in Various Countries
Figure 3.3 Long-term Relative Performance of Initial Public Offerings
How Securities are Traded <ul><li>Types of Markets </li></ul><ul><ul><li>Direct search </li></ul></ul><ul><ul><ul><li>Leas...
Types of Orders <ul><li>Market—executed immediately </li></ul><ul><ul><li>Bid Price </li></ul></ul><ul><ul><li>Ask Price <...
Figure 3.4 The Limit Order Book for Intel  on the Archipelago Market,  January 19, 2007
Figure 3.5 Price-Contingent Orders
Trading Mechanisms <ul><li>Dealer markets </li></ul><ul><li>Electronic communication networks (ECNs) </li></ul><ul><li>Spe...
U.S. Security Markets <ul><li>Nasdaq and NYSE have evolved in response to new information technology </li></ul><ul><li>Bot...
Nasdaq <ul><li>National Market System </li></ul><ul><li>Nasdaq Small Cap Market </li></ul><ul><li>Levels of subscribers </...
Table 3.1 Partial Requirements for Listing on NASDAQ Markets
New York Stock Exchange <ul><li>Member functions  </li></ul><ul><ul><li>Commission brokers </li></ul></ul><ul><ul><li>Floo...
Table 3.2 Some Initial Listing Requirements for the NYSE
Table 3.3 Block Transactions on the  New York Stock Exchange
Other Systems <ul><li>Electronic Communication Networks </li></ul><ul><ul><li>Private computer networks that directly link...
Market Structure in Other Countries <ul><li>London - predominately electronic trading </li></ul><ul><li>Euronext – market ...
Figure 3.6 Market Capitalization of Major World Stock Exchanges, 2007
Trading Costs <ul><li>Commission : fee paid to broker for making the transaction </li></ul><ul><li>Spread : cost of tradin...
Buying on Margin <ul><li>Using only a portion of the proceeds for an investment </li></ul><ul><li>Borrow remaining compone...
Stock Margin Trading <ul><li>Margin  is currently 50%; you can borrow up to 50% of the stock value </li></ul><ul><ul><li>S...
Margin Trading - Initial Conditions Example 3.1 <ul><li>X Corp $100 </li></ul><ul><li>60% Initial Margin </li></ul><ul><li...
Margin Trading - Maintenance Margin Example 3.1 <ul><li>Stock price falls to $70 per share </li></ul><ul><li>New Position ...
Margin Trading - Margin Call Example 3.2 <ul><li>How far can the stock price fall before a margin call? </li></ul><ul><li>...
Table 3.4 Illustration of Buying Stock  on Margin
Short Sales <ul><li>Purpose :  to profit from a decline in the price of a stock or security </li></ul><ul><li>Mechanics </...
Short Sale – Initial Conditions Example 3.3 <ul><li>Dot Bomb 1,000 Shares </li></ul><ul><li>50% Initial Margin </li></ul><...
Short Sale - Maintenance Margin <ul><li>Stock Price Rises to $110 </li></ul><ul><li>Sale Proceeds $10,000 </li></ul><ul><l...
Short Sale - Margin Call <ul><li>How much can the stock price rise before a margin call? </li></ul><ul><li>($150,000 *  - ...
Regulation of Securities Markets <ul><li>Major regulations </li></ul><ul><ul><li>Securities Act of 1933  </li></ul></ul><u...
Regulation Securities Markets Continued <ul><li>Regulatory Responses to Recent Scandals </li></ul><ul><ul><li>Public Compa...
Circuit Breakers <ul><li>Trading halts </li></ul><ul><li>Collars  </li></ul>
Insider Trading <ul><li>Officers, directors, major stockholders must report all transactions in firm’s stock </li></ul><ul...
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Chapter 3: How Securities are Traded

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Chapter 3: How Securities are Traded

  1. 1. CHAPTER 3 How Securities are Traded
  2. 2. How Firms Issue Securities <ul><li>Primary </li></ul><ul><ul><li>New issue </li></ul></ul><ul><ul><li>Key factor: issuer receives the proceeds from the sale </li></ul></ul><ul><li>Secondary </li></ul><ul><ul><li>Existing owner sells to another party </li></ul></ul><ul><ul><li>Issuing firm doesn’t receive proceeds and is not directly involved </li></ul></ul>
  3. 3. How Firms Issue Securities Continued <ul><li>Investment Banking </li></ul><ul><li>Shelf Registration </li></ul><ul><li>Private Placements </li></ul><ul><li>Initial Public Offerings (IPOs) </li></ul>
  4. 4. Investment Banking <ul><li>Underwritten: firm commitment on proceeds to the issuing firm </li></ul><ul><li>Red herring </li></ul><ul><li>Prospectus </li></ul>
  5. 5. Figure 3.1 Relationship Among a Firm Issuing Securities, the Underwriters and the Public
  6. 6. Shelf Registrations <ul><li>SEC Rule 415 </li></ul><ul><li>Introduced in 1982 </li></ul><ul><li>Ready to be issued – on the shelf </li></ul>
  7. 7. <ul><li>Sale to a limited number of sophisticated investors not requiring the protection of registration </li></ul><ul><li>Allowed under Rule 144A </li></ul><ul><li>Dominated by institutions </li></ul><ul><li>Very active market for debt securities </li></ul><ul><li>Not active for stock offerings </li></ul>Private Placements
  8. 8. Initial Public Offerings <ul><li>Process </li></ul><ul><ul><li>Road shows </li></ul></ul><ul><ul><li>Bookbuilding </li></ul></ul><ul><li>Underpricing </li></ul><ul><ul><li>Post sale returns </li></ul></ul><ul><ul><li>Cost to the issuing firm </li></ul></ul>
  9. 9. Figure 3.2 Average Initial Returns for IPOs in Various Countries
  10. 10. Figure 3.3 Long-term Relative Performance of Initial Public Offerings
  11. 11. How Securities are Traded <ul><li>Types of Markets </li></ul><ul><ul><li>Direct search </li></ul></ul><ul><ul><ul><li>Least organized </li></ul></ul></ul><ul><ul><li>Brokered </li></ul></ul><ul><ul><ul><li>Trading in a good is active </li></ul></ul></ul><ul><ul><li>Dealer </li></ul></ul><ul><ul><ul><li>Trading in a particular type of asset increases </li></ul></ul></ul><ul><ul><li>Auction </li></ul></ul><ul><ul><ul><li>Most integrated </li></ul></ul></ul>
  12. 12. Types of Orders <ul><li>Market—executed immediately </li></ul><ul><ul><li>Bid Price </li></ul></ul><ul><ul><li>Ask Price </li></ul></ul><ul><li>Price-contingent </li></ul><ul><ul><li>Investors specify prices </li></ul></ul><ul><ul><li>Stop orders </li></ul></ul>
  13. 13. Figure 3.4 The Limit Order Book for Intel on the Archipelago Market, January 19, 2007
  14. 14. Figure 3.5 Price-Contingent Orders
  15. 15. Trading Mechanisms <ul><li>Dealer markets </li></ul><ul><li>Electronic communication networks (ECNs) </li></ul><ul><li>Specialists markets </li></ul>
  16. 16. U.S. Security Markets <ul><li>Nasdaq and NYSE have evolved in response to new information technology </li></ul><ul><li>Both have increased their commitment to automated electronic trading </li></ul>
  17. 17. Nasdaq <ul><li>National Market System </li></ul><ul><li>Nasdaq Small Cap Market </li></ul><ul><li>Levels of subscribers </li></ul><ul><ul><li>Level 1 – inside quotes </li></ul></ul><ul><ul><li>Level 2 – receives all quotes but they can’t enter quotes </li></ul></ul><ul><ul><li>Level 3 – dealers making markets </li></ul></ul>
  18. 18. Table 3.1 Partial Requirements for Listing on NASDAQ Markets
  19. 19. New York Stock Exchange <ul><li>Member functions </li></ul><ul><ul><li>Commission brokers </li></ul></ul><ul><ul><li>Floor brokers </li></ul></ul><ul><ul><li>Specialists </li></ul></ul><ul><li>Block houses </li></ul><ul><li>SuperDot </li></ul>
  20. 20. Table 3.2 Some Initial Listing Requirements for the NYSE
  21. 21. Table 3.3 Block Transactions on the New York Stock Exchange
  22. 22. Other Systems <ul><li>Electronic Communication Networks </li></ul><ul><ul><li>Private computer networks that directly link buyers with sellers </li></ul></ul><ul><li>National Market System </li></ul><ul><ul><li>Securities Act of Amendments of 1975 </li></ul></ul><ul><li>Bond Trading </li></ul><ul><ul><li>Automated Bond System (ABS) </li></ul></ul>
  23. 23. Market Structure in Other Countries <ul><li>London - predominately electronic trading </li></ul><ul><li>Euronext – market formed by combination of the Paris, Amsterdam and Brussels exchanges </li></ul><ul><li>Tokyo Stock Exchange </li></ul><ul><li>Globalization and consolidation of stock markets </li></ul>
  24. 24. Figure 3.6 Market Capitalization of Major World Stock Exchanges, 2007
  25. 25. Trading Costs <ul><li>Commission : fee paid to broker for making the transaction </li></ul><ul><li>Spread : cost of trading with dealer </li></ul><ul><ul><li>Bid : price dealer will buy from you </li></ul></ul><ul><ul><li>Ask : price dealer will sell to you </li></ul></ul><ul><ul><li>Spread : ask - bid </li></ul></ul><ul><li>Combination : on some trades both are paid </li></ul>
  26. 26. Buying on Margin <ul><li>Using only a portion of the proceeds for an investment </li></ul><ul><li>Borrow remaining component </li></ul><ul><li>Margin arrangements differ for stocks and futures </li></ul>
  27. 27. Stock Margin Trading <ul><li>Margin is currently 50%; you can borrow up to 50% of the stock value </li></ul><ul><ul><li>Set by the Fed </li></ul></ul><ul><li>Maintenance margin : minimum amount equity in trading can be before additional funds must be put into the account </li></ul><ul><li>Margin call : notification from broker that you must put up additional funds </li></ul>
  28. 28. Margin Trading - Initial Conditions Example 3.1 <ul><li>X Corp $100 </li></ul><ul><li>60% Initial Margin </li></ul><ul><li>40% Maintenance Margin </li></ul><ul><li>100 Shares Purchased </li></ul><ul><li>Initial Position </li></ul><ul><li>Stock $10,000 Borrowed $4,000 </li></ul><ul><li>Equity $6,000 </li></ul>
  29. 29. Margin Trading - Maintenance Margin Example 3.1 <ul><li>Stock price falls to $70 per share </li></ul><ul><li>New Position </li></ul><ul><li>Stock $7,000 Borrowed $4,000 </li></ul><ul><li>Equity $3,000 </li></ul><ul><li>Margin% = $3,000/$7,000 = 43% </li></ul>
  30. 30. Margin Trading - Margin Call Example 3.2 <ul><li>How far can the stock price fall before a margin call? </li></ul><ul><li>(100P - $4,000) * / 100P = 30% </li></ul><ul><li>P = $57.14 * 100P - Amt Borrowed = Equity </li></ul>
  31. 31. Table 3.4 Illustration of Buying Stock on Margin
  32. 32. Short Sales <ul><li>Purpose : to profit from a decline in the price of a stock or security </li></ul><ul><li>Mechanics </li></ul><ul><ul><li>Borrow stock through a dealer </li></ul></ul><ul><ul><li>Sell it and deposit proceeds and margin in an account </li></ul></ul><ul><ul><li>Closing out the position: buy the stock and return to the party from which is was borrowed </li></ul></ul>
  33. 33. Short Sale – Initial Conditions Example 3.3 <ul><li>Dot Bomb 1,000 Shares </li></ul><ul><li>50% Initial Margin </li></ul><ul><li>30% Maintenance Margin </li></ul><ul><li>$100 Initial Price </li></ul><ul><li>Sale Proceeds $100,000 </li></ul><ul><li>Margin & Equity 50,000 </li></ul><ul><li>Stock Owed 100,000 </li></ul>
  34. 34. Short Sale - Maintenance Margin <ul><li>Stock Price Rises to $110 </li></ul><ul><li>Sale Proceeds $10,000 </li></ul><ul><li>Initial Margin 5,000 </li></ul><ul><li>Stock Owed 11,000 </li></ul><ul><li>Net Equity 4,000 </li></ul><ul><li>Margin % (4000/11,000) 36% </li></ul>
  35. 35. Short Sale - Margin Call <ul><li>How much can the stock price rise before a margin call? </li></ul><ul><li>($150,000 * - 1000P) / (100P) = 30% </li></ul><ul><li>P = $115.38 </li></ul><ul><li>* Initial margin plus sale proceeds </li></ul>
  36. 36. Regulation of Securities Markets <ul><li>Major regulations </li></ul><ul><ul><li>Securities Act of 1933 </li></ul></ul><ul><ul><li>Securities Act of 1934 </li></ul></ul><ul><ul><li>Securities Investor Protection Act of 1970 </li></ul></ul><ul><li>Self-Regulation </li></ul><ul><ul><li>Stock markets are largely self-regulating </li></ul></ul>
  37. 37. Regulation Securities Markets Continued <ul><li>Regulatory Responses to Recent Scandals </li></ul><ul><ul><li>Public Company Accounting Oversight Board </li></ul></ul><ul><ul><li>Financial experts to serve on audit committees of boards of directors </li></ul></ul><ul><ul><li>CEOs and CFOs personally certify firms’ financial reports </li></ul></ul><ul><ul><li>Boards must have independent directors </li></ul></ul><ul><ul><li>Sarbanes-Oxley Act </li></ul></ul>
  38. 38. Circuit Breakers <ul><li>Trading halts </li></ul><ul><li>Collars </li></ul>
  39. 39. Insider Trading <ul><li>Officers, directors, major stockholders must report all transactions in firm’s stock </li></ul><ul><li>Insiders do exploit their knowledge </li></ul><ul><li>Leakage of useful information to some traders </li></ul>
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