Securities are first issued in primary markets like the NYSE and later traded in secondary markets. Underwriters help distribute new issues. The SEC regulates markets through acts regulating disclosure, insider trading, and other rules. Stocks trade on exchanges through specialists or market makers and various order types. Bonds trade over-the-counter. Mutual funds and other vehicles provide diversification. Risk and return concepts include expected return, variance, covariance, and efficient portfolios offering the highest return for a given risk.

1. How Securities Are Traded
• Process of Securities Issue
– New securities issued in a primary market such as
NYSE
– Initial Public Offer (IPO)/Seasoned Issues
– IPOs are typically smaller firms,
no public history
– Bond issue:
(1) public offer is sold to public and later traded;
(2) private placement - sold to few
institutional investor and then held
until maturity

2. •Underwriting
–lead bank forms underwriting syndicate to share
with other banks share the commitment, which can
be firm commitment or best-efforts basis
• Shelf Registration
–in 1982, SEC passed Rule 415 that
allows firms to register securities for
a 2-year period and market them
when needed
• Underpricing
– New issues are often underpriced
– conflict of interest: a guarantee of
issue success, less proceeds to
issuing firm.

3. Trading Places
• Secondary Market
– trading of existing securities
– adds liquidity to primary market
– all exchanges are in the secondary market
– most US stocks are traded on the exchanges; most bonds
are traded over-the-counter (OTC) market
• OTC Market
– a loosely organized network of dealers
linked by a computer quotation system
• Third Market
– exchange-listed securities traded in OTC
• Fourth Market
– market where traders trade exchange-listed
securities directly between themselves

4. Trading Systems
• Specialist System
– A person in charge of 8-10 stocks and smoothes out the
supply and demand of the stocks
– specialist sometimes provides liquidity by buying/selling
on his/her account
– performs broker and dealer function
– specialist system exists in NYSE
• Market Maker System
– a market maker quotes a bid-ask price for a stock in the
market for other investors to buy/sell stock;
– market maker takes risk
– OTC market/FX market

5. Trading on Exchanges
• Trading Methods
– Continuous Auction
– Call Method
• Settlement Method
– exchange order must be settled within five business days;
– often stock certificates are left with the brokerage firm, in
street name.
• Participants
– commission broker (large retail brokerage firms’
employees) owns the largest seats, executes their clients’
orders
– floor broker: independent broker and act for commission
broker in trades

6. – registered traders, execute their own portfolios and few in
number
– specialists
• Types of Orders
– market order: order to buy/sell at prevailing price
– limit order: a order to buy/sell at a certain price or within a
certain time period
– stop-loss order: stop-loss order is an order to sell if the
price falls below a certain level; a stop-buy order to buy if
price is above a certain level --- these orders are
accompanied by short sales.
<$40 >$50
Buy Limit Buy Stop-buy order
sell Stop-loss limit sell order

7. Regulations of Stock Market
• Securities Act of 1933 requires disclosure of new
issues
• Securities Act of 1934 established the SEC to enforce
the 1933 act
• Circuit Breakers: if DIJA falls below 250 pts from
previous day close, trading halts for 1-hr and if 400 pts,
trading halts for 2-hrs (also individual stock trading halts
• Insider Trading
Insiders are major shareholders, officers and directors.
They must disclose their trades to the SEC, and cannot
profit from insider information when trade

8. •Margin Requirement
Initial margin is the percentage (50%) of fund acquired from
investor; the balance is borrowed from broker. It is set by
Federal Reserve System.
Maintenance margin (MM): the amount below which there will
be margin call from brokers.
It is set by NYSE and the brokerage firm.
– Below MM: investor must either send in cash or sell the
shares
– Above MM: investor can (1) do nothing, (2) buy additional
shares without paying, or (3) increase loan.
No Margin buy:No Margin buy:
buy 100 shares @$50; sell them for $70 1-yr laterbuy 100 shares @$50; sell them for $70 1-yr later
Profit = $2000 (i.e., $20x100)Profit = $2000 (i.e., $20x100)
Return = profit/initial investmentReturn = profit/initial investment
= 2000/5000= 2000/5000
= 40%= 40%

9. Margin BuyMargin Buy::
Purchase 200 shares @$50Purchase 200 shares @$50
(borrow $5000 @ 9%)(borrow $5000 @ 9%)
Interest cost = $450 (i.e., 5000x9%)
sell shares @$70 in 1-yr
profit = $3,550
(i.e., ($70-50)x200 - $450)
Return = profit/initial investment
= 3550/5000
= 71%

10. • Short Sales
– allows investor to profit from stock price decline
– uptick rule
– Illustration:
(1) You go short 100 Shares @$50, (2) MM =30%, (3)
50% IM (which means $2,500 cash deposited with
broker). Your initial account at broker will be:
Assets Liab & Equity
Proceed $5,000 Short $5,000
Cash $2,500 Equity $2,500
$7,500 $7,500
IM = Equity/stock value = 2500/5000=0.5
MM= 0.3 = (Asset- liabilities)/liability
= (7,500-100P)/100P
P = $57.69

11. Mutual Funds
• Mutual funds pool the funds of many investors and
purchase securities in large blocks
• Open-End Funds
– Open-end funds are continuously issuing new shares,
which sell at net asset value (NAV) plus commission
(load), if any:
NAV = MKT value of securities/#shares
– load funds are purchased from a broker; no-load are
purchased directly from the investment company and
involve no commissions
• Closed-End Funds
– Do NOT issue new shares and trade at prices differing
from NAV

12. Cost/benefit of Mutual funds
• Diversification
• Professional management
• Small investment
• Switching privileges
• reinvestment of dividends and realized capital gains
Disadvantage
• commission may be high (including front-end load about
4-8.5%, a back-end load and operating expenses about 0.2-
2% per year)
• may not receive funds immediately upon selling of mutual
funds
AdvantageAdvantage

13. Other Investment Cos
• Unit investment Trusts
pools of funds invested in portfolio that is fixed for the life
of the fund
• Commingled Funds
These funds are managed by banks or insurance
companies and pool retirement and trust accounts that are
too small to be managed individually
• Real Estate Investment Trust (REITs)
similar to closed mutual funds, except that they invest in
real estate (equity trusts) or in real estate mortgages
(mortgage trusts)
• Index Fund
replicates broad market index

14. Investment Concepts
• Real vs Nominal Return (rate)
1 + R = (1+r)(1+inf)
where R = Nominal rate (or
interest rate)
r = real rate
inf= inflation rate
R = r + inf + r*inf
or
R = r + inf (Fisher equation)

15. Interest Rate vs Inflation
• To test if Treasury bill is a good proxy for
inflation, i.e, it is tested against the Fisher
effect, (i.e., one-to-one relationship with
inflation rate)
• R = a + b(inflation) + e
where R is the nominal Tbill
rate
a is the intercept
e is the residual (error)
term
Ho : b =1 (null hypothesis)

16. Stock Return vs Inflation
• R = (P1 - P0+ cash dividend)/P0
where P1 is the ending period price
P0 is the beginning price
R = return (or HPR)
Suppose the price of share is currently $100, in one-year,
you received $4 dividend and the year-end price is $110,
then:
R = (110 - 100 + 4)/100 = 14%
• In hypothesis testing for equity return, the null
hypothesis (one-one relationship between return
and inflation) is generally rejected, i.e.,
R = a + b(inf) + e

17. Some basic concepts
• Risk premium= expected return - riskfree
rate
• Excess return = actual return - riskfree rate
• Hedging is investing in an asset that can
reduce the overall risk of the portfolio
• Statistical definition of return and risk

18. Mean and Variances
• Expected return
E(R) = p1R1 + ... + pnRn
where p is the probability at state i
R is the return
• Variance (var):
pi(Ri-E(R))2
+...+ pn(Rn-E(R))2
• Sample statistics (mean and var)
R = (R1+...+Rn)/n
s2
= [(R -R)2
+...+(R -R)]2
/n

19. Covariance (i.e., cov(x,y))
= [(Rx,1-Rx)(Ry,1-Ry)+...
(Rx,n-Rx)(Ry,n-Ry)]/(n-1)
Correlation coefficient
= cov(x,y)/sxsy
where correlation coefficient is between
-1 and +1, a standardized measure of
relationship between two variables, x and y.
xx
yy
timetime
ReturnReturn

20. Risk vs Return
Return
RiskRisk
(s(s22
or s)or s)
Intuition tells us that higher risk means
higher return