2. 3-2
• How firms issue securities
• Primary vs. secondary market
• Privately held vs. publicly traded companies
• Initial public offerings
• Market transactions
• Short selling and buying on margin
• Rise of electronic trading and globalization of
stock markets
• Market regulation
Chapter Overview
3. 3-3
3.1 How Firms Issue Securities
• Primary vs. Secondary Market Security Sales
• Primary
• New issue created/sold
• Key factor: Issuer receives proceeds from sale
• Public offerings: Registered with SEC; sale made to
investing public
• Private offerings: Not registered; sold only to limited
number of investors with restrictions on resale
• Secondary
• Existing owner sells to another party
• Issuing firm doesn’t receive proceeds, is not directly
involved
4. 3-4
Privately Held Firms
• Up to 499 shareholders
• Middlemen have formed partnerships to buy
shares and get around the 499-investor
restrictions
• Raise funds through private placement
• Lower liquidity of shares
• Have fewer obligations to release financial
statements and other information
3.1 How Firms Issue Securities
5. 3-5
3.1 How Firms Issue Securities
Publicly Traded Companies
• Raise capital from a wider range of investors
through initial public offering, IPO
• Seasoned equity offering: The sale of
additional shares in firms that already are
publicly traded
• Public offerings are marketed by investment
bankers or underwriters
• Registration must be filed with the SEC
7. 3-7
3.1 How Firms Issue Securities
• Shelf Registration
• SEC Rule 415
• Security is preregistered and then may be
offered at any time within the next two years
• 24-hour notice: Any or all of preregistered
amount may be offered
• Introduced in 1982
• Allows timing of issues
8. 3-8
3.1 How Firms Issue Securities
Initial Public Offerings
Issuer and banker put on “road show”
Purpose: Bookbuilding and pricing
Underpricing
• Post-initial sale returns average
10% or more—“winner’s curse”
problem?
• Easier to market issue; costly to issuing firm
9. 3-9
Initial Public Offerings
Underwriter bears price risk associated with
placement of securities:
• IPOs are commonly underpriced compared
to the price they could be marketed (ex.:
Groupon)
• Some IPOs, however, are well overpriced
(ex.: Facebook); others cannot even fully be
sold
3.1 How Firms Issue Securities
12. 3-12
3.2 How Securities Are Traded
• Functions of Financial Markets
• Overall purpose: Facilitate low-cost investment
• Bring together buyers and sellers at low cost
• Provide adequate liquidity by minimizing time
and cost to trade and promoting price
continuity
• Set and update prices of financial assets
• Reduce information costs associated with
investing
13. 3-13
3.2 How Securities Are Traded
• Types of Markets
• Direct Search Markets
• Buyers and sellers locate one another on their own
• Brokered Markets
• Third-party assistance in locating buyer or seller
• Dealer Markets
• Third party acts as intermediate buyer/seller
• Auction Markets
• Brokers and dealers trade in one location
• Trading is more or less continuous
14. 3-14
3.2 How Securities Are Traded
• Types of Orders
• Market order: Execute immediately at best price
• Bid price: price at which dealer will buy security
• Ask price: price at which dealer will sell security
• Price-contingent order: Buy/sell at specified price
or better
• Limit buy/sell order: specifies price at which
investor will buy/sell
• Stop order: not to be executed until price point
hit
16. 3-16
3.2 How Securities Are Traded
• Trading Mechanisms
• Dealer markets
• Over-the-counter (OTC) market: Informal network of
brokers/dealers who negotiate securities sales
• NASDAQ stock market: Computer-linked price quotation
system for OTC market
• Electronic communication networks (ECNs)
• Computer networks that allow direct trading without market
makers
• Specialist markets
• Specialist: Makes market in shares of one or more firms;
maintains “fair and orderly market” by dealing personally
17. 3-17
• In the US, the share of electronic trading
rose from 16% to 80% in 2000s and was
triggered by an interaction of new
technologies and new regulations
• 1975: Elimination of fixed commissions on
the NYSE
• 1994: New order-handling rules on
NASDAQ, leading to narrower bid-ask
spreads
3.3 The Rise of Electronic Trading
18. 3-18
3.4 U.S. Securities Markets
NASDAQ
Lists about 3,200 firms
Originally, NASDAQ was primarily a dealer market
with a price quotation system
Today, NASDAQ’s Market Center offers a
sophisticated electronic trading platform with
automatic trade execution.
Large orders may still be negotiated through
brokers and dealers
21. 3-21
New York Stock Exchange
1792: 24 brokers and merchants started with five securities
1817: Formal organization: the New York Stock & Exchange Board
1835: Average daily volume: exceed 8,000 shares
1863: Adopted the name of the New York Stock Exchange
December 15, 1886: One million shares exchange hands
1961: Average trading volume exceeds 4 millions shares per day
1982: Over 100 million shares are exchanged in just one day
1992: Average daily volume exceeds 200 million shares
1997: October 27: volume tops one billion shares for the first time
2005: On June 24: volume over 3 billion shares
About 3,000 companies listed (September 2011); capitalization of
$16.613 trillion (May 2013); average daily volume of about 6 billion
shares; average daily trading value was approximately US$169 billion in
2013.
21
22. 3-22
NYSE, NASDAQ, Stocks, Bonds
April 4, 2007: NYSE Group, Inc. merged with Euronext N.V. to form
the first global equities exchange
October 1, 2008: NYSE Euronext acquired Amex (American Stock
Exchange)
The NYSE is now owned by Intercontinental Exchange
"NASDAQ“: "National Association of Securities Dealers Automated
Quotations“; second-largest stock exchange by market
capitalization in the world; as of January 25, 2011, there were 2,711
listings, with a total capitalization of over $4.5 trillion; average
daily volume now of about 7 billion shares; began trading on
February 8, 1971 as the world's first electronic stock market.
Nov 2013: Global equity market capitalization (58 countries): $63.4
trillion
March 2012: Global bond market: $100 trillion
22
24. 3-24
3.4 U.S. Securities Markets
NYSE
Lists about 2,800 firms
Automatic electronic trading runs side-by-side with
traditional broker/specialist system
SuperDot : electronic order-routing system
DirectPlus: fully automated execution for small orders
Specialists: Handle large orders and maintain orderly
trading
26. 3-26
3.4 U.S. Securities Markets
Electronic Communication Networks
ECNs: Private computer networks that directly link buyers with
sellers for automated order execution without market makers
Major ECNs include NASDAQ’s Market Center, ArcaEx, Direct
Edge, BATS, and LavaFlow.
“Flash Trading”: Computer programs look for even the smallest
mispricing opportunity and execute trades in tiny fractions of a
second.
Latency: Time it takes to accept, process, and deliver a trading
order; speed is important in ECNs; BATs latency time about
.0002 second
27. 3-27
3.3 U.S. Securities Markets
• Timeline of Market Changes
• 1969: Instinet (first ECN) established
• 1975: Fixed commissions on NYSE eliminated
• Congress amends Securities and Exchange Act to
create National Market System (NMS)
• 1994: NASDAQ scandal
• SEC institutes new order-handling rules
• NASDAQ integrates ECN quotes into display
• SEC adopts Regulation Alternative Trading
Systems, giving ECNs ability to register as stock
exchanges
28. 3-28
3.3 U.S. Securities Markets
Timeline of Market Changes
•1997: SEC drops minimum tick size from 1/8 to
1/16 of $1
•2000: National Association of Securities Dealers
splits from NASDAQ
•2001: Minimum tick size $.01
•2006: NYSE acquires Archipelago Exchanges
and renames it NYSE Arca
• 2007: SEC adopts Regulation NMS, requiring
exchanges to honor quotes of other exchanges
29. 3-29
Figure 3.6 The Effective Spread Fell Dramatically
as the Minimum Tick Size Fell
(Value-weighted average of NYSE-listed shares)
31. 3-31
Algorithmic Trading
The use of computer programs to make trading
decisions
High-Frequency Trading
Special class of algorithmic with very short order
execution time
Dark Pools
Trading venues that preserve anonymity, mainly
relevant in block trading
3.5 New Trading Strategies
32. 3-32
3.5 New Trading Strategies
Bond Trading
Most bond trading takes place in the OTC market
among bond dealers.
Market for many bond issues is “thin”.
NYSE is expanding its bond-trading system.
NYSE Bonds is the largest centralized bond market of
any U.S. exchange
33. 3-33
3.6 Globalization of Stock Markets
Globalization & Consolidation of Stock Markets
NYSE mergers and acquisitions:
Archipelago (ECN)
American Stock Exchange
Euronext
NASDAQ mergers and acquisitions:
Instinet/INET (ECN)
Boston Stock Exchange
Merges with OMX to form NASDAQ OMX Group
Chicago Mercantile Exchange acquired:
Chicago Board of Trade
New York Mercantile Exchange
34. 3-34
Figure 3.8 The Biggest Stock Markets in the World
by Domestic Market Capitalization
0
2,000
4,000
6,000
8,000
10,000
12,000
$
Billion
35. 3-35
3.6 Globalization of Stock Markets
London - predominately electronic trading
Euronext – market formed by combination of the
Paris, Amsterdam and Brussels exchanges, then
merged with NYSE
Tokyo Stock Exchange – Roughly 2,400 listed firms;
switched to electronic trading in 1999; three sections:
first section for large companies, second for mid-sized
companies, and third for about 200 small high-growth
stocks
36. 3-36
3.6 Globalization of Stock Markets
• Moving to automated electronic trading
• Current trends will eventually result in 24-
hour global markets
• Moving toward market consolidation
37. 3-37
3.7 Trading Costs
1. Brokerage Commission: fee paid to broker for
making the transaction
Explicit cost of trading
Full Service vs. Discount brokerage
2. Spread: Difference between the bid and asked
prices
Implicit cost of trading
• Bid: Price at which dealer will buy from you
• Ask: Price at which dealer will sell to you
• Spread: Ask — bid
38. 3-38
3.X Steps in Trading
1. Selecting a broker
Full service
Discount
2. Opening an account
Cash account
Margin account
Discretionary account
3. Initiating a position
Long
Short
Short sales
39. 3-39
3.8 Buying on Margin
Margin: Describes securities
purchased with money borrowed
in part from broker
• Net worth of investor's account: the equity
Initial Margin Requirement (IMR)
• Minimum set by Federal Reserve under
Regulation T, currently 50% for stocks
• Minimum % initial investor equity
• 1 − IMR = Maximum % amount investor can
borrow
40. 3-40
3.8 Buying on Margin
Equity
• Position value – Borrowing + Additional cash
Maintenance Margin Requirement (MMR)
• Minimum amount equity can be before
additional funds must be put into account
• Exchanges mandate minimum 25%
Margin Call
• Notification from broker that you must put up
additional funds or have position liquidated
41. 3-41
3.8 Buying on Margin
If Equity/Market value MMR, then margin
call occurs
(Market value – Borrowed) / Market Value
MMR; solve for market value
A margin call will occur when:
• Market value = Borrowed/(1 − MMR)
Borrowed amount also known as debit balance
43. 3-43
3.8 Buying on Margin
Stock price falls to $60 per share: Equity (E)=
Position value (V) – Borrowing (B) + Additional cash
= $60 x 1000 sh. - $35,000 = $25,000
Margin %: (V – B)/V = E/V = $25,000/$60,000 = 41.67%
How far can price fall before margin call? Margin call
when Market value = Borrowed/(1 − MMR)
• Market value = $35,000/(1 – .40) = $58,333
New Position
Stock $60,000 Borrowed $35,000
Equity $25,000
44. 3-44
3.8 Buying on Margin
With 1,000 shares, stock price for margin
call is $58,333/1,000 = $58.33
• $58,333 - $35,000 (Borrowing) = $23,333 (Equity)
Margin % = $23,333/$58,333 = 40%
• To restore IMR, equity needed = ½ x $58,333 = $29,167
Equity in account: $23,333; cash needed:
New Position
Stock $60,000 Borrowed $35,000
Equity $23,333
45. 3-45
3.8 Buying on Margin
Buy at $70 per share
• Borrow at 7% APR interest cost if using margin;
use full amount margin
• APRs:
Buy at $70 Sell at $72 in
90 days
Sell at $68 in
90 days
No margin 11.59% −11.59%
Margin 16.17% −30.17%
Leverage factor 1.4x 2.6x
46. 3-46
3.9 Short Sales
Sale of shares not owned by
investor but borrowed through broker and later
purchased to replace loan
Mechanics
• Borrow stock from broker; must post margin
• Broker sells stock, and deposits proceeds/margin
in margin account (you cannot withdraw proceeds
until you “cover”)
• Covering or closing out position: Buy stock; broker
returns title to party from which it was borrowed
48. 3-48
3.9 Short Sales
• Required initial margin: Usually 50%
• More for low-priced stocks
• Liable for any cash flows
• Dividend on stock
49. 3-49
3.9 Short Sales
Short-sale maintenance margin
requirements (equity)
Price MMR
< $2.50 $2.50
$2.50-$5.00 100% market value
$5.00-$16.75 $5.00
> $16.75 30% market value
50. 3-50
3.9 Short Sales
Example
You sell short 100 shares of stock at $60 per share
$6,000 must be pledged to broker
You must also pledge 50% margin
You put up $3,000; now you have $9,000 in margin
account
Short sale equity = Total margin account – Market
value = $9,000 - $6,000 = $3,000
51. 3-51
3.9 Short Sales
Example
Maintenance margin for short sale of stock with price
> $16.75 is 30% market value
30% x $6,000 = $1,800
You have $1,200 excess margin: $3,000 - $1,800
What price for margin call?
52. 3-52
3.9 Short Sales
Example
When equity (.30 x 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 for margin call: $6,293/100 shares = $69.23
53. 3-53
3.9 Short Sales
Example
If this occurs:
Equity = Total margin account – Market value
Equity = $9,000 − $6,923 = $2,077
Equity as % market value = $2,077/$6,923 = 30%
To restore 50% initial margin:
($6,923x0.5) − $2,077 = $1,384.50
54. 3-54
Table 3.5 Cash Flows from Purchasing vs. Short-Selling
Purchase of Stock
Time Action Cash Flow*
0 Buy share − Initial price
1 Receive dividend, sell share Ending price + Dividend
Profit = (Ending price + Dividend) – Initial price
Short Sale of Stock
Time Action Cash Flow*
0 Borrow share; sell it + Initial price
1 Repay dividend and buy share to replace
share originally borrowed
− (Ending price + Dividend)
Profit = Initial price – (Ending price + Dividend)
*Note: A negative cash flow implies a cash outflow.
55. 3-55
3.X Return on Invested Capital(ROIC)
Problems: You buy 100 shares of Hazelnut at $80 per share using
60% margin. Margin loan is obtained at an interest rate of 9%
per year. The stock pays a dividend of $4 per year per share.
Broker commission is $0.05 per transaction per share. Find
the return on invested capital if in three months the stock
price:
(a) Goes to $95 per share:
55
56. 3-56
ROIC or Return on Equity (ROE)
(b) Goes to $65 per share:
(c) Stays at $80 per share:
56
57. 3-57
ROIC or ROE
2. Redo the above problems under the assumption there is no
margin trading.
(a) Price goes to $95 per share:
(b) Price goes to $65 per share:
(c) Price stays at $80 per share:
57
58. 3-58
ROIC or ROE
3. What are the advantages and disadvantages of margin
trading?
58
59. 3-59
3.10 Regulation of Securities Markets
Major regulations:
Securities Act of 1933
Securities Act of 1934
Securities Investor Protection Act of 1970
Self-Regulation
Financial Industry Regulatory Authority
CFA Institute standards of professional conduct
60. 3-60
3.10 Regulation of Securities Markets
Sarbanes-Oxley Act
Public Company Accounting Oversight
Board
Independent financial experts to serve on
audit committees of boards of directors
CEOs and CFOs personally certify firms’
financial reports
Boards must have independent directors
61. 3-61
3.10 Regulation of Securities Markets
Insider Trading
Officers, directors, major stockholders must
report all transactions in firm’s stock
Insiders do exploit their knowledge
Jaffe study:
Inside buyers>inside sellers = stock does well
Inside sellers>inside buyers = stock does poorly
63. 3-63
CONCLUSION
Globalization has brought about mergers and
consolidations of exchanges
Technological developments have created massive
changes in the way securities are traded
More rapid inflow of news
greater use of electronic trading
much greater volume of trading
and volatility
70. 3-70
CONCLUSION
Characteristics of a well-functioning market:
Availability of past transaction information in a timely
and accurate manner
Liquidity
Marketability
Price continuity
Depth
Low transaction costs
Rapid adjustment of prices to new information