Primary and Secondary Markets

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Primary and Secondary Markets

  1. 1. Chapter 7: Primary and Secondary Markets Members: Malonzo, Minette Manalastas, Zoren Manalo, Kevin Manddal, Honedean Mendoza, Vanessa Joy 1 Chapter7PrimaryandSecondaryMarkets
  2. 2. Primary Markets: -dealing with newly issued financial claims Regulation of the Issuance of Securities •Underwriting activities- are regulated by the Securities and Exchange Commission •Securities Act of 1933-governs the issuance of securities. The act requires that a registration statement be filed with the SEC by the issuer of the security -the act provides for penalties in the form of fines and/or imprisonments if the information provided is inaccurate or material information is omitted. Two parts of a registration 2Chapter 7 Primary and Secondary Markets
  3. 3. Chapter 7 Primary and Secondary Markets 3 (1) Part 1 is the prospectus- this part is typically distributed to the public as an offering of the securities (2) Part II contains supplemental information, which is not distributed to the public as part of the offering but is available from the SEC upon request Due diligence- one of the most important duties of an underwriter to perform The filing of a registration statement with the SEC doesn’t mean that the security can be offered to the public. The registration statement must be reviewed and approved by the SEC’s Division of Corporate Finance before the security can be offered to the public. The staff sends a “letter of comments” or “deficiency letter” to the issuer explaining the problem it encountered. The issuer must then remedy any problem by filing an amendment to the registration
  4. 4. Chapter 7 Primary and Secondary Markets 4 Waiting period- the time interval between the initial filing of the registration statement and the time the registration statement becomes effective Red herring- because the prospectus is not effective, the cover page of the prospectus states this status in red ink and as a result, the preliminary prospectus is commonly referred to as red herring. Rule 415: Shelf Registration Rule -In 1982 the SEC approved Rule 415 , which permits certain issuers to file a single registration document indicating that it intends to sell a certain amount of a certain class of securities at one or more times within the next 2 years. Rule 415 is popularly referred to as the shelf registration rule because the securities can be viewed as sitting on a “shelf” and can be taken off that shelf and sold to the public w/o obtaining addditional SEC approval
  5. 5. Chapter 7 Primary and Secondary Markets 5 Continued Reporting -any company that publicly offers a security in the United States becomes a reporting company. Private Placement of Securities Securities Act of 1933 & The Securities Exchange Act of 1934- require that all securities offered to the general public must be registered with the SEC, unless given specific exemption Three exemptions allowed by the securities act from federal registrations. •First, intrastate offerings –that is securities sold only within a state –are exempt.
  6. 6. Chapter 7 Primary and Secondary Markets 6 •Second, a small –offering exemption (Regulation A) specifically applies if the offerings is for $1million or less, then the securities need not be registered . •Finally , Section 4(2) of the 1933 Act exempts from registration “transactions by an issuer not involving any public offering” In 1982 the SEC adopted Regulation D, which sets forth the specific guidelines that must be satisfied to qualify for exemption from registration under Section 4(2). “accredited” investors- with the capability to evaluate the risk and return characteristics of the securities -with the resources to bear the economic risks.
  7. 7. Chapter 7 Primary and Secondary Markets 7 Rule 144A -In April 1990, however , SEC Rule 144A became effective. This rule eliminate the 2-year holding period by permitting large institutions to trade securities acquired in a private placement among themselves w/o having to register these securities with the SEC. -Private Placements are now classifieds as Rule 144A offerings or non-Rule 144A offerings. The latter are commonly referred to as traditional private placements. Rule144A offerings are underwritten by the investment bankers. -Rule 144A also improves liquidity, reducing the cost of raising funds.
  8. 8. Chapter 7 Primary and Secondary Markets 8 Variations in Underwriting of Securities Variations –include the “bought deal” for the underwriting of bonds, the auction process for both stocks and bonds and a right offerings for common stock Bought Deal Bought deal –was introduced in the Eurobond Market in 1981 when Credit Suisse First Boston purchased from General Motors Acceptance Corporation a $100million issue w/o lining up an underwriting syndicate prior to the purchase.
  9. 9. Chapter 7 Primary and Secondary Markets 9 Mechanics of a bought deal: Lead manager/group manager –offers a potential issuer of debt securities a firm bid to purchase a specified amount of the securities with a certain interest rate and maturity Issuer –is given a day or so to accept or reject the bid. If the bid is accepted, the underwriting firm has “bought the deal” Auction Process -another variation for the issuance of securities. In this method the issuer announces the terms of the issue, and interested parties submit bids for the entire issue.
  10. 10. Chapter 7 Primary and Secondary Markets 10 auction form –is mandated for certain securities of regulated public utilities and many municipal debt obligations. It is commonly referred to as a competitive bidding under writing Single-price auction or a Dutch auction -One way in which a competitive bidding can occur is all bidders pay the highest winning yield bid (or, equivalently, the lowest winning price). Multiple-price auction -Another way is for each bidder to pay whatever they bid Preemptive Rights Offerings
  11. 11. Chapter 7 Primary and Secondary Markets 11 -A corporation can issue new common stock directly to existing shareholders via a preemptive rights offering. A preemptive right grants existing shareholders the right to buy some proportion of the new share issued at a price below market value. -A rights offering insures that current shareholders may maintain their proportionate equity interest in the corporation. subscription price- The price at which new shares can be purchased Standby underwriting arrangement -This arrangement calls for underwriter to buy the unsubscribed shares. The issuing corporation pays a standby fee to the investment banking firm.
  12. 12. Chapter 7 Primary and Secondary Markets 12 Word Capital Markets Integration and Fund-Raising Implications -An entity may seek funds outside its local capital market with the expectation of doing so at a lower cost than if its funds are raised in its local capital markets. At the two extremes, the world capital markets can be classified as either completely segmented or completely integrated. completely segmented market -investors in one country are not permitted to invest in the securities issued by an entity in another country completely integrated market -contains no restriction to prevent investors from investing in securities issued in any capital market throughout the world
  13. 13. Chapter 7 Primary and Secondary Markets 13 Real-world capital markets are neither completely segmented nor completely integrated, but fall somewhere in between. A mildly segmented market or mildly integrated market implies that world capital markets offer opportunities to raise funds at a lower cost outside the local capital market. Motivation for raising funds outside of the domestic market In the case of debt the cost will reflect two factors: (1) the risk free rate, which is accepted as the interest rate on a US Treasury security with the same maturity or some other low-risk security (called the base rate) (2) a spread to reflect the greater risks that investors perceive as being associated with the issue or issuer
  14. 14. Chapter 7 Primary and Secondary Markets 14 market frictions-occur because of differences in security regulations in various countries, tax structures, restrictions imposed on regulated institutional investors, and the credit risk perception of the issuer Secondary markets -Already –issued financial assets trade; market for seasoned securities. -the issuer of the asset does not receive funds from the buyer. Rather, the existing issue changes hands in the secondary market, and funds flow from the buyer of the asset to the seller. Functions of secondary Markets The secondary market provides to an issuer of securities, whether the issuer is a corporation or a governmental unit, regular information about the value of
  15. 15. Chapter 7 Primary and Secondary Markets 15 It provides the opportunity for the original buyers of the asset to reverse their investments by selling it for cash. It brings together many interested parties and so can reduce the cost of searching for likely buyers and sellers of assets Architectural Structure of Secondary Markets Two general architectural structures that can be used in establishing a secondary market for a financial asset: Order-driven Quote –driven Markets
  16. 16. Chapter 7 Primary and Secondary Markets 16 Potential Parties to Trade Natural Buyers Natural Sellers Brokers Dealers Natural buyers and natural sellers-want to take position for their own portfolio. They can be retail investors or institutional investors. Broker –is a third party in a trade that acts on behalf of a buyer or seller who wishes to execute an order. -it is said to be an “agent” of the one of the parties to the trade Dealer –is an entity that acts as an intermediary in a trade by buying and selling for its own account; a dealer will buy a financial asset to place in its inventory or will sell a financial asset from its own inventory -it is said to; “take a position in an asset”
  17. 17. Chapter 7 Primary and Secondary Markets 17 -a dealer is acting as a principal in a trade The ask price –the potential income earned from this intermediary activity is the difference between the price at which a dealer is willing to offer a financial asset to investors The bid price –the price at which the dealer is willing to buy a financial asset from investors Bid-ask spread –the difference between ask price and bid price Market maker –special type of dealer; it describe a dealer who has a special obligation in the secondary market. Open-driven Market and Quote-Driven Market Open-driven market –is where all participants in the
  18. 18. Chapter 7 Primary and Secondary Markets 18 Quote-driven market –in here rather than having the interaction of natural buyers and natural sellers determine the price, the price is determined by the dealer based on prevailing information; it is also referred as dealer market or dealership market Types of Order-Driven Market Continuous order-driven market-prices are determined continuously through-out the trading days buyers and sellers submit orders. Periodic call auction- orders are batched or grouped together for simultaneous execution at preannounced times Price scan auction –an auctioneer announces tentative prices and the participants physically present respond indicating how much they would be willing to buy and sell at each tentative price
  19. 19. Chapter 7 Primary and Secondary Markets 19 sealed bid/ ask auction- bid price/ask price and quantities at which a participants is willing to transact are submitted Trading Location Classification of organized Secondary Markets: Exchanges –secondary markets that are legally established as national securities exchanges. The products traded are approved by the director of the exchange and referred to as “listed products” Over-the-counter Market (OTC Market) –is simply the market where non-exchange traded products are traded. Trading is done by the geographically dispersed traders who are linked to one another via telecommunications system. In the case of common stock, unlisted stock are traded in the OTC market also the non-exchange traded
  20. 20. Chapter 7 Primary and Secondary Markets 20 Perfect Markets -a perfect market results when the number of buyers and sellers is sufficiently large, and all participants are small enough relative to the market so that no individual market agent can influence the commodity’s price. More is involved in a perfect market than market agents being price takers. No transaction costs or impediments must interfere with the supply and demand of the commodity. Economists refer to these various costs and impediments as “friction.” In the case of financial markets, frictions would include the following: Commissions charged by brokers Bid-ask spreads charged by dealers Order handling and clearance charges Taxes (notably on capital gains) and government- imposed transfer fees
  21. 21. Chapter 7 Primary and Secondary Markets 21 Costs of acquiring information about the financial asset Trading restrictions, such as exchange-imposed restrictions on the size of a position in the financial asset that a buyer or seller may take Restrictions on market makers Halts to trading that may be imposed by regulators where the financial asset is traded Types of Orders Investors must provide information to the broker about the conditions under which the will transact. The types of order include market orders, limit orders, stop orders, time-specific orders: market orders and limit orders. The simplest type of order is the market order, an order executed at the best price available in the market
  22. 22. Chapter 7 Primary and Secondary Markets 22 To avoid the danger of adverse unexpected price changes, an investor can place a limit order that designates a price threshold for the execution of the trade. The limit order is a conditional order- it is executed only if the limit price or a better price can be obtained A buy limit order indicates that the security may be purchased only at the designated price or lower. A sell limit order indicates that the security may be sold at the designated price or higher. On an exchange, a limit order that is not executable at the time it reaches the market is recorded in a limit order book. The orders recorded in this book are treated equally with other orders in term of priority.
  23. 23. Chapter 7 Primary and Secondary Markets 23 This practice of selling securities that are not owned at the time of sale is referred to as selling short. The security is purchased subsequently by the investor and returned to the party that lent it. When the security is returned, the investor is said to have “covered the short position.” A profit will be realized if the purchase price is less than the price that the investor sold shortly the security. A transaction in which an investor borrows to buy additional securities using the securities themselves as collateral is called buying on margin. The interest rate that banks charge brokers for the transactions is known as the call money rate (also called the broken loan rate).
  24. 24. Chapter 7 Primary and Secondary Markets 24 Initial margin requirement- is the proportion of the total market value of the securities that the investor must pay for in cash. The initial margin requirement varies for stocks and bonds and is current 50%, although it has been below 40%. The 1934 act- gives the board of Governors of the Federal Reserve’s the responsibility to set initial margin requirement, under regulation T and U. For the market to accommodate these types of transactions mechanism must be available in the market place where the financing of positions in securities can be done quickly and at reasonable cost and where securities can be borrowed so that short selling can take replace. The financing in securities and borrowing of securities fall into a little known, but obviously important, area of finance called security finance
  25. 25. Chapter 7 Primary and Secondary Markets 25 Securities finance involves two activities: securities lending and repurchase agreements. Securities lending -The short seller borrows the security from the broker. That’s short answer, however, masks the role of a major activity in financial markets called securities lending and the motivation of the parties in a securities lending transaction. Securities lending involves the temporary transferring of a security by one party to another party. security lender -The party that transfers the security security borrower -The party needs the security The security lending agreement calls for the borrower to return the borrowed security to the security lender either on demand or by specified date.
  26. 26. Chapter 7 Primary and Secondary Markets 2 6 When there is cash collateral that is posted by the security borrower, the security lender now has cash available to invest. The agreement will call for the security lender to pay to the security borrower a fee referred to as the rebate. The amount of the rebate is equal to the amount of the cash collateral multiplied by the rebate rate. The securities lending groups assist customers in negotiating the rebate rate, identifying acceptable counterparties in transactions, and investing the cash collateral to generate a spread over the rebate rate. Repurchase agreements -being able to finance positions in securities is critical in financial market. This can be done by using the securities purchase as collateral for loan.
  27. 27. Chapter 7 Primary and Secondary Markets 27 A repurchase agreement, more popularly referred to as repo, is the sale of a security with a commitment by the seller to buy the same security back from the purchaser at a specified price at a designated future date. repurchase price-The price at which the seller must subsequently repurchase the security repurchase date- the date that the security must be repurchased a repo is a collateralized loan, where the collateral is the security sold and subsequently repurchased. repo rate- The term of the loan and the interest rate that the entity seeking financing agrees to pay When the term of the loan is one day, it is called an overnight repo; a loan for more than one day is called a term repo.
  28. 28. Chapter 7 Primary and Secondary Markets 28 The transaction is referred to as a repurchase agreement because it calls for the sale of the security and its repurchase at a future date. Both the sale price and purchase price are specified in the agreement: The difference between the purchase (repurchase) price and the sale price is the dollar interest cost of the loan. One party is lending money and accepting a security as collateral for the loan: the other party is borrowing money and providing collateral to borrow the money. When someone lends securities in order to receive cash (i.e., borrow money), the party is said to be “reversing out” securities. A party that lends money with the security as collateral is said to be “reversing in” securities.
  29. 29. Chapter 7 Primary and Secondary Markets 29 The amount by which the market value of the security used as collateral exceeds the value of the loan is called repo margin. Repo margin is also referred to as the “haircut”. Repo margin is generally between 1% and 3%. For borrowers of lower creditworthiness and/or when less liquid securities are used as collateral, the repo margin can be 10% or more. There is not one repo rate in the market. The rate varies from transaction to transaction depending on a variety of factors: quality of collateral, term of the repo, delivery requirement, availability of collateral, and the prevailing federal funds rate. The higher the credit quality and liquidity of the collateral, the lower the repo rate. The more difficult it is to obtain the collateral, the lower the repo rate.
  30. 30. Chapter 7 Primary and Secondary Markets 30 Role of brokers and dealers in real markets Common occurrences in real markets keep them from being theoretically perfect. Because of these occurrences, brokers and dealers are necessary to the smooth functioning of a secondary market. Brokers Most investors in even smoothly functioning markets need professional assistance. Investors need someone to receive and keep track of their orders for buying or selling, to find other parties wishing to sell or buy, to negotiate for good prices, to serve as a focal point for trading, and to execute the orders. The broker performs all of these functions.
  31. 31. Chapter 7 Primary and Secondary Markets 31 Dealers as market makers The dealer acts as an auctioneer in some market structures, thereby providing order and fairness in the operations of the market. The role of a market maker in a call market structure is that of an auctioneer. The market maker does not take a position in the traded security, as a dealer does in a continuous market. Dealers also have to be compensated for bearing risk. A dealers position may involved carrying inventory of a security (a long position) or selling a security that is not in inventory (a short position). Three types of risks are associated with maintaining a long or short position in a given security:
  32. 32. Chapter 7 Primary and Secondary Markets 32 First, the uncertainty about the future price of the security presents a substantial risk. A dealer who takes a long position in the security is concerned that the prices will decline in the future; a dealer who is in a short position I concerned that the price will rise. The second type of risk concerns the expected time it will take the dealer to unwind a position and its position and its uncertainty, which, in turn, depends primarily on the rate at which buy and sell orders for the security reach the market. Finally, although a dealer may be able to access better information about order flows than the general public, in some trades the dealer takes the risk of trading with someone in possession of better information.
  33. 33. Chapter 7 Primary and Secondary Markets 33 Market efficiency The term efficient, used in several context, describe the operating characteristics of a capital market. A distinction, however, can be made between an operationally (or internally) efficient market and a pricing (or externally) efficient capital market. Operational efficiency In an operationally efficient market, inventors can obtain transaction services as cheaply as possible, given the costs associated with furnishing those services Pricing efficiency Refers to a market where prices at all times fully reflect all available information that is relevant to the valuation of securities.
  34. 34. Chapter 7 Primary and Secondary Markets 34 Price formation process defined the “relevant” information set that prices should reflect. Fama classified the pricing efficiency of a market into three forms: weak, semi-strong, and strong. Weak efficiency- means that the price of the security reflects the past price and trading history of the security. Semi-strong efficiency- means that the price of the security fully reflects all public information, which includes but is not limited to historical price and trading patterns. Strong efficiency- exist in a market when the price of a security reflects all information, whether or not it is publicly available. A price efficient market carries certain implications for the investment strategy investors may wish the
  35. 35. Chapter 7 Primary and Secondary Markets 35 Transaction costs In an investment era where one half of one percentage point can make a difference when a money manager is compared against a performance benchmark, an important aspect of the investment process is the cost of implementing an investment strategy. Transaction costs are more than merely brokerage commissions-they consist of commissions, fees, execution cost, and opportunity costs. Commissions- are the fees paid to brokers to trade securities. In may 1975 commissions became fully negotiable and have declined dramatically since then. Included in the category of fees are custodial fees and transfer fees. Custodial fees are the fees charged by an institution that holds securities in safe keeping for an investors.
  36. 36. Chapter 7 Primary and Secondary Markets 36 Execution costs represent the difference between the execution price of a security and the price that would have existed in the absence of trade. Execution costs can be further decomposed into market (or prices) impact and market timing costs. Market impact costs- is the result of the bid-ask spread and a price concession extracted by dealers to mitigate their risk that an investors demand for liquidity is information motivated. Market timing costs- arises when an adverse price movement of the security during the time of the transaction can be attributed in part to other activity in the security and is not the result of a particular transaction.
  37. 37. Chapter 7 Primary and Secondary Markets 37 Information-motivated trading occurs when the investors believe they possess pertinent information not currently reflected in the security’s prices. Informationless trades results from either a reallocation of wealth or implementation of an investing strategy that utilizes only existing information. Opportunity costs may arise when a desired trade fails to be executed. This components of costs represents the difference in performance between an investors desired investment and the same investors actual investment after adjusting for execution costs, commissions, and fees.
  38. 38. Chapter 7 Primary and Secondary Markets 38 …END… God Bless!

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