Principles of Investing FIN 330 Chapter 2 Investing Markets Dr. David P Echevarria All Rights Reserved

Student Learning Objectives Review Primary functions of security markets Primary, Secondary and Electronic Markets Regulation of Security Markets Dr. David P Echevarria All Rights Reserved

Financial Market Functions Efficient allocation of capital Funds to most mean and variance efficient investments Free flow of information ~ transparency Provision for Risk Management and Risk reduction Instruments for hedging Encourage diversification Efficient transfer of financial claims (equity, debt) Provide low cost liquidity services Facilitate efficient movement of capital Dr. David P Echevarria All Rights Reserved

Venture Capital Raising money for a businesses Private equity – equity financing for privately held companies Venture capital Angel investors Capital in exchange for share of company, advice If the new business succeeds, big pay-off is when the company is sold or it “goes public” (IPO). Venture capitalists / Angel investors most file secondary registration in order to sell their shares. May be subject to IPO lockup period (90 to 180 days) Dr. David P Echevarria All Rights Reserved

Primary Markets Initial public offerings (IPOs): a company offers stock to the public for the first time. General cash offer – securities are offered to the public on a “first-come, first-served” basis. Often allocated by brokers. Role of lettered stock: private placement Role of Investment Bankers Financial intermediaries who get providers and demanders of capital together (for a fee) Help in pricing and issuing new securities (advice) Bear risk of selling new securities (underwriting) Distributes issue to the public (selling) Dr. David P Echevarria All Rights Reserved

Investment Banking Process The IB (or underwriting syndicate) buys the agreed upon shares of the company at an agreed upon price. Example: buys [all] 2 million shares to be offered at $10/share. Example of full underwriting Lead underwriter is also term the “book runner” The IB believes if can sell shares for $12 per share Get some idea of demand from the polling by selling syndicate members of their customers. The $2 difference is termed the underwriting spread. Dr. David P Echevarria All Rights Reserved

Investment Banking Process A. For large issues, underwriters often combine to form an underwriting group to share the risk and to help sell the issue. Lead manager sets the price based on feedback from members of the selling syndicate Recall that they have some idea of the anticipated demand; selling syndicate gets indications of interest from customers. Dr. David P Echevarria All Rights Reserved

Visualizing the investment banking process

Investment Banking Process B. Different types of efforts Firm commitment – most popular – firm sells entire issue to underwriters Best efforts – very uncommon – underwriters “do their best…” Dutch auction – no price is set, investors bid on shares. Popular with bonds, but not stocks. Google had a Dutch auction for their IPO.

Shelf Registrations A. The timing of new stock issuances can be controlled. Perhaps the market is down and the firm wishes to wait until the economy improves before listing its stock; or perhaps the company wants to gradually sell their stock to the public over several years. B. SEC Rule 415 Security is preregistered and then may be offered at any time within the next two years. 24 hour notice, any part or all of the preregistered amount may be offered →

Secondary Markets Trading of seasoned securities Provide liquidity Cost of liquidity services = bid-ask spread Bid: the price investors will pay to buy security Ask: the price investors will take to sell security Participants: Market makers, Specialists, other traders (customers) Spread size a function of risk and activity Provide current price information Dr. David P Echevarria All Rights Reserved

Types of Secondary Markets Direct Search Markets Buyers and sellers locate one another on their own Very rare except for lettered stock – subject to restrictions Brokered Markets: Most common 3rd party assistance in matching buyers & sellers NYSE is best example (registered exchange) Floor brokers or specialists May act as agents or principals Dr. David P Echevarria All Rights Reserved

Types of Secondary Markets Dealer Markets (market makers) 3rd party acts as intermediate buyer/seller May act as agent or principal OTC is good example Auction Markets: all markets are this type today Brokers & dealers trade in centralized [computer] locations. Trading is more or less continuous Most common; i.e., NYSE. AMEX, etc. Dr. David P Echevarria All Rights Reserved

Types of Secondary Markets E. Electronic Communication Networks (ECN) Computerized systems that automatically match buy and sell orders Larger ECN’s owned the larger exchange systems: i.e., Archipelago acquired by NYSE F. Dark Pools Not directly accessible to public investors. Order matching done by computerized systems on a first in first out basis. Subject to front running by high frequency traders (HFT) Lack full transparency Dr. David P Echevarria All Rights Reserved

Secondary Markets: NYSE The New York Stock Exchange (NYSE) is the largest exchange in the world. The NYSE (or Big Board) lists over $18 trillion of company stocks and the average trading volume is approximately $170 billion each day. The NYSE is owned by a holding company – the Intercontinental Exchange (ICE). ICE stock is traded on the NYSE

Types of NYSE members Commission/floor brokers – Companies like Merrill Lynch (about 500 NYSE members) Specialists – obligated to make and maintain a fair and orderly market for the securities assigned to them Floor traders – independents who trade on their own accounts (small number) SuperDOT system – designated order turnaround – allows orders to be transmitted electronically to a specialist with best Bid or Ask price quote or public trader (most likely)

NYSE Order Processing Typically, only very large (over 100,000 shares) orders are manually executed on the NYSE floor. All other orders are transacted electronically (via the SuperDOT system) Assume a trader places a market order to buy 100 round lots (10,000 shares) of Bank of America stock (BAC). Broker electronically submits the order to the floor of the NYSE. Commission broker takes/sends order to specialist post. May trade with another broker or with specialist. Dr. David P Echevarria All Rights Reserved

NASDAQ Order Processing National Association of Securities Dealers Automated Quotation system. A computer network of securities dealers who disseminate timely security price quotes to subscribers. There is no physical location. Dealers act as market makers Post bid and ask prices Post number of shares that they obligate themselves to trade at that price Trade on an inventory basis There are multiple market makers for any given stock (rather than specialists) Dr. David P Echevarria All Rights Reserved

NASDAQ Quotation Access Levels Levels of subscribers to NASDAQ quotation system Level 1: inside quotes (everyone) Lowest Ask – highest bid (the market) Level 2: receive all quotes but can’t enter quotes – used to execute trades only (small fee – sometimes free) Essentially a peek at the limit order book Level 3: dealers can see and post quotes (large fee) Dr. David P Echevarria All Rights Reserved

ECNs It is possible to trade securities without the use of an exchange. Some trades take place entirely in the third market, which is an over-the-counter (OTC) market where broker-dealers and large institutional investors trade directly with each other, rather than through an exchange. There is even a fourth market where securities are traded without the use of a broker-dealer, using ECNs to avoid brokerage fees. These trades can take place at any time. Dr. David P Echevarria All Rights Reserved

Market regulation Securities Acts of 1933 Securities Acts of 1934 Requires full disclosure of information by issuers of new securities Securities Acts of 1934 Established the SEC and required periodic disclosure of relevant financial information for firms with publicly traded securities. Gives authority to regulate exchanges and OTC trading/traders to the SEC. Dr. David P Echevarria All Rights Reserved

Market regulation Investment Advisors Act of 1940 Self Regulation Governs investment advisors – defines roles and responsibilities for those who “advise” on financial matters. Self Regulation Financial Industry Regulatory Authority (FINRA) Formed in 2007 by consolidating regulatory arms of the NASD and the NYSE. Examines securities firms, promulgates trading practice rules and administers a dispute resolution forum for investors and firms. Dr. David P Echevarria All Rights Reserved

Increasing regulation Sarbanes-Oxley – new set of laws (drafted in 2002) that increases disclosure requirements of all U.S. publicly traded companies. Response to financial scandals of 2000-2002. Dodd-Frank Wall Street Reform and Consumer Protection Act – new complicated set of rules for banks and financial institutions, designed to lesson the risk these institutions are able to take in their investing activities. Response to the “great recession” of 2008-2009. Dr. David P Echevarria All Rights Reserved

Homework Questions 1. What are the three functions of financial markets? 2. What role do venture capitalist play in new ventures? 3. What is the difference between primary and secondary markets? 4. What is the difference between an investment banker providing an full underwriting function and a “best-efforts” offering? 5. What is a shelf registration? How does it work? 6. How do we measure the cost of liquidity? 7. How does the SuperDOT system work? 8. What are electronic communication networks (ECNs)? 9. Indicate the primary purpose of the Securities Act of 1933. Why was it enacted? Does the SEC certify that a security is fairly priced? 10. Explain the purpose of the Securities Investor Protection Corporation (SIPC). Dr. David P Echevarria All Rights Reserved