INVESTMENTS Lecture 2 Security Markets

Security market organization §Markets are meant to allow buyers and sellers to interact. §Good financial markets allow resources to flow to their most productive use.

§Desirable market characteristics l 1. Information availability l 2. Liquidity l 3. Price continuity – market depth l 4. Low transactions costs (operational or internal efficiency) l 5. Quick and accurate price adjustments when information arrives (informational or external efficiency) Security market organization

§ Primary markets l Primary markets are original issue markets where capital is acquired by the government and corporations. l Government bond issues (Treasury securities) Separated into bills, notes, and bonds Treasury securities are sold through an auction process

Taking a Firm Public §Process involved in an IPO l Pitch the firm l Due diligence l Drafting session l Valuation l Roadshow l Support the deal

§Underwriting an issue l Unlike government security issues, most municipal and corporate security issues are underwritten by a brokerage house or a syndicate of brokerage houses. l Underwriting refers to the purchase of an issue by an investment banker at a set or negotiated price with the intent of selling the issue to the public. Security market organization

§Underwriting an issue l Functions of underwriter: l 1. Origination l 2. Risk bearing l 3. Distribution

Security market organization §Underwriting an issue l Types of underwriting arrangements l 1. Negotiated l 2. Competitive bid l 3. Best-efforts

Security market organization §Primary Municipal Bond Issues l Types of issuance Competitive bids Negotiated bids Private placements Revenue and GO bonds

Security market organization §Primary Corporate Issues l Corporations issue both debt and equity securities Seasoned issues IPOs

Security market organization §Primary Corporate Issues l IPOs New corporate issues are generally underwritten by investment banks –-- Negotiated –-- Competitive bids (typical for utilities) –-- Best efforts (for speculative issues) Shelf Registration (rule 415) Private Placements (rule 144A)

Security market organization §Secondary markets l Secondary markets are the markets where existing securities are traded. l Trades occur between existing and potential owners of securities. l Proceeds of sales in secondary markets do not go to the issuing unit but the owner of the security. l Secondary markets provide liquidity and a current market price

Security market organization §Secondary bond markets l Generally dealer markets where large banks and investment banks make markets in the bonds. (OTC market) l Some corporate bonds trade on securities exchanges such as the NYSE l Bond markets are somewhat illiquid for smaller investors and the transactions costs involved in trading bonds are relatively high. l There is a push for more uniform reporting of bond prices so as to encourage secondary market transactions

Security market organization §Secondary equity markets l 1. National Stock exchanges l 2. Regional stock exchange Provide trading facilities for local companies not large enough to qualify for listing on the larger exchanges Provides "dual-listings" for companies l 3. Over the counter markets (NASDAQ) NASDAQ is the dominant OTC market NASDAQ is an association of securities dealers

Secondary Markets §pure auction §dealer market §how and when stocks are traded l call markets l continuous markets

Membership for Listed Exchanges §specialists §commission brokers §floor brokers §registered traders

Security market organization §Differences between OTC and organized exchanges trading mechanism l The specialist in organized exchanges 1. Broker 2. Quotes bid/ask prices. –Bid -- Price at which specialist is willing to buy (Price at which you can sell) –Ask -- Price at which specialist is willing to sell (Price at which you can buy) 3. Dealer 4. Maintain limit order book -- Keep track of limit orders and execute trades for floor brokers

§Differences between OTC and organized exchanges trading mechanism l The dealer in OTC exchanges There is no central location in OTC markets so dealers take a position in every transaction. There are varying numbers of dealers in every OTC stock and each dealer quotes a bid and ask price. Dealers make money on the difference between the bid and the ask price. In OTC markets each transaction is completed at either the bid or ask. In exchanges the specialist rarely takes a position so transactions often occur between the specialists bid and ask prices. Security market organization

§Third and fourth markets l Third market describes over-the-counter trading of exchange listed shares. l Fourth market describes private transactions of shares.

Security market trends §1. Growth of institutional investors l No relationship between stock volatility and institutional trading l **Here's what Peter Lynch has to say about institutional trading, "If you invest like an institution, you're doomed to perform like one, which in many cases isn't very well.” §2. Negotiated commissions

§3. Block Trades l Can move the market §4. Technology §5. Central market §6. Growth of international investments l Integration between markets Security market trends

Electronic Computer Networks (ECNs) §Major ECNs l Island ECN l Instinet l REDIBook l Archipeligo §Competing with Nasdaq and NYSE for volume §Leads to some fragmentation of markets