Chapter 3 How Securities are Traded

Chapter Summary Objective: To explain the institutional details and mechanics of investing in securities. How firms issue securities Organization of secondary markets Trading and execution Margin trading Costs and regulation

Primary vs. Secondary Security Sales New issue Key factor: issuer receives the proceeds from the sale Secondary Existing owner sells to another party Issuing firm doesn’t receive proceeds and is not directly involved

Investment Banking Arrangements Underwritten vs. “Best Efforts” Underwritten: firm commitment on proceeds to the issuing firm Best Efforts: no firm commitment Negotiated vs. Competitive Bid Negotiated: issuing firm negotiates terms with investment banker Competitive bid: issuer structures the offering and secures bids

Public Offerings Public offerings: registered with the OSC (Ontario - SEC in USA) and sale is made to the investing public Red herring Prompt offering prospectus Initial Public Offerings (IPOs) Evidence of underpricing Performance

Private Placements Private placement: sale to a limited number of sophisticated investors not requiring the protection of registration Dominated by institutions Very active market for debt securities Not active for stock offerings

Types of Markets Direct search markets Brokered markets Block transactions Dealer markets OTC market Auction markets Major exchanges

Organization of Secondary Markets Organized exchanges OTC market Third market Fourth market

Organized Exchanges Auction markets with centralized order flow Dealership function: can be competitive or assigned by the exchange (specialists or registered traders) Securities: stock, futures contracts, options, and to a lesser extent, bonds Examples: TSE, ME, NYSE, AMEX

OTC Market Dealer market without centralized order flow NASDAQ: largest organized stock market for OTC trading; information system for individuals, brokers and dealers Levels of interaction: users, market-makers Securities: stocks, bonds and derivatives Most secondary bonds transactions

Third Market Trading of listed securities away from the exchange Institutional market: to facilitate trades of larger blocks of securities Involves services of dealers and brokers

Fourth Market Institutions trading directly with institutions No middleman involved in the transaction Organized information and trading systems INSTINET POSIT ECN development

The execution of trades Registered trader (market-maker) functions Maintaining a “book” Maintain a “fair and orderly market” Execute “stabilizing” trades Registered traders possess valuable inside information about the future direction of the market

Types of Orders Instructions to the brokers on how to complete the order Market Limit Stop loss

Summary Reminder Objective: To explain the institutional details and mechanics of investing in securities. How firms issue securities Organization of secondary markets Trading and execution Margin trading Costs and regulation

Margin Trading Using only a portion of the proceeds for an investment Borrow remaining component Margin arrangements differ for stocks and futures

Stock Margin Trading Greatest margin Minimum margin Margin call Currently 30% Set by the securities commissions Minimum margin Minimum level the equity margin can be (called “maintenance” in USA) Margin call Call for more equity funds

Margin Trading - Initial Conditions X Corp $70 50% Initial Margin 30% Minimum Margin 1000 Shares Purchased Initial Position Stock $70,000 Borrowed $35,000 Equity $35,000

Margin Trading - Minimum Margin Stock price falls to $60 per share New Position Stock $60,000 Borrowed $35,000 Equity $25,000 Margin% = $25,000/$60,000 = 41.67%

Margin Trading - Margin Call How far can the stock price fall before a margin call? Therefore, P = $50 Note: 1,000xP – Amount Borrowed = Equity

Leveraging effect of margin purchases You buy 200 shares of XYZ at $100, expecting a 30% appreciation of the stock in one year: Initial margin: 50% Financed by a 9% loan for one year Expected net return: 51% A 30% drop in the price, though, brings a negative rate of return of -69%.

Short Sales Purpose: to profit from a decline in the price of a stock or security Mechanics Borrow stock through a dealer Sell it and deposit proceeds and margin in an account Close out the position: buy the stock and return it to the owner

Short Sale - Initial Conditions Z Corp 100 Shares 50% Initial Margin 30% Minimum Margin $100 Initial Price Sale Proceeds $10,000 Margin & Equity $ 5,000 Stock Owed $10,000

Short Sale - Minimum Margin Stock Price Rises to $110 Sale Proceeds $10,000 Initial Margin $ 5,000 Stock Owed $11,000 Net Equity $ 4,000 Margin % (4,000/11,000) = 36%

Short Sale - Margin Call How much can the stock price rise before a margin call? So, P = $115.38 Note: $15,000 = Initial margin + sale proceeds

Summary Reminder Objective: To explain the institutional details and mechanics of investing in securities. How firms issue securities Organization of secondary markets Trading and execution Margin trading Costs and regulation

Costs of Trading Commission: fee paid to broker for making the transaction Full service broker Discount broker Spread: cost of trading with dealer Bid: price dealer will buy from you Ask: price dealer will sell to you Spread: ask - bid Execution: better price obtained

Internet Trading On-line brokers (discount or full-service) ECNs – electronic communication networks Pre- and post-market trading (lack of integration, thin trading)

Regulation of Securities Markets Government Regulation Self-Regulation in the Industry Circuit Breakers Insider Trading