INVESTMENTS | BODIE, KANE, MARCUS Copyright © 2011 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin CHAPTER 3 How Securities are Traded

INVESTMENTS | BODIE, KANE, MARCUS OUTLINES How Firms Issue Securities: Primary versus secondary market Types of Markets: Brokered, Auction, and Dealers markets Types of Orders: Market Order, Price-Contingent Order, and Stop Order Trading Mechanisms: Dealer Markets, Electronic communication networks (ECNs), and Specialists markets. Buying on Margin Short Sales Short covering Trailing Stop Orders 3-2

INVESTMENTS | BODIE, KANE, MARCUS 3-3 How Firms Issue Securities Primary Market –Firms issue new securities through underwriter to public –Investors get new securities; firm gets funding Secondary Market –Investors trade previously issued securities among themselves

INVESTMENTS | BODIE, KANE, MARCUS 3-4 Primary Market Stocks –Initial Public Offerings (IPOs) –Seasoned Equity Offering –Private placement Bonds –Public offering –Private placement

INVESTMENTS | BODIE, KANE, MARCUS 3-5 Primary Market I. Public Offerings (Bonds and Stocks): An issue of Securities to the public for the first time by a formerly privately owned company that is going public Underwriting: Investment bank helps the firm to issue and market new securities

INVESTMENTS | BODIE, KANE, MARCUS Primary Market: Underwriting Process –Road shows to publicize new offering –Bookbuilding to determine demand for the new issue –Degree of investor interest in the new offering provides valuable pricing information 3-6

INVESTMENTS | BODIE, KANE, MARCUS 3-7 Primary Market: Underwriting Process: Red herring: Preliminary registration statement filed with the securities and Exchange Commission (SEC) Prospectus: Final and accepted Statement that describes the issue and the prospects of the company Announcement of the price at which the security will be offered to the public. A Firm Commitment: the issuing firm sells the securities to the underwriting syndicate for the public offering price less a spread.

INVESTMENTS | BODIE, KANE, MARCUS 3-8 Figure 3.3 Long-term Relative Performance of Initial Public Offerings

INVESTMENTS | BODIE, KANE, MARCUS Primary Markets: II. Seasoned Equity Offerings (SEO) Xiaohui Gao and Jay Ritter, JFE (Forthcoming) SEO: as issue by companies that already have floated equity 1. Fully Marketed Offers: Similar to IPOs 2. Accelerated Offers: Bought Deals: Bought deals started in the mid-1980s. With a bought deal, the issuing firm announces the amount of stock it wishes to sell and investment banks bid for these shares, usually by submitting bids shortly after the market’s close. The bank that offers the highest net price wins the deal. The winning bank then resells the shares, primarily to institutional investors, usually within 24 hours. Because of this timing, bought deals are also known as overnight deals. Bought deals are essentially auctions to underwriters followed by open market sales. 3-9

INVESTMENTS | BODIE, KANE, MARCUS Primary Markets: Seasoned Equity Offerings (SEO) Accelerated Bookbuilt Offers: Banks submit proposals, usually specifying a gross spread but not necessarily an offer price, for the right to underwrite the sale of the shares. The winning bank then usually forms a small underwriting syndicate and begins marketing the shares to institutional investors. The offer price is then negotiated between the issuing firm and the bank. The bookbuilding procedure is “accelerated” in the sense that no road show is conducted and the underwriting procedure is typically completed within 48 hours. 3. Right Offers: Current shareholders are given short-term warrants to purchase newly issued shares at a fixed offer price. (very rare in U.S.) 3-10

INVESTMENTS | BODIE, KANE, MARCUS 3-11 Primary Market III. Private Placements –Firm uses investment bankers to sell securities directly to a small group of institutional or wealthy investors. –Cheaper than public offerings –Less suited for very large offerings. –Private placements not traded in secondary markets –In this process, instead of underwriters, placement agents act as intermediaries between the issuer and investors. However, they do not assume any underwriting risks. In recent years, some issuers have bypassed placement agents and have done private placements directly with ultimate investors.

INVESTMENTS | BODIE, KANE, MARCUS 3-12 How Securities are Traded Types of Markets: Direct search –Buyers and sellers seek each other Brokered markets –Brokers search out buyers and sellers Example, Investment Bankers who market a firm’s securities to the public act as brokers Dealer markets –Dealers have inventories of assets from which they buy and sell Example, most bonds trade in over-the-counter dealer markets. Auction markets –traders converge at one place to trade either physically or electronically. Example, New York Exchange Stock (NYSE)

INVESTMENTS | BODIE, KANE, MARCUS 3-13 Bid and Asked Prices Bid Price Bids are offers to buy. In dealer markets, the bid price is the price at which the dealer is willing to buy. Investors “sell to the bid”. Bid-Asked spread is the profit for making a market in a security. Ask Price Asked prices represent offers to sell. In dealer markets, the asked price is the price at which the dealer is willing to sell. Investors must pay the asked price to buy the security.

INVESTMENTS | BODIE, KANE, MARCUS 3-14 Types of Orders I.Market Order: They are buy or sell orders that are to be executed immediately at the current market prices. Complications: 1. Market order might be filled at multiple price 2. Another trader may beat our investor to the quote 3. The best price quote may change before our investor’s order arrives

INVESTMENTS | BODIE, KANE, MARCUS Types of Orders II.Price-contingent Order: Traders specify buying or selling price – A limit buy order: Instruct the broker to buy some number of shares if and when the share can be obtained at or below a stipulated price. –A limit sell order: Instruct the broker to sell some number of shares if and when the share can be sold at or above a stipulated price. 3-15

INVESTMENTS | BODIE, KANE, MARCUS Types of Orders III.Stop order: –Stop-loss orders: Specify that the stock is to be sold if its price falls below a stipulated level. –Stop-buy orders: Specify that a stock should be bought when its price rises above a stipulated level. 3-16

INVESTMENTS | BODIE, KANE, MARCUS 3-17 Figure 3.5 Price-Contingent Orders

INVESTMENTS | BODIE, KANE, MARCUS 3-18 Trading Mechanisms I.Dealer Markets: Dealers quote prices at which they are willing to buy or sell securities. A broker then executes a trade by contracting a dealer listing an attractive quote. Computer network where prices are quoted is called National Association of Securities Dealers Automatic Quotations System (NASDAQ)

INVESTMENTS | BODIE, KANE, MARCUS Trading Mechanisms II.Electronic communication networks (ECNs) It allows participants to post market and limit orders that can be automatically executed. 3-19

INVESTMENTS | BODIE, KANE, MARCUS Trading Mechanisms III.Specialists markets 3-20

INVESTMENTS | BODIE, KANE, MARCUS Trading Mechanisms 3-21

INVESTMENTS | BODIE, KANE, MARCUS Trading Mechanisms 3-22

INVESTMENTS | BODIE, KANE, MARCUS Trading Mechanisms 3-23

INVESTMENTS | BODIE, KANE, MARCUS 3-24 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

INVESTMENTS | BODIE, KANE, MARCUS 3-25 Table 3.1 Partial Requirements for Listing on NASDAQ Markets

INVESTMENTS | BODIE, KANE, MARCUS 3-26 New York Stock Exchange Lists about 2,800 firms Automatic electronic trading runs side-by-side with traditional broker/specialist system

INVESTMENTS | BODIE, KANE, MARCUS New York Stock Exchange: Traditional broker/specialist system 3-27

INVESTMENTS | BODIE, KANE, MARCUS York Stock Exchange: Automatic electronic trading System 3-28

INVESTMENTS | BODIE, KANE, MARCUS 3-29 Table 3.2 Some Initial Listing Requirements for the NYSE

INVESTMENTS | BODIE, KANE, MARCUS 3-30 Electronic Communication Networks ECNs: Private computer networks that directly link buyers with sellers for automated order execution 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. Some high-speed traders are given direct access to their broker’s computer-trading codes and can execute trades in a little as 250 microseconds ( seconds)

INVESTMENTS | BODIE, KANE, MARCUS Electronic Communication Networks 3-31

INVESTMENTS | BODIE, KANE, MARCUS 3-32 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

INVESTMENTS | BODIE, KANE, MARCUS 3-33 Market Structure in Other Countries London - predominately electronic trading Euronext – market formed by combination of the Paris, Amsterdam and Brussels exchanges, then merged with NYSE Tokyo Stock Exchange

INVESTMENTS | BODIE, KANE, MARCUS 3-34 Globalization and Consolidation of Stock Markets NYSE mergers and acquisitions: –Archipelago (ECN), (2006) –American Stock Exchange (2008) –Euronext (2007) NASDAQ mergers and acquisitions: –Instinet/INET (ECN), (2005) –Boston Stock Exchange, (2007)

INVESTMENTS | BODIE, KANE, MARCUS 3-35 Globalization and Consolidation of Stock Markets Chicago Mercantile Exchange acquired: –Chicago Board of Trade, (2007) –New York Mercantile Exchange, (2008)

INVESTMENTS | BODIE, KANE, MARCUS 3-36 Figure 3.6 Market Capitalization of Major World Stock Exchanges, 2007

INVESTMENTS | BODIE, KANE, MARCUS 3-37 Trading Costs 1.Brokerage Commission: fee paid to broker for making the transaction –Explicit cost of trading –Full Service vs. Discount brokerage (the only information they provide is the price quotation) 2.Spread: Difference between the bid and asked prices –Implicit cost of trading

INVESTMENTS | BODIE, KANE, MARCUS 3-38 Buying on Margin Borrowing part of the total purchase price of a position using a loan from a broker (Broker’s Call Loans). The act of taking advantage of broker’s call loans is called buying on margin Investor contributes the remaining portion. Margin refers to the percentage or amount contributed by the investor. You profit when the stock appreciates. The brokers borrow from banks at the call money rate and then charge their clients that rate plus a service charge for the loan. All securities purchased on margin must be determined with the brokerage firm.

INVESTMENTS | BODIE, KANE, MARCUS 3-39 Buying on Margin (Ctd.) Initial margin is set by the Fed –Currently 50% Maintenance margin –Minimum equity that must be kept in the margin account –Margin call if value of securities falls too much

INVESTMENTS | BODIE, KANE, MARCUS 3-40 Margin Trading: Initial Conditions Example 3.1 Share price$100 60% Initial Margin 40% Maintenance Margin 100 Shares Purchased Initial Position Stock $10,000 Borrowed $4,000 Equity $6,000

INVESTMENTS | BODIE, KANE, MARCUS 3-41 Maintenance Margin Example 3.1 Stock price falls to $70 per share New Position Stock $7,000 Borrowed $4,000 Equity $3,000 Margin% = Equity on Account / Value of Stock = $3,000 / $7,000 = 43%

INVESTMENTS | BODIE, KANE, MARCUS 3-42 Margin Call Example 3.2 How far can the stock price fall before a margin call? Let maintenance margin = 30% Equity = 100P - $4000 Percentage margin =.3 = Equity on Account / Value of Stock = (100P - $4,000) / 100P Solve to find: P = $57.14

INVESTMENTS | BODIE, KANE, MARCUS 3-43 Table 3.4 Illustration of Buying Stock on Margin

INVESTMENTS | BODIE, KANE, MARCUS Buying On Margin 3-44

INVESTMENTS | BODIE, KANE, MARCUS Buying On Margin 3-45

INVESTMENTS | BODIE, KANE, MARCUS 3-46 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 –Closing out the position: buy the stock and return to the party from which it was borrowed

INVESTMENTS | BODIE, KANE, MARCUS Short-Selling Versus Purchasing 3-47

INVESTMENTS | BODIE, KANE, MARCUS 3-48 Short Sale: Initial Conditions Example 3.3 Dot Bomb1000 Shares 50%Initial Margin 30%Maintenance Margin $100Initial Price Sale Proceeds $100,000 Margin & Equity $50,000 Stock Owed 1000 shares

INVESTMENTS | BODIE, KANE, MARCUS Short Sale: Initial Conditions Example 3.3 Percentage Margin = = Equity / Value of Stock Owed = 50,000 / 100,000 =.5 If Price falls to $70 Profit = ending equity – beginning equity = $80,000 - $50,000 = $30,000 = decline in share price x number of shares sold short 3-49

INVESTMENTS | BODIE, KANE, MARCUS 3-50 Short Sale - Margin Call How much can the stock price rise before a margin call? Percentage margin =.3 = Equity on Account / Value of Stock ($150,000 * P) / (1000P) P = $ If stock price rise above $ per share, you will get a margin call, and you will either have to put up additional cash or cover your short postion by buying shares to replace the ones borrowed. * Initial margin plus sale proceeds

INVESTMENTS | BODIE, KANE, MARCUS Short Sale 3-51

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INVESTMENTS | BODIE, KANE, MARCUS Short covering Short covering is the act of buying back shares in order to close out a short position. Let's assume a trader was short Citigroup at $23.50 in early October. In order to open this position the trader would sell short 500 shares by borrowing these from their broker and selling them on open market. This creates a net short position for the trader. So, the only way to close out this position is to buy back or cover the position. In the below chart Citigroup experienced a free fall down to $3. This leads to a massive short squeeze which shot the stock up over $8 in a matter of days. Many investors believe that shorting is evil. However, shorting is a normal part of the markets and adds to its liquidity.short squeeze 3-53

INVESTMENTS | BODIE, KANE, MARCUS Short covering For example, as a stock begins to fall precipitously, many traders that are short will begin to cover their position to get out with a profit. This short covering sends a large number of buy orders into the market which in turn creates counter move rallies. Without short covering, the market will just continue to float lower, as buyers are not willing to step in front of a falling knife.falling knife

INVESTMENTS | BODIE, KANE, MARCUS Short Covering 3-55

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INVESTMENTS | BODIE, KANE, MARCUS Trailing Stop Orders A sell trailing stop order sets the stop price at a fixed amount below the market price with an attached "trailing" amount. As the market price rises, the stop price rises by the trail amount, but if the stock price falls, the stop loss price doesn't change, and a market order is submitted when the stop price is hit. This technique is designed to allow an investor to specify a limit on the maximum possible loss, without setting a limit on the maximum possible gain. "Buy" trailing stop orders are the mirror image of sell trailing stop orders, and are most appropriate for use in falling markets. ps.php 3-57

INVESTMENTS | BODIE, KANE, MARCUS Trailing Stop Orders You have purchased 100 shares of XYZ for $66.34 per share (your Average Price) and want to lock in a profit and limit your loss. You set a trailing stop order with the trailing amount 20 cents below the current market price. To do this, first create a SELL order, then select TRAIL in the Type field and enter 0.20 in the Trailing Amt field. The trailing amount is the amount used to calculate the initial Stop Price, by which you want the limit price to trail the stop price. You submit the order. You transmit your order. The current market price of XYZ is $62.46 and the initial stop price is calculated as $62.26, or $62.46 – the trailing amount of

INVESTMENTS | BODIE, KANE, MARCUS Trailing Stop Orders 3-59 Avg Price66.34 ActionSELL Qty100 Order TypeTRAIL Market Price62.46 Trailing Amount0.20 Stop Price (Calculated as Market Price – Trailing Amount) 62.26

INVESTMENTS | BODIE, KANE, MARCUS Trailing Stop Orders As soon as you submit your order, the price of XYZ starts to rise and hits $ The trailing stop price has adjusted accordingly and is at $62.46, or $62.66 – the $0.20 trailing amount Avg Price66.34 ActionSELL Qty100 Order TypeTRAIL Market Price62.66 Trailing Amount0.20 Stop Price (Calculated as Market Price – Trailing Amount) 62.46

INVESTMENTS | BODIE, KANE, MARCUS Trailing Stop Orders Suddenly the market price of XYZ drops to Your stop price remains at If the market price continues to drop and touches your stop price, the trailing stop order will be triggered, and a market order to sell 100 shares of XYZ will be submitted Avg Price66.34 ActionSELL Qty100 Order TypeTRAIL Market Price62.56 Stop Price (Calculated as Market Price – Trailing Amount) 62.46

INVESTMENTS | BODIE, KANE, MARCUS Trailing Stop Orders The market price of XYZ continues to drop and touches your stop price or A market order to sell 100 shares of XYZ at is submitted and filled Avg Price66.34 ActionSELL Qty100 Order TypeTRAIL Market Price62.46 Stop Price (Calculated as Market Price – Trailing Amount) Order Filled at 62.46

INVESTMENTS | BODIE, KANE, MARCUS 3-63 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

INVESTMENTS | BODIE, KANE, MARCUS 3-64 Regulation of Securities Markets (Ctd.) 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

INVESTMENTS | BODIE, KANE, MARCUS 3-65 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

INVESTMENTS | BODIE, KANE, MARCUS A Group Assignment 3-66