1. CHAPTER 3 How Securities are Traded

2. Table of Contents How Firms Issue Securities How Securities are Traded Types of Orders NYSE vs. NASDAQ Cash vs. Margin Trading Short Sales 2

3. HOW FIRMS ISSUE SECURITIES 3

4. 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 4

5. Privately Held Firms Up to 499 shareholders Middlemen have formed partnerships to buy shares and get around the 499-investor restrictions Raise funds through private placement Lower liquidity of shares Have fewer obligations to release financial statements and other information How Firms Issue Securities 5

6. Publicly Traded Companies Raise capital from a wider range of investors through initial public offering, IPO Seasoned equity offering: The sale of additional shares in firms that already are publicly traded Public offerings are marketed by investment bankers or underwriters Registration must be filed with the SEC How Firms Issue Securities 6

7. Initial Public Offerings 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 –Underwriter bears price risk associated with placement of securities: IPOs are commonly underpriced compared to the price they could be marketed (ex.: Groupon) Some IPOs, however, are well overpriced (ex.: Facebook); others cannot even fully be sold 7

8. Investment Banking Underwriting: Investment bank helps the firm to issue and market new securities Prospectus: Describes the issue and the prospects of the company. –Red herring Firm commitment –Investment bank purchases securities from the issuing company and then resells them to the public. 8

9. Investment Banking (Ctd.) Shelf Registration –SEC Rule 415: Allows firms to register securities and gradually sell them to the public for two years –Shares can be sold on short notice and in small amounts without incurring high floatation cost Private placements –Firm uses underwriter to sell securities to a small group of institutional or wealthy investors. –Cheaper than public offerings –Private placements not traded in secondary markets 9

10. Relationship Among a Firm Issuing Securities, the Underwriters, and the Public 10

11. Google - History The first funding for Google was secured on August 1998 in the form of a $100,000 contribution from Andy Bechtolsheim, co- founder of Sun Microsystems.Andy BechtolsheimSun Microsystems On June 7, 1999, a round of equity funding totaling $25 million was given by rival venture capital firms Kleiner Perkins Caufield & Byers and Sequoia Capital.Kleiner Perkins Caufield & ByersSequoia Capital In January 2004, Google announced the hiring of Morgan Stanley and Goldman Sachs Group to arrange an IPO.Morgan StanleyGoldman Sachs Group Google's IPO took place on August 19, 2004. A total of 19.6 million shares were offered at a price of $85 per share. –Of that, 14 million were floated by Google and 5.5 million by selling stockholders. –The sale raised US$1.67 billion, and gave Google a market capitalization of more than $23 billion.market capitalization –The vast majority of Google's 271 million shares remained under Google's control. –Many of Google's employees became instant paper millionaires. 11

12. Example: Underwriter Spread Source: IPO Prospectus 12

13. Annual IPO Data, 1999–2008 One Extreme Case: VA Linux, the IPO Offering Price at $30 and closed on the first day of trading at $239.25, a 698% one-day return! 13

14. Long-term Relative Performance of Initial Public Offerings 14

15. HOW SECURITIES ARE TRADED 15

16. How Securities are Traded Type of Markets Direct search –Buyers and sellers seek each other Brokered markets –Brokers search out buyers and sellers Dealer markets –Dealers have inventories of assets from which they buy and sell Auction markets –traders converge at one place to trade 16

17. 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. 17

18. Secondary Market: NYSE- Specialists Bid Ask IBM$160.25$160.75 Specialist buys low, sells high Specialists buys at $160.25, so you sell at $160.25. Specialist sells at $160.75, so you buy at $160.75 $160.75 - $160.25 = $0.50 = “spread” 18

19. Secondary Market: NASDAQ Suppose three dealers posts their best quotes for DELL Computers. Jennifer Joe Bob Bid AskBid AskBid Ask 8.00 8.507.75 8.257.50 8.50 NASDAQ reports: BidAsk 8.008.25 19

20. TYPE OF ORDERS 20

21. Basic Types of Orders: Two Most Common Orders Market Orders –Orders to buy or sell stock at best price available when order is placed for immediate execution –Fastest way to fill order –Trader receives current market price Limit Orders –Traders specify buying or selling price –Order to buy at or below a specified price or to sell at or above a specified price –If price limits are not met, order is not filled 21

22. Basic Types of Orders (cont’d) Stop Orders –Stop order (to Sell): Convert to a market order to sell when the stock price crosses the stop price from above. “Suspended” order is placed to sell a stock if price reaches or falls below a specified level Once activated, becomes a market order Typically used to protect investors from stock price declines Also known as a “stop-loss.” –Stop order (to Buy): Convert to a market order to buy when the stock price crosses the stop price form below. Can be used to limit risk on short sales 22

23. Basic Types of Orders (cont’d) Stop-Limit Orders –Convert to a limit order to buy (sell) when the stock price crosses the stop price from below (above) –Orders to sell stock at or better than specified price –Prevents sales at undesirable price –No sale may occur if prices continues to decline 23

24. Price-Contingent Orders 24

25. Stock Market Order Types 25

26. Examples: Market vs. Limit Order 26 Suppose the current market price is $364 –Buy 100 shares at market order –Buy 100 shares at limit order @ $354 –Buy 100 shares at limit order @ $355 –Buy 100 shares at stop order @ $365

27. Limit Order vs. Stop Order Suppose you own AAPL shares that has been hovering around $700 per share. –You can put a stop order to sell at $680. If the price crosses 680 from above, the stop order becomes a market order. You say “Price is more likely to decline, but I am not sure.” Your goal is to limit a loss or protect profit. Your attitude is pessimistic. Since once it get triggered and becomes a market order, there will be no guarantee that you will get shares at $680. – You can also put a limit order to sell at $710. If the price crosses 710 from below, your shares will be sold at 710 or better price. You say, “Price is more likely to rise, but I am not sure.” Your goal is to profit a little more with volatile price movements. Your attitude is optimistic. 27

28. Trading on the Web 28

29. Example Marcus just placed a stop limit order to sell 100 shares at $21 stop, $18 limit. Which one of the following statements is correct concerning this order if the current market price is $16? A. As soon as the price rises to $18, the stock will be sold. B. The stock will sell for at least $18 but less than $21. C. The stock will sell for $18 a share as soon as the price hits $21. D. The order will become a limit order to sell at $21 once the market price reaches $18. E. The order will become a limit order to sell at $18 once the market price reaches $21. 29

30. NYSE VS. NASDAQ 30

31. Trading Mechanisms Dealer markets Electronic communication networks (ECNs) True trading systems that can automatically execute orders Specialists markets Maintain a “fair and orderly market” Have been largely replaced by ECNs 31

32. The Rise of Electronic Trading In the US, the share of electronic trading rose from 16% to 80% in 2000s and was triggered by an interaction of new technologies and new regulations 1975: Elimination of fixed commissions on the NYSE 1994: New order-handling rules on NASDAQ, leading to narrower bid-ask spreads 32

33. The Rise of Electronic Trading 1997 and 2001: Reduction of minimum tick size from one-eighth to one-sixteenth, and 1 cent, respectively 2000: Emergence of NASDAQ Stock Market 2006: NYSE is renamed to NYSE Arca after acquiring the electronic Archipelago Exchange 2007: Creation of National Market System (NMS) to link exchanges electronically 33

34. The Effective Spread Fell Dramatically as the Minimum Tick Size Fell (Value-weighted average of NYSE-listed shares) 34

35. NASDAQ Lists about 3,000 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 35

36. Partial Requirements for Listing on NASDAQ Markets 36

37. New York Stock Exchange Lists about 2,800 firms The largest U.S. stock exchange as measured by the value of the stocks listed on the exchange Automatic electronic trading runs side-by- side with traditional broker/specialist system –SuperDot : electronic order-routing system –DirectPlus: fully automated execution for small orders –Specialists: Handle large orders and maintain orderly trading 37

38. Some Initial Listing Requirements for the NYSE 38

39. 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. Private computer networks that directly link buyers with sellers for automated order execution over multiple exchanges Compete in terms of the speed they can offer Latency: The time it takes to accept, process, and deliver a trading order “Flash Trading”: Computer programs look for even the smallest mispricing opportunity and execute trades in tiny fractions of a second. 39

40. Algorithmic Trading –The use of computer programs to make trading decisions High-Frequency Trading –Special class of algorithmic with very short order execution time Dark Pools –Trading venues that preserve anonymity, mainly relevant in block trading New Trading Strategies 40

41. Bond Trading Most bond trading takes place in the OTC market among bond dealers NYSE Bonds is the largest centralized bond market of any U.S. exchange Market for many bond issues is “thin” and is subject to liquidity risk 41

42. Widespread trend to form international and local alliances and mergers NYSE acquired Archipelago (ECN), American Stock Exchange, and merged with Euronext NASDAQ acquired Instinet/INET (ECN), Boston Stock Exchange, and merged with OMX to form NASDAQ OMX Group Chicago Mercantile Exchange acquired Chicago Board of Trade and New York Mercantile Exchange Globalization of Stock Markets 42

43. The Biggest Stock Markets in the World by Domestic Market Capitalization 43

44. Trading Costs 1.Brokerage Commission: fee paid to broker for making the transaction –Explicit cost of trading –Full Service vs. Discount brokerage 2.Spread: Difference between the bid and asked prices –Implicit cost of trading 44

45. CASH VS. MARGIN TRADING 45

46. Brokerage Accounts A Cash account is a brokerage account in which securities are paid for in full. A Margin account is a brokerage account in which, subject to limits, securities can be bought and sold short on credit. (more on selling short later) 46

47. Getting Started (c) Buy 100 Shares of Disney at $33 per share (c) Buy 100 Shares of Disney at $33 per share (e) $6,650 Cash in Account $3,300 Stock In Account (e) $6,650 Cash in Account $3,300 Stock In Account (d) Pay Commission, Say $50 (d) Pay Commission, Say $50 (b) Deposit $10,000 into account (b) Deposit $10,000 into account (a) Open a brokerage or trading account (a) Open a brokerage or trading account 47

48. Margin Accounts 48

49. Practices Example 1: Margin requirement = 80%. –This means that your money represents at least 80% of the total dollars you spend to buy stocks. –Suppose KO is traded at $40 per share AND you have only $40,000. –Without margin, you can buy only 1,000 shares (=$40,000/$40 per share). –With margin, you can spend up $50,000 ($40,000/80%) or 1,250 shares (=$50,000/$40 per share). Margin loan is $10,000. –If KO rises to $50 per share, new margin = (62,500- 10,000)/62,500=84% –If KO falls to $30 per share, new margin = (37,500- 10,000)/37,500=73.33% Example 2: Margin requirement = 50%. –This means that your money represents at least 50% of the total dollars you spend to buy stocks. –Suppose KO is traded at $40 per share AND you have only $40,000. –Without margin, you can buy only 1,000 shares (=$40,000/$40 per share). –With margin, you can spend up $80,000 ($40,000/50%) or 2,000 shares. Margin loan is $40,000. –If KO rises to $50 per share, new margin = (100,000- 40,000)/100,000=60% –If KO falls to $30 per share, new margin = (60,000- 40,000)/60,000=33.33% 49

50. Margin Accounts In a margin purchase, the minimum margin that must be supplied is called the initial margin. –Initial margin is set by the Fed - Currently 50% The maintenance margin is the margin amount that must be present at all times in a margin account. When the margin drops below the maintenance margin, the broker can demand more funds. This is known as a margin call. When the margin call is provoked, an investor must bring the margin back to the initial margin. 50

51. Example: Margin Accounts, The Balance Sheet Assets Liabilities and Account Equity 1,000 Shares, PFE$ 24,000 Margin Loan$ 6,000 Account Equity$ 18,000 Total$ 24,000 Total$ 24,000 You buy 1,000 Pfizer shares at $24 per share. You put up $18,000 and borrow the rest. Amount borrowed = $24,000 – $18,000 = $6,000 Margin = $18,000 / $24,000 = 75%

52. Simulation Analysis Stock Price Value of Securities Margin Loan Equity (“Your Money”) Margin $24$24,000$6,000$18,000 (=24,000-6,000) 75% (=18,000/24,000) $3030,0006,00024,00080% $2020,0006,00014,00070% $1010,0006,0004,00040% Example: Buying 1,000 shares of stock at $24 with a margin loan of $6,000 If the brokerage firm requires your account to maintain 50% margin and currently the stock price is $10 per share, you need to deposit additional $1,000 into an account. Detail: 50% = X / 10,000, X=5,000. This means that you must maintain at least $5,000 equity in your account, but currently your equity is only $4,000. 52

53. Margin Account Example Assets Liabilities and Account Equity 800 Shares of WHOA @ $50/share $ 40,000 Margin Loan$ 20,000 Equity$ 20,000 Total$ 40,000 Total$ 40,000 Your margin account requires: an initial margin of 50%, and a maintenance margin of 30% A Share in Miller Moore Equine Enterprises (WHOA) is selling for $50. You have $20,000, and you want to buy as much WHOA as you can. You may buy up to $20,000 / 0.5 = $40,000 worth of WHOA. 53

54. Margin Account Example (cont’d) Assets Liabilities and Account Equity 800 Shares of WHOA @ $35/share $ 28,000 Margin Loan$ 20,000 Equity$ 8,000 Total$ 28,000 Total$ 28,000 After your purchase, shares of WHOA fall to $35. (Woe!) New margin = $8,000 / $28,000 = 28.6% < 30% Therefore, you are subject to a margin call. You must deposit $6,000 ( = 50% of $28,000 - $8,000) 54

55. How Low Can it Go? At what price will you receive a margin call? 55

56. How Low Can it Go? (cont’d) Similarly, Equity = 800P - $20,000 Percentage margin = Equity / Value of Stock = (800P - $20,000) / 800P Since maintenance margin = 30% (800P* - $20,000) / 800P* = 0.30 560P* = $20,000 P* = $20,000 / 560 shares P* = $35.71 56

57. Example: The Effects of Margin, I. You have $30,000 in a margin account, 60% initial margin required. You can buy $50,000 of stock with this account (why?). Your borrowing rate from your broker is 6.00%. Suppose you buy 1,000 shares of Coca-Cola (KO), for $50/share. Assume no dividends, and that your borrowing rate is still 6.00%, what is your return if: –In one year, KO is selling for $60 per share? –In one year, KO stock is selling for $60 per share, but you did not borrow money from your broker? +20% 57

58. Example: The Effects of Margin, II. KO is selling for $60 per share. Your investment is worth $60,000. You owe 6% on the $20,000 you borrowed: $1,200. If you pay off the loan with interest, your account balance is: $60,000 – $21,200 = $38,800. You started with $30,000. Therefore, your return is $8,800 / $30,000 = 29.33%. Suppose Coca-Cola stock was selling for $40 per share instead of $60 per share? What is your return? 58

59. Example: The Effects of Margin, III. Coca-Cola stock is selling for $60 per share, but you did not borrow from your broker. You started with $30,000, which means you were able to buy $30,000 / $50 = 600 shares. Your investment is now worth $36,000. Therefore, your return is $6,000 / $30,000 = 20.00%. Suppose Coca-Cola is selling for $40 per share instead of $60 per share. What is your return in this case? -20% 59

60. Example: Annualizing Returns on a Margin Purchase, I You buy 1,000 shares of Costco (COST) at $60 per share. Your initial margin is 50%. You borrow at the 9 percent call money rate plus 2 percent. You sell Costco (COST) 3 months later for $63. There were no dividends paid (and suppose the prices above are net of commissions). What is your holding period percentage return and your EAR? 60

61. Annualizing Returns on a Margin Purchase, II Answer: First, you have to repay the 3-month loan, so: t = (3/12 =.25) Amount Repaid = Amount Borrowed × (1 + interest rate per year) t Amount Repaid = $30,000 × (1 +.11).25 = $30,000 × 1.02643 = $30,792.90 Your Sale Proceeds = Cash from Sale – Amount Repaid = $63,000 – 30,792.90 = $32,207.10 Your Profit = Your Sale Proceeds – Your Investment = $32,207.10 - $30,000 = $2,207.10 61

62. Annualizing Returns on a Margin Purchase, III 62 Note that there are 12/3 = 4 three- month holding periods in a year. Therefore, m = 4.

63. SHORT SALES 63

64. Short Sales An investor with a long position benefits from price increases. –You buy today at $34, and sell later at $57, you profit! –Buy low, sell high –“Go long” means you buy. An investor with a short position benefits from price decreases. –You sell today at $83, and buy later at $27, you profit. –Sell high, buy low –“Go short” means you sell. –Purpose: to profit from a decline in the price of a stock or security 64

65. Short Sales Note that an investor who buys and owns shares of stock is said to be “long the stock” or to have a “long position.” Short Sale is a sale in which the seller does not actually own the security that is sold. Borrow shares from someone through a dealer Borrow shares from someone through a dealer Sell the Shares in the market Sell the Shares in the market Buy shares From the market Buy shares From the market Return the shares Return the shares TodayIn the Future 65

66. Short Sales Short sale requirements –There is an initial margin and a maintenance margin –After you sell the borrowed stock, the proceeds from the sale are credited to your account. –But, you cannot use them until you “cover” the short position. –If any dividends are paid on the stock while you have a short –position, you must repay them. –The owner of the shares need NOT know that the shares have been lent to the short-seller. –If the owner wishes to sell the shares, the brokerage firm will simply borrow shares from another investor. 66

67. Long vs. Short on Stocks 67

68. Short Sales Four items on the account balance sheet –Proceeds from sale –Margin deposit –Short position –Account equity 68

69. Example: Short Sales, I You short 100 shares of Texas Instruments (TXN) at $30 per share. Your broker has a 50% initial margin and a 40% maintenance margin on short sales. The value of stock borrowed that will be sold short is: $30 × $100 = $3,000 Assets Liabilities and Account Equity Sale Proceeds$ 3,000 Short Position $ 3,000 Initial Margin Deposit$ 1,500 Account Equity $ 1,500 Total$ 4,500 Total $ 4,500 69

70. Example: Short Sales, II Assets Liabilities and Account Equity Sale Proceeds$ 3,000 Short Position $ 2,000 Initial Margin Deposit$ 1,500 Account Equity $ 2,500 Total$ 4,500 Total $ 4,500 Texas Instrument stock price falls to $20 per share. Sold at $30, value today is $20, so you are "ahead" by $10 per share, or $1,000. Also, new margin: $2,500 / $2,000 = 125% 70

71. Example: Short Sales, III AssetsLiabilities and Account Equity Sale Proceeds$ 3,000 Short Position $ 4,000 Initial Margin Deposit$ 1,500 Account Equity $ 500 Total$ 4,500 Total $ 4,500 Texas Instruments stock price rises to $40 per share. You sold short at $30, stock price is now $40, you are "behind" by $10 per share, or $1,000. (He who sells what isn’t his, must buy it back.) Also: new margin = $500 / $4,000 = 12.5% < 40% Therefore, you are subject to a margin call. 71

72. Example: Short Sales, IV 72

73. 73

74. Finding P* How much can the stock price rise before a margin call? ($225,000 * - 5,000P) / (5,000P) = 40% $225,000 = 2,000P + 5,000P $225,000 = 7,000P P = $225,000 /7,000 P = $32.14 * Initial margin plus sale proceeds 74

75. More on Short Sales Short interest is the amount of common stock held in short positions. In practice, short selling is quite common and a substantial volume of stock sales are initiated by short sellers. Note that with a short position, you may lose more than your total investment, as there is no theoretical limit to how high the stock price may rise. 75

76. Biggest Short Positions (from The Wall Street Journal) 76

77. Finding Actual Short Positions (from finance.yahoo.com)finance.yahoo.com 77

78. 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 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 78

79. 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 79

80. Major Full-Service, Premium Discount, and Basic Discount Brokers 80

81. IPO Tombstone 81