1. Principles of Investing FIN 330
Chapter 2
Investing Markets
Dr. David P Echevarria
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2. Student Learning Objectives
Review Primary functions of security markets
Primary, Secondary and Electronic Markets
Regulation of Security Markets
Dr. David P Echevarria
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3. 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
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4. 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
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5. 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
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6. 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
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7. 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
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8. Visualizing the investment banking process

9. 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.

10. 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 →

11. 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
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12. 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
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13. 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
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14. 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
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15. 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

16. 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)

17. 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
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18. 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
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19. 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
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20. 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
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21. 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
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22. 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
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23. 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
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
Dr. David P Echevarria
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24. 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 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
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