1. How Securities are Traded
CHAPTER 3
How Securities are Traded
With Shakil Al Mamun

2. How Firms Issue Securities
Primary
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
There are two types of primary market issues of common stock. Initial public offerings, or IPOs, are stocks issued by a formerly privately owned company that is going public, that is, selling stock to the public for the first time. Seasoned new issues are offered by companies that already have floated equity. For example, a sale by IBM of new shares of stock would constitute a seasoned new issue.

3. How Firms Issue Securities Continued
Investment Banking
Shelf Registration
Private Placements
Initial Public Offerings (IPOs)

4. Investment Banking
Underwriter: purchase securities from the issuing company and resell them.
firm commitment on proceeds to the issuing firm
Red herring
Prospectus
Red herring: A preliminary registration statement must be filed with the Securities and Exchange Commission (SEC), describing the issue and the prospects of the company. This preliminary prospectus is known as a red herring because it includes a statement printed in red, stating that the company is not attempting to sell the security before the registration is approved.
Prospectus: A description of the firm and the security it is issuing. At this time, price at which the securities will be offered to public is announced.

5. Figure 3.1 Relationship Among a Firm Issuing Securities, the Underwriters and the Public

6. Shelf Registrations SEC Rule 415 Introduced in 1982
Ready to be issued – on the shelf
allows firms to register securities and gradually sell them to the public for two years following the initial registration. Because the securities are already registered, they can be sold on short notice, with little additional paperwork.

7. Private Placements
Sale to a limited number of sophisticated investors not requiring the protection of registration
Allowed under Rule 144A
Dominated by institutions
Very active market for debt securities
Not active for stock offerings
Primary offerings in which shares are sold directly to a small group of institutional or wealthy investors.

8. Initial Public Offerings
Process
Road shows
Book building
Underpricing
Post sale returns
Cost to the issuing firm
These road shows serve two purposes.
First, they generate interest among potential investors and provide information about the offering.
Second, they provide information to the issuing firm and its underwriters about the price at which they will be able to market the securities.

9. How Securities are Traded
Types of Markets
Direct search
Least organized
Brokered
Trading in a good is active
Dealer
Trading in a particular type of asset increases
Auction
Most integrated
Direct Search Market: Buyers and sellers must seek each other out directly. An example of a transaction in such a market is the sale of a used refrigerator where the seller advertises for buyers in a local newspaper. Such markets are characterized by sporadic participation and low-priced and nonstandard goods.
Brokered mkt: markets where trading in a goods is active, brokers find it profitable to offer search services to buyers and sellers. A good example is the real estate market, where economies of scale in searches for available homes and for prospective buyers make it worthwhile for participants to pay brokers to conduct the searches. Brokers in particular markets develop specialized knowledge on valuing assets traded in that market.
Dealer mkt: When trading activity in a particular type of asset increases, dealer markets arise. The spreads between dealers’ buy (or “bid”) prices and sell (or “ask”) prices are a source of profit. Eg. OTC
Auction mkt: The most integrated market is an auction market, in which all traders converge at one place to buy or sell an asset. The New York Stock Exchange (NYSE) is an example of an auction market. An advantage of auction markets over dealer markets is that one need not search across dealers to find the best price for a good. If all participants converge, they can arrive at mutually agreeable prices and save the bid-ask spread.

10. Types of Orders Market order (Executed immediately) Bid Price
Ask Price
Price-contingent (Limit Order)
Investors specify prices
Stop orders
Market orders: Market orders are simply buy or sell orders that are to be executed immediately at current market prices. For example, an investor might call his broker and ask for the market price of IBM. The retail broker will wire this request to the commission broker on the floor of the exchange, who will approach the specialist’s post and ask the specialist for best current quotes. Finding that the current quotes are $98 per share bid, and $98.10 asked, the investor might direct the broker to buy 100 shares “at market,” meaning that he is willing to pay $98.10 per share for an immediate transaction. Similarly, an order to “sell at market” will result in stock sales at $98 per share.
Investors also may choose to place a limit order, where they specify prices at which they are willing to buy or sell a security. If IBM is selling at $98 bid, $98.10 asked, for example, a limit buy order may instruct the broker to buy the stock if and when the share price falls below $97
Stop-loss orders are similar to limit orders in that the trade is not to be executed unless the stock hits a price limit. Here, however, the stock is to be sold if its price falls below a stipulated level. As the name suggests, the order lets the stock be sold to stop further losses from accumulating. Similarly, stop-buy orders specify that a stock should be bought when its price rises above a limit.

11. Figure 3.5 Price-Contingent Orders

12. Trading Mechanisms Dealer markets
Electronic communication networks (ECNs)
Specialists markets
A trader who makes a market in the shares of one or more firms and who maintains a “fair and orderly market” by dealing personally in the market.
The specialist’s role as a broker is simply to execute the orders of other brokers. Specialists also may buy or sell shares of stock for their own portfolios. When no other broker can be found to take the other side of a trade, specialists will do so even if it means they must buy for or sell from their own accounts.

13. U.S. Security Markets
Nasdaq and NYSE have evolved in response to new information technology
Both have increased their commitment to automated electronic trading

14. Nasdaq National Market System Nasdaq Small Cap Market
Levels of subscribers
Level 1 – inside quotes
Level 2 – receives all quotes but they can’t enter quotes
Level 3 – dealers making markets
National association of security dealers automated quotations system.

15. Table 3.1 Partial Requirements for Listing on NASDAQ Markets

16. New York Stock Exchange (NYSE)
Member functions
Commission brokers
Floor brokers
Specialists
Block houses
Super Dot
“Block houses” have evolved to aid in the placement of larger block trades. Block houses are brokerage firms that specialize in matching block buyers and sellers. Once a buyer and a seller have been matched, the block is sent to the exchange floor where specialists execute the trade. If a buyer cannot be found, the block house might purchase all or part of a block sale for its own account. The block house then can resell the shares to the public.
SuperDot enables exchange members to send orders directly to the specialist’s Display Book over computer lines.

17. Table 3.2 Some Initial Listing Requirements for the NYSE

18. Other Systems Electronic Communication Networks
Private computer networks that directly link buyers with sellers
National Market System
Securities Act of Amendments of 1975
Bond Trading
Automated Bond System (ABS)

19. Market Structure in Other Countries
London - predominately electronic trading
Euronext – market formed by combination of the Paris, Amsterdam and Brussels exchanges
Tokyo Stock Exchange
Globalization and consolidation of stock markets

20. Trading Costs
Commission: fee paid to broker for making the transaction
Spread: cost of trading with dealer
Bid: price dealer will buy from you
Ask: price dealer will sell to you
Spread: ask - bid
Combination: on some trades both are paid

21. Buying on Margin
Using only a portion of the proceeds for an investment
Borrow remaining component
Margin arrangements differ for stocks and futures
Purchasing stocks on margin means the investor borrows part of the purchase price of the stock from a broker. The broker, in turn, borrows money from banks at the call money rate to finance these purchase, and charge its clients that rate plus a service charge for the loan.

22. Stock Margin Trading
Margin is currently 50%; you can borrow up to 50% of the stock value
Set by the Fed
Maintenance margin: minimum amount equity in trading can be before additional funds must be put into the account
Margin call: notification from broker that you must put up additional funds
If the stock value were to fall below $4,000, owners’ equity would become negative, meaning the value of the stock is no longer sufficient collateral to cover the loan from the broker. To guard against this possibility, the broker sets a maintenance margin. If the percentage margin falls below the maintenance level, the broker will issue a margin call, which requires the investor to add new cash or securities to the margin account. If the investor does not act, the broker may sell securities from the account to pay off enough of the loan to restore the percentage margin to an acceptable level.

23. Margin Trading - Initial Conditions Example 3.1
X Corp $100
60% Initial Margin
40% Maintenance Margin
100 Shares Purchased
Initial Position
Stock $10,000 Borrowed $4,000
Equity $6,000

24. Margin Trading - Maintenance Margin Example 3.1
Stock price falls to $70 per share
New Position
Stock $7,000 Borrowed $4,000
Equity $3,000
Margin% = $3,000/$7,000 = 43%

25. Margin Trading - Margin Call Example 3.2
How far can the stock price fall before a margin call?
(100P - $4,000)* / 100P = 40%
P = $ * 100P - Amt Borrowed = Equity

26. Table 3.4 Illustration of Buying Stock on Margin

27. Short Sales
The sale of shares not owned by the investor but borrowed through a broker and later purchased to replace the loan.
Normally, an investor would 1st buy stock and later sell it. But in short sale position, the order is reversed. So, here u sale 1st, then buy. At the end, u begin and end with no shares.

28. 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 is was borrowed
Short sellers must not only replace the shares but also pay the lender of the security any dividends paid during the short sale.

29. Short Sale – Initial Conditions Example 3.3
Dot Bomb 1,000 Shares
50% Initial Margin
30% Maintenance Margin
$100 Initial Price
Sale Proceeds $100,000
Margin & Equity ,000
Stock Owed ,000

30. Short Sale - Maintenance Margin
Stock Price Rises to $110
Sale Proceeds $100,000
Initial Margin ,000
Stock Owed ,000
Net Equity ,000
Margin % (40,000/110,000) 36%

31. Short Sale - Margin Call
How much can the stock price rise before a margin call?
($150,000* P) / (100P) = 30%
P = $115.38
* Initial margin plus sale proceeds 31