1. Chapter 3 Securities Markets McGraw-Hill/Irwin
Copyright © by The McGraw-Hill Companies, Inc. All rights reserved.

2. 3.1 How Firms Issue Securities

3. Primary vs. Secondary Market Security Sales
New issue is created and sold
Key factor: issuer receives the proceeds from the sale
Public offerings: registered with the SEC and sale is made to the investing public
Private offerings: not registered, and sold to only a limited number of investors, with restrictions on resale
Secondary
Existing owner sells to another party
Issuing firm doesn’t receive proceeds and is not directly involved

4. Primary vs. Secondary Security Sales
General Cash Offer or GCO is an underwritten offering
3rd market is trading of listed securities away from the exchange. It is largely an institutional market: to facilitate trades of larger blocks of securities
4th market: Investors trading directly with other investors; Originally developed for institutional trading
Trading now on ECNs; technological developments leading to individual investors trading directly

5. Investment Banking Arrangements
Underwritten vs. “Best Efforts”
Underwritten: banker makes a firm commitment on proceeds to the issuing firm
Best Efforts: banker(s) helps sell but makes no firm commitment
Negotiated vs. Competitive Bid
Negotiated: issuing firm negotiates terms with investment banker
Competitive bid: issuer structures the offering and secures bids

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

7. Shelf Registrations SEC Rule 415 Introduced in 1982
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
Introduced in 1982
Allows timing of the issues →

8. Private Placements
Private placement: sale to a limited number of sophisticated investors not requiring the protection of registration
Allowed under SEC Rule 144A
Dominated by institutions
Very active market for debt securities
Not active for stock offerings

9. Initial Public Offerings
IPO Process
Underpricing
Issuer and banker put on the “Road Show”
Purpose: Book building and pricing
Post initial sale returns average about 10% or more, “Winner’s curse” problem?
Easier to market the issue, but costly to the issuing firm
some data say 11%
Good time to handout sheet on Google;
Google Dutch auction, (Price is set at the highest level that will result in all shares sold), addresses the two big complaints of IPO process:
1. cutting out individual investor (winner's curse idea)
2. limiting underpricing

10. Figure 3.2 Average First Day Returns for European and Non-European IPOs

11. Figure 3.3 Long-term Relative Performance of Initial Public Offerings 1970-2006

12. 3.2 How Securities are Traded

13. Functions of Financial Markets
Overall purpose: facilitate low cost investment
Bring together buyers and sellers at low cost
Provide adequate liquidity by minimizing time and cost to trade and promoting price continuity.
Set & update prices of financial assets
Reduces information costs associated with investing
Direct search: put an ad in the paper to find a buyer or seller
Brokered: real estate

14. Types of Markets Direct Search Markets Brokered Markets Dealer Markets
Buyers and sellers locate one another on their own
Brokered Markets
3rd party assistance in location buyer or seller
Dealer Markets
3rd party acts as intermediate buyer/seller
Auction Markets
Brokers & dealers trade in one location, trading is more or less continuous

15. Types of Orders Market order: execute immediately at the best price
Instructions to the brokers on how to complete the order
Market order: execute immediately at the best price
Limit order: Order to buy or sell at a specified price or better
On the exchange the limit order is placed in a limit order book kept by an exchange official or computer
E.G.: Stock trading at $50, could place a buy limit at ______ or a sell limit order at ______.
On NASDAQ, limit may have stayed with broker in old days, now goes to SuperMontage I believe
$49.90
$50.25

16. Limit Order Book for Intel on Archipelago

17. Types of Orders Continued
Stop loss order: Becomes a market sell order when the trigger price is encountered.
E.G.: You own stock trading at $40. You could place a stop loss at ___. The stop loss would become a market order to sell if the price of the stock hits ___.
Stop buy order: Becomes a market buy order when the trigger price is encountered.
E.G.: You shorted stock trading at $40. You could place a stop buy at ___. The stop buy would become a market order to buy if the price of the stock hits ___.
$38
$38
$42
$42

18. Types of Orders Continued
Discretionary order: gives the broker the power to buy and sell for your account at the broker's discretion.
Time dimension on orders (other than market orders):
IOC: immediate or cancel
Day: by default
GTC: good until canceled (usually 60 days max)

19. 3.3 U.S. Security Markets

20. U.S. Security Markets Overview
Nasdaq
Small stock OTC
Pink sheets
Organized Exchanges
New York Stock Exchange
American Stock Exchange
Regionals
Electronic Communication Networks (ECNs)
National Market System

21. NASDAQ Dealer market is a market without centralized order flow
Dealer Markets
Dealer market is a market without centralized order flow
NASDAQ: largest organized stock market for OTC trading; information system for individuals, brokers and dealers
Securities:
NASDAQ takes in data from more than 350,000 terminals from around the world and processes more than 5,000 transactions per second. With SuperMontage's new computer architecture, quotes and orders will go through single-computer architecture, adding even greater speed and efficiency to the market and allowing for easy expansion as volumes grow.
stocks, most bonds and some derivatives

22. NASDAQ Nasdaq National Market: Types of securities?
Nasdaq SmallCap Market
Levels of subscribers to Nasdaq quotation system
Level 1: inside quotes
Level 2: receives all quotes but they can’t enter quotes
Level 3: dealers can see and post quotes
SuperMontage: Centralized limit order book for Nasdaq securities that allows automatic trade execution
OTC Bulletin Board
Pink Sheet Stocks
NASDAQ takes in data from more than 350,000 terminals from around the world and processes more than 5,000 transactions per second. With SuperMontage's new computer architecture, quotes and orders will go through single-computer architecture, adding even greater speed and efficiency to the market and allowing for easy expansion as volumes grow.

23. Table 3.1 Partial Requirements for Listing on NASDAQ Markets

24. Organized Exchanges
Auction markets are markets with centralized order flow
Dealership function: can be competitive or assigned by the exchange (Specialists)
Securities:
Examples:
stock, futures contracts, options, and to a lesser extent bonds
NYSE, ASE, Regionals, CBOE, CME

25. Exchanges
Auction Markets
NYSE
ASE and Regionals

26. Exchange Markets Members of the exchange: Commission broker:
Purchase a seat on the exchange, gives the right to trade and a say in the governance of the exchange.
Commission broker:
Employee of a member firm, processes orders for the firm, earns a commission.
Floor broker:
Independent broker who works for various member firms as needed.

27. Exchange Participants
Floor trader:
Independent trader who buys and sells securities for his/her own account. Often called speculator or arbitrageur.
Specialist:
Exchange appointed firm in charge of running the market for a given stock(s).
Acts as both a broker and a dealer charged with matching buy and sell orders from customers and/or filling customer's orders by adding to or selling their own inventory of stock.

28. Specialists
a) Appointed by exchange to serve as "market maker" for one or more stocks.
b) Specialist acts as a broker:
Facilitating trades for certain types public orders (limit orders)

29. Specialists
c) Specialist acts as a dealer: Charged with maintaining a "continuous, orderly market."
Must at times trade against the market
Can petition exchange to halt trading
Incur inventory costs/risks of holding stock
Specialists monitor and limit the bid-ask spread
Specialists have been accused of earning "excessive" rates of return on their capital invested

30. Placing an order
Place a market order to buy 1 round lot of AMD with your broker.
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.
Trade improvement from trading with another broker: Limit Inside quotes: Bid $20.00, Ask $ (too big a spread). Your buy market order will be executed at $20.10 against the book. A seller would execute at $ If two brokers arrive at the same time both may get price improvement by negotiating a trade at $20.05.

31. Trade improvement from trading with another broker:
You place a buy market order when limit inside quotes are Bid $20.00, Ask $20.10
Your buy market order will be executed at ______ against the book.
A sell market order would execute at _______ against the book.
In an auction market, if two brokers arrive at the same time both may get price improvement by negotiating a trade at _______.
$20.10
$20.00
Trade improvement from trading with another broker:
Limit Inside quotes: Bid $20.00, Ask $ (too big a spread). Your buy market order will be executed at $20.10 against the book. A seller would execute at $ If two brokers arrive at the same time both may get price improvement by negotiating a trade at $20.05.
$20.05

32. Electronic Trading on the NYSE
SuperDot
Electronic order routing system allows brokers to electronically send orders directly to specialist.
Useful for program trading 0
DirectPlus
Fully automated trade execution system
Execution time < ½ second
Electronic order placement is growing, large orders still require human intervention.
SuperDot average execution time is about 17 seconds.

33. Block Transactions and Block Houses
Specialize in large block trades
Trade for ≥ 10,000 shares
Block trade is for 10,000 shares or more

34. Electronic Computer Networks (ECNs)
ECNs allow institutional investors to post quotes and trade directly with each other. (4th Market)
Public limit order book
Automatic execution
Advantages include
Lower transactions costs (usually < 1¢ per share)
Speed even on large trade sizes
Anonymity
ECNs
The limit order book is available to all participants. Automatic execution of orders occurs without using a broker or dealer.
Making the other markets nervous. Acquiring the ECNs. ECNs may potentially fragment the market. Probably eventually move to electronic trading in all markets.
Ask students to read about NMS in book.

35. Market Consolidation Trends
NYSE:
Merged with Archipelago ECN in 2006
Merged with Euronext in 2007
Acquired the ASE in 2008
Entering Indian and Japanese stock markets
NASDAQ
Acquired Instinet/Island in 2005
Acquired Boston Stock Exchange in 2007
Jointly acquired Swedish exchange OMX
NASDAQ acquired OMX with Borse Dubai.

36. Market Consolidation Trends
Euronext
Formed from merger of Paris, Brussels, Lisbon and Amsterdam exchanges
Acquired the Liffe in London
Merged with NYSE in 2007
CME acquired CBOT in 2007

37. 3.4 Market Structures in Other Countries

38. Market Structures in Other Countries
Moving to automated electronic trading
Specialist system is largely unique to U.S.
Tokyo Stock Exchange (TSE)
No trading floor, all electronic trading
Three sections for different size firms
Two major indexes: Nikkei 225 and TOPIX
On the TSE the “First Section” is for large companies, the second for midsized and the “Mothers” section is for emerging and high growth stocks.
The Nikkei is a price weighted average of the 225 top tier Japanese firms and the TOPIX is a value weighted index of the First Section.

39. Market Capitalization of Major Exchanges

40. Dollar Volume of Trading in Major World Markets, 2004
generally much lower public holdings of equities overseas, equities held by other corporations, governments and financial institutions

41. 3.5 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

42. Characteristics of well-functioning markets
a) Low cost transfer of funds (competition among market makers and brokers).
b) Adequate trading activity to ensure purchases and sales occur in timely fashion without affecting price. (Trading volume)
Operational or internal efficiency
a) Perhaps Nasdaq style system has an edge here
b) NYSE and Nasdaq are both deep and active
c) Perhaps slight edge to NYSE? w/ more analyst coverage and institutional interest (excluding techs)
c) Informational: Are price changes predictable so that you can earn more than you should for the risk level you are taking
Allocational: Are prices accurately reflecting the prospects of firm/issuer cash flows? Behavioralism attacks the allocational efficiency more than informational efficiency so the distinction is important.
Operational or internal efficiency

43. Characteristics of well-functioning markets
c) Prices speedily reflect public information
Informational efficiency
Informational: Are price changes predictable so that you can earn more than you should for the risk level you are taking?
Allocational efficiency
Allocational: Are prices accurately reflecting the prospects of firm/issuer’s cash flows?

44. Comparing the NYSE and NASDAQ
Which is better in terms of the characteristics, the NYSE or NASDAQ?
Effective spreads for Nasdaq and NYSE:
2004
Nasdaq Median
NYSE Median
Effective spread in $
$0.038
$0.031
Effective spread / Price
Order fill rate on limits
0.27%
0.19%
72.3%
83.4%
Adjusted for liquidity differences with matched samples. Differences are statistically significant at the 1% level
Source: NYSE, NYSE Execution Quality,
$1.5 million
This translates to a cost savings of about __________ per stock per year that trades on the NYSE as opposed to Nasdaq

45. 3.6 Margin Trading

46. Buying on Margin 1-IMR = ________________________
Defined: borrowing money to purchase stock.
Initial Margin Requirement IMR (minimum set by Federal Reserve under Regulation T), currently 50% for stocks
The IMR is the minimum % initial investor equity.
1-IMR = ________________________
maximum % amount investor can borrow

47. Buying on Margin
From whom do you borrow? What is a hypothecation agreement? Do you pay interest on the loan?
Equity =
Maintenance margin requirement (MMR): minimum amount equity can be before additional funds must be put into the account
Exchanges mandate minimum _____.
Position Value - Borrowing + Additional Cash
Brokerage rules are generally more restrictive than exchange minimum requirements and typically include fixed dollar minimums.
25%

48. Margin Call
Margin call: notification from broker you must put up additional funds or have your position liquidated.
At what price does the investor receive a margin call?
While the position is open the investor's equity = Market Value - Amount borrowed
Thus a declining stock price reduces the investor's equity.

49. Margin Call If the Equity / Market Value  MMR a margin call occurs.
(Market Value - Borrowed) / Market Value  MMR ; solve for Market Value
A margin call will occur when:
Market Value = Borrowed / (1 – MMR)
DNH last line

50. Margin Trading Margin Trading: Initial Conditions
X Corp Stock price = $70
50% Initial Margin
40% Maintenance Margin
1000 Shares Purchased
Initial Position
Stock
$70,000
Borrowed
Equity
$35,000

51. Margin Trading Stock price falls to $60 per share (1000 shares)
(MMR = 40%)
Stock price falls to $60 per share (1000 shares)
Margin% =
Margin Trading: Margin Call How far can the stock price fall before a margin call? (MMR = 40%)
Market Value = Borrowed / (1 – MMR)
Market Value = $35,000 / (1 – 0.40) =
New Position
Stock
$60,000
Borrowed
$35,000
Equity
$25,000
$25,000 / $60,000 = 41.67%
$58,333

52. Margin Trading
With 1000 shares, the stock price at which we receive a margin call is $58,333 / 1000 = $58.33
New Position
Stock
$60,000
Borrowed
$35,000
Equity
$23,333
%Margin = $23,333 / $58,333 = 40%
How much cash must you put up?
To restore the IMR you will need equity =
have equity = so owe
½ x $58,333 = $29,167
$23,333
$ 5,834

53. Margin Trading Why do people purchase on margin? APRs (365 day year)
Suppose you buy at $70 per share (borrow at a 7% APR interest cost if use margin, use full amt. margin)
APRs (365 day year)
Do institutions generally purchase on margin?
Buy at $70
Sell at $72 in 90 days
Sell at $68 in 90 days
No Margin
11.59%
-11.59%
Margin
16.17%
-30.17%
Leverage Factor
1.4x
2.6x
7% rate will be at a markup over the "Call Money Rate," which is currently at 7%, Sep 07, see Money Rates, WSJ Online

54. 3.7 Short Sales

55. Short Sales How is it done? Mechanics
Borrow stock from a broker/dealer, must post margin
Broker sells stock and deposits proceeds and margin in a margin account (you are not allowed to withdraw the sale proceeds until you ‘cover’)
Covering or closing out the position: Buy the stock and broker returns the stock title to the party from which it was borrowed
Street name?
May want to talk about 'naked short selling,‘ although this will show up in a later slide. In a naked short a trader sells shares that have not yet been borrowed. This is problematic and probably should be prohibited.

56. The Long & Short of “Round Trips”
A “Round Trip” is a purchase and a sale
Long position
Buy first and then sell later
Bullish
Short position
Sell first and then buy later
Bearish
Not in notes

57. Short Sales
Required initial margin: usually 50% but more for low priced stocks
Liable for any cash flows: Dividend on stock
Zero tick, uptick rule
Zero tick, uptick rule was eliminated by the SEC in July 2007
Zero tick, uptick rule was eliminated by the SEC in July 2007 although I think it may be restored. This rule originated in the 1930s after the crash.

58. Short Sales Short sale maintenance margin requirements (equity) Price
MMR
< $ 2.50
$2.50
$ $ 5.00
100% market value
$ $16.75
$5.00
> $16.75
30% market value

59. Short Sales
Example: You sell short 100 shares of stock priced at $60 per share.
The proceeds of $6000 must be pledged to broker.
You must also pledge 50% margin.
You put up ______. Now you have ______ invested in margin account.
Short Sale Equity = Total Margin Account - Market Value
$3000
$9000

60. Short Sales
Maintenance margin for short sale of a stock with price > $16.75 is 30% of market value or
________________________________.
So you have _______in excess margin. (This may be withdrawn at your pleasure but assume that it is not.)
At what stock price do you get a margin call?
30% x $6,000 = $1,800
$1,200

61. Short Sales When: Equity  (0.30 * Market Value) Equity =
When: Market Value = Total Margin Account / (1 + MMR)
Market Value = $9,000 / ( ) = $6,923
Price at which get a margin call: $6,923 / 100 shares = $69.23
Total Margin Account – Market Value
We sold short 100 shares of stock so margin call occurs at a stock price of $6,923 / 100 = $69.23.

62. Short Sales If this occurs: Equity = Equity as % market value =
You get a margin call &
You may have to restore the 50% initial margin.
If so you must deposit an additional
($6,923 / 2) - $2,077 = $1,384.5
$9,000 - $6,923 = $2,077
$2,077 / $6,923 = 30%

63. Short Sales Naked short sales
Should any or all short sales be prohibited?
Should the zero tick/uptick rule be utilized?

64. 3.8 Regulation of Securities Markets

65. 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 require periodic disclosure of relevant financial information for firms with publicly traded securities
Gives authority to regulate exchanges and OTC trading/traders to the SEC
CFTC retains authority over commodity futures and Federal Reserve sets margin requirements

66. Market Regulation Securities Investor Protection Act of 1970
Protects investors from losses if a brokerage firm fails (up to $500,000 per customer).
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.

67. Insider Trading Illegal, but what is it?
Definition of insiders can be ambiguous
SEC’s Official Summary of Securities Transactions and Holdings

68. Response to Scandals Increased regulation Sarbanes-Oxley
Additional regulation will occur as a result of the financial crisis

69. Response to the Financial Crisis
Too soon to know the details of what will happen
Likely have reform of the SEC
Reform of the ratings agencies approval process and funding model.
Some type of ‘systemic’ regulator
Continued government involvement in the markets

70. Selected Problems

71. Chapter 3: Problem 1 Explicit and Implicit costs.
Explicit: Underwriter’s Fee $70,000
Implicit: Underpricing ($53 -$50) x 100,000 = $300,000
Total Costs = $370,000
No. The underwriters did not directly profit from the underpricing of the securities. 71

72. Chapter 3: Problem 2
If the price keeps going up your losses are unlimited.
The stop-buy order at $128 limits your max loss to about $8 per share. 72

73. Chapter 3: Problem 3
a. The stock is purchased for: 300  $40 = $12,000 The amount borrowed is $4, Therefore, the investor put up equity, or margin, of $8,000. 73

74. Chapter 3: Problem 3
b. If the share price falls to $30, then the value of the stock falls to $30 x $300 = $9,000. By the end of the year, the amount of the loan owed to the broker grows to:
$4,000  1.08 = $4,320
Therefore, the remaining equity in the investor’s account is:
$9,000  $4,320 = $4,680
The percentage margin is now: __________________________
Therefore the investor will not receive a margin call.
$4,680 / $9,000 = 0.52 = 52% 74

75. Chapter 3: Problem 3
c. The rate of return on the investment over the year is:
(Ending equity in the account  Initial equity) / Initial equity
HPR = ($4,680  $8,000) / $8,000 = 0.415 = 41.5%
Beginning Equity = $8,000
End Equity = $4,680 75

76. Chapter 3: Problem 4 Many exchanges and the ECNs have pretty much
eliminated market-making specialists.
Here the computer finds the best prices to make the trades. 76

77. Chapter 3: Problem 5
$50.25
$51.50
a. The buy order will be filled at the best limit-sell order, $50.25
b. The next market buy order would be filled at the next best price, $51.50
c. You should probably increase your position. There is plenty of buying demand at prices just below $50, so downside risk is limited. The limit sell orders are less concentrated. 77

78. Chapter 3: Problem 6 You buy $10,000/$50= 200 shares
Shares go up 10% $50$55 $55 X 200=$6000
You pay interest .08 X $5000 = $400
Rate of return = 6000 – 400 – = 12%
5000
b. The margin call will occur when Market Value = Amount Borrowed / (1 - MMR)
Market Value =
Stock price =
$5,000 / (1 – 0.30) = $7,142.86
$7, / 200 shares = $35.71 78

79. Chapter 3: Problem 7 a
55.25
The trade will not be executed because the bid price is lower than the price specified in the limit sell order.
The trade will not be executed because the ask price is greater than the price specified in the limit buy order. 79

80. Chapter 3: Problem 8
a. In an exchange market, there can be price improvement in the two market orders. Brokers for each of the market orders (i.e., the buy and the sell orders) can agree to execute a trade inside the quoted spread.
For example, they can trade at $55.37, thus improving the price for both customers by either $0.12 or $0.13 relative to the quoted bid and asked prices.
For example, they can trade at $55.37, thus improving the price for both customers by $0.12 or $0.13 relative to the quoted bid and asked prices.
The buyer gets the stock for $0.13 less than the quoted asked price,
The seller receives $0.12 more for the stock than the quoted bid price. 80

81. Chapter 3: Problem 8
b. Whereas the limit order to buy at $55.37 would not be executed in a dealer market (since the asked price is $55.50), it could be executed in an exchange market.
A broker for another customer with a market sell order would view the limit buy order as the best bid price; the two brokers could agree to the trade and bring it to the specialist, who would then execute the trade. 81

82. Chapter 3: Problem 9
(Round Trip) 82

83. Chapter 3: Problem 10 Cannot tell from the information given. The
broker will attempt to sell after the first
transaction at $55 or less. 83