1. Securities Markets
CHAPTER 3

2. Learning Objectives Role of investment bankers in primary issues
Identify the various security markets
Describe the role of brokers
Compare trading practices in exchanges vs dealer markets
Buy Stock on Margin and Sell Stock Short

3. 3.1 HOW FIRMS ISSUE SECURITIES

4. HOW FIRMS ISSUE SECURITIES
securities resell and rebuy
first issue securities
Firms
Primary market
Secondary
market
(2)
(1)
New securities
Issuers receive fund
Existing owner sells to another party
Issuing firm doesn’t receive proceeds and is not directly involved

5. Primary issues for stocks and bonds
There are 2 types of primary issues for stock
IPO (initial public offering): first sale of stock by a formerly private company
SEO (seasoned equity offering): offered by companies which already have stocks trading in the market
There are 2 types of primary issues for bond:
Public offering: issue of bonds sold to public and then can be traded on the secondary market
Private placement: issue of bonds that is usually sold to one or a few institutional investors and held to maturity.

6. How Securities Are Issued
Investment Banking
Shelf Registration
Private Placements
Initial Public Offerings (IPOs)

7. Investment Banking Arrangements
Underwritten vs. “Best Efforts”
Underwritten: firm commitment on proceeds to the issuing firm
Assume the risk of not being able to resell to public
Best effort
I.B. does not buy securities
Agree to help to sell to public
Less common than underwritten
Underwriting syndicate:
More than one I.B. involved in the underwriting process
resell
sell
firms
I.B.
Public
securities
securities

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

9. Figure 3.2 A Tombstone Advertisement

10. Shelf Registrations
SEC Rule 415 (1982): SEC allows firms to register securities and sell to public within 2 years
Avoid flotation cost
Little paperwork, ready to be issued – on the shelf
limited in time (2 years)
Why limited in time?

11. Private Placements
Private placement: sale to a limited number of sophisticated investors not requiring the protection of registration
Allowed under Rule 144A
Much cheaper than public offering
Don’t trade in secondary market
Dominated by few institutions
Very active market for debt securities
Not active for stock offerings

12. Initial public offerings
IPO: investment bank assists companies going from private to public (first issuance of securities to public)
I.B advise companies on terms of the issue (price, volume, find buyers)
Step 1:
I.B. file preliminary draft with SEC.
The draft (red herring): information about issues and the company
Step 2:
Once SEC approve, I.B. organizes a road show
Road show: travel around countries to publicize the offerings
Generate interest among investors, provide info about offerings
provide feedback to issuers and I.B. about the price, volume of the issues to be sold

13. Initial public offerings
Book building is important
Provides feedback to the issuer and I.B. about the issue
Issuers and I.B. revise the initial estimates
New price
New volume
Identify potential buyers
Investors
Investment bank
book building
show interest “book”
poll all potential investors

14. Initial public offerings
IPO is usually underpriced
Dec 1999, VA Linux sold IPO for $30/share, after 1 day the price went up to $239.25/share, (698% return)
Why IPO is underpriced?
I.B. organizes road shows to provide info about the issue to public and get feedback
I.B. mainly contact institutional investors (big buyers)
Why big buyer is important?
they can buy at large volume
they can provide feedback about the issue
Big buyers should get the discount for their activities, hence IPO is underpriced
Long-term performance of IPO is poor

15. Figure 3.3 Average Initial Returns for IPOs in Various Countries

16. Figure 3.4 Long-term Relative Performance of Initial Public Offerings

17. HOW SECURITIES ARE TRADED

18. Types of Secondary Markets
Direct search:
Least organized market
buyers and seller meet directly
Brokered
Assist buyers and sellers in finding each other
get commission fees
Dealer
Traders specializing in particular assets buy and sell for their own accounts. Buyers buy from the dealer. Sellers sell to the dealer
Bid-ask spread
Auction
all traders meet at one place to buy or sell an asset
specialist system
May not need to trade with the specialists so can save the bid-ask spread

19. Types of Orders
Market—executed immediately at the current market price
Bid Price: price at which a dealer or other trader is willing to buy
Ask Price: price at which a dealer or other trader is willing to sell
Price-contingent: investor specify prices they are willing to buy or to sell
limit orders:
Limit-buy: buy if the price falls below a certain level
Limit-sell: sell if the price rises above a certain level
Stop orders: trades not to be executed unless stock hits a price limit
Stop-buy: buy when price rises above a certain level
Stop-loss: sell when price falls below a certain level

20. Figure 3.6 Price-Contingent Orders

21. Figure 3.5 Limit Order Book for Intel on Archipelago

22. Concept check
what type of trading order you might give to your broker in each of the following circumstances
you want to buy shares of Intel to diversify your portfolios. You believe that the share price is at the “fair value”, you want the trade done quickly and cheaply
you want to buy shares of Intel but believe that the current price is too high given the firm’s prospect. If shares could be obtained at a price 5% lower than the current value, you would like to purchase shares for your portfolio
you plan to purchase a house sometime next month, and will sell your shares of Intel to provide funds for your down payment. While you believe that Intel share price is going to rise over the next few weeks, if you are wrong and the share price drops suddenly, you will not be able to afford the purchase. Therefore, you want to hold on to the shares for as long as possible, but still protect yourself against the risk of a big loss

23. Trading Mechanisms in the US
Dealer markets (over-the-counter market)
Specialists markets (formal or organized exchanges)
Electronic communication networks (ECNs)

24. Dealer markets investors brokers dealers instructions to buy or sell
confirmation
Ask
Dealer
Dealer
Dealer
Bid
Dealer
Dealer
Dealer
contact through a computer network
confirm-ation
dealers
50.20 is the inside bid (best bid)
50.25 is the inside ask (best ask)

25. Nasdaq The most important market in the OTC or dealer system
Nasdaq Global Select Market
Nasdaq Global Market
Nasdaq Capital Market
Small stock OTC
Pink sheets

26. Nasdaq requirements for listing

27. Trading on Nasdaq

28. Trading on Nasdaq No specialist
Dealers can be located anywhere they can communicate effectively with buyers and sellers
3 levels of members
Level 3: market makers, dealers
maintain inventories
stand ready to buy and sell
set bid-ask quotes
Level 2: brokers
receive all quotes, try to get best quotes for clients
deal with level 3 (dealers)
Level 1: investors
receive only inside quotes
not active investors, only need current information on prices

29. New York Stock Exchange
Largest exchange in the U.S.
2,800 firms, market cap is $15 trillion
daily trading: 1.8 (bil) shares, valued at $75 (bil)
Three members
Commission brokers
Floor brokers
Specialist
if the order is small, commission brokers can send the order directly to computer network
If the order is large, commission brokers send the order to floor brokers, and then floor brokers either send order to specialist or negotiate directly with other floor brokers

30. New York Stock Exchange (NYSE)

31. New York Stock Exchange
Now a publicly held company
Merge with Archipelago Exchange to form NYSE group in 2006
Merge with Euronext to form NYSE-Euronext in 2007
Block sales
Blocks of tens of thousands of shares of stock
Block houses
SuperDot
Enables members to send order directly to specialists
in 2006, processed about 13 mil trades per day, executed in matter of seconds
small orders
Bond Trading
2006 NYSE obtained approval to expand bond trading

32. NYSE listing requirements

33. NYSE block transactions

34. Other Exchanges and Trading Systems
American Stock Exchange (AMEX)
Regionals
Electronic Communication Networks (ECNs)
Directly between the two parties.
INET and Archipelago
National Market System
Established by Exchange Act of 1975
Intent was to link firms electronically
Resulted in Consolidated Tape

35. Other Countries London - predominately electronic trading
Euronext – market formed by combination of the Paris, Amsterdam and Brussels exchanges
Tokyo Stock Exchange

36. Figure 3.7 Market Capitalization of Listed Firms, 2005

37. 3.5 TRADING COSTS

38. Trading Costs Explicit cost Implicit cost
Commission: fee paid to broker for making the transaction
Implicit cost
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

39. Cost of Trading Impact of trading costs on returns
Example: You bought a stock for $70 and later sold it for $80 You received $8 in dividends, paid an initial broker’s fee of $1% of purchase price, and paid another $1% of selling price when you sold the stock. What is your return on this investment (ignoring taxes)?

40. 3.6 BUYING ON MARGIN

41. Buying on Margin
Using only a portion of the proceeds for an investment
Borrow remaining component
Margin arrangements differ for stocks and futures

42. Buying on Margin
Maximum 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 you must put up additional funds

43. Buying on Margin Investor’s account: Assets Liabilities
Value of stocks purchased Loan from Broker
Equity
Cost of setting up a margin strategy

44. Buying on Margin
At time 0:
At any future time

45. Buying on Margin
Example: What is the initial margin if the investor purchases 100 shares of stock at $100 per share using $6,000 of her own money and borrows the rest?

46. Buying on Margin
Example (continued): If the value of the above stock fell to $70 per share, what is now the actual margin?

47. Buying on Margin
Example (continued): If the value of the above stock fell to $50 per share, what is now the actual margin?
Below 30% ===> margin call

48. Buying on Margin Margin Call
Pmin= the lowest price a share can fall to without a call
L = the loan value
M = the margin requirement
N = the number of shares

49. Buying on Margin
Margin Call Example: An investor purchases 100 shares of stock at $100 per share using $6,000 of her own money and borrows the rest. If the maintenance margin is 30%, what is the lowest price a share can fall without a call?

50. Margin Trading - Initial Conditions
X Corp $70
50% Initial Margin
40% Maintenance Margin
Shares Purchased
Initial Balance Sheet Position:
Stock $70,000 Borrowed $35,000
Equity ,000

51. Margin Trading - Maintenance Margin
Stock price falls to $60 per share
New Balance Sheet Position:
Stock $60,000 Borrowed $35,000
Equity ,000
Margin% = $25,000/$60,000 = 41.67%

52. Margin Trading - Margin Call
How far can the stock price fall before a margin call?
Since 1000P - Amt Borrowed = Equity then:
(1000P - $35,000) / 1000P = 40%
P = $58.33

53. Problem 3, Chapter 3
Dee Trader opens a brokerage account, and purchases 300 shares of Internet Dreams at $40 per share. She borrows $4,000 from her broker to help pay for the purchase. The interest rate on the loan is 8%.
a. What is the margin in Dee’s account when she first purchases the stock?
b. If the share price falls to $30 per share by the end of the year, what is the remaining margin in her account? If the maintenance margin requirement is 30%, will she receive a margin call?
c. What is the rate of return on her investment

54. 3.7 SHORT SALES

55. Short Sales Borrow Securities to sell them Sell first -- then buy!
Margin is required (cost of short selling)
Short position must be covered
Investor expects price to decline

56. Short Selling Original Stock Holder 100 Shares Short Seller 100 Shares
Broker
100 Shares
New Stock Holder

57. Short Sales

58. Short Sales
Example: An investor sells short 100 shares of stock at $100 per share. The margin requirement is 50% of the short sale.
a. If the investor covers her short sale when the stock price declines to $70 per share, what is the return on the short sale?
b. What is the return if there is no margin requirement?

59. Short Sales
Example: An investor sells short 100 shares of stock at $100 per share. The margin requirement is 50% of the short sale.
c. If the investor covers her short sale when the stock price increases to $130 per share, what is the return on the short sale?

60. Short-sale initial margin
Investor’s account at time t = 0
Assets Liabilities + Equity
Cash (sale) = P0*N Value of stocks = P0*N
(borrowed)
Cash (deposit) Equity or initial margin
or initial margin
Percentage of initial margin =
(equity at time 0)/(value of stocks borrowed at time0)

61. Short-sale margin at time t
Investor’s account at time t
Assets Liabilities + Equity
Cash (sale) = P0*N Value of stocks = Pt*N
(borrowed)
Cash (deposit) Equity or current margin
or initial margin at time t
Percentage of margin at time t = (equity at time t)/(value of stocks borrowed at time t)
As time elapses, the value of stock changes hence affecting the value of percentage margin

62. Short Sales
Example: An investor sells short 100 shares of stock at $100 per share. The initial margin requirement is 50% of the short sale. If the maintenance margin is 30%, what is the maximum stock price without a margin call on the short sale?

63. Short Sale - Initial Conditions
Z Corp 100 Shares
50% Initial Margin
30% Maintenance Margin
$100 Initial Price
Sale Proceeds $10,000
Margin & Equity 5,000
Stock Owed 10,000

64. Short Sale - Maintenance Margin
Stock Price Rises to $110
Sale Proceeds $10,000
Initial Margin ,000
Stock Owed ,000
Net Equity ,000
Margin % (4000/11000) %

65. Short Sale - Margin Call
How much can the stock price rise before a margin call?
Since Initial margin plus sale proceeds = $15,000, then:
($15, P) / (100P) = 30%
P = $115.38

66. Problem 4, Chapter 3
Old Economy Traders opened an account to short sell 1,000 shares of Internet Dreams from Question 3. The initial margin requirement was 50%. (The margin account pays no interest.) A year later, the price of Internet Dreams has risen from $40 to $50, and the stock has paid a dividend of $2 per share.
a. What is the remaining margin in the account?
b. If the maintenance margin requirement is 30%, will Old Economy receive a margin call?
c. What is the rate of return on the investment?

67. Summary Issuing securities Trading Buying on margin and short sales
Next class: Bonds