1. McGraw-Hill/Irwin © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved. Securities Markets CHAPTER 3

2. 3-2 3.1 HOW FIRMS ISSUE SECURITIES

3. 3-3 Primary Versus Secondary Markets 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

4. 3-4 How Securities Are Issued Investment Banking Shelf Registration Private Placements Initial Public Offerings (IPOs)

5. 3-5 Investment Banking Arrangements Underwritten vs. “Best Efforts” –Underwritten: firm commitment on proceeds to the issuing firm –Best Efforts: no commitment on proceeds… Negotiated vs. Competitive Bid –Negotiated: issuing firm negotiates terms with investment banker –Competitive bid: issuer structures the offering and secures bids

6. 3-6 Figure 3.1 Relationship Among a Firm Issuing Securities, the Underwriters and the Public

7. 3-7 Figure 3.2 A Tombstone Advertisement

8. 3-8 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

9. 3-9 Private placement: sale to a limited number of sophisticated investors not requiring the protection of registration Allowed under Rule 144A Dominated by institutions; suitable for smaller offerings; less expensive to issuer Very active market for debt securities Not active for stock offerings Private Placements

10. 3-10 Initial Public Offerings Process –Road shows (generate interest; provide info on prices the offering might command) –Bookbuilding (indications of interest) Underpricing –Post-sale returns (median 1-day return, NASDAQ, 1997-02, was 17.8%) –An added cost to the issuing firm (over and above the explicit cost about 7%)

11. 3-11 Figure 3.3 Average Initial Returns for IPOs in Various Countries

12. 3-12 Figure 3.4 Long-term Relative Performance of Initial Public Offerings

13. 3-13 3.2 HOW SECURITIES ARE TRADED

14. 3-14 Types of Secondary Markets Direct search (e.g. newspaper want-ads) Brokered (e.g. real estate brokers) Dealer (e.g. OTC securities market) Auction (e.g. NYSE)

15. 3-15 Types of Orders Market—executed immediately –Bid Price –Ask Price Price-contingent –Investors specify prices –Stop orders

16. 3-16 Price-Contingent Orders Limit Orders Name a Limit Price Limit-Buy Order: Buy if Market Price is Below Limit Price Limit-Sell Order: Sell if Market Price is Above Limit Price Stop-Loss Orders Name a Limit Price Stop-Loss Order: Sell if Market Price is Below Limit Price Stop-Buy Order: Buy if Market Price is Above Limit Price

17. 3-17 Figure 3.5 Limit Order Book for Intel on Archipelago

18. 3-18 Figure 3.6 Price-Contingent Orders

19. 3-19 Trading Mechanisms Dealer markets (e.g. OTC markets; dealers quote prices for buy/sell) Electronic communication networks or ECNs (traders post market and limit orders over computer networks; orders matched without broker) Specialists markets (e.g. NYSE; trade in a security managed by specialist; specialist may act as dealer and as broker)

20. 3-20 3.3 U.S. SECURITIES MARKETS

21. 3-21 U.S. Security Markets Nasdaq Small stock OTC –Pink sheets Organized Exchanges –New York Stock Exchange –American Stock Exchange –Regionals Electronic Communication Networks (ECNs)

22. 3-22 Nasdaq Nasdaq Global Select Market Nasdaq Global Market Nasdaq Capital Market Small stock OTC –Pink sheets

23. 3-23 New York Stock Exchange Largest exchange in the U.S. Automated for small orders Member functions –Commission brokers –Floor brokers; takes orders to specialist’s post –Specialists

24. 3-24 New York Stock Exchange Now a publicly held company Block sales SuperDot (electronic order routing system; allows firms to send market and limit orders directly to the specialist) Bond Trading –2006 NYSE obtained approval to expand bond trading –May provide OTH dealer market in bonds

25. 3-25 Other Exchanges and Trading Systems American Stock Exchange (AMEX) Regionals Electronic Communication Networks (ECNs) National Market System

26. 3-26 3.4 MARKET STRUCTURE IN OTHER COUNTRIES

27. 3-27 Other Countries London - predominately electronic trading Euronext – market formed by combination of the Paris, Amsterdam and Brussels exchanges Tokyo Stock Exchange (saitori maintains public limit order book; tries to slow down large price changes; does not trade from own account)

28. 3-28 Figure 3.7 Market Capitalization of Listed Firms, 2005

29. 3-29 3.5 TRADING COSTS

30. 3-30 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

31. 3-31 3.6 BUYING ON MARGIN

32. 3-32 Buying on Margin Using only a portion of the proceeds for an investment Borrow remaining component Margin arrangements differ for stocks and futures

33. 3-33 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

34. 3-34 Margin Trading - Initial Conditions X Corp$70 50%Initial Margin 40%Maintenance Margin 1000Shares Purchased Initial Balance Sheet Position: Stock $70,000 Borrowed $35,000 Equity 35,000 Equity 35,000

35. 3-35 Margin Trading - Maintenance Margin Stock price falls to $60 per share New Balance Sheet Position: Stock $60,000 Borrowed $35,000 Equity 25,000 Equity 25,000 Margin% = $25,000/$60,000 = 41.67%

36. 3-36 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

37. 3-37 3.7 SHORT SALES

38. 3-38 Short Sales Purpose: to profit from a decline in the price of a stock or security Purpose: to profit from a decline in the price of a stock or security Mechanics 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

39. 3-39 Short Sale - Initial Conditions Z Corp100 Shares  First borrow 100 shares, then sell them. 50%Initial Margin 30%Maintenance Margin $100Initial Price Sale Proceeds:$10,000 Margin & Equity: 5,000 Initial Margin: $5,000/$10,000 = 50% Value of Stock Owed $10,000

40. 3-40 Short Sale - Maintenance Margin Stock Price Rises to $110 Sale Proceeds$10,000 Initial Margin (T-Bills?) 5,000 Value of Stock Owed$11,000 Margin (5,000 – 1,000) 4,000 Margin % (4,000/11,000) 36%

41. 3-41 Short Sale - Margin Call How much can the stock price rise before a margin call? Since Initial margin plus sale proceeds = $15,000, then: ($15,000 - 100P) / (100P) = 30% P = $115.38

42. 3-42 3.8 REGULATION OF SECURITIES MARKETS

43. 3-43 Major Regulations Securities Acts of 1933 Securities Acts of 1934 Securities Investor Protection Act of 1970

44. 3-44 Self-Regulation National Association of Securities Dealers (NASD) –Oversees participants in the Nasdaq market NYSE has its own regulatory arm

45. 3-45 Regulation Response to Recent Scandals Sarbanes-Oxley Act

46. 3-46 Circuit Breakers Trading halts: If DJIA falls by 10%, trading halted fro 1 hour (prior to 2:00 pm.) or ½ hour (between 2 and 2:30 pm) or not at all (after 2:30 pm.) If DJIA falls 20%, trading halted for 2 hours (before 1:00), 1 hour (between 1:00 and 2:00), rest of day (after 2:00). If DJIA falls by 30%, market closed rest of day. Collars: When Dow moves -2% from prior day’s close, Rule 80A of NYSE requires that index arbitrage orders pass a “tick test”. In a falling market, sell orders executed only on a plus tick or, if last price was an uptick, at the last price.

47. 3-47 Insider Trading Illegal Definition of insiders can be ambiguous SEC’s Official Summary of Securities Transactions and Holdings