1. FIN670: Investment Analysis
Chapter 3:Securities Markets

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 3.2 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. Limit orders and stop orders
Limit-buy: buy if the price falls below a certain level
Example: current price of IBM = Think it is too high, only buy if the price is 85 or below. So you make a limit buy order with the limit is $85
Limit-sell: sell if the price rises above a certain level
Example: current price of MSFT = Think it is too low, only sell if the price is 30 or higher. So you make a limit sell order with the limit is $30

21. Limit orders and stop orders
Stop orders: trades not to be executed unless stock hits a price limit
Stop-buy: buy when price rises above a certain level
Example: the current price of Apple is If you believe the price will go down, you short Apple stock
If the price actually goes down, make profit
However, in case it may not go down, you might want to make a stop-buy order with the price limit is to prevent loss
Stop-loss: sell when price falls below a certain level
example: the current price of Dell is You believe stock price will go up so you buy Dell stock
Stock price might go down, and you might have loss. To prevent that, make a stop-loss order with the price limit is 12.25

22. Figure 3.6 Price-Contingent Orders

23. Figure 3.5 Limit Order Book for Intel on Archipelago

24. 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

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

26. 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)

27. 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

28. Nasdaq requirements for listing

29. Trading on Nasdaq

30. 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

31. 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

32. New York Stock Exchange (NYSE)

33. 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

34. NYSE listing requirements

35. NYSE block transactions

36. 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

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

38. Figure 3.6 Market Capitalization of Major World Stock Exchanges, 2007

39. 3.5 TRADING COSTS

40. 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

41. 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)?

42. 3.6 BUYING ON MARGIN

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

44. 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

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

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

47. 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?

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

49. 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

50. 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

51. 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?

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

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

54. 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

55. 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

56. 3.7 SHORT SALES

57. 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

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

59. Short Sales

60. 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?

61. 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?

62. 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)

63. 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

64. 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?

65. 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

66. Short Sale - Maintenance Margin
Stock Price Rises to $110 Sale Proceeds $10,000 Initial Margin 5,000 Stock Owed 11,000 Net Equity 4,000 Margin % (4000/11000) 36%

67. 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

68. 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?

69. CHAPTER 4: INVESTMENT COMPANIES

70. Investment Companies
Definition: financial intermediaries that collect funds from individual investors and invest those funds in a potentially wide range of securities
Administration & record keeping
issue periodic status reports, keeping track of capital gain distributions, dividends, investments, and redemption
Diversification & divisibility: diversify portfolios and investors can buy fractional shares of many different securities
Professional management: full-time staffs of security analysts and portfolio managers
Reduced transaction costs: can achieve substantial savings on brokerage fees and commissions because of large transactions

71. Investment Companies: Net Asset Value
Used as a basis for valuation of investment company shares
Selling new shares
Redeeming existing shares
Calculation:
Market Value of Assets - Liabilities
Shares Outstanding

72. 4.2 TYPES OF INVESTMENT COMPANIES

73. Unit Trusts
Pools of money from many investors that is invested in a portfolio fixed for the life of the fund
Little active management
Example: invest in municipal bond, corporate bond

74. Managed Investment Companies: Open-End and Closed-End
Hire managers to manage portfolio
Open-End
stand ready to redeem or issue shares at their net asset value. If investors in open-end funds want to cash out shares, they sell back to the fund at NAV
Closed-End
Funds cannot issue or redeem shares. Investors who want to cash out must sell shares to other investors
Sold at premium or discount to NAV
Shares of close-end fund are traded on organized exchanges just like other common stocks.

75. Figure 4.1 Closed-End Mutual Funds

76. Other Investment Organizations
Commingled funds
partnership of investors that pool their funds. Similar to open-end fund. Example: trust or retirement account that have portfolios much larger than those of most individual investors but still too small to warrant managing on a separate basis
REITs: similar to closed-end fund but invest in real estate or loans secured by real estate
Hedge Funds
like mutual fund: hedge fund allows private investors to pool assets to be invested by a fund manager
Unlike mutual fund: hedge fund are commonly structured as private partnerships and are not subject to many SEC regulations

77. 4.3 MUTUAL FUNDS

78. Investment Policies
mutual fund is a common name for open- end investment company. Account for >90% of investment company asset.
Described in the prospectus
Management companies manage a family of mutual funds. Some examples include:
Fidelity
Vanguard
Putnam
Dreyfus

79. Types of Mutual Funds Money Market: invest in money market securities.
Equity: invest in stocks
Income fund and growth fund
Specialized Sector: sector funds
Bond: invest in bond

80. Types of Mutual Funds
Balanced Funds: hold both equities and fixed income securities in relatively stable proportions to meet needs of individual investors
Asset Allocation and Flexible: similar to balance funds but the proportion can change according to managers’ forecasts
Indexed: match performance of a broad market index. Example: Vanguard 500 Index Fund
International

81. Table 4.1 Mutual Funds by Investment Classification

82. 4.4 COSTS OF INVESTING IN MUTUAL FUNDS

83. Fee Structure Fee Structure Operating expenses 12 b-1 charges
Front-end load: commission or sale charge paid when purchasing the shares
Back-end load: redemption or exit fee incurred when you sell shares.
Operating expenses
12 b-1 charges
distribution costs paid by the fund
Alternative to a load
Fees and performance

84. Example 4.1 From Text

85. Fees and Mutual Fund Returns

86. Fees and Mutual Fund Returns: An Example
Initial NAV = $20
Income distributions of $.15
Capital gain distributions of $.05
Ending NAV = $20.10:

87. Table 4.2 Impacts of Costs on Investment Performance

88. 4.6 EXCHANGE-TRADED FUNDS

89. Exchange Traded Funds
ETF allow investors to trade index portfolios like shares of stock
Examples – SPDRs, Diamonds, and WEBS
Potential advantages
Trade continuously
Lower taxes
Lower costs
Potential disadvantages

90. Table 4.3 EFT Sponsors and Products

91. 4.7 MUTUAL FUND INVESTMENT PERFORMANCE: A FIRST LOOK

92. Mutual Fund Performance
Evidence shows that average mutual fund performance is generally less than broad market performance
Evidence suggests that over certain horizons some persistence in positive performance
Evidence is not conclusive
Some inconsistencies

93. Figure 4.2 Diversified Equity Funds Versus Wilshire 5000 Index

94. Figure 4.3 Percentage of Funds Below Wilshire 5000

95. Table 4.4 Consistency of Investment Results

96. 4.8 INFORMATION ON MUTUAL FUNDS

97. Sources of Information
Wiesenberger’s Investment Companies
Morningstar (
Yahoo (finance.yahoo.com/funds)
Investment Company Institute
Popular press
Investment services