1. McGraw-Hill/Irwin 3-1 How Securities Are Traded Chapter 3

2. McGraw-Hill/Irwin 3-2 CHAPTER OVERVIEW How securities are traded on both the primary and secondary markets Organized exchange and over the counter activities Margin trading and short selling Regulation and ethics issues associated with security transactions

3. McGraw-Hill/Irwin 3-3 LEARNING OBJECTIVES Have considerable insight as to how securities are traded on both the primary and secondary markets Understand the mechanics, risk, and calculations involved in both margin trading and short selling. Begin to understand some of the implications, ambiguities, and complexities of insider trading and the regulations concerning these issues.

4. McGraw-Hill/Irwin 3-4 Stage of Business Development

5. McGraw-Hill/Irwin 3-5 S&P 500 Index ’Enterprises Assets and Market Value (1988-1998)

6. McGraw-Hill/Irwin 3-6 Primary vs. Secondary Security Sales Primary: when firms need to raise capital they may choose to sell(or float) new securities. These new issues of stocks, bonds, or other securities typically are marketed in the primary market. -New issue -Key factor: issuer receives the proceeds from the sale. 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 selling stocks to the public for the first time. Second new issues are offered by companies that already have floated equity. We also have distinguish between two types of primary market issues: a public offering, which is an issue of stock or bonds sold to the general investing public that can then be traded on the secondary market; and a private placement, which is an issue that is sold to a few wealthy or institutional investors at most, and, in the case of bonds, is generally held to maturity.

7. McGraw-Hill/Irwin 3-7 Primary vs. Secondary Security Sales Secondary: purchase and sale of already issued securities among private investors take a place in the secondary market. The secondary markets consist of (1) national and local securities exchanges,(2) the over-the-counter market, and (3) direct trading between two parties. -Existing owner sells to another party. -Issuing firm doesn’t receive proceeds and is not directly involved. Public offerings of both stocks and bonds typically are marketed by investment bankers, who in this role are called underwriters. More than one investment banker usually markets the securities.

8. McGraw-Hill/Irwin 3-8 Investment Banking Arrangements Underwritten vs. “Best Efforts” the issue of whether the issuing firm or the investment banker bears the risk that the issue will be sold at the offering price. In an underwriting arrangement the investment bankers purchase the securities from the issuing company and then resell them to the public. In the best-efforts agreement the investment banker agrees to help the firm sell the issue to the public but not actually purchase the securities. -Underwritten: firm commitment on proceeds to the issuing firm. -Best Efforts: no firm commitment.

9. McGraw-Hill/Irwin 3-9 Investment Banking Arrangements Negotiated vs. Competitive Bid I ssues can be arranged on either a competitive or negotiated offering. Negotiation is far more common. Besides being compensated by the spread between the purchase price and the public offering price, an investment banker may receive shares of common stock or other securities of the firm. While virtually all stock offerings and corporate bond offerings are done on a negotiated basis, many municipal offerings are completed on a competitive bid basis. -Negotiated: issuing firm negotiates terms with investment banker. -Competitive bid: issuer structures the offering and secures bids.

10. McGraw-Hill/Irwin 3-10 Figure 3.1 Relationship Among a Firm Issuing Securities, the Underwriters and the Public

11. McGraw-Hill/Irwin 3-11 Public Offerings Public offerings: A public offering is an issue of stock or bonds sold to the general investing public that can then be traded on the secondary market. Once the SEC has commented on the registration statement and a preliminary prospectus has been distributed to interested investors, the investment bankers organize road shows in which they travel around the country to publicize the imminent offering. Shares of IPOs are located to investors in part based on the strength of each investor’s expressed interest in the offering. Shelf registration (Rule 415, since 1982): An important innovation in the method of issuing securities was introduced in 1982, when the SEC approved Rule 415, which allows firms to register securities and gradually sell them to the public for two years after the initial registration. Because the securities are already registered, they can be sold on short notice with little additional paperwork.

12. McGraw-Hill/Irwin 3-12 Figure 3.2 A Tombstone Advertisement

13. McGraw-Hill/Irwin 3-13 Public Offerings Initial Public Offerings (IPOs) -Evidence of underpricing: IPOs commonly are underpriced compared to the price at which they could be marketed. Such underpricing is reflected in price jumps on the date when the first traded in public security markets.

14. McGraw-Hill/Irwin 3-14 Figure 3.3 Average Initial Returns for IPOs in Various Countries

15. McGraw-Hill/Irwin 3-15 Public Offerings -Performance:

16. McGraw-Hill/Irwin 3-16 Private Placements Private placement: sale to a limited number of sophisticated investors not requiring the protection of registration. Primary offering can also be sold in a private placement rather than a public offering. In this case, the firm sells shares directly to a small group of institutional or wealthy investors. Private placement do not trade in secondary markets such as stock exchanges. This greatly reduces their liquidity and presumably reduces the prices that investors will pay for the issue.While most stock offerings employ public offerings, many issues of debt are completed using private placements. It is useful to discuss differences in the markets for equity and bond when discussing this material. Bond markets are dominated by financial institutions and many of the special characteristics of bond issues lend themselves to private placements. In some years the volume of private placements exceed public offerings of corporate bond issues.

17. McGraw-Hill/Irwin 3-17 Private Placements Characteristic: Dominated by institutions. Very active market for debt securities. Not active for stock offerings.

18. McGraw-Hill/Irwin 3-18 Organization of Secondary Markets Organized exchanges: Organized exchanges assign the dealership function differently and the role of the specialist can be developed and contrasted with competitive dealers that exist on many organized exchanges. An exchange provides a facility for its members to trade securities, and only members of the exchange may trade there. The commissions that members can earn through this activity determine the market value of a seat. The NYSE is by far the largest single exchange. The American Stock Exchange, or Amex, is also national in scope, but it focus on listing smaller and younger firms than does the NYSE.

19. McGraw-Hill/Irwin 3-19 Organization of Secondary Markets OTC market: The OTC market is not a formal exchange. There are no membership requirements for trading, nor are there listing requirements for securities. Any securities may be traded on the over- the-counter (OTC) market. In the OTC market thousands of brokers register with the SEC as dealers in OTC securities. Security dealers quote prices at which they are willing to buy or sell securities. A broker can execute a trade by contacting the dealer listing an attractive quote. The over-the-counter Nasdaq market has posed a bigger competitive challenge to the NYSE. Its share of trading volume in NYSE-listed firms increased from 2.5% in 1983 to 8% in 1999. Moreover, many large firms that would be eligible to list their shares on the NYSE now choose to list their shares on Nasdaq.

20. McGraw-Hill/Irwin 3-20 Organization of Secondary Markets Third market: The third market was used to describe the trades of listed securities in the OTC market. The restriction of the organized security market led brokerage firms that were not members of the NYSE, and so not bound by its rules, to establish trading in the OTC market on large NYSE-listed firms. Trading of listed securities away from the exchange. Institutional market: to facilitate trades of larger blocks of securities. Involves services of dealers and brokers

21. McGraw-Hill/Irwin 3-21 Organization of Secondary Markets Fourth market: The fourth market refers to direct trading between investors in exchange-listed securities without benefit of a broker. The direct trading among investors that characterized the fourth market has exploded in recent years due to the advent of the electronic communication network, or ECN. The portion of trades taking place over ECNs will only grow in the future. The advent of ECNs is putting increasing pressure on the NYSE to respond. Institutions trading directly with institutions No middleman involved in the transaction Organized information and trading systems ECN Development

22. McGraw-Hill/Irwin 3-22 Organized Exchanges Auction markets with centralized order flow. Dealership function: can be competitive or assigned by the exchange (Specialists). Securities: stock, futures contracts, options, and to a lesser extent, bonds. Examples: NYSE, AMEX, Regionals, CBOE.

23. McGraw-Hill/Irwin 3-23 OTC Market Dealer market without centralized order flow. NASDAQ: largest organized stock market for OTC trading; information system for individuals, brokers and dealers. Securities: stocks, bonds and some derivatives. -Most secondary bonds transactions

24. McGraw-Hill/Irwin 3-24 International Market Structures London Stock Exchange: The London Stock Exchange is similar to our NASDAQ featuring competitive market making. The London Stock Exchange is attractive to some traders because it offers greater anonymity than U.S. market, primarily because records of trades are not published for a period of the time until after they are completed. This anonymity can be quite attractive to institutional traders that wish to buy or sell large quantities of stock over a period of time. -Dealer market similar to NASDAQ -Stock Exchange Automated Quotation -Greater Anonymity

25. McGraw-Hill/Irwin 3-25 International Market Structures Tokyo Stock Exchange: The Tokyo Stock Exchange does not have a specialist or dealer market making system. The Satori provides a bookkeeping role similar to the specialist on the New York Stock Exchange but the Satori will not step in and trade to eliminate any trading imbalances. -No market making service -Sartori provides bookkeeping service -Feature a floor and electronic trading Global Market Alliances: In recent years many national markets are forming alliances with other national markets leading to a truly global market place.

26. McGraw-Hill/Irwin 3-26 Costs of Trading 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

27. McGraw-Hill/Irwin 3-27 Types of Orders Instructions to the brokers on how to complete the order Market:Market orders are simply buy or sell orders that are to be executed immediately at current market prices. It may have to pay a slightly higher price than the quoted asked price when the investor wishes to purchase a large shares. Limit:With a limit order, price is the first priority. Investors may also place limit orders, whereby they specify prices at which they are willing to buy or sell a security. If the stock falls bellow the limit on a limit-buy order then the trade is to be executed. Correspondingly, a limit-sell order instructs the broker to sell as soon as the stock price goes above the specified limit. Stop loss:With a stop loss, price is the signal to change the trade priority from price to time. 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. Symmetrically, stop-buy orders specify that the stock should be bought when its price rises above a given limit. These traders often accompany short sales, and they are used to limit potential losses from the short posotion.

28. McGraw-Hill/Irwin 3-28 When purchasing securities, investors have easy access to a source of debt financing called brokers’ call loans. The act of taking advantage of brokers’ call loans is called buying on margin. The use of actual borrowing of funds contrasts with margin arrangement in futures. While both futures and stock trading have maintenance margins and margin calls which are similar, the costs of borrowed funds must be factored into analysis of the returns of stock margin trading. The degree of leverage available in equities is set by the Federal Reserve Board and is far less than is available in futures. The percentage margin is defined as the ratio of the net worth, or “equity value” of the account to the market value of the securities. But the value of the stock may be 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 requiring the investor to add new cash or securities to the margin account. If the investor does not act, the broker may sell the securities from the account to pay off enough of the loan to restore the percentage margin to an acceptable level. Margin Trading

29. McGraw-Hill/Irwin 3-29 Margin Trading Characteristics: Using only a portion of the proceeds for an investment. Borrow remaining component. Margin arrangements differ for stocks and futures.

30. McGraw-Hill/Irwin 3-30 A sample margin trade is used to develop the concepts of margin call and maintenance margin. Maximum margin -Currently 50% -Set by the Fed Maintenance margin -Minimum level the equity margin can be Margin call -Call for more equity funds Stock Margin Trading

31. McGraw-Hill/Irwin 3-31 X Corp$70 50%Initial Margin 40%Maintenance Margin 1000Shares Purchased Initial Position Stock $70,000 Borrowed $35,000 Equity $35,000 Margin Trading - Initial Conditions (A sample )

32. McGraw-Hill/Irwin 3-32 Margin Trading - Maintenance Margin (A sample ) Stock price falls to $60 per share New Position Stock $60,000 Borrowed $35,000 Equity 25,000 Margin% = $25,000/$60,000 = 41.67%

33. McGraw-Hill/Irwin 3-33 Margin Trading - Margin Call (A sample ) How far can the stock price fall before a margin call? (1000P - $35,000)* / 1000P = 40% P = $58.33 * 1000P - Amount Borrowed = Equity

34. McGraw-Hill/Irwin 3-34 Short Sales A short sale allows investors to profit from a decline in a security’s price. An investor borrows a share of stock from a broker and sells it. Later, the short seller must purchase a share of the same stock in the market in order to replace the share that was borrowed. This is called covering the short position. Exchange rules permit short sales only when the last recorded change in the stock price is positive. Exchange rules require that proceeds from a short sale must be kept on account with the broker. While stock is generally available for short sellers, sometimes short sellers are not able to find additional stock to borrow when stock is called back from loan （ that is when the brokerage firm cannot locate new shares to replace the ones sold ）. If the short seller is not able to find other stock to borrow in that situation, she may be forced to close out her position.

35. McGraw-Hill/Irwin 3-35 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 it was borrowed.

36. McGraw-Hill/Irwin 3-36 Short Sale - Initial Conditions(A sample ) A sample calculation of margin, maintenance margin and margin calls is developed for a short sale : Z Corp100 Shares 50%Initial Margin 30%Maintenance Margin $100Initial Price Sale Proceeds$10,000 Margin & Equity 5,000 Stock Owed 10,000

37. McGraw-Hill/Irwin 3-37 Short Sale - Maintenance Margin (A sample ) 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%

38. McGraw-Hill/Irwin 3-38 Short Sale - Margin Call (A sample ) How much can the stock price rise before a margin call? ($15,000* - 100P) / (100P) = 30% P = $115.38 * Initial margin plus sale proceeds

39. McGraw-Hill/Irwin 3-39 Short Sale - Margin Call (A sample ) Your initial percentage margin is the ratio of the equity in the account to the current value of the shares you have borrowed and eventually must return. The profit equals the decline in the share price times the number of shares sold short. The short sale involves 100 shares of a stock that has an initial price of $100 with the maintenance margin of 30%. The example works through calculation of the margin position when the stock price rises to $110. The amount borrowed and owed is no longer constant with a short sale. The amount owed is actually equal to number of shares shorted time the current price. The amount owed is subtracted from the original sale proceeds plus the customers margin to determine the equity.

40. McGraw-Hill/Irwin 3-40 Regulation of Securities Markets Government Regulation:Trading in securities markets in the United States is regulated under a myriad of laws. The two major laws are the Securities Act of 1933 and the Securities Exchange Act of 1934. Self-Regulation :Much of the securities industry relies on self-regulation. For example, the SEC delegates to secondary exchanges much of the responsibility for day-to-day oversight of trading.

41. McGraw-Hill/Irwin 3-41 Regulation of Securities Markets Circuit Breakers: The circuit breakers were put in place following the market collapse of 1987. Some of the current circuit breakers are as follows: trading halts, collars. The idea behind circuit breakers is that a temporary halt in trading during periods of very high volatility can help mitigate informational problems that might contribute to excessive price swings. Circuit breaker will be switched on if the calling price is 6% more or less than the closing price of the last trading-day and it continues 1miniute.But there is only one circuit breaker happened in one trading- day. Its limit down and limit up are same as the stock market which is 10%. When the future price comes to the limit down or the limit up, the transaction matching will follow the principle of the closing position and the time priority.

42. McGraw-Hill/Irwin 3-42 Regulation of Securities Markets Insider Trading: One of the important restrictions on trading involves insider trading. It is illegal for anyone to transact in securities to profit from inside information. The difficulty is that the definition of insiders can be ambiguous. These ambiguities plague security analysts, whose job is to uncover as much information as possible concerning the firm’s expected prospects. The distinction between legal private information and illegal inside information can be fuzzy. ECNs and Fragmentation: With the development of ECNs and the on-line trading, the SEC is facing addition regulatory challenges. Trading on ECNs fragments order flow. In recent years, several cases of manipulation of information have appeared in the electronic markets.