1. 3-1 FIN 200Investments CHAPTER 3 How Securities are Traded

2. 3-2 Figure 3.1 Relationship Among a Firm Issuing Securities, the Underwriters and the Public.

3. 3-3 How Firms Issue Securities  Initial Public Offerings (IPOs)  Investment Banking  Shelf Registration  Private Placements

4. 3-4 How Firms Issue Securities IPO = Initial Public Offering  Stocks issued by a company that has been privately owned until the sale of their shares.  Why would a company sell shares of their company and go public?  New issues of stocks or bonds marketed (sold) by investment bankers on Primary Markets.

5. 3-5 Seasoned Equity Offerings (All Equities)  Offerings of equity by companies that are already publicly owned. Why would a company that is already publicly owned, 1. Sell more shares in their company? 2. Expect that people will buy their shares?

6. 3-6 Bond Markets  Public Offering  Sold to the general investing public that can be traded on secondary markets.  Private Placement  Sold to institutional investors and usually held to maturity.

7. 3-7 The issuer (business firm) receives the proceeds (money) from the sale. Secondary Markets  Existing owner sells to another person.  Issuing firm doesn’t receive proceeds and is not directly involved

8. 3-8 Secondary Markets  Existing owner sells to another person.  Issuing firm doesn’t receive proceeds and is not directly involved.  What future relationship will the issuing firm have with the person who purchased the equity on the secondary market?  Trading in the secondary market is the changing of ownership.

9. 3-9 The role of Investment Banks UNDERWRITERS  Public Offerings are marketed and sold by investment bankers.  A team of investment bankers is usually needed to do the job.

10. 3-10 Investment Bankers advise the issuer about how to best sell their securities  Prospects for the resale values  Complete the registration paperwork with the Securities exchange Commission (SEC) which promises that they will not attempt to sell until permission is granted.  Known as a red herring and printed in red.  When approved by the SEC, the approval is known as a Prospectus and information can be shared with the public.

11. 3-11 Usual Practise The underwriter (investment bank) purchases the securities for one price and resells them to the pubic for a higher price. Their profit (commission). The profit to the underwriter is known as the firm commitment.

12. 3-12 Shelf Registrations  SEC Rule 415  Introduced in 1982  Ready to be issued – on the shelf Allows firms to register their securities and gradually sell them to the public for up to 2 years following initial registration.  The benefits of shelf registration include  Do not have to release all the equity at one time  Only have to service the debt or commitment when the money is being used  Minimal paperwork and low cost incurred when it is time to sell (float more securities

13. 3-13 Concept Check 1  Why does it make sense for shelf registration to be limited in time?  Limited time shelf registration was introduced because of its favorable trade-off of saving issue cost against mandated disclosure. Allowing unlimited shelf registration would circumvent “blue sky” laws that ensure proper disclosure as financial circumstances of the firm change over time.

14. 3-14  Sale to a limited number of large institutional investors not requiring the protection of registration  Less expensive because the fewer SEC registration requirements = lower cost = better value Private Placements do not trade on Secondary Markets Name an investor that would be willing to buy private placements.  This reduces their liquidity (WHY?)  Reduces the price that investors are willing to pay (WHY?) Private Placements versus public offering

15. 3-15 Initial Public Offerings Process –Road shows –Bookbuilding Underpricing –Post sale returns –Cost to the issuing firm

16. 3-16 IPO – The Process The SEC commented on the registration so that the public can see if there are any concerns. A Preliminary Prospectus is distributed. Prospectus = the companies prospects (the good things about the company, the challenges in their market, the economy, etc.) Investment bankers begin to tour the country (Road Show) to publicize (market) the offering. 1

17. 3-17 The purpose of the Road Show a.Generate interest among potential investors and share information about the offering (pre- sell). b.Allows the Lead Underwriter to gather information from the people they meet and share it with I.the issuing firm II.partner underwriters

18. 3-18  Underwriters collect the names of those interested in buying, in a book. The term Book or Bookbuilding refers to the list of people who will be called back when the security goes on sale.  Institutional investors provide valuable information to investment bankers and underwriters, about a. Current market demand and value of the security. b. Competition from other firms in the same industry as the issuer.

19. 3-19 Based on the road-show discussions with the investing community it is common for the investment bankers to  revise their original estimates of the offering price, and  number of shares to be offered

20. 3-20 The success of relationships is based on trust Truth is the best policy The markets are built on trust  Why do investors truthfully reveal their interest in an offering to an investment banker?  If they pretend to be less interested, maybe the purchase price will be less.  If the purchase price is less, maybe the profit will be less. 1

21. 3-21  If they are a team and work together, they can create a win-win situation.  When shares are sold, the decision on how many shares to issue is based on the information gathered from prospective investors.  If the information is not good, they may issue to few shares.  Therefore, if investors are optimistic, the security will be offered in the quantity that is most profitable for everyone involved.

22. 3-22  Underwriters (investment bankers) therefore must offer the security at a lower price to their prospective investors who will  have their name added to the book  tell others about the offering  IPOs are often underpriced to encourage investors to buy in early.  Prices sometimes increase significantly when they are first publicly traded.

23. 3-23 Textbook example. Page 56-57 VA Linux (software).  Linux was priced at $30 per share in the IPO.  At closing on the first day of public trading, the price was $239.25.  Historically, IPO expenses are approximately 7% of the total funds raised.  If the shares would have been priced at $239.25, the company would have raised 8X as much money.  Within 1 year the share price was $9 and 2 years later was less than $1.

24. 3-24  The difference between the $30 per share and the $239 per share is known as “the money left on the table”. This example is very uncommon. Reminder. Under-pricing is necessary, but requires careful evaluation.

25. 3-25 Figure 3.2 Average Initial Returns for IPOs in Various Countries  Why do you think that the five countries on the far right have much higher first day returns?  Institutional investors purchase the bulk of newly issued stock, which some people consider unfair. If there were no discounts offered to the institutional investors, what would be their motivation for providing accurate information about a fair value and market competition? The discounts are their payment for the most reliable information available, which can lead to future profits by everybody.

26. 3-26 Risks and Abuse  Scandals in 2002 revealed that some IPOs were very underpriced.  Known as “spinning”, and sold by investment bankers to other business people (like a kickback), with the promise of future investment banking services between the two.  Not all IPOs are underpriced.  Some stock is valued at less than the IPO price within days.  Others can not be fully sold off and underwriters must sell them for a loss.

27. 3-27 How Securities are Traded Types of Markets Direct search  Least organized Brokered  Trading in a good is active Dealer  Trading in a particular type of asset increases Auction  Most integrated

28. 3-28 Direct Search Markets - Least organized  Buyers and sellers must look for each other.  Sporadic participation – only when needed  Used goods (refrigerators, fish tanks, cars, motorcycles, hockey equipment, stereos. Name some things that you might want to buy used instead of new.  Tao Bao, Kijiji, Craig’s List, E-Bay, etc.

29. 3-29 Brokered Markets – Trading is active  Trading is active  Search services are beneficial to the buyer and the seller Real Estate  Payment (commission) is sometimes a percentage of the sale  Specialized knowledge on valuation, risks, resale, legalities, etc is required

30. 3-30 Dealer Markets – are created by need, when trading volume in a particular type of asset increases Dealers of coins, rare books, stamps, stocks and bonds. Profit = the spread (difference) between the price the dealer buys it “bid” and the price sell price “ask” is the profit. OTC – Over the Counter Securities Markets is one example of a financial brokered market

31. 3-31 Auction Markets - The most integrated  Traders come to the market to do their trading  Physically or electronically to buy or sell  Toronto Stock Exchange (TSE) and New York Stock Exchange (NYSE) are examples  Sales are continuous (non-stop) as opposed to the sale of art work  The cost of this market is expensive and is therefore limited to equities that are traded in great volume

32. 3-32 Concept Check 2: Page 59. What is the answer?

33. 3-33 Types of Orders Market — executed immediately at the current market price Bid – Ask = Stockbroker’s quotation = ‘bid’ refers to the highest price the buyer wants to pay, and ‘ask’ refers to the lowest price the seller will accept. The difference between the two prices is called a bid and asked spread. Bid Price: $90.00 if I sell it, this is what I get Ask Price: $90.05 if I buy it, this is what I pay Bid – Ask Spread =.05

34. 3-34 Potential Complications  The quotes are a commitment to trade up to a previously agreed amount.  If the order is for more shares than the commitment, they buyer will have to find other sellers and may have to pay a different price.  If another buyer gets to this quote before we do, our order will be executed at a worse price.  The price may change before our order arrives, so the execution price will be different.

35. 3-35 Types of Orders Price-contingent –Investors specify prices –Stop orders

36. 3-36 Types of Orders Market—executed immediately at the current market price Example: Bid Price: $90.00 if I sell it, this is what I get Ask Price: $90.05 if I buy it, this is what I pay Price-contingent –Investors specify prices –Stop orders

37. 3-37 Figure 3.4 The Limit Order Book for Intel on the Archipelago Market, January 19, 2007

38. 3-38 Figure 3.5 Price-Contingent Orders

39. 3-39 Trading Mechanisms Dealer markets Electronic communication networks (ECNs) Specialists markets

40. 3-40 U.S. Security Markets Nasdaq and NYSE have evolved in response to new information technology Both have increased their commitment to automated electronic trading

41. 3-41 Nasdaq National Market System Nasdaq Small Cap Market Levels of subscribers –Level 1 – inside quotes –Level 2 – receives all quotes but they can’t enter quotes –Level 3 – dealers making markets

42. 3-42 Table 3.1 Partial Requirements for Listing on NASDAQ Markets

43. 3-43 New York Stock Exchange Member functions –Commission brokers –Floor brokers –Specialists Block houses SuperDot

44. 3-44 Table 3.2 Some Initial Listing Requirements for the NYSE

45. 3-45 Table 3.3 Block Transactions on the New York Stock Exchange

46. 3-46 Other Systems Electronic Communication Networks –Private computer networks that directly link buyers with sellers National Market System –Securities Act of Amendments of 1975 Bond Trading –Automated Bond System (ABS)

47. 3-47 Market Structure in Other Countries London - predominately electronic trading Euronext – market formed by combination of the Paris, Amsterdam and Brussels exchanges Tokyo Stock Exchange Globalization and consolidation of stock markets

48. 3-48 Figure 3.6 Market Capitalization of Major World Stock Exchanges, 2007

49. 3-49 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

50. 3-50 Buying on Margin Using only a portion of the proceeds for an investment Borrow remaining component Margin arrangements differ for stocks and futures

51. 3-51 Stock Margin Trading 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 that you must put up additional funds

52. 3-52 Margin Trading - Initial Conditions Example 3.1 X Corp$100 60%Initial Margin 40%Maintenance Margin 100Shares Purchased Initial Position Stock $10,000 Borrowed $4,000 Equity $6,000

53. 3-53 Margin Trading - Maintenance Margin Example 3.1 Stock price falls to $70 per share New Position Stock $7,000 Borrowed $4,000 Equity $3,000 Margin% = $3,000/$7,000 = 43%

54. 3-54 Margin Trading - Margin Call Example 3.2 How far can the stock price fall before a margin call? (100P - $4,000) * / 100P = 30% P = $57.14 * 100P - Amt Borrowed = Equity

55. 3-55 Table 3.4 Illustration of Buying Stock on Margin

56. 3-56 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 is was borrowed

57. 3-57 Short Sale – Initial Conditions Example 3.3 Dot Bomb1,000 Shares 50%Initial Margin 30%Maintenance Margin $100Initial Price Sale Proceeds$100,000 Margin & Equity 50,000 Stock Owed 100,000

58. 3-58 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 % (4000/11,000) 36%

59. 3-59 Short Sale - Margin Call How much can the stock price rise before a margin call? ($150,000 * - 1000P) / (100P) = 30% P = $115.38 * Initial margin plus sale proceeds

60. 3-60 Regulation of Securities Markets Major regulations –Securities Act of 1933 –Securities Act of 1934 –Securities Investor Protection Act of 1970 Self-Regulation –Stock markets are largely self-regulating

61. 3-61 Regulation Securities Markets Continued Regulatory Responses to Recent Scandals –Public Company Accounting Oversight Board –Financial experts to serve on audit committees of boards of directors –CEOs and CFOs personally certify firms’ financial reports –Boards must have independent directors –Sarbanes-Oxley Act

62. 3-62 Circuit Breakers Trading halts Collars

63. 3-63 Insider Trading Officers, directors, major stockholders must report all transactions in firm’s stock Insiders do exploit their knowledge Leakage of useful information to some traders