1. FINA 2802: Investments and Portfolio Analysis Securities Markets Dragon Yongjun Tang January 21 & 23, 2010

2. Lecture 4 & 5: Securities Markets
Reading: Chapter 3
Practice Problem Sets: 1,2,3,4,6,7,8,9,10,12,13,14,18,20,21

3. 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

4. Life Cycle of a Company Private (Entrepreneur + VC) Primary Commission
Investment Bank
Public
(NYSE/Nasdaq)
Secondary
Dealer
Market Maker
Buy on Margin
Sell Short
Broker
Bid-ask Spread
Buy
Commission
Commission
Sell

5. How Firms Issue Securities
Primary Market:
Initial Public Offering (IPO)
Seasoned Equity Offering (SEO)
Investment Bankers:
Assist firms in issuing securities
Firm Commitment (Take a risk in underwriting)
Best efforts (issuer bears the risk of not placement)

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

7. Figure 3.2 A Tombstone Advertisement

8. Shelf Registration SEC Rule 415
Allows firms to register securities and sell them gradually to the public for two years.

9. Private Placements
Firms sell shares directly to a small group of institutional or wealthy investors
Cheaper: No need to register to SEC (Rule 144A)
Smaller offerings

10. Initial Public Offering (IPO)
Road shows, bookbuilding
Cost: commissions (7%) + underpricing
Investment bankers tend to underprice new issues
IPO prices tend to rise after IPO (“Money left on the table”)
IPO are usually poor long-term investments
Internet Auction

11. IPO Underpricing: A dramatic example (VA Linux)
IPO price: $30
First day closing price: $239.25
Today’s price: $1.00
Replicate this picture using finance.yahoo.com (LNUX)
Day's Range:
52wk Range:
0.32 – 2.18
Volume:
28,795
Avg Vol (3m):
270,871
Market Cap:
64.31M
P/E (ttm):
N/A
EPS (ttm):
-0.055
Div & Yield:
N/A (N/A)
Last Trade:
1.0025
1y Target Est:
1.59

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

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

14. Where Securities Are Traded
Secondary Market
Organized exchanges
NYSE (or the Big Board); AMEX; regional exchanges
Over the counter (OTC)
Nasdaq: market makers; three levels
Bond trading
Directly between the two parties
Electronic Communication Networks (ECN)

15. National Market System
Established by Exchange Act of 1975
Intent was to link firms electronically
Resulted in Consolidated Tape

16. Bond Trading
Major concern: Liquidity
Automated Bond System (ABS)
OTC market

17. Trading on Exchanges The participants: Investors
Brokerage firms (owns a “seat” on the exchange)
Commission brokers
Floor brokers

18. Trading on Exchanges The specialist (or market maker): Makes a market
The brokers’ broker
Maintains the limit order book
Maintains a fair and orderly market
NYSE is an example

19. New York Stock Exchange (NYSE)

20. Trading on Exchanges Types of orders: Market Limit Day
Good-till-canceled
Stop-loss orders; stop-buy orders

21. Figure 3.5 Limit Order Book for Intel on Archipelago

22. Figure 3.6 Price-Contingent Orders

23. Trading on Exchanges Block orders - at least 10,000 shares
DOT & SuperDOT - direct to specialist
Settlement – three business days
Shares “In Street Name”. Shares kept
by the broker after a transaction

24. Trading on OTC Markets Negotiated market No specialist
NASDAQ computer system

25. Nasdaq

26. Market Structures in Other Countries
London - predominately electronic trading
Euronext – market formed by combination of the Paris, Amsterdam and Brussels exchanges
Tokyo Stock Exchange
Hong Kong Stock Exchange
Shanghai Stock Exchange

27. Cost of Trading Broker’s commissions: “Hidden” costs: Explicit
Bid-Ask Spread
Price Concession

28. Cost of Trading
Impact of trading costs on returns

29. Cost of Trading
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)?

30. Placing an Order Should you use a full-service or a discount broker?
What is the value of the full-service broker’s advice?
Research indicates that full-service brokers do not earn investors any higher returns than what they can make on their own.
Discretionary accounts allow the broker to make the buy and sell decisions without contacting the investor.
Churning the account is trading securities excessively with the sole purpose of generating commissions.

31. Student Loan You think your value will go up
You want to make the most out of it
So you borrow money to finance education

32. Buying on Margin
Borrow to buy securities (make use of the Broker call’s loan)
Securities stay with the broker as collateral

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

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

35. Buying on Margin
The Federal Reserve System sets minimum initial margin requirements currently 50%
All exchanges set a minimum maintenance margin requirement currently around 30%

36. 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?

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

38. 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

39. 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

40. 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?

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

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

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

44. Problem 3, Chapter 3 (p. 93)
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

45. Problem 7, Chapter 3 (p. 94)
You are bullish on Telecom stock. The current market price is $50 per share, and you have $5,000 of your own to invest. You borrow an additional $5,000 from your broker at an interest rate of 8% per year and invest $10,000 in the stock.
a. What will be your rate of return if the price of Telecom stock goes up by 10% during the next year? (Ignore the expected dividend.)
b. How far does the price of Telecom stock have to fall for you to get a margin call if the maintenance margin is 30% of the value of the short position? Assume the price all happens immediately.

46. Why buy on margin?
Borrowing magnifies ROE (risky strategy)

47. Leverage and ROE
ROE

48. 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

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

50. Short Sales

51. 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?

52. 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?

53. Short Sales-Initial Margin
Investor’s account at time 0:
Assets Liabilities
Value of stocks sold Value of Stocks owed
Initial Margin (E0) Equity (Current Margin)
Percentage Initial Margin=
As time elapses, the value of stocks owed changes, affecting the %Margin!

54. Short Sales-Margin Investor’s account at time t: Assets Liabilities
Value of stocks sold Value of Stocks owed
Initial Margin (E0) DIVIDENDS DUE
Equity (Et=Current Margin)
Percentage Margin=
As time elapses, the value of stocks owed changes, affecting the %Margin!

55. Short Sales -Margin
How high can the price of stock go before a margin call is issued?
Actual margin=
We want actual margin > required margin.
Solve for

56. Short Sales
Margin call price:

57. 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?

58. 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

59. 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) %

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

61. Problem 4, Chapter 3 (p. 93)
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?

62. Problem 8, Chapter 3 (p. 94)
You are bearish on Telecom and decide to sell short 100 shares at the current market price of $50 per share.
a. How much in cash or securities must you put into your brokerage account if the broker’s initial margin requirement is 50% of the value of the short position?
b. How high can the price of the stock go before you get a margin call if the maintenance margin is 30% of the value of the short position?

63. Regulations of Securities Markets
Securities Act of 1933
Securities Exchange Act of 1934
Securities Investor Protection Act of 1970
Blue Sky Laws
Circuit Breakers
Main Concern: Insider Trading
Trading scandals and reactions: Sarbanes-Oxley Act
The Securities Act of 1933 requires full disclosure of relevant information relating to the issue of new securities. This act requires registration of new securities and a prospectus.
The Securities Exchange Act of 1934 established the Securities and Exchange Commission (SEC) to administer the provisions of the 1933 Act. Also, empowered the SEC to register and regulate securities exchanges, OTC trading, brokers and dealers.
The Securities Investor Protection Act of 1970 established the Securities Investor Protection Corporation (SIPC). Protection of investor from Broker’s failures
Blue Sky laws are state laws regulating securities trading in a state.
Circuit breakers halt trading for one hour when the DJIA falls 250 points from the previous day’s close; trading is stopped for two hours if the drop is 400 points. Market participants are thus able to evaluate their positions while prices are frozen. These trading restrictions were suggested as a result of the stock market crash of October 19, Also, the SuperDOT systems shuts down if the DJIA moves up or down 50 points ion one day making it difficult to engage in program trading.

64. Summary Issuing securities Trading Buying on margin and short sales
Next class: Mutual Funds