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 MARKET SECONDARY MARKET -firstly issued securities are traded - Issuers raise new capital -existing securites are traded - Issuers do not raise new capital

4. 3-4 IPOs Initial Public Offerings (IPOs): Selling stock to the public for the first time. Stocks are issued by a formerly privately owned company (Investment Banking)

5. 3-5 IPOs 1. Go to the brokerage firm 2. Investigation 3. Visit the company 4. Prepare proposal and suggest a price band. 5. Issue prospectus on financial times or other newspapers.

6. 3-6 How Securities Are Issued Investment Banking: Public offerings of both stocks and bonds are marketed by investment bankers. Primary market activities can be divided into two as best effort selling and underwriting activities. Best Effort Selling: Investment banking firm does not buy the entire issue from the issuer but agrees to use its expertise to sell the securities.

7. 3-7 IPOs Underwriting: Underwriters purchase the securities from the issuer and promises to sell them at a specified price during the determined period. –Stand-by Underwriting –Firm Commitment (Bought Deal) Underwriting discount (fee) Underwriting Syndicate

8. 3-8 Figure 3.1 Relationship Among a Firm Issuing Securities, the Underwriters and the Public

9. 3-9 Figure 3.2 A Tombstone Advertisement

10. 3-10 Private placement: Primary offerings in which shares are sold directly to a small group of institutional or wealthy investors. Dominated by institutions Very active market for debt securities Not active for stock offerings Private Placements

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: The least orginized market. Buyers and sellers must seek each other out directly. Brokered: In markets where trading in a good is active, brokers find it profitable to effer search services to buyers and sellers (real estate market) Dealer: Markets in which traders specializing in particukar assets buy and sell for their own accounts (Over the Counter-OTC Market). Auction: Market where all traders meet at one place to buy and sell an asset (NYSE)

15. 3-15 Types of Orders Marke orders: buy and sell orders that are to be executed immediately at current market prices. –Bid Price –Ask Price –Bid-Ask Spread Price-contingent orders –Limit buy (sell) order: An order specifiying a price at which they are willing to buy or sell. –Stop orders: Trade is not to be executed unless stock hits a price limit. –For stop-loss orders, the stock is to be sold if its price falls below a specified level. –For stop-buy orders, a stock should be bought when its price rises above a limit.

16. 3-16 Figure 3.5 Limit Order Book for Intel on Archipelago

17. 3-17 Figure 3.6 Price-Contingent Orders

18. 3-18 Trading Mechanisms Dealer markets (OTC market): An informal network of brokers and dealers who negotiate sales of scurities. Electronic communication networks (ECNs): Computer networks that allow direct trading without the need for market makers. Specialists markets: A trader who makes a market in the shares of one or more firms and who maintains a fair and orderly market” by dealing personaly in the market.

19. 3-19 3.3 U.S. SECURITIES MARKETS

20. 3-20 Nasdaq Nasdaq stock market: The computer- linked priced quotation system for the OTC market.

21. 3-21 New York Stock Exchange Stock exchanges: Secondary markets where already-issued securities are bought and sold by members. NYSE: –Largest exchange in the U.S. –Automated for small orders –Floor brokers for large orders –Specialists

22. 3-22 New York Stock Exchange Now a publicly held company Block sales: Large transactions in which at least 10,000 shares of stock are bought and sold. SuperDot: Electronic ordering system Bond Trading –2006 NYSE obtained approval to expand bond trading –However, the vast majority of bond trading occurs in the OTC market among bond dealers.

23. 3-23 Other Exchanges and Trading Systems American Stock Exchange (AMEX) Regionals Electronic Communication Networks (ECNs) National Market System

24. 3-24 3.4 MARKET STRUCTURE IN OTHER COUNTRIES

25. 3-25 Other Countries London - predominately electronic trading Euronext – market formed by combination of the Paris, Amsterdam and Brussels exchanges Tokyo Stock Exchange

26. 3-26 Figure 3.7 Market Capitalization of Listed Firms, 2005

27. 3-27 3.5 TRADING COSTS

28. 3-28 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

29. 3-29 3.6 BUYING ON MARGIN

30. 3-30 Buying on Margin is the use of credit to purchase securities You can borrow up to 50% of the stock value. marginable securities by using your own assets as collateral. (Initial Margin) Benefits; –Increase the purchaing power of the investors. Risks associated with margin borrowing; –The value of the securities you deposited or purchased on margin may decrease. –If the equity in your account falls below the min maintenance level (maintanence margin), a margin call will exist. –If the margin call occurs, you will be required to increase the equity up to the min. maintenance levels by immediately deposited additional funds or marginable securities.

31. 3-31 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

32. 3-32 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%

33. 3-33 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

34. 3-34 3.7 SHORT SALES

35. 3-35 Short Sales Sale of the borrowed securities that are not owned. Sale of the borrowed securities that are not owned. It is required from the customers to deposit at least 50% of the deal for short-selling in cash or in securities. 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

36. 3-36 Short Sale - Initial Conditions Z Corp100 Shares 50%Initial Margin 30%Maintenance Margin $100Initial Price Sale Proceeds$10,000 Margin & Equity 5,000 Stock Owed 10,000

37. 3-37 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%

38. 3-38 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

39. 3-39 3.8 REGULATION OF SECURITIES MARKETS

40. 3-40 Self-Regulation National Association of Securities Dealers (NASD) –Oversees participants in the Nasdaq market NYSE has its own regulatory arm