1. Chapter 3
How Securities are Traded

2. Chapter Summary
Objective: To explain the institutional details and mechanics of investing in securities.
How firms issue securities
Organization of secondary markets
Trading and execution
Margin trading
Costs and regulation

3. Primary vs. Secondary Security Sales
New issue
Key factor: issuer receives the proceeds from the sale
Secondary
Existing owner sells to another party
Issuing firm doesn’t receive proceeds and is not directly involved

4. Investment Banking Arrangements
Underwritten vs. “Best Efforts”
Underwritten: firm commitment on proceeds to the issuing firm
Best Efforts: no firm commitment
Negotiated vs. Competitive Bid
Negotiated: issuing firm negotiates terms with investment banker
Competitive bid: issuer structures the offering and secures bids

5. Public Offerings
Public offerings: registered with the OSC (Ontario - SEC in USA) and sale is made to the investing public
Red herring
Prompt offering prospectus
Initial Public Offerings (IPOs)
Evidence of underpricing
Performance

6. Private Placements
Private placement: sale to a limited number of sophisticated investors not requiring the protection of registration
Dominated by institutions
Very active market for debt securities
Not active for stock offerings

7. Types of Markets Direct search markets Brokered markets
Block transactions
Dealer markets
OTC market
Auction markets
Major exchanges

8. Organization of Secondary Markets
Organized exchanges
OTC market
Third market
Fourth market

9. Organized Exchanges Auction markets with centralized order flow
Dealership function: can be competitive or assigned by the exchange (specialists or registered traders)
Securities: stock, futures contracts, options, and to a lesser extent, bonds
Examples: TSE, ME, NYSE, AMEX

10. OTC Market Dealer market without centralized order flow
NASDAQ: largest organized stock market for OTC trading; information system for individuals, brokers and dealers
Levels of interaction: users, market-makers
Securities: stocks, bonds and derivatives
Most secondary bonds transactions

11. Third Market Trading of listed securities away from the exchange
Institutional market: to facilitate trades of larger blocks of securities
Involves services of dealers and brokers

12. Fourth Market Institutions trading directly with institutions
No middleman involved in the transaction
Organized information and trading systems
INSTINET
POSIT
ECN development

13. The execution of trades
Registered trader (market-maker) functions
Maintaining a “book”
Maintain a “fair and orderly market”
Execute “stabilizing” trades
Registered traders possess valuable inside information about the future direction of the market

14. Types of Orders
Instructions to the brokers on how to complete the order
Market
Limit
Stop loss

15. Summary Reminder
Objective: To explain the institutional details and mechanics of investing in securities.
How firms issue securities
Organization of secondary markets
Trading and execution
Margin trading
Costs and regulation

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

17. Stock Margin Trading Greatest margin Minimum margin Margin call
Currently 30%
Set by the securities commissions
Minimum margin
Minimum level the equity margin can be
(called “maintenance” in USA)
Margin call
Call for more equity funds

18. Margin Trading - Initial Conditions
X Corp $70
50% Initial Margin
30% Minimum Margin
Shares Purchased
Initial Position
Stock $70,000 Borrowed $35,000
Equity $35,000

19. Margin Trading - Minimum Margin
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%

20. Margin Trading - Margin Call
How far can the stock price fall before a margin call?
Therefore, P = $50
Note: 1,000xP – Amount Borrowed = Equity

21. Leveraging effect of margin purchases
You buy 200 shares of XYZ at $100, expecting a 30% appreciation of the stock in one year:
Initial margin: 50%
Financed by a 9% loan for one year
Expected net return: 51%
A 30% drop in the price, though, brings a negative rate of return of -69%.

22. 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
Close out the position: buy the stock and return it to the owner

23. Short Sale - Initial Conditions
Z Corp 100 Shares
50% Initial Margin
30% Minimum Margin
$100 Initial Price
Sale Proceeds $10,000
Margin & Equity $ 5,000
Stock Owed $10,000

24. Short Sale - Minimum Margin
Stock Price Rises to $110
Sale Proceeds $10,000
Initial Margin $ 5,000
Stock Owed $11,000
Net Equity $ 4,000
Margin % (4,000/11,000) = 36%

25. Short Sale - Margin Call
How much can the stock price rise before a margin call?
So, P = $115.38
Note: $15,000 = Initial margin + sale proceeds

26. Summary Reminder
Objective: To explain the institutional details and mechanics of investing in securities.
How firms issue securities
Organization of secondary markets
Trading and execution
Margin trading
Costs and regulation

27. Costs of Trading
Commission: fee paid to broker for making the transaction
Full service broker
Discount broker
Spread: cost of trading with dealer
Bid: price dealer will buy from you
Ask: price dealer will sell to you
Spread: ask - bid
Execution: better price obtained

28. Internet Trading On-line brokers (discount or full-service)
ECNs – electronic communication networks
Pre- and post-market trading (lack of integration, thin trading)

29. Regulation of Securities Markets
Government Regulation
Self-Regulation in the Industry
Circuit Breakers
Insider Trading