1. McGraw-Hill/Irwin Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. 3-1 How Securities Are Traded Chapter 3

2. McGraw-Hill/Irwin Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. 3-2 Primary vs. Secondary Security Sales Primary -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.

3. McGraw-Hill/Irwin Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. 3-3 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.

4. McGraw-Hill/Irwin Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. 3-4 Public Offerings Public offerings: registered with the SEC and sale is made to the investing public. -Shelf registration (Rule 415, since 1982) Initial Public Offerings (IPOs) -Evidence of underpricing -Performance

5. McGraw-Hill/Irwin Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. 3-5 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.

6. McGraw-Hill/Irwin Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. 3-6 Organization of Secondary Markets Organized exchanges OTC market Third market Fourth market

7. McGraw-Hill/Irwin Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. 3-7 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.

8. McGraw-Hill/Irwin Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. 3-8 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

9. McGraw-Hill/Irwin Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. 3-9 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

10. McGraw-Hill/Irwin Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. 3-10 Fourth Market Institutions trading directly with institutions No middleman involved in the transaction Organized information and trading systems ECN Development

11. McGraw-Hill/Irwin Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. 3-11 International Market Structures London Stock Exchange -Dealer market similar to NASDAQ -Stock Exchange Automated Quotation -Greater Anonymity Tokyo Stock Exchange -No market making service -Sartori provides bookkeeping service -Feature a floor and electronic trading Global Market Alliances

12. McGraw-Hill/Irwin Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. 3-12 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

13. McGraw-Hill/Irwin Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. 3-13 Types of Orders Instructions to the brokers on how to complete the order Market Limit Stop loss

14. McGraw-Hill/Irwin Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. 3-14 Using only a portion of the proceeds for an investment. Borrow remaining component. Margin arrangements differ for stocks and futures. Margin Trading

15. McGraw-Hill/Irwin Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. 3-15 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

16. McGraw-Hill/Irwin Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. 3-16 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

17. McGraw-Hill/Irwin Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. 3-17 Margin Trading - Maintenance 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%

18. McGraw-Hill/Irwin Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. 3-18 Margin Trading - Margin Call How far can the stock price fall before a margin call? (1000P - $35,000)* / 1000P = 40% P = $58.33 * 1000P - Amount Borrowed = Equity

19. McGraw-Hill/Irwin Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. 3-19 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.

20. McGraw-Hill/Irwin Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. 3-20 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

21. McGraw-Hill/Irwin Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. 3-21 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%

22. McGraw-Hill/Irwin Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. 3-22 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

23. McGraw-Hill/Irwin Copyright © 2001 by The McGraw-Hill Companies, Inc. All rights reserved. 3-23 Regulation of Securities Markets Government Regulation Self-Regulation Circuit Breakers Insider Trading ECNs and Fragmentation