1. Chapter 3 How Securities are Traded

2. McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. Primary vs. Secondary Security Sales Primary Secondary

3. McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. Investment Banking Arrangements Underwritten vs. “Best Efforts” Underwritten: Best Efforts: Negotiated vs. Competitive Bid Negotiated: Competitive bid:

4. McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. Public offerings: registered with the SEC and sale is made to the investing public Shelf registration (Rule 415, since 1982) Initial Public Offerings (IPOs) Public Offerings

5. McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. Private placement: sale to a limited number of sophisticated investors not requiring the protection of registration Allowed under Rule 144A Dominated by institutions Very active market for debt securities Not active for stock offerings Private Placements

6. McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. Organization of Secondary Markets Organized exchanges OTC market Third market Fourth market

7. McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. 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 © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. OTC Market Dealer market without centralized order flow NASDAQ: largest organized stock market for OTC trading; information system for individuals, brokers and dealers National Market System Nasdaq SmallCap Market Lower volume securities OTC Bulletin Board Pink Sheets from NASD Securities: stocks, bonds and some derivatives Most secondary bond transactions

9. McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. 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 © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. Fourth Market Investors trading directly with other investors Originally developed for institutional trading Trading now on ECNs Technological developments leading to individual investors trading directly

11. McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. Electronic Computer Networks (ECNs) Major ECNs Island ECN Instinet REDIBook Archipeligo Competing with Nasdaq and NYSE for volume Leads to some fragmentation of markets

12. McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. 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 © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. Types of Orders Instructions to the brokers on how to complete the order Market Limit Stop loss

14. McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. Margin Trading Using only a portion of the proceeds for an investment Borrow remaining component Margin arrangements differ for stocks and futures

15. McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. Stock Margin Trading Maximum margin is currently 50%; Maintenance margin: Margin call:

16. McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. Margin Trading - Initial Conditions X Corp$70 50%Initial Margin 40%Maintenance Margin 1000Shares Purchased Initial Position Stock $70,000 Borrowed $35,000 Equity 35,000

17. McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. Margin Trading - Maintenance Margin Stock price falls to $60 per share New Position Stock $60,000 Borrowed $35,000 Equity 25,000 Margin% =

18. McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. Margin Trading - Margin Call How far can the stock price fall before a margin call? (1000P - $35,000) * / 1000P = 40% P = * 1000P - Amt Borrowed = Equity

19. McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. Short Sales Purpose: to profit from a decline in the price of a stock or security Mechanics

20. McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. 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

21. McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. 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 %

22. McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. Short Sale - Margin Call How much can the stock price rise before a margin call? ($15,000 * - 100P) / (100P) = 30% P = * Initial margin plus sale proceeds

23. McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. Regulation and Trends in Markets ECNs present new challenges in regulation Global markets with alliances are developing Current Issues with Agency problems associated with investment banking and research Insider trading violations