1. Essentials of Investments © 2001 The McGraw-Hill Companies, Inc. All rights reserved. Fourth Edition Irwin / McGraw-Hill Bodie Kane Marcus 1 Chapter 3 How Securities are Traded

2. Essentials of Investments © 2001 The McGraw-Hill Companies, Inc. All rights reserved. Fourth Edition Irwin / McGraw-Hill Bodie Kane Marcus 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. Essentials of Investments © 2001 The McGraw-Hill Companies, Inc. All rights reserved. Fourth Edition Irwin / McGraw-Hill Bodie Kane Marcus 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. Essentials of Investments © 2001 The McGraw-Hill Companies, Inc. All rights reserved. Fourth Edition Irwin / McGraw-Hill Bodie Kane Marcus 4 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 Public Offerings

5. Essentials of Investments © 2001 The McGraw-Hill Companies, Inc. All rights reserved. Fourth Edition Irwin / McGraw-Hill Bodie Kane Marcus 5 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 Private Placements

6. Essentials of Investments © 2001 The McGraw-Hill Companies, Inc. All rights reserved. Fourth Edition Irwin / McGraw-Hill Bodie Kane Marcus 6 Organization of Secondary Markets Organized exchanges OTC market Third market Fourth market

7. Essentials of Investments © 2001 The McGraw-Hill Companies, Inc. All rights reserved. Fourth Edition Irwin / McGraw-Hill Bodie Kane Marcus 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. Essentials of Investments © 2001 The McGraw-Hill Companies, Inc. All rights reserved. Fourth Edition Irwin / McGraw-Hill Bodie Kane Marcus 8 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 bonds transactions

9. Essentials of Investments © 2001 The McGraw-Hill Companies, Inc. All rights reserved. Fourth Edition Irwin / McGraw-Hill Bodie Kane Marcus 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. Essentials of Investments © 2001 The McGraw-Hill Companies, Inc. All rights reserved. Fourth Edition Irwin / McGraw-Hill Bodie Kane Marcus 10 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. Essentials of Investments © 2001 The McGraw-Hill Companies, Inc. All rights reserved. Fourth Edition Irwin / McGraw-Hill Bodie Kane Marcus 11 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. Essentials of Investments © 2001 The McGraw-Hill Companies, Inc. All rights reserved. Fourth Edition Irwin / McGraw-Hill Bodie Kane Marcus 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. Essentials of Investments © 2001 The McGraw-Hill Companies, Inc. All rights reserved. Fourth Edition Irwin / McGraw-Hill Bodie Kane Marcus 13 Types of Orders Instructions to the brokers on how to complete the order Market Limit Stop loss

14. Essentials of Investments © 2001 The McGraw-Hill Companies, Inc. All rights reserved. Fourth Edition Irwin / McGraw-Hill Bodie Kane Marcus 14 Margin Trading Using only a portion of the proceeds for an investment Borrow remaining component Margin arrangements differ for stocks and futures

15. Essentials of Investments © 2001 The McGraw-Hill Companies, Inc. All rights reserved. Fourth Edition Irwin / McGraw-Hill Bodie Kane Marcus 15 Stock Margin Trading Maximum margin is currently 50%; you can borrow up to 50% of the stock value Set by the Fed Maintenance margin: minimum amount equity in trading can be before additional funds must be put into the account Margin call: notification from broker you must put up additional funds

16. Essentials of Investments © 2001 The McGraw-Hill Companies, Inc. All rights reserved. Fourth Edition Irwin / McGraw-Hill Bodie Kane Marcus 16 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. Essentials of Investments © 2001 The McGraw-Hill Companies, Inc. All rights reserved. Fourth Edition Irwin / McGraw-Hill Bodie Kane Marcus 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. Essentials of Investments © 2001 The McGraw-Hill Companies, Inc. All rights reserved. Fourth Edition Irwin / McGraw-Hill Bodie Kane Marcus 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 - Amt Borrowed = Equity

19. Essentials of Investments © 2001 The McGraw-Hill Companies, Inc. All rights reserved. Fourth Edition Irwin / McGraw-Hill Bodie Kane Marcus 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 is was borrowed

20. Essentials of Investments © 2001 The McGraw-Hill Companies, Inc. All rights reserved. Fourth Edition Irwin / McGraw-Hill Bodie Kane Marcus 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. Essentials of Investments © 2001 The McGraw-Hill Companies, Inc. All rights reserved. Fourth Edition Irwin / McGraw-Hill Bodie Kane Marcus 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. Essentials of Investments © 2001 The McGraw-Hill Companies, Inc. All rights reserved. Fourth Edition Irwin / McGraw-Hill Bodie Kane Marcus 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