1. Chapter 11 Securities Markets © 2010 John Wiley and Sons

2. 2 Chapter Outcomes Describe the processes and institutions used by businesses to distribute new securities to the investing public. n Outline the recent difficulties and changes in structure of the investment banking industry. n Describe how securities are traded among investors. n Identify the regulatory mechanisms by which the securities exchanges and the over-the-counter markets are controlled. Explain influences that affect broker commissions.

3. 3 Issuing Securities: Primary Security Markets n Primary versus secondary securities markets n Initial Public Offerings (IPOs) n Investment Banks

4. 4 Functions of Investments Banks n Three Main Functions: –Origination –Underwriting –Selling n Origination –Public Offering –Private Placement –Prospectus

5. 5 Investment Bank Functions, continued n Underwriting –“Carrying the risk” –Best efforts –Shelf registration –Private placement –Rights offerings –Competitive bids –Dutch auction

6. 6 Dutch Auction Example n Yoogle to offer 100 million shares n Bidder Price Number of shares A$20.5025 million B$20.4725 million C$20.4525 million D$20.4325 million E$20.4025 million n Clearing price: $20.43

7. 7 Investment Bank Functions, continued n Selling –Syndicate –Tombstone Ad –Aftermarket n Underwriting fees in 2009: $59.8 billion n http://www.businessweek.com/news/2010-03-04/jpmorgan-tops-goldman-in-investment-banking-as-fees-swell-13-.html http://www.businessweek.com/news/2010-03-04/jpmorgan-tops-goldman-in-investment-banking-as-fees-swell-13-.html

8. 8 The Costs of Raising Capital n The costs of issuing stocks and bonds are called “flotation costs.” –Out-of-pocket costs –Spread –Underpricing n The sum of these costs can total 20- 30% or more of the funds raised n Hot/cold IPO markets

9. 9 Innovations in Investment Banking n Security design to meet needs of issuers/purchases n Offering securities via internet “dutch auctions”—both stocks and bonds (Internotes, Direct Access Notes)

10. 10 What else do Investment Banks do? n Commercial paper n Mergers and acquisitions n Manage investment funds (e.g., company pension funds)

11. 11 Investment Banking Regulations n Securities Act of 1933 –Full, fair, and accurate disclosure –Prevent fraud n Securities Exchange Act of 1934 –Established SEC –Brokers, dealers register with SEC n State “blue sky” laws

12. 12 Investment Banking Regulations n Glass-Steagall Act –Commercial banks cannot underwrite securities n Gramm-Leach-Bliley Act –Removed many restraints of Glass- Steagall on financial services firms

13. 13 Trading Securities: Secondary Securities Markets n Organized Exchange versus Over-the- Counter (OTC) n Organized Exchange: NYSE n NYSE is a private firm which went “public” in 2006 by acquiring a publicly traded firm (Archipelago) which offers electronic trading of securities

14. 14 Structure of the NYSE n Before 2006: members own “seats” n Now: 1500 trading licenses exist— called Stock Exchange Auction Trading System (SEATS) n SEATS allow holders access to the NYSE trading floor (physical location) and electronic trading access.

15. 15 Structure of the NYSE n Floor brokers –House or commission brokers –Independent brokers n Registered traders n Designated Market Makers –Maintain inventory of stocks assigned to them –Maintain a liquid and orderly market –Took over the role of “specialists” on the NYSE

16. 16 Structure of the NYSE n Companies need to meet listing requirements, pay fees n Original listing fee: $150,000- $250,000 n Annual fee: $35,000-$500,000 depending on number of shares n Listing requirements: http://www.nyse.com/regulation/nyse/1147474807344.html http://www.nyse.com/regulation/nyse/1147474807344.html

17. 17 Security Transactions n Bid price: offered by buyer n Ask: requested by seller n Spread: the difference between them –Narrower spreads imply more liquidity and faster completion of a trade n Typical display: –Bid: 30.42 x 50900 –Ask: 30.43 x 50800

18. 18 Security Transactions n Market order n Limit order n Stop order n Short sale –Uptick rule –19.95 19.95 20.00 20.00 –20.07 20.01 20.01 –Abolished in 2007, on a trial basis; occasionally consider re-instating it for all or some stocks.

19. 19 Buying on Margin n “Buying on margin” means to use some of your money (equity) and some borrowed funds to purchase a security n Margin: investor’s equity position n Margin requirements: minimum percentage of the purchase price that the investor must pay from his/her funds

20. 20 Margin’s effect on trading profits Assume: 60% margin Initially buy securities worth $50,000 Initial position t=1 t=2 Mkt value $50,000 $55,000 $45,000 Less: borrowed funds 20,000 20,000 20,000 Equity $30,000 $35,000 $25,000

21. 21 More investing terms n Margin call n Maintenance margin Margin = equity/market value = (MV - $ borrowed)/MV = (price x # shares - $ borrowed) price x # shares Price for margin call: $ borrowed / [# shares (1-maint. margin)]

22. 22 More terms… n Round lot n Odd lot n Program trading

23. 23 Over-The-Counter Market (OTC) n NASDAQ n Not just for small firms –Intel, Apple, Microsoft n Centralized versus non-centralized location n Specialists versus dealers

24. 24 Other Secondary Markets n Third Market –Large blocks (10,000 shares) traded OTC n Fourth Market –Electronic trading, ECNs

25. 25 Securities Markets and Ethics Issues n In the past, some market makers and specialists have been accused of: –Front running –Negative obligation –Maintaining high spreads

26. 26 What Makes a Good Market? n NYSE, AMEX, NASDAQ, 3 rd and 4 th market all compete for listings, trades n Four characteristics of a “good” market: –Liquidity (breadth and depth) –Quick, accurate trade execution –Reasonable listing requirements –Low costs

27. 27 Commissions Commission affected by: n Type of broker –Full service brokers –Discount brokers –On-line brokers n Size of trade, security price n Liquidity of securities traded n Ethics: –Account churning –Placing funds in high-commission or “fee kickback” products

28. 28 Some issuing firms allow… n Direct investing –Buy shares directly from the firm n Dividend Reinvestment Plan

29. 29 How’s the Market Doing? n Security Market Indexes are used to track overall market and sector performance for stocks, bonds, and other investments n Well-known stock market indexes: –Dow Jones Industrial Average Based on price –Standard & Poor’s (S&P) 500 Based on market value

30. 30 Wandering from Home: Investing Overseas n Diversification benefits n Harder to do trades –Liquidity –Currency differences –Regulations, tax laws n Solutions: –American Depository Receipts –Global Depository Receipts –Mutual funds--professional investing

31. 31 Ethics Issues n Insider trading n An insider: someone with access to important non-public information n can be a corporate officer, investment banker, major shareholder n blue-collar workers, too (e.g., printing press operators)

32. 32 Ethics n Regulation FD n Churning of accounts n Professional designations (CFA®, CFP TM ) have ethics components as a central feature of their certification programs

33. 33 What will the future hold? n Electronic and on-line trading n Technology linking markets together (NYSE, Euronext merger) n Continued globalization

34. 34 Learning Extension 11 Introduction to Futures and Options n What is a derivative security? n Why do they exist? n Future Contracts n Options

35. 35 What is a derivative security? A derivative security has its value determined by, or derived from, the value of another investment vehicle. They represent a contract on an underlying security or asset

36. 36 Why do derivatives exist? n Shift risk from those who don’t want to carry risk to those who are willing to do so. n Bring additional information into the market from hedgers, speculators, market expectations. n Lower commissions and margin requirements than in spot market

37. 37 Futures contracts n A futures contract obligates the owner to purchase the underlying asset at a specified price (the exercise or strike price) on a specified date

38. 38 Types of futures contracts n Corn, wheat, soybeans… n Stock indexes, interest rates, foreign currency values… n Gold, copper, silver, oil… n Coffee, sugar, cocoa...

39. 39 Options An options contract gives the owner the choice of trading the underlying asset at a specified price (the exercise or strike price) on or before a specified date or expiration date.

40. 40 Two basic types of options n Call option: an option to buy the underlying asset at the strike price n Put option: an option to sell the underlying asset at the strike price

41. 41 Call Options n Suppose you buy an option to buy 100 shares of ExxonMobil stock at $75 a share. How much is the option worth if on the expiration date the price of Exxon is: n a) $60 a share? n b) $75 a share? n c) $80 a share?

42. 42 Put Options n Suppose you buy an option to sell 100 shares of ExxonMobil stock at $75 a share. How much is the option worth if on the expiration date the price of Exxon is: n a) $60 a share? n b) $75 a share? n c) $80 a share?

43. 43 Web Links www.openipo.com www.ml.com www.morganstanley.com http://bear.ufl.edu/ritter www.wrhambrecht.com www.witcapital.com www.sec.gov www.labranche.com www.nyse.com www.amex.com www.nasdaq.com www.tse.com www.londonstockexchange.c om www.ftse.com www.tse.or.jp/english/index/s html www.exchange.de www.fibv.com www.instinet.com www.archipelago.com www.schwab.com www.etrade.com www.netstockdirect.com www.adrbny.com www.virt-x.com www.cme.com www.cbot.com www.cboe.com