1. CHAPTER 3

2. 3-2 How firms issue securities Primary vs. secondary market Privately held vs. publicly traded companies Initial public offerings Market transactions Short selling and buying on margin Rise of electronic trading and globalization of stock markets Market regulation Chapter Overview

3. 3-3 3.1 How Firms Issue Securities Primary vs. Secondary Market Security Sales Primary New issue created/sold Key factor: Issuer receives proceeds from sale Public offerings: Registered with SEC; sale made to investing public Private offerings: Not registered; sold only to limited number of investors with restrictions on resale Secondary Existing owner sells to another party Issuing firm doesn’t receive proceeds, is not directly involved

4. 3-4 Privately Held Firms Up to 499 shareholders Middlemen have formed partnerships to buy shares and get around the 499-investor restrictions Raise funds through private placement Lower liquidity of shares Have fewer obligations to release financial statements and other information 3.1 How Firms Issue Securities

5. 3-5 3.1 How Firms Issue Securities Publicly Traded Companies Raise capital from a wider range of investors through initial public offering, IPO Seasoned equity offering: The sale of additional shares in firms that already are publicly traded Public offerings are marketed by investment bankers or underwriters Registration must be filed with the SEC

6. 3-6 Figure 3.1 Relationship among a Firm Issuing Securities, the Underwriters, and the Public

7. 3-7 3.1 How Firms Issue Securities Shelf Registration SEC Rule 415 Security is preregistered and then may be offered at any time within the next two years 24-hour notice: Any or all of preregistered amount may be offered Introduced in 1982 Allows timing of issues

8. 3-8 3.1 How Firms Issue Securities Initial Public Offerings Issuer and banker put on “road show” Purpose: Bookbuilding and pricing Underpricing Post-initial sale returns average 10% or more—“winner’s curse” problem? Easier to market issue; costly to issuing firm

9. 3-9 Initial Public Offerings Underwriter bears price risk associated with placement of securities: IPOs are commonly underpriced compared to the price they could be marketed (ex.: Groupon) Some IPOs, however, are well overpriced (ex.: Facebook); others cannot even fully be sold 3.1 How Firms Issue Securities

10. 3-10 Figure 3.2 Average First-Day Returns for European IPOs

11. 3-11 Figure 3.2 Average First-Day Returns for Non-European IPOs

12. 3-12 3.2 How Securities Are Traded Functions of Financial Markets Overall purpose: Facilitate low-cost investment Bring together buyers and sellers at low cost Provide adequate liquidity by minimizing time and cost to trade and promoting price continuity Set and update prices of financial assets Reduce information costs associated with investing

13. 3-13 3.2 How Securities Are Traded Types of Markets Direct Search Markets Buyers and sellers locate one another on their own Brokered Markets Third-party assistance in locating buyer or seller Dealer Markets Third party acts as intermediate buyer/seller Auction Markets Brokers and dealers trade in one location Trading is more or less continuous

14. 3-14 3.2 How Securities Are Traded Types of Orders Market order: Execute immediately at best price Bid price: price at which dealer will buy security Ask price: price at which dealer will sell security Price-contingent order: Buy/sell at specified price or better Limit buy/sell order: specifies price at which investor will buy/sell Stop order: not to be executed until price point hit

15. 3-15 Figure 3.5 Price-Contingent Orders

16. 3-16 3.2 How Securities Are Traded Trading Mechanisms Dealer markets Over-the-counter (OTC) market: Informal network of brokers/dealers who negotiate securities sales NASDAQ stock market: Computer-linked price quotation system for OTC market Electronic communication networks (ECNs) Computer networks that allow direct trading without market makers Specialist markets Specialist: Makes market in shares of one or more firms; maintains “fair and orderly market” by dealing personally

17. 3-17 In the US, the share of electronic trading rose from 16% to 80% in 2000s and was triggered by an interaction of new technologies and new regulations 1975: Elimination of fixed commissions on the NYSE 1994: New order-handling rules on NASDAQ, leading to narrower bid-ask spreads 3.3 The Rise of Electronic Trading

18. 3-18 3.4 U.S. Securities Markets NASDAQ Lists about 3,200 firms Originally, NASDAQ was primarily a dealer market with a price quotation system Today, NASDAQ’s Market Center offers a sophisticated electronic trading platform with automatic trade execution. Large orders may still be negotiated through brokers and dealers

19. 3-19 3.4 U.S. Securities Markets

20. 3-20 New York Stock Exchange 20

21. 3-21 New York Stock Exchange 1792: 24 brokers and merchants started with five securities 1817: Formal organization: the New York Stock & Exchange Board 1835: Average daily volume: exceed 8,000 shares 1863: Adopted the name of the New York Stock Exchange December 15, 1886: One million shares exchange hands 1961: Average trading volume exceeds 4 millions shares per day 1982: Over 100 million shares are exchanged in just one day 1992: Average daily volume exceeds 200 million shares 1997: October 27: volume tops one billion shares for the first time 2005: On June 24: volume over 3 billion shares About 3,000 companies listed (September 2011); capitalization of $16.613 trillion (May 2013); average daily volume of about 6 billion shares ; average daily trading value was approximately US$169 billion in 2013. 21

22. 3-22 NYSE, NASDAQ, Stocks, Bonds April 4, 2007: NYSE Group, Inc. merged with Euronext N.V. to form the first global equities exchange October 1, 2008: NYSE Euronext acquired Amex (American Stock Exchange) The NYSE is now owned by Intercontinental Exchange "NASDAQ“: "National Association of Securities Dealers Automated Quotations“; second-largest stock exchange by market capitalization in the world; as of January 25, 2011, there were 2,711 listings, with a total capitalization of over $4.5 trillion; average daily volume now of about 7 billion shares; began trading on February 8, 1971 as the world's first electronic stock market. Nov 2013: Global equity market capitalization (58 countries): $63.4 trillion March 2012: Global bond market: $100 trillion 22

23. 3-23

24. 3-24 3.4 U.S. Securities Markets NYSE Lists about 2,800 firms Automatic electronic trading runs side-by-side with traditional broker/specialist system SuperDot : electronic order-routing system DirectPlus: fully automated execution for small orders Specialists: Handle large orders and maintain orderly trading

25. 3-25 3.4 U.S. Securities Markets

26. 3-26 3.4 U.S. Securities Markets Electronic Communication Networks ECNs: Private computer networks that directly link buyers with sellers for automated order execution without market makers Major ECNs include NASDAQ’s Market Center, ArcaEx, Direct Edge, BATS, and LavaFlow. “Flash Trading”: Computer programs look for even the smallest mispricing opportunity and execute trades in tiny fractions of a second. Latency: Time it takes to accept, process, and deliver a trading order; speed is important in ECNs; BATs latency time about.0002 second

27. 3-27 3.3 U.S. Securities Markets Timeline of Market Changes 1969: Instinet (first ECN) established 1975: Fixed commissions on NYSE eliminated Congress amends Securities and Exchange Act to create National Market System (NMS) 1994: NASDAQ scandal SEC institutes new order-handling rules NASDAQ integrates ECN quotes into display SEC adopts Regulation Alternative Trading Systems, giving ECNs ability to register as stock exchanges

28. 3-28 3.3 U.S. Securities Markets Timeline of Market Changes 1997: SEC drops minimum tick size from 1/8 to 1/16 of $1 2000: National Association of Securities Dealers splits from NASDAQ 2001: Minimum tick size $.01 2006: NYSE acquires Archipelago Exchanges and renames it NYSE Arca 2007: SEC adopts Regulation NMS, requiring exchanges to honor quotes of other exchanges

29. 3-29 Figure 3.6 The Effective Spread Fell Dramatically as the Minimum Tick Size Fell (Value-weighted average of NYSE-listed shares)

30. 3-30 Figure Market Share of Trading in NYSE-Listed Shares

31. 3-31 Algorithmic Trading The use of computer programs to make trading decisions High-Frequency Trading Special class of algorithmic with very short order execution time Dark Pools Trading venues that preserve anonymity, mainly relevant in block trading 3.5 New Trading Strategies

32. 3-32 3.5 New Trading Strategies Bond Trading Most bond trading takes place in the OTC market among bond dealers. Market for many bond issues is “thin”. NYSE is expanding its bond-trading system. NYSE Bonds is the largest centralized bond market of any U.S. exchange

33. 3-33 3.6 Globalization of Stock Markets Globalization & Consolidation of Stock Markets NYSE mergers and acquisitions: Archipelago (ECN) American Stock Exchange Euronext NASDAQ mergers and acquisitions: Instinet/INET (ECN) Boston Stock Exchange Merges with OMX to form NASDAQ OMX Group Chicago Mercantile Exchange acquired: Chicago Board of Trade New York Mercantile Exchange

34. 3-34 Figure 3.8 The Biggest Stock Markets in the World by Domestic Market Capitalization

35. 3-35 3.6 Globalization of Stock Markets London - predominately electronic trading Euronext – market formed by combination of the Paris, Amsterdam and Brussels exchanges, then merged with NYSE Tokyo Stock Exchange – Roughly 2,400 listed firms; switched to electronic trading in 1999; three sections: first section for large companies, second for mid-sized companies, and third for about 200 small high-growth stocks

36. 3-36 3.6 Globalization of Stock Markets Moving to automated electronic trading Current trends will eventually result in 24- hour global markets Moving toward market consolidation

37. 3-37 3.7 Trading Costs 1.Brokerage Commission: fee paid to broker for making the transaction Explicit cost of trading Full Service vs. Discount brokerage 2.Spread: Difference between the bid and asked prices Implicit cost of trading Bid: Price at which dealer will buy from you Ask: Price at which dealer will sell to you Spread: Ask — bid

38. 3-38 3.X Steps in Trading 1. Selecting a broker Full service Discount 2. Opening an account Cash account Margin account Discretionary account 3. Initiating a position Long Short Short sales

39. 3-39 3.8 Buying on Margin Margin: Describes securities purchased with money borrowed in part from broker Net worth of investor's account: the equity Initial Margin Requirement (IMR) Minimum set by Federal Reserve under Regulation T, currently 50% for stocks Minimum % initial investor equity 1 − IMR = Maximum % amount investor can borrow

40. 3-40 3.8 Buying on Margin Equity Position value – Borrowing + Additional cash Maintenance Margin Requirement (MMR) Minimum amount equity can be before additional funds must be put into account Exchanges mandate minimum 25% Margin Call Notification from broker that you must put up additional funds or have position liquidated

41. 3-41 3.8 Buying on Margin If Equity/Market value  MMR, then margin call occurs (Market value – Borrowed) / Market Value  MMR; solve for market value A margin call will occur when: Market value = Borrowed/(1 − MMR) Borrowed amount also known as debit balance

42. 3-42 3.8 Buying on Margin Margin Trading: Initial Conditions Dot.com Corp: Stock price = $70 50%: Initial margin 40%: Maintenance margin 1000 shares purchased Initial Position Stock$70,000Borrowed $35,000 Equity$35,000

43. 3-43 3.8 Buying on Margin Stock price falls to $60 per share: Equity (E)= Position value (V) – Borrowing (B) + Additional cash = $60 x 1000 sh. - $35,000 = $25,000 Margin %: (V – B)/V = E/V = $25,000/$60,000 = 41.67% How far can price fall before margin call? Margin call when Market value = Borrowed/(1 − MMR) Market value = $35,000/(1 –.40) = $58,333 New Position Stock$60,000Borrowed$35,000 Equity $25,000

44. 3-44 3.8 Buying on Margin With 1,000 shares, stock price for margin call is $58,333/1,000 = $58.33 $58,333 - $35,000 (Borrowing) = $23,333 (Equity) Margin % = $23,333/$58,333 = 40% To restore IMR, equity needed = ½ x $58,333 = $29,167 Equity in account: $23,333; cash needed: New Position Stock$60,000Borrowed$35,000 Equity$23,333

45. 3-45 3.8 Buying on Margin Buy at $70 per share Borrow at 7% APR interest cost if using margin; use full amount margin APRs: Buy at $70Sell at $72 in 90 days Sell at $68 in 90 days No margin11.59%−11.59% Margin16.17%−30.17% Leverage factor1.4x2.6x

46. 3-46 3.9 Short Sales Sale of shares not owned by investor but borrowed through broker and later purchased to replace loan Mechanics Borrow stock from broker; must post margin Broker sells stock, and deposits proceeds/margin in margin account (you cannot withdraw proceeds until you “cover”) Covering or closing out position: Buy stock; broker returns title to party from which it was borrowed

47. 3-47 3.9 Short Sales

48. 3-48 3.9 Short Sales Required initial margin: Usually 50% More for low-priced stocks Liable for any cash flows Dividend on stock

49. 3-49 3.9 Short Sales Short-sale maintenance margin requirements (equity) PriceMMR < $2.50$2.50 $2.50-$5.00100% market value $5.00-$16.75$5.00 > $16.7530% market value

50. 3-50 3.9 Short Sales Example You sell short 100 shares of stock at $60 per share $6,000 must be pledged to broker You must also pledge 50% margin You put up $3,000; now you have $9,000 in margin account Short sale equity = Total margin account – Market value = $9,000 - $6,000 = $3,000

51. 3-51 3.9 Short Sales Example Maintenance margin for short sale of stock with price > $16.75 is 30% market value 30% x $6,000 = $1,800 You have $1,200 excess margin: $3,000 - $1,800 What price for margin call?

52. 3-52 3.9 Short Sales Example When equity  (.30 x Market value) Equity = Total margin account – Market value When Market value = Total margin account / (1 + MMR) Market value = $9,000/(1 + 0.30) = $6,923 Price for margin call: $6,293/100 shares = $69.23

53. 3-53 3.9 Short Sales Example If this occurs: Equity = Total margin account – Market value Equity = $9,000 − $6,923 = $2,077 Equity as % market value = $2,077/$6,923 = 30% To restore 50% initial margin: ($6,923x0.5) − $2,077 = $1,384.50

54. 3-54 Table 3.5 Cash Flows from Purchasing vs. Short-Selling Purchase of Stock TimeActionCash Flow* 0Buy share − Initial price 1Receive dividend, sell shareEnding price + Dividend Profit = (Ending price + Dividend) – Initial price Short Sale of Stock TimeActionCash Flow* 0Borrow share; sell it+ Initial price 1Repay dividend and buy share to replace share originally borrowed − (Ending price + Dividend) Profit = Initial price – (Ending price + Dividend) *Note: A negative cash flow implies a cash outflow.

55. 3-55 3.X Return on Invested Capital(ROIC) Problems: You buy 100 shares of Hazelnut at $80 per share using 60% margin. Margin loan is obtained at an interest rate of 9% per year. The stock pays a dividend of $4 per year per share. Broker commission is $0.05 per transaction per share. Find the return on invested capital if in three months the stock price: (a)Goes to $95 per share: 55

56. 3-56 ROIC or Return on Equity (ROE) (b) Goes to $65 per share: (c) Stays at $80 per share: 56

57. 3-57 ROIC or ROE 2. Redo the above problems under the assumption there is no margin trading. (a) Price goes to $95 per share: (b) Price goes to $65 per share: (c)Price stays at $80 per share: 57

58. 3-58 ROIC or ROE 3. What are the advantages and disadvantages of margin trading? 58

59. 3-59 3.10 Regulation of Securities Markets Major regulations: Securities Act of 1933 Securities Act of 1934 Securities Investor Protection Act of 1970 Self-Regulation Financial Industry Regulatory Authority CFA Institute standards of professional conduct

60. 3-60 3.10 Regulation of Securities Markets Sarbanes-Oxley Act Public Company Accounting Oversight Board Independent financial experts to serve on audit committees of boards of directors CEOs and CFOs personally certify firms’ financial reports Boards must have independent directors

61. 3-61 3.10 Regulation of Securities Markets Insider Trading Officers, directors, major stockholders must report all transactions in firm’s stock Insiders do exploit their knowledge Jaffe study: Inside buyers>inside sellers = stock does well Inside sellers>inside buyers = stock does poorly

62. 3-62 CONCLUSION Many different financial markets with different trading mechanisms

63. 3-63 CONCLUSION Globalization has brought about mergers and consolidations of exchanges Technological developments have created massive changes in the way securities are traded More rapid inflow of news greater use of electronic trading much greater volume of trading and volatility

64. 3-64 CONCLUSION

65. 3-65 CONCLUSION

66. 3-66 CONCLUSION Financial markets have ballooned in size over time.

67. 3-67 CONCLUSION

68. 3-68 CONCLUSION Possibly has created opportunities for greater consolidation of wealth – rich getting richer

69. 3-69 CONCLUSION

70. 3-70 CONCLUSION Characteristics of a well-functioning market: Availability of past transaction information in a timely and accurate manner Liquidity Marketability Price continuity Depth Low transaction costs Rapid adjustment of prices to new information

71. 3-71 CONCLUSION

72. 3-72 CONCLUSION