Chapter 3 investments securities markets

Secondary Market Security Sales• Primary – New issue is created and sold – Key factor: issuer receives the proceeds from the sale – Initial Public Offerings IPOs and Seasoned Equity Offe

Securities Markets Chapter 3

3.1 How Firms Issue Securities

Primary vs Secondary Market Security Sales

• Primary

– New issue is created and sold

– Key factor: issuer receives the proceeds from the sale

– Initial Public Offerings (IPOs) and Seasoned Equity Offerings(SEOs)

– Public offerings: registered with the SEC and sale is made to the investing public

– Private offerings: not registered, and sold to only a limited number of investors, with restrictions on resale

• Secondary

– Existing owner sells to another party

– Issuing firm doesn’t receive proceeds and is not directly involved

– Trading in secondary markets does not affect the outstanding amount of securities

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• Privately Held Firms

- Up 499 shareholders

: Limits their ability to raise large amounts of capital

- Fewer obligations to release financial statements to public : Saves money and frees the firm from disclosing information

- Private placement: Primary offerings sold directly to a small group of investors

• 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

- Do not trade in secondary markets, reducing their liquidity and presumably reducing the prices that investors will pay for the issue

Private Placements

→

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Publicly Traded Companies

- Sell securities to the general public; allow investors to trade shares in securities markets

- Initial public offering (IPO): First sale of stock by a formerly private company

- Seasoned equity offering (SEO): The sale of additional shares in firms that already are publicly

Figure 3.1 Relationship Among a Firm Issuing Securities, the Underwriters and the Public

→

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Shelf Registrations

: The securities are “on the shelf”, ready to be issued

• SEC Rule 415

- Security is preregistered and then may be offered

at any time within the next two years

• Introduced in 1982

• Allows timing of the issues

- Allow firms to gradually sell them to the public

for two years

Initial Public Offerings

• IPO Process

- Issuer and banker put on the “Road Show”

- Purpose: Book building and pricing

• Underpricing

- Post initial sale returns average about 10% or more.

(“Left on the table”)

- Easier to market the issue, but costly to the issuing firm

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Figure 3.2 Average First Day Returns for European and Non-European IPOs

Long-term Relative Performance of Initial Public Offerings 1970-2006

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3.2 How Securities are Traded

Functions of Financial Markets

Overall purpose: facilitate low cost investment

1 Bring together buyers and sellers at low cost

2 Provide adequate liquidity by minimizing time and cost to trade and

promoting price continuity.

3 Set & update prices of financial assets

4 Reduce information costs associated with investing

Types of Markets

• Direct Search Markets

- The least organized market

- Buyers and sellers must seek each other out directly

• Brokered Markets

- Third party assistance in location buyer or seller

- Brokers offer search serviced to buyers and sellers

- Real estate market and primary market

• Dealer Markets

- Third party acts as intermediate buyer/seller

- Dealers specialize in various assets, purchase these assets for their own accounts, and later sell them for a profit from their inventory

- The over-the counter (OTC) securities market

• Auction Markets

- All traders trade in one location (e.g NYSE)

- One need not search across dealers to find the best price for a good

Types of Orders

Instructions to the brokers on how to complete the order

• Market order : buy or sell orders that are to be executed immediately at current market prices

- Bid price: price at which dealer will buy security

- Ask price: price at which dealer will sell security

- Bid-ask spread: the difference between bid price and ask price

• Price-contingent order: Place orders specifying prices at which they are willing to buy or sell a sec urity

1) Limit order : Order to buy or sell at a specified price or better

- On the exchange the limit order is placed in a limit order

book kept by an exchange official or computer

- E.G: Stock trading at $50, could place a buy limit at $40.90 or a sell limit order at $50.25

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Figure 3.4 Limit Order Book for Intel on the NYSE Arca Market, July 22, 2011

Types of Orders

2) Stop loss order: Becomes a market sell order when

the trigger price is encountered

- E.G: You own stock trading at $40 You could place a stop loss at $38 The stop loss would become a market order to sell if the price of the stock hits $38

3) Stop buy order: Becomes a market buy order when

the trigger price is encountered

- E.G: You shorted stock trading at $40 You could place a stop buy at $42 The stop buy would become a market order to buy if the price of the stock hits $42

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Types of Orders

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

3.3 The Rise of Electronic Trading

 Timeline of Market Changes

• 1969: Instinet (first ECN) established

- Congress amends Securities and Exchange Act to create National Market System (NMS)

- 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

3.3 The Rise of Electronic Trading

 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

renames it NYSE Arca

- SEC adopts Regulation NMS, requiring exchanges to honor quotes of other exchanges

Figure 3.6 Effective Spread vs Minimum Tick Size

3.4 U.S Security Markets

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U.S Security Markets Overview

• Nasdaq

• Small stock OTC

- Pink sheets

• Organized Exchanges

- New York Stock Exchange

- American Stock Exchange

- Regionals

• Electronic Communication Networks (ECNs)

• NASDAQ

- Approximately 3,000 firms

• New York Stock Exchange (NYSE)

already-issued securities are bought and sold

- NYSE is largest U.S Stock exchange

• ECNs

- Latency: Time it takes to accept, process, and deliver a trading order

U.S Security Markets

Figure 3.7 Market Share of Trading in NYSE-Listed Shares

3.5 New Trading Strategies

• Algorithmic Trading

- Use of computer programs to make rapid trading decisions

- More than 50% of all equity volume

- High-frequency trading:

 Uses computer programs to make very rapid trading

decisions in order to compete for very small profits

 Profit from the bid-ask spread or cross-market arbitrage

3.5 New Trading Strategies

• Dark Pools

- Many large traders seek anonymity

- ECNs where participants can buy/sell large blocks of securities anonymously

- Blocks: Transactions of at least 10,000 shares

Figure 3.8 Market Capitalization of Major World Stock Exchanges, 2011

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

3.7 Trading Costs

• Commission: Fee paid to broker for making

transaction (Explicit cost)

• Spread: Cost of trading with dealer (Implicit cost)

- Bid: Price at which dealer will buy from you

- Ask: Price at which dealer will sell to you

- Spread: Ask — bid

• Combination: On some trades both are paid

3.8 Buying on Margin

Buying on Margin

• Defined: borrowing money to purchase stock.

• Initial Margin Requirement (IMR) (minimum set by

Federal Reserve under Regulation T), currently 50%

for stocks

• The IMR is the minimum % initial investor equity.

(= the ratio of the equity value in the account to the

market value of the securities)

1-IMR = Maximum % amount investor can borrow

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Buying on Margin

• From whom do you borrow?

- From a broker

• Do you pay interest on the loan?

- The call money rate + a service charge

• Equity = Position Value - Borrowing + Additional Cash

• Maintenance margin requirement (MMR)

: Minimum amount equity can be before additional funds must

be put into the account

Margin Call

• Margin call: notification from broker you must put up

additional funds or have your position liquidated.

• At what price does the investor receive a margin call?

The investor's equity = Market Value - Amount borrowed

Thus, a declining stock price reduces the investor's equity.

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Margin Call

• If (the Equity / Market Value) ≤ MMR, a margin call occurs.

• (Market Value - Borrowed) / Market Value ≤ MMR

; Solve for Market Value

• A margin call will occur when:

Market Value = Borrowed / (1 – MMR)

Margin Trading

 Margin Trading: Initial Conditions

- X Corp’s Stock price = $70

- 50%: Initial Margin

- 40%: Maintenance Margin

- 1000: Shares Purchased

Initial Position Stock $70,000 Borrowed

Equity

$35,000

$35,000

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Equity $25,000

Margin Trading

 With 1000 shares, the stock price for a margin call is

$58,333 / 1000 = $58.33

- Margin % = $23,333 / $58,333 = 40%

 How much cash must you put up?

To restore the IMR, you will need equity = ½ X $58,333 = $29,167

- Have equity = $23,333

- so you need more = $5,834

New Position Stock $58,333 Borrowed $35,000

Equity $23,333

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Margin Trading

Why do people purchase on margin?

- Achieve greater upside potential, but expose to greater

downside risk.

E.G) Suppose you buy at $100 per share with $10,000

(borrow at a 10% APR interest cost if use margin, use full

Margin Trading

• Buy at $70 per share

- Borrow at 7% APR interest cost if using margin

; use full amount margin (50%)

- APRs (365-day year)

Buy at $70 Sell at $72 in 90 days Sell at $68 in 90 days

No margin 11.59% −11.59%

Margin 16.17% −30.17%

Leverage factor 1.4x 2.6x

3.9 Short Sales

: Borrows a share of stock from a broker and sells it

Later, the short-seller must purchase a share of the

same stock in order to replace the share that was

borrowed (Covering the short position)

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Short Sales

• Required initial margin: Usually 50%

- More for low-priced stocks

• Liable for any cash flows

- Dividend on stock

Short Sales

Example:

-Required initial margin: 50%

(= the ratio of the equity in the account to the current value of the

shares you have borrowed)0% 50%

- Short sale maintenance margin requirements: 30% of market value

- You sell short 100 shares of stock priced at $60 per share

 The proceeds of $6000 must be pledged to broker

 You must also pledge 50% margin

• You put up $3,000 Now you have $9,000 invested in margin account

- Short Sale Equity = Total Margin Account - Market Value

Short Sales

- Maintenance margin for short sale is 30% of market value

- So you have $1,200 in excess margin

(This may be withdrawn at your pleasure but assume that it is not.)

- At what stock price do you get a margin call?

: 30% x $6,000 = $1,800

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Total Margin Account – Market Value

When: Market Value = Total Margin Account / (1 + MMR)

Short Sales

 If this occurs:

Equity =

Equity as % market value =

• You get a margin call &

You may have to restore the 50% initial margin

• If so, you must deposit an additional

($6,923 *0.5) - $2,077 = $1,384.5

$9,000 - $6,923 = $2,077

$2,077 / $6,923 = 30%

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Table 3.2 Cash Flows from Purchasing vs Short-Selling

Purchase of Stock

1 Receive dividend, sell share Ending price + Dividend Profit = (Ending price + Dividend) – Initial price

Short Sale of Stock

0 Borrow share; sell it + Initial price

1 Repay 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.

3.10 Regulation of Securities Markets

• Government regulation and self-regulation

- Passed by Congress in 2002 in response to a series of accounting scandals and misleading

research reports

• Insider Trading

- Inside information: Non-public knowledge about a corporation possessed by officers, major

owners, etc., with privileged access to information

- Prohibit insider trading.