Chapter 3

Report
CHAPTER 3
Securities Markets
McGraw-Hill/Irwin
© 2008 The McGraw-Hill Companies, Inc., All Rights Reserved.
3.1 HOW FIRMS ISSUE SECURITIES
3-2
Primary Versus Secondary Markets
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
3-3
How Securities Are Issued
Investment Banking
Shelf Registration
Private Placements
Initial Public Offerings (IPOs)
3-4
Investment Banking Arrangements
Underwritten vs. “Best Efforts”
– Underwritten: firm commitment on proceeds to the
issuing firm
– Best Efforts: no commitment on proceeds…
Negotiated vs. Competitive Bid
– Negotiated: issuing firm negotiates terms with
investment banker
– Competitive bid: issuer structures the offering and
secures bids
3-5
Figure 3.1 Relationship Among a Firm
Issuing Securities, the Underwriters
and the Public
3-6
Figure 3.2 A Tombstone Advertisement
3-7
Shelf Registrations
SEC Rule 415
Introduced in 1982
Ready to be issued – on the shelf
Allows firms to register securities and
gradually sell them to the public for two
years following the initial registration
3-8
Private Placements
Private placement: sale to a limited
number of sophisticated investors not
requiring the protection of registration
Allowed under Rule 144A
Dominated by institutions; suitable for
smaller offerings; less expensive to issuer
Very active market for debt securities
Not active for stock offerings
3-9
Initial Public Offerings
Process
– Road shows (generate interest; provide info
on prices the offering might command)
– Bookbuilding (indications of interest)
Underpricing
– Post-sale returns (median 1-day return,
NASDAQ, 1997-02, was 17.8%)
– An added cost to the issuing firm (over and
above the explicit cost about 7%)
3-10
Figure 3.3 Average Initial Returns for
IPOs in Various Countries
3-11
Figure 3.4 Long-term Relative
Performance of Initial Public Offerings
3-12
3.2 HOW SECURITIES ARE TRADED
3-13
Types of Secondary Markets
Direct search (e.g. newspaper want-ads)
Brokered (e.g. real estate brokers)
Dealer (e.g. OTC securities market)
Auction (e.g. NYSE)
3-14
Types of Orders
Market—executed immediately
– Bid Price
– Ask Price
Price-contingent
– Investors specify prices
– Stop orders
3-15
Price-Contingent Orders
Limit Orders
Name a Limit Price
Limit-Buy Order: Buy
if Market Price is
Below Limit Price
Limit-Sell Order: Sell
if Market Price is
Above Limit Price
Stop-Loss Orders
Name a Limit Price
Stop-Loss Order: Sell
if Market Price is
Below Limit Price
Stop-Buy Order: Buy
if Market Price is
Above Limit Price
3-16
Figure 3.5 Limit Order Book for Intel
on Archipelago
3-17
Figure 3.6 Price-Contingent Orders
3-18
Trading Mechanisms
Dealer markets (e.g. OTC markets;
dealers quote prices for buy/sell)
Electronic communication networks or
ECNs (traders post market and limit orders
over computer networks; orders matched
without broker)
Specialists markets (e.g. NYSE; trade in a
security managed by specialist; specialist
may act as dealer and as broker)
3-19
3.3 U.S. SECURITIES MARKETS
3-20
U.S. Security Markets
Nasdaq
Small stock OTC
– Pink sheets
Organized Exchanges
– New York Stock Exchange
– American Stock Exchange
– Regionals
Electronic Communication Networks
(ECNs)
3-21
Nasdaq
Nasdaq Global Select Market
Nasdaq Global Market
Nasdaq Capital Market
Small stock OTC
– Pink sheets
3-22
New York Stock Exchange
Largest exchange in the U.S.
Automated for small orders
Member functions
– Commission brokers
– Floor brokers; takes orders to specialist’s post
– Specialists
3-23
New York Stock Exchange
Now a publicly held company
Block sales
SuperDot (electronic order routing system;
allows firms to send market and limit
orders directly to the specialist)
Bond Trading
– 2006 NYSE obtained approval to expand
bond trading
– May provide OTH dealer market in bonds
3-24
Other Exchanges and Trading Systems
American Stock Exchange (AMEX)
Regionals
Electronic Communication Networks
(ECNs)
National Market System
3-25
3.4 MARKET STRUCTURE IN
OTHER COUNTRIES
3-26
Other Countries
London - predominately electronic trading
Euronext – market formed by combination
of the Paris, Amsterdam and Brussels
exchanges
Tokyo Stock Exchange (saitori maintains
public limit order book; tries to slow down
large price changes; does not trade from
own account)
3-27
Figure 3.7 Market Capitalization of
Listed Firms, 2005
3-28
3.5 TRADING COSTS
3-29
Trading Costs
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
3-30
3.6 BUYING ON MARGIN
3-31
Buying on Margin
Using only a portion of the proceeds for an
investment
Borrow remaining component
Margin arrangements differ for stocks and
futures
3-32
Buying on Margin
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
3-33
Margin Trading - Initial Conditions
X Corp
$70
50%
Initial Margin
40%
Maintenance Margin
1000
Shares Purchased
Initial Balance Sheet Position:
Stock $70,000 Borrowed $35,000
Equity
35,000
3-34
Margin Trading - Maintenance Margin
Stock price falls to $60 per share
New Balance Sheet Position:
Stock $60,000 Borrowed $35,000
Equity
25,000
Margin% = $25,000/$60,000 = 41.67%
3-35
Margin Trading - Margin Call
How far can the stock price fall before a
margin call?
Since 1000P - Amt Borrowed = Equity then:
(1000P - $35,000) / 1000P = 40%
P = $58.33
3-36
3.7 SHORT SALES
3-37
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
3-38
Short Sale - Initial Conditions
Z Corp
100 Shares
 First borrow 100 shares, then sell them.
50%
Initial Margin
30%
Maintenance Margin
$100
Initial Price
Sale Proceeds:
$10,000
Margin & Equity:
5,000
Initial Margin: $5,000/$10,000 = 50%
Value of Stock Owed $10,000
3-39
Short Sale - Maintenance Margin
Stock Price Rises to $110
Sale Proceeds
$10,000
Initial Margin (T-Bills?)
5,000
Value of Stock Owed
$11,000
Margin (5,000 – 1,000)
4,000
Margin % (4,000/11,000) 36%
3-40
Short Sale - Margin Call
How much can the stock price rise before a
margin call?
Since Initial margin plus sale proceeds =
$15,000, then:
($15,000 - 100P) / (100P) = 30%
P = $115.38
3-41
3.8 REGULATION OF
SECURITIES MARKETS
3-42
Major Regulations
Securities Acts of 1933
Securities Acts of 1934
Securities Investor Protection Act of 1970
3-43
Self-Regulation
National Association of Securities Dealers
(NASD)
– Oversees participants in the Nasdaq market
NYSE has its own regulatory arm
3-44
Regulation Response to Recent
Scandals
Sarbanes-Oxley Act
3-45
Circuit Breakers
Trading halts: If DJIA falls by 10%, trading halted
fro 1 hour (prior to 2:00 pm.) or ½ hour (between
2 and 2:30 pm) or not at all (after 2:30 pm.) If
DJIA falls 20%, trading halted for 2 hours (before
1:00), 1 hour (between 1:00 and 2:00), rest of
day (after 2:00). If DJIA falls by 30%, market
closed rest of day.
Collars: When Dow moves -2% from prior day’s
close, Rule 80A of NYSE requires that index
arbitrage orders pass a “tick test”. In a falling
market, sell orders executed only on a plus tick
or, if last price was an uptick, at the last price.
3-46
Insider Trading
Illegal
Definition of insiders can be ambiguous
SEC’s Official Summary of Securities
Transactions and Holdings
3-47

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