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Securities Markets3Bodie, Kane, and MarcusEssentials of Investments, 9th EditionMcGraw-Hill/Irwin Copyright 2013 by The McGraw-Hill Companies, Inc. All rights reserved.13.1 How Firms Issue SecuritiesPrimary vs. Secondary Market Security SalesPrimaryNew issue created/soldKey factor: Issuer receives proceeds from salePublic offerings: Registered with SEC; sale made to investing publicPrivate offerings: Not registered; sold only to limited number of investors with restrictions on resaleSecondaryExisting owner sells to another partyIssuing firm doesnt receive proceeds, is not directly involved3-#23.1 How Firms Issue SecuritiesPrivately Held FirmsUp to 499 shareholdersFewer obligations to release financial statements to publicPrivate placement: Primary offerings sold directly to a small group of investors3-#33.1 How Firms Issue SecuritiesPublicly Traded CompaniesSell securities to the general public; allow investors to trade shares in securities marketsInitial public offering: First sale of stock by a formerly private companyUnderwriters: Purchase securities from issuing company and resell themProspectus: Description of firm and security being issued3-#4Figure 3.1 Relationship among a Firm Issuing Securities, the Underwriters, and the Public

3-#53.1 How Firms Issue SecuritiesShelf RegistrationSEC Rule 415Security is preregistered and then may be offered at any time within the next two years24-hour notice: Any or all of preregistered amount may be offeredIntroduced in 1982Allows timing of issues3-#63.1 How Firms Issue SecuritiesInitial Public OfferingsIssuer and banker put on road showPurpose: Bookbuilding and pricingUnderpricingPost-initial sale returns average 10% or morewinners curse problem?Easier to market issue; costly to issuing firm3-#77Figure 3.2 Average First-Day Returns for European IPOs

3-#8Figure 3.2 Average First-Day Returns for Non-European IPOs

3-#3.2 How Securities Are TradedFunctions of Financial MarketsOverall purpose: Facilitate low-cost investmentBring together buyers and sellers at low costProvide adequate liquidity by minimizing time and cost to trade and promoting price continuitySet and update prices of financial assetsReduce information costs associated with investing3-#10103.2 How Securities Are TradedTypes of MarketsDirect Search MarketsBuyers and sellers locate one another on their ownBrokered MarketsThird-party assistance in locating buyer or sellerDealer MarketsThird party acts as intermediate buyer/sellerAuction MarketsBrokers and dealers trade in one locationTrading is more or less continuous3-#113.2 How Securities Are TradedTypes of OrdersMarket order: Execute immediately at best priceBid price: price at which dealer will buy securityAsk price: price at which dealer will sell securityPrice-contingent order: Buy/sell at specified price or betterLimit buy/sell order: specifies price at which investor will buy/sellStop order: not to be executed until price point hit3-#12Figure 3.4 Limit Order Book for Intel on the NYSE Arca Market, July 22, 2011

3-#133.2 How Securities Are TradedTrading MechanismsDealer marketsOver-the-counter (OTC) market: Informal network of brokers/dealers who negotiate securities salesNASDAQ stock market: Computer-linked price quotation system for OTC marketElectronic communication networks (ECNs)Computer networks that allow direct trading without market makersSpecialist marketsSpecialist: Makes market in shares of one or more firms; maintains fair and orderly market by dealing personally3-#14Figure 3.5 Price-Contingent Orders

3-#153.3 The Rise of Electronic TradingTimeline of Market Changes1969: Instinet (first ECN) established1975: Fixed commissions on NYSE eliminatedCongress amends Securities and Exchange Act to create National Market System (NMS)1994: NASDAQ scandalSEC institutes new order-handling rulesNASDAQ integrates ECN quotes into displaySEC adopts Regulation Alternative Trading Systems, giving ECNs ability to register as stock exchanges3-#163.3 The Rise of Electronic TradingTimeline of Market Changes1997: SEC drops minimum tick size from 1/8 to 1/16 of $12000: National Association of Securities Dealers splits from NASDAQ2001: Minimum tick size $.012006: NYSE acquires Archipelago Exchanges and renames it NYSE ArcaSEC adopts Regulation NMS, requiring exchanges to honor quotes of other exchanges

3-#17Figure 3.6 Effective Spread vs. Minimum Tick Size

3-#183.4 U.S. MarketsNASDAQApproximately 3,000 firmsNew York Stock Exchange (NYSE)Stock exchanges: Secondary markets where already-issued securities are bought and soldNYSE is largest U.S. Stock exchangeECNsLatency: Time it takes to accept, process, and deliver a trading order3-#19Figure 3.7 Market Share of Trading in NYSE-Listed Shares

3-#203.5 New Trading StrategiesAlgorithmic TradingUse of computer programs to make rapid trading decisionsHigh-frequency trading: Uses computer programs to make very rapid trading decisions in order to compete for very small profitsDark PoolsECNs where participants can buy/sell large blocks of securities anonymouslyBlocks: Transactions of at least 10,000 shares

3-#21Figure 3.8 Market Capitalization of Major World Stock Exchanges, 2011

3-#223.6 Globalization of Stock MarketsMoving to automated electronic tradingCurrent trends will eventually result in 24-hour global marketsMoving toward market consolidation3-#233.7 Trading CostsCommission: Fee paid to broker for making transactionSpread: Cost of trading with dealerBid: Price at which dealer will buy from youAsk: Price at which dealer will sell to youSpread: Ask bidCombination: On some trades both are paid3-#243.8 Buying on MarginMargin: Describes securities purchased with money borrowed in part from brokerNet worth of investor's accountInitial Margin Requirement (IMR)Minimum set by Federal Reserve under Regulation T, currently 50% for stocksMinimum % initial investor equity1 IMR = Maximum % amount investor can borrow3-#253.8 Buying on MarginEquityPosition value Borrowing + Additional cashMaintenance Margin Requirement (MMR)Minimum amount equity can be before additional funds must be put into accountExchanges mandate minimum 25%Margin CallNotification from broker that you must put up additional funds or have position liquidated3-#263.8 Buying on MarginIf Equity / Market value MMR, then margin call occurs(Market value Borrowed) / Market Value MMR; solve for market valueA margin call will occur when:Market value = Borrowed/(1 MMR)3-#273.8 Buying on MarginMargin Trading: Initial ConditionsX Corp: Stock price = $7050%: Initial margin40%: Maintenance margin1000 shares purchasedInitial PositionStock$70,000Borrowed$35,000Equity$35,0003-#283.8 Buying on MarginStock price falls to $60 per share Position value Borrowing + Additional cashMargin %: $25,000/$60,000 = 41.67%How far can price fall before margin call?Market value = $35,000/(1 .40) = $58,333New PositionStock$60,000Borrowed$35,000Equity$25,0003-#293.8 Buying on MarginWith 1,000 shares, stock price for margin call is $58,333/1,000 = $58.33Margin % = $23,333/$58,333 = 40%To restore IMR, equity = x $58,333 = $29,167New PositionStock$60,000Borrowed$35,000Equity$23,3333-#303.8 Buying on MarginBuy at $70 per shareBorrow at 7% APR interest cost if using margin; use full amount marginAPRs (365-day year)Buy at $70Sell at $72 in 90 daysSell at $68 in 90 daysNo margin11.59%11.59%Margin16.17%30.17%Leverage factor1.4x2.6x3-#31Table 3.1 Illustration of Buying Stock on Margin

3-#323.9 Short SalesSale of shares not owned by investor but borrowed through broker and later purchased to replace loanMechanicsBorrow stock from broker; must post marginBroker 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 borrowed3-#333.9 Short SalesRound TripsLong positionBuy first, sell laterBullishShort positionSell first, buy laterBearishRound trip is a purchase and a sale3-#343.9 Short SalesRequired initial margin: Usually 50%More for low-priced stocksLiable for any cash flowsDividend on stockZero tick, uptick ruleEliminated by SEC in July 20073-#353.9 Short SalesShort-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 value3-#363.9 Short SalesExampleYou sell 100 short shares of stock at $60 per share$6,000 must be pledged to brokerYou must also pledge 50% marginYou put up $3,000; now you have $9,000 in margin accountShort sale equity = Total margin account Market value3-#373.9 Short SalesExampleMaintenance margin for short sale of stock with price > $16.75 is 30% market value30% x $6,000 = $1,800You have $1,200 excess marginWhat price for margin call?3-#383.9 Short SalesExampleWhen equity (.30 x Market value)Equity = Total margin account Market valueWhen Market value = Total margin account / (1 + MMR)Market value = $9,000/(1 + 0.30) = $6,923Price for margin call: $6,293/100 shares = $69.233-#393.9 Short SalesExampleIf this occurs:Equity = $9,000 $6,923 = $2,077Equity as % market value = $2,077/$6,923 = 30%To restore 50% initial margin:($6,923/2) $2,077 = $1,384.503-#40Table 3.2 Cash Flows from Purchasing vs. Short-SellingPurchase of StockTimeActionCash Flow*0Buy share Initial price1Receive dividend, sell shareEnding price + DividendProfit = (Ending price + Dividend) Initial priceShort Sale of StockTimeActionCash Flow*0Borrow share; sell it+ Initial price1Repay 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-#413.10 Regulation of Securities MarketsSelf-RegulationThe Sarbanes-Oxley ActInsider TradingInside information: Nonpublic knowledge about a corporation possessed by officers, major owners, etc., with privileged access to information3-#42Selected Problems3-433-#43Chapter 3: Problem 1 Explicit and Implicit costs.Explicit: Underwriters Fee $70,000Implicit: Underpricing ($53 -$50) x 100,000 = $300,000Total Costs = $370,000No. The underwriters did not directly profit from the underpricing of the securities.

3-4444Chapter 3: Problem 2If the price keeps going up your losses are unlimited. The stop-buy order at $128 limits your max loss to about $8 per share.

3-4545Chapter 3: Problem 3a. The stock is purchased for: 300 $40 = $12,000The amount borrowed is $4,000. Therefore, the investor put up equity, or margin, of $8,000.

3-4646Chapter 3: Problem 3b. If the share price falls to $30, then the value of the stock falls to $30 x $300 = $9,000. By the end of the year, the amount of the loan owed to the broker grows to:$4,000 1.08 = $4,320Therefore, the remaining equity in the investors account is:$9,000 $4,320 = $4,680The percentage margin is now: __________________________

Therefore the investor will not receive a margin call.$4,680 / $9,000 = 0.52 = 52%

3-4747Chapter 3: Problem 3c. The rate of return on the investment over the year is:

(Ending equity in the account Initial equity) / Initial equity

HPR = ($4,680 $8,000) / $8,000 = 0.415 = 41.5%Beginning Equity = $8,000End Equity = $4,680

3-4848Chapter 3: Problem 4Many exchanges and the ECNs have pretty mucheliminated market-making specialists. Here the computer finds the best prices to make the trades.

3-4949Chapter 3: Problem 5$50.25$51.50

c. You should probably increase your position. There is plenty of buying demand at prices just below $50, so downside risk is limited. The limit sell orders are less concentrated.3-5050a. The buy order will be filled at the best limit-sell order, $50.25b. The next market buy order would be filled at the next best price, $51.50

Chapter 3: Problem 6You buy $10,000/$50= 200 shares b. The margin call will occur whenMarket Value = Amount Borrowed / (1 - MMR)Market Value= Stock price = Shares go up 10% $50$55 $55 X 200=$6000You pay interest .08 X $5000 = $400Rate of return = 6000 400 5000 = 12% 5000

$5,000 / (1 0.30) = $7,142.86$7,142.86 / 200 shares = $35.713-5151Chapter 3: Problem 7a. 55.50 55.25The trade will not be executed because the bid priceis lower than the price specified in the limit sell order.The trade will not be executed because the ask priceis greater than the price specified in the limit buy order.

3-5252Chapter 3: Problem 8a.In an exchange market, there can be price improvement in the two market orders. Brokers for each of the market orders (i.e., the buy and the sell orders) can agree to execute a trade inside the quoted spread.

For example, they can trade at $55.37, thus improving the price for both customers by either $0.12 or $0.13 relative to the quoted bid and asked prices.3-5353For example, they can trade at $55.37, thus improving the price for both customers by $0.12 or $0.13 relative to the quoted bid and asked prices. The buyer gets the stock for $0.13 less than the quoted asked price, The seller receives $0.12 more for the stock than the quoted bid price.

Chapter 3: Problem 8b.Whereas the limit order to buy at $55.37 would not be executed in a dealer market (since the asked price is $55.50), it could be executed in an exchange market. A broker for another customer with a market sell order would view the limit buy order as the best bid price; the two brokers could agree to the trade and bring it to the specialist, who would then execute the trade.

3-5454Chapter 3: Problem 9

(Round Trip)

3-5555Chapter 3: Problem 10Cannot tell from the information given. The broker will attempt to sell after the first transaction at $55 or less.

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