Chapter

3

How Securities are Traded

Primary vs. Secondary Security Sales

• 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

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Investment Banking Arrangements

• Underwritten vs. “Best Efforts” • Underwritten: firm commitment on proceeds to the issuing firm • Best Efforts: no firm commitment • Negotiated vs. Competitive Bid • Negotiated: issuing firm negotiates terms with investment banker • Competitive bid: issuer structures the offering and secures bids

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Public Offerings

• Public offerings: registered with the SEC and sale is made to the investing public • Shelf registration (Rule 415, since 1982) • Initial Public Offerings (IPOs) • Evidence of underpricing • Performance

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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 • Very active market for debt securities • Not active for stock offerings

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Organization of Secondary Markets

• Organized exchanges • OTC market • Third market • Fourth market

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Organized Exchanges

• Auction markets with centralized order flow • Dealership function: can be competitive or assigned by the exchange (Specialists) • Securities: stock, futures contracts, options, and to a lesser extent, bonds • Examples: NYSE, AMEX, Regionals, CBOE

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OTC Market

• Dealer market without centralized order flow • NASDAQ: largest organized stock market for OTC trading; information system for individuals, brokers and dealers • National Market System • Nasdaq SmallCap Market • Lower volume securities • OTC Bulletin Board • Pink Sheets from NASD • Securities: stocks, bonds and some derivatives • Most secondary bonds transactions

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Third Market

• Trading of listed securities away from the exchange • Institutional market: to facilitate trades of larger blocks of securities • Involves services of dealers and brokers

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Fourth Market

• Investors trading directly with other investors • Originally developed for institutional trading • Trading now on ECNs • Technological developments leading to individual investors trading directly

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Electronic Computer Networks (ECNs)

• Major ECNs • Island ECN • Instinet • REDIBook • Archipeligo • Competing with Nasdaq and NYSE for volume • Leads to some fragmentation of markets

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Costs of Trading

•

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

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Types of Orders

Instructions to the brokers on how to complete the order • Market • Limit • Stop loss

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Margin Trading

• Using only a portion of the proceeds for an investment • Borrow remaining component • Margin arrangements differ for stocks and futures

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Stock Margin Trading

•

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

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Margin Trading - Initial Conditions

X Corp $70 50% 40% 1000 Initial Position Initial Margin Maintenance Margin Shares Purchased Stock $70,000 Borrowed $35,000 Equity 35,000

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Margin Trading Maintenance Margin

Stock price falls to $60 per share New Position Stock $60,000 Borrowed $35,000 Equity 25,000 Margin% = $25,000/$60,000 = 41.67%

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Margin Trading - Margin Call

How far can the stock price fall before a margin call?

(1000P - $35,000) * / 1000P = 40% P = $58.33

* 1000P - Amt Borrowed = Equity

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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

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Z Corp 50% 30% $100

Short Sale - Initial Conditions

100 Shares Initial Margin Maintenance Margin Initial Price Sale Proceeds Margin & Equity Stock Owed $10,000 5,000 10,000

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Short Sale - Maintenance Margin

Stock Price Rises to $110 Sale Proceeds Initial Margin Stock Owed Net Equity Margin % (4000/11000) $10,000 5,000 11,000 4,000 36%

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Short Sale - Margin Call

How much can the stock price rise before a margin call?

($15,000 * - 100P) / (100P) = 30% P = $115.38 * Initial margin plus sale proceeds

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Regulation and Trends in Markets

• ECNs present new challenges in regulation • Global markets with alliances are developing • Current Issues with • Agency problems associated with investment banking and research • Insider trading violations

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