Transcript Slide 1

FIN 200
Investments
CHAPTER 3
How Securities are Traded
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Figure 3.1 Relationship Among a Firm Issuing
Securities, the Underwriters and the Public.
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How Firms Issue Securities

Initial Public Offerings (IPOs)

Investment Banking

Shelf Registration

Private Placements
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How Firms Issue Securities
IPO = Initial Public Offering
 Stocks issued by a company that has been
privately owned until the sale of their shares.
 Why would a company sell shares of their
company and go public?
 New issues of stocks or bonds marketed
(sold) by investment bankers on Primary
Markets.
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Seasoned Equity Offerings (All Equities)

Offerings of equity by companies that are
already publicly owned.
Why would a company that is already publicly
owned,
1. Sell more shares in their company?
2. Expect that people will buy their shares?
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

Bond Markets
Public Offering
 Sold to the general investing public that
can be traded on secondary markets.
Private Placement
 Sold to institutional investors and usually
held to maturity.
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The issuer (business firm) receives the
proceeds (money) from the sale.
Secondary Markets
 Existing owner sells to another person.
 Issuing firm doesn’t receive proceeds and is
not directly involved
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Secondary Markets
 Existing owner sells to another person.
 Issuing firm doesn’t receive proceeds and is
not directly involved.
 What future relationship will the issuing firm
have with the person who purchased the
equity on the secondary market?
 Trading in the secondary market is the
changing of ownership.
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The role of Investment Banks
UNDERWRITERS

Public Offerings are marketed and sold by
investment bankers.
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A team of investment bankers is usually
needed to do the job.
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Investment Bankers advise the issuer about
how to best sell their securities
 Prospects for the resale values
 Complete the registration paperwork with the
Securities exchange Commission (SEC)
which promises that they will not attempt to
sell until permission is granted.
 Known as a red herring and printed in red.
 When approved by the SEC, the approval is
known as a Prospectus and information can
be shared with the public.
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Usual Practise
The underwriter (investment bank) purchases the
securities for one price and resells them to the
pubic for a higher price. Their profit (commission).
The profit to the underwriter is known as the firm
commitment.
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Shelf Registrations
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SEC Rule 415
Introduced in 1982
Ready to be issued – on the shelf
Allows firms to register their securities and gradually sell them to
the public for up to 2 years following initial registration.
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The benefits of shelf registration include
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Do not have to release all the equity at one time
Only have to service the debt or commitment when the money
is being used
Minimal paperwork and low cost incurred when it is time to sell
(float more securities
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Concept Check 1
Why does it make sense for shelf registration
to be limited in time?
Limited time shelf registration was introduced
because of its favorable trade-off of saving
issue cost against mandated disclosure.
Allowing unlimited shelf registration would
circumvent “blue sky” laws that ensure proper
disclosure as financial circumstances of the
firm change over time.
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Private Placements versus public offering

Sale to a limited number of large institutional
investors not requiring the protection of
registration

Less expensive because the fewer SEC registration
requirements = lower cost = better value
Private Placements do not trade on Secondary
Markets
Name an investor that would be willing to buy
private placements.

This reduces their liquidity (WHY?)

Reduces the price that investors are willing to pay
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(WHY?)
Initial Public Offerings
• Process
– Road shows
– Bookbuilding
• Underpricing
– Post sale returns
– Cost to the issuing firm
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IPO – The Process
The SEC commented on the registration so
that the public can see if there are any
concerns.
A Preliminary Prospectus is distributed.
Prospectus = the companies prospects (the
good things about the company, the
challenges in their market, the economy,
etc.)
Investment bankers begin to tour the country
(Road Show) to publicize (market) the
offering.
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The purpose of the Road Show
a.Generate interest among potential investors
and share information about the offering (presell).
b.Allows the Lead Underwriter to gather
information from the people they meet and
share it with
I. the issuing firm
II.partner underwriters
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

Underwriters collect the names of those
interested in buying, in a book. The term
Book or Bookbuilding refers to the list of
people who will be called back when the
security goes on sale.
Institutional investors provide valuable
information to investment bankers and
underwriters, about
a. Current market demand and value of the
security.
b. Competition from other firms in the same
industry as the issuer.
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Based on the road-show discussions with the
investing community it is common for the
investment bankers to

revise their original estimates of the
offering price, and

number of shares to be offered
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The success of relationships is based on trust
Truth is the best policy
The markets are built on trust
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Why do investors truthfully reveal their interest
in an offering to an investment banker?
If they pretend to be less interested, maybe the
purchase price will be less.
If the purchase price is less, maybe the profit
will be less.
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If they are a team and work together, they
can create a win-win situation.
When shares are sold, the decision on how
many shares to issue is based on the
information gathered from prospective
investors.
If the information is not good, they may
issue to few shares.
Therefore, if investors are optimistic, the
security will be offered in the quantity that is
most profitable for everyone involved.
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Underwriters (investment bankers)
therefore must offer the security at a lower
price to their prospective investors who will
 have their name added to the book
 tell others about the offering
IPOs are often underpriced to encourage
investors to buy in early.
Prices sometimes increase significantly
when they are first publicly traded.
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Textbook example. Page 56-57 VA Linux
(software).
 Linux was priced at $30 per share in the
IPO.
 At closing on the first day of public trading,
the price was $239.25.
 Historically, IPO expenses are
approximately 7% of the total funds raised.
 If the shares would have been priced at
$239.25, the company would have raised
8X as much money.
 Within 1 year the share price was $9 and
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2 years later was less than $1.

The difference between the $30 per share
and the $239 per share is known as “the
money left on the table”. This example is
very uncommon.
Reminder. Under-pricing is necessary, but
requires careful evaluation.
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Figure 3.2 Average Initial Returns for
IPOs in Various Countries
 Why do you think that the five countries on the far right have
much higher first day returns?
 Institutional investors purchase the bulk of newly issued stock,
which some people consider unfair.
If there were no discounts offered to
the institutional investors, what
would be their motivation for
providing accurate information about
a fair value and market competition?
The discounts are their payment for
the most reliable information
available, which can lead to future
profits by everybody.
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Risks and Abuse
Scandals in 2002 revealed that some IPOs
were very underpriced.
Known as “spinning”, and sold by investment
bankers to other business people (like a
kickback), with the promise of future investment
banking services between the two.
Not all IPOs are underpriced.
 Some stock is valued at less than the IPO
price within days.
 Others can not be fully sold off and
underwriters must sell them for a loss.
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How Securities are Traded
Types of Markets
Direct search
 Least organized
Brokered
 Trading in a good is active
Dealer
 Trading in a particular type of asset
increases
Auction
 Most integrated
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Direct Search Markets - Least organized
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Buyers and sellers must look for each other.
Sporadic participation – only when needed
Used goods (refrigerators, fish tanks, cars,
motorcycles, hockey equipment, stereos.
Name some things that you might want to
buy used instead of new.
Tao Bao, Kijiji, Craig’s List, E-Bay, etc.
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Brokered Markets – Trading is active
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Trading is active
Search services are beneficial to the buyer
and the seller Real Estate
Payment (commission) is sometimes a
percentage of the sale
Specialized knowledge on valuation, risks,
resale, legalities, etc is required
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Dealer Markets – are created by need,
when trading volume in a particular type
of asset increases
Dealers of coins, rare books, stamps,
stocks and bonds.
Profit = the spread (difference) between
the price the dealer buys it “bid” and the
price sell price “ask” is the profit.
OTC – Over the Counter Securities
Markets is one example of a financial
brokered market
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Auction Markets - The most integrated
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Traders come to the market to do their trading
Physically or electronically to buy or sell
 Toronto Stock Exchange (TSE) and New
York Stock Exchange (NYSE) are examples
Sales are continuous (non-stop) as opposed to
the sale of art work
The cost of this market is expensive and is
therefore limited to equities that are traded in
great volume
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Concept Check 2: Page 59.
What is the answer?
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Types of Orders
Market — executed immediately at the current
market price
Bid – Ask = Stockbroker’s quotation = ‘bid’ refers to the
highest price the buyer wants to pay, and ‘ask’ refers
to the lowest price the seller will accept. The
difference between the two prices is called a bid and
asked spread.
Bid Price: $90.00 if I sell it, this is what I get
Ask Price: $90.05 if I buy it, this is what I pay
Bid – Ask Spread = .05
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Potential Complications
The quotes are a commitment to trade up to a
previously agreed amount.

If the order is for more shares than the commitment,
they buyer will have to find other sellers and may
have to pay a different price.
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If another buyer gets to this quote before we do, our
order will be executed at a worse price.
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The price may change before our order arrives, so
the execution price will be different.
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Types of Orders
Price-contingent
– Investors specify prices
– Stop orders
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Types of Orders
• Market—executed immediately at the current
market price
Example:
Bid Price: $90.00 if I sell it, this is what I get
Ask Price: $90.05 if I buy it, this is what I pay
• Price-contingent
– Investors specify prices
– Stop orders
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Figure 3.4 The Limit Order Book for Intel
on the Archipelago Market,
January 19, 2007
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Figure 3.5 Price-Contingent Orders
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Trading Mechanisms
• Dealer markets
• Electronic communication networks (ECNs)
• Specialists markets
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U.S. Security Markets
• Nasdaq and NYSE have evolved in response
to new information technology
• Both have increased their commitment to
automated electronic trading
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Nasdaq
• National Market System
• Nasdaq Small Cap Market
• Levels of subscribers
– Level 1 – inside quotes
– Level 2 – receives all quotes but they can’t
enter quotes
– Level 3 – dealers making markets
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Table 3.1 Partial Requirements for Listing
on NASDAQ Markets
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New York Stock Exchange
• Member functions
– Commission brokers
– Floor brokers
– Specialists
• Block houses
• SuperDot
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Table 3.2 Some Initial Listing
Requirements for the NYSE
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Table 3.3 Block Transactions on the
New York Stock Exchange
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Other Systems
• Electronic Communication Networks
– Private computer networks that directly link
buyers with sellers
• National Market System
– Securities Act of Amendments of 1975
• Bond Trading
– Automated Bond System (ABS)
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Market Structure in Other Countries
• London - predominately electronic trading
• Euronext – market formed by combination of
the Paris, Amsterdam and Brussels
exchanges
• Tokyo Stock Exchange
• Globalization and consolidation of stock
markets
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Figure 3.6 Market Capitalization of Major
World Stock Exchanges, 2007
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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
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Buying on Margin
• 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
• 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 that you
must put up additional funds
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Margin Trading - Initial Conditions
Example 3.1
X Corp
$100
60%
Initial Margin
40%
Maintenance Margin
100
Shares Purchased
Initial Position
Stock $10,000 Borrowed
Equity
$4,000
$6,000
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Margin Trading - Maintenance Margin
Example 3.1
Stock price falls to $70 per share
New Position
Stock $7,000 Borrowed $4,000
Equity
$3,000
Margin% = $3,000/$7,000 = 43%
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Margin Trading - Margin Call Example 3.2
How far can the stock price fall before a
margin call?
(100P - $4,000)* / 100P = 30%
P = $57.14
* 100P - Amt Borrowed = Equity
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Table 3.4 Illustration of Buying Stock
on Margin
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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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Short Sale – Initial Conditions Example 3.3
Dot Bomb
50%
30%
$100
1,000 Shares
Initial Margin
Maintenance Margin
Initial Price
Sale Proceeds $100,000
Margin & Equity 50,000
Stock Owed
100,000
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Short Sale - Maintenance Margin
Stock Price Rises to $110
Sale Proceeds
Initial Margin
Stock Owed
Net Equity
Margin % (4000/11,000)
$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?
($150,000* - 1000P) / (100P) = 30%
P = $115.38
* Initial margin plus sale proceeds
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Regulation of Securities Markets
• Major regulations
– Securities Act of 1933
– Securities Act of 1934
– Securities Investor Protection Act of 1970
• Self-Regulation
– Stock markets are largely self-regulating
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Regulation Securities Markets Continued
• Regulatory Responses to Recent Scandals
– Public Company Accounting Oversight
Board
– Financial experts to serve on audit
committees of boards of directors
– CEOs and CFOs personally certify firms’
financial reports
– Boards must have independent directors
– Sarbanes-Oxley Act
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Circuit Breakers
• Trading halts
• Collars
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Insider Trading
• Officers, directors, major stockholders must
report all transactions in firm’s stock
• Insiders do exploit their knowledge
• Leakage of useful information to some
traders
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