Transcript Slide 1

CHAPTER 3
How Securities
are Traded
Investments, 8th edition
Bodie, Kane and Marcus
Slides by Susan Hine
McGraw-Hill/Irwin
Copyright © 2009 by The McGraw-Hill Companies, Inc. All rights reserved.
How Firms Issue Securities
• 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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How Firms Issue Securities Continued
• Investment Banking
• Shelf Registration
• Private Placements
• Initial Public Offerings (IPOs)
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Investment Banking
• Underwritten: firm commitment on proceeds
to the issuing firm
-buying out all stock at lower price than
announced one (spread) and sell them to
public
• Red herring: preliminary prospectus
• Prospectus
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Figure 3.1 Relationship Among a Firm Issuing
Securities, the Underwriters and the Public
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Shelf Registrations
• SEC(securities and exchange commission)
Rule 415
• Introduced in 1982
• Ready to be issued – on the shelf
can gradually sell for two years
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Private Placements
• Sale to a limited number of sophisticated
investors not requiring the protection of
registration
• Allowed under Rule 144A
-less costly because registration statements
are not required
• Less liquid and lower price due to absence of
general public
• Very active market for debt securities
• Not active for stock offerings
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Initial Public Offerings
• Process
– Road shows: distribute and gather info
– Bookbuilding: finally decide price
Investors give true info? If yes, why?
• Underpricing
– Post sale returns
– Cost to the issuing firm
• Long term poor performer?
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Figure 3.2 Average Initial Returns for
IPOs in Various Countries
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Figure 3.3 Long-term Relative
Performance of Initial Public Offerings
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How Securities are Traded
• Types of Markets
– Direct search
• Least organized
– Brokered
• Trading in a good is active
• e.g. primary market; broker=underwriter
– Dealer
• Trading in a particular type of asset
increases;
– Auction
• Most integrated, e.g. NYSE
• No need to compare prices bet. dealers
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Types of Orders
• Market orders—executed immediately
– Bid Price, Ask Price
• Price-contingent orders
– Limit orders
• Buy limit order
$21 for the current market price $23
• Sell limit order
$24 for the current market price $23
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Types of Orders…
– Stop orders
• Buy stop order (stop loss order)
$24 for the current market price $23
• Sell stop order
$20 for the current market price $23
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Figure 3.4 The Limit Order Book
to be sold at $20.77; to be bought at $20.78
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Figure 3.5 Price-Contingent Orders
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Trading Mechanisms
• Dealer markets
-Dealers quote prices
-Brokers contact dealers and match quotes
• Electronic communication networks (ECNs)
-No intermediation of brokers
-Executed automatically if orders are matched
• Specialists markets
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Trading Mechanisms…
• Specialists markets
-Each security is assigned to a specialist
-Brokers with clients’ orders send them to
specialist
-Specialist acts as broker, executing orders
-Specialist maintains fair and orderly market
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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
• Orig. over-the-counter dealer market, now
electronic communication network
• NASDAQ Global Select Market, Global
Market, Capital Market
• Levels of subscribers
– Level 1 – only receives inside quotes
– Level 2 – receives all quotes but they can’t
enter quotes
– Level 3 – can enter all quotes; are 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
• How it works
– Investor sends order to brokers, who contact
– Floor brokers go to
– Specialists try to find party to accept order
license of floor broker is bought by the year.
• Block houses: brokers who match big
block trades.
• SuperDot: electronic trading system
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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
– attempt to integrate all markets
• Bond Trading
– Automated Bond System (ABS)
– Developing but still by OTC dealer market
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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
-First section, Second section, Mothers
-Nikkei 225(price weighted), TOPIX(value
weighted) of first section company
• 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
Full service brokers, discount brokers
• 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
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Buying on Margin
• Paying only part of price and borrowing rest
from broker
• Margin in the account is part payed by
investor
• Broker borrows that money from bank at
broker's call rate and charges investor with
that rate plus service charge.
• Securities bought this was are kept at
broker's as collateral for the loan.
Margin arrangements differ for stocks and
futures
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Stock Margin Trading
• Initial Margin is currently 50%; you can borrow
up to 50% of the stock value
– Set by the Fed
• Maintenance margin,usually 25%: minimum
amount which net worth (equity) in trading
can be
• Margin call: notification from broker that you
must put up additional funds when net worth
falls below maintenance margin
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Margin Trading - Example 3.1
Buying 110 shares of X Corp at $100

60%
Initial Margin

40%
Maintenance Margin

Initial Position
Assets
Stock value $10,000
Liabilities and net worth
Loan
$4,000
Equity
$6,000
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Margin Trading - Example 3.1...
Suppose stock price falls to $70 per share

New Position
Assets
Stock value $7,000
Liabilities and net worth
Loan $4,000
Equity $3,000

Investor's new margin is now
Margin% = $3,000/$7,000 = 43%

Still, ok. It's above maintenance margin.

But if maintenance margin is 45%,
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Margin Trading - Example 3.1...

But if maintenance margin is 50%, margin
call is made to put in at least additional funds
of:

($3,000+x)/$7,000=0.5→ x=$500

New position here
Assets
Liabilities and net worth
Stock value $7,000
Loan $4,000
Deposit
Equity $3,000
$500
Deposit $500
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Margin Trading - Margin Call Example 3.2
How far can stock price P fall before a
margin call?

Suppose maintenance margin is %30.

(100P - $4,000)* / 100P ≥ 30%

!100P - Amount Borrowed = Net worth(Equity)!
P ≥ $57.14

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Table 3.4 Buying Stock on Margin
$100 per share, investing $10,000 cash and buying on
margin total of $20,000, 9% margin loan rate
Buying on margin can bring huge gain and loss, too.
30% price rise: ((26,000-10,900)-10,000)/10,000=0.51
No price change((20,000-10,900)-10,000)/10,000=-0.09
30% price fall:((14,000-10,900)-10,000)/10,000=-0.69
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Short Sales
• Sell security without having it
• Mechanics
– Borrow stock through a broker from someone
– Sell it and deposit proceeds plus
margin(again!) in an account at broker
– Cover the short position: buy the stock from
someone and return to the party from whom
you borrowed

Purpose: profit from a decline in the price of
security
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Short Sale – Initial Conditions Example 3.3
Dot Bomb
$100
50%
30%
 Position
Assets
Cash $100,000
T-bills 50,000
1,000 Shares
Initial Price
Initial Margin
Maintenance Margin
Liabilities and net worth
Short position $100,000
Net worth(equity)50,000
Net worth/Value of security owed=
$x/$100,000=0,5---->x=$50,000
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Short Sale – Example 3.3...
-Sale Proceeds
-Margin & Equity
-Stock Owed
$100,000
$ 50,000
$100,000
Suppose Stock price falls down to $70
 Cover(close out) short position now
-Buy 1,000 shares at $70 on market, costing
$70,000
-Your gain: 100,000-70,000=$30,000

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Short Sale - Maintenance Margin
Suppose stock Price Rises to $110
 Position
Assets
Liabilities and net worth
Cash $100,000
Short position $110,000
T-bills 50,000
Net worth(equity)40,000

Sale Proceeds
$100,000
Initial Margin
50,000
Stock Owed
110,000
Net Equity
40,000
Margin % (40,000/110,000)
36%
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Short Sale - Maintenance Margin...
Suppose maintenance margin is 40%
 Maintenance call is made.
 How many more additional fund to put in:
$x/$110,000=40% ---> x=$44,000
 Put in additional $4,000
 New Position
Assets
Liabilities and net worth
Cash $100,000
Short position $110,000
T-bills 50,000
Net worth(equity)44,000
Cash 4,000

(or whatever)
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Short Sale - Margin Call...
Suppose maintenance margin is 30%.
How much can stock price P rise before
margin call?
Debt(value of shares to pay back)1,000P
Net worth(equity) in your account $150,0001000P
Your margin ration is
($150,000 - 1000P) / (1000P) ≥ 30%
P ≥ $115.38

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Regulation of Securities Markets
• Major regulations
– Securities Act of 1933; registration of new
securities, prospectus etc.
– Securities Exchange Act of 1934
Securities Investor Protection Act of 1970;
protect investors from default of brokers
• Self-Regulation
– Stock markets are largely self-regulating
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Regulation Securities Markets Continued
• Regulatory Responses to Recent Scandals
--->Sarbanes-Oxley Act
– Public Company Accounting Oversight
Board
– Independent financial experts to serve on
audit committees of boards of directors
– CEOs and CFOs personally certify firms’
financial reports and are liable to penalties
– Auditors no longer provide other services
– Boards must have independent directors
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Circuit Breakers
• Trading halts
If DJIA falls 30%, market closes down.
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Insider Trading
• Officers, directors, major stockholders must
report all transactions in firm’s stock
• Insiders do exploit their knowledge; proof?
-Criminal conviction
-Leakage of useful information to some traders
before public announcement
-Study reports that insiders make abnormal
gains over share trade.
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