I. The Primary Market

Transcription

1 University of California, Merced ECO 163-Economics of Investments Chapter 3 Lecture otes Professor Jason Lee I. The Primary Market A. Introduction Definition: The primary market is the market where new issues of stocks and bond are sold by firms in order to raise capital. There are two types of primary market equity issues: 1. Initial Public Offerings (IPOs) are stocks that are issued for the first time by a formerly private company. 2. Seasoned Equity (Secondary) Offering are new shares that are issued by a firm that has already issued outstanding shares in the past. There are also two types of primary market debt (bond) issues: 1. Public Offering are bonds that are issued by firms to the general public and that can be traded in the secondary market (market where previously issued securities are traded). 2. Private Placement are bonds that are issued by firms to institutional investors and are not sold in the secondary market. Typically private placement bonds are held to maturity. B. The Role of Investment Banking Definition: An underwriter is an investment bank that markets the public offerings of stocks and bonds in the primary market. There may be more than one investment bank who underwrites a new issue. Investment banks advises the firms on the terms (such as the price of the new issue) of the public offering. New issues must file a prospectus (detailing the prospects of the company) with the SEC. Typically, an investment bank buys the new issues from the corporation and resells them (at a slightly higher price) to the general public. The underwriter is responsible for marketing the new shares through road shows. The road shows are designed to generate interest among potential investors and provide information about the offering. The road shows provide information to the underwriters about the general price that they will be able to sell the securities. Investment banks typically under-price the IPO in order to build investor interest in the IPO. If the underwriter was unable to sell the securities to the public it would be forced to buy the remaining unsold securities and sell them at a loss in the secondary market.

2 The price jump that is typically observed when a new issue is first traded reflects the fact that the IPO was under-priced. C. Private Placement in Primary Market Definition: Private placement is when the firms sells shares directly to a small group of institutional or wealthy investors. The benefits of private placement is that it allows firms to raise fund without having to prepare a prospectus and register with the SEC (a costly process). Since the offering is available to only a small number of investors, it limits the amount of funds that can be raised through the offering. Private placement shares do not trade in the secondary markets and are thus illiquid making it less attractive to prospective investors. II. How Securities are Traded? A. Market Types There are 4 broad categories of markets in which assets can trade: 1. Direct Search Markets Definition: Direct search markets are markets in which buyers and sellers must seek each other out directly. Financial assets such as stocks and bonds are not traded on direct search markets. Example: An individual that has an asset (such as a used sofa or a used car) may advertise the asset on the internet (Craiglist) in order to seek out a buyer for the asset. 2. Brokered Markets Definition: Brokered Markets are markets in which a broker (an individual or firm with specialized knowledge of the asset trading in the market) offers search services to buyers and/or sellers. Example: In the real estate market, real estate brokers help buyers find a house and also help sellers sell the house. In the primary market, the investment bank acts as a broker by seeking buyers for the new issue. 3. Dealer Markets Definition: Dealer Markets are markets in which a dealer purchase assets for their own accounts and later sells them for a small profit from their inventory.

3 Dealer markets are attractive for traders because they know they can go directly to a dealer who will be willing to either buy or sell an asset. However, traders, may have to contact several dealers before they find the best price for the asset. Most bonds trade in dealer markets. 4. Auction Market Definition: An Auction market is a market in which buyers and sellers meet at one place (either a physical location or electronically) to conduct transactions. An advantage of an auction market over a dealer market is that traders don t have to go around to different dealers to get the best price. Since all the buyers and sellers are at the same place the asset will be traded at the best price. NYSE is an example of an auction market. Orders in an auction market can either be market orders or limit (price contingent orders). Definition: A market order is a buy or sell order that is executed immediately at the current market price. A market buy order would buy the stock at the current ask price. A market sell order would sell the stock at the current bid price. Definition: A limit order (price-contingent order) is a buy or sell order in which the investor specifies a price (a limit). A limit buy order is for shares to be purchased at or below the limit price. A limit sell order is for shares to be sold at or above the limit price. Definition: A stop order is a market order to buy or sell a stock once the stock hits the investor s specified limit price. A stop-loss order is a market order to sell a stock once the current price of the stock falls below a specified limit. A stop-buy order is a market order to purchase a stock once the current price of the stock rises above a specified limit. III. U.S. Securities Markets A. New York Stock Exchange (NYSE) The NYSE is the largest stock exchange in the U.S. The exchange lists approximately 2800 firms on the exchange. Only members of the NYSE can trade there. Membership can be purchased for an annual license fee and are primarily owned by large brokerage firms. Membership on the

4 exchange entitles the brokerage firm to place one of its brokers on the floor of the exchange where he or she execute trades for their customers. The exchange member charges investors a commission for executing trades on their behalf. In a formal exchange, such as NYSE, each security is managed by a specialist. A specialist s role is to act as a broker and a dealer. The specialist role as a broker is to execute buy and sell orders. The specialist role as a dealer is to buy or sell shares of a stock for their own portfolio. They must stand ready to buy or sell shares if no other trader can be found to take the other side of the trade. By regulation, a transaction that is executed on an exchange must settle within 3 business days. In other words, the buyer must deliver the cash and the seller must deliver the stock within three business days. B. NASDAQ NASDAQ (National Association of Securities Dealers Automated Quotation System) is not a formal exchange like the NYSE. There is no membership requirements for trading on the NASDAQ. The NASDAQ is an OTC (Over the Counter) market where security dealers quote prices at which they are willing to buy or sell securities. NASDAQ provides a computer-linked system which shows the bid and asked prices for stocks offered by various dealers. A brokerage firm who receives a buy or sell order from an investor can examine all the current quotes, contact the dealer with the best quote, and execute the trade. C. Bond Trading Vast majority of bond trading occurs on the OTC market among bond dealers (dealer markets). Unlike stocks, dealers do not have an extensive inventories of every issued bond (especially for corporate bonds). Because the bond trading market for corporate bonds is illiquid, there is a risk that the investor may be unable to sell the bond. D. Brokers Assisting investors in the purchase and selling of securities are brokers. There are two broad types of brokers that are used by investors. 1. Full-Service Brokers are brokers who execute orders for clients as well as provide information and advice on investment strategy. Some full-service brokers are given discretion by their clients and such brokers also actively buy and sell securities in their client s account.

5 2. Discount brokers are brokers who execute orders for clients only. They do not provide investment advice for their clients. Since they provide less services they generally incur less fees than a full-service broker. (E-Trade is an example of a discount broker). IV. Short Sales Definition: A short sale is when an investor borrows a share of stock and sells it. The stock must be repurchased at a later date. An investor who sells short is anticipating that the stock price will fall. In practice, in a short sale, the borrowed shares are loaned out by the brokerage firm (which borrow the shares from other customers who own the shares). The proceeds of the short sale cannot be invested or withdrawn. It is kept in an account with the broker. Numerical Example: Suppose that an investor has a negative outlook on Best Buy stock which is currently trading at $35. The investor believes that the stock price will fall in the near future and decides to short 1000 shares of Best Buy stock. The investor will have his or her brokerage firm borrow 1000 shares of Best Buy which the investor sells at the current market price of $35. Thus the investor will have $35,000 in proceeds which will be held at his brokerage firm. Let s consider two possible scenarios: Scenario #1: Suppose that the investor is correct in their forecast that Best Buy stock will fall and within a month the stock falls to $15. At the time, the investor will purchase 1000 shares of Best Buy (cover the short position) to return the borrowed shares. The cost of the purchase is $15,000. The investor s profit is equal to $35,000 - $15,000 = $20,000. Scenario #2: Suppose that the investor is incorrect in their forecast and Best Buy stock rises to $45 within a month. The investor decides to cover his short position at that price. The cost to cover his short position is $45 x 1000 shares = $45,000. The investor s profit is equal to $35,000 - $45,000 = -$10,000. An investor who is short a security has the potential for unlimited losses, while the upside potential is maximized at 100%. During times of stock market downturn, there may be regulations limiting the ability of investors to short stocks. This is down to prevent further drops in stock prices.

6 V. Margin Definition: Margin is a loan from the broker that the investor to partially finance the purchase of stock. The Federal Reserve limits how much can be purchased using margin. For a trade to be entered an initial margin requirement of 50% is required. In other words, in order for an investor to purchase stock using margin, at least 50% of the purchase must be paid in cash. Afterwards, brokerage firms require a margin maintenance which is a minimum amount of equity (cash or securities) in order to maintain the margin account. If the equity amount falls below the margin maintenance, a margin call is initiated which requires the investor to deposit more cash or transfer additional securities to build up equity. If the investor fails to meet the margin call, the brokerage firm will liquidate the position. Example #1: Suppose that the current price of Chevron stock is $120 and you want to purchase 100 shares which would cost you a total of $12,000 shares. However you only have $6000 in cash to buy the shares. You can still buy the 100 shares by opening a margin account and borrowing the balance of $6,000 from your brokerage firm. Recall that the initial margin requirement is 50% when you open a position. To check whether or not you meet this requirement we can use the following formula: Margin Percentage= Equity Stock Value x 100% Equity (also known as net worth) is the difference between what you own minus what you owe. For simplicity let s assume that you only own 1 asset (the Chevron stock) in your portfolio. Equity = $12,000 - $6,000 = $6000 and Stock Value = $120 x 100 shares = $12000 The margin percentage is equal to 50% which meets the initial margin requirement. Example #2 Now suppose that Chevron shares falls to $90, calculate the margin percentage after the fall in stock price.

7 Stock Value = $90 x 100 shares = $9000 Equity = $ $6000 = $3000 Margin Percentage = ($3000/$9000) x 100% = 33.33% If the margin percentage falls below the maintenance margin a margin call will be issued. At this point, the investor must add new cash or securities to raise equity and increase the margin percentage. Example #3: Suppose that the maintenance margin is equal to 25%. How far could the price of Chevron stock fall before the investor would get a margin call? We can use algebra to find the stock price. Stock Value = $P x 100 shares = 100P Equity = 100P - $ P = x 100% 100P Solve for P = $80. Thus if the stock price falls below $80, the investor will receive a margin call and will be forced to increase equity to maintain his position. Margin is popular because it allows for greater upside if the asset price appreciates. However, it also allows for greater downside if the asset price depreciates. Example #4: Suppose that Chevron stock increases to $150. Calculate the percentage return of the investor. Recall that the investor paid $6000 in cash for the stock and borrowed $6000. If the investor sells the stock the proceeds will be $150 x 100 shares = $15,000. The investor can repay the margin loan of $6000 and have $9000 left. Thus the return is equal to [($9,000 - $6,000)/$6000] = 50%. Although the stock increased by 25%, the return on investment for the investor was 50%. Example #5: Suppose that Chevron stock decreases to $90. Calculate the percentage return to the investor. If the investor sells the stock the proceeds will be $90 x 100 shares = $9,000. The investor can still repay the margin loan of $6000 and have $3000 left. Thus the return is equal to [($3,000 - $6,000)/$6,000] = -50%. Although the stock fell by -25%, the return on investment for the investor is negative 50%.

8 VI. Regulation of Securities Markets A. Securities Act of 1933 Required the full disclosure of information in the issuance of new securities. Corporations who wanted to issue shares were required to file a prospectus detailing the prospects of the company. Allowed investors to evaluate the risk of the corporation. B. Securities Exchange Act of 1934 Established the Securities and Exchange Commission to oversee the securities markets. Corporations that traded publically on the secondary exchanges (NYSE) are required to provide periodic disclosures of their financial information. C. Securities Investor Protection Act of 1970 Established the Securities Investor Protection Corporation (SIPC) which ensures that investors are protected (up to $500,000) should the brokerage firm fail. D. Sarbanes-Oxley Act of 2002 Act was a response to the financial scandals that were plaguing the financial industry between A main problem was firms releasing misleading or fraudulent financial statements. Required the creation of a board to oversee the auditing of public corporations. Required that the CEO (chief executive officer) and the CFO (chief financial officer) personally certify that their firms financial report was correct. Established penalties for the officers who give incorrect information. Auditing firms were no longer able to provide other services to their clients. Board of Directors must be comprised of independent directors (management could not be part of the directors). E. Insider Trading Definition: Insider Information is private information that is held by management, directors or others that has not been released to the general public. Regulations prohibit the use of insider information. However, determining what is considered insider information is subject to debate.