Part I: Investment Environment (continued)

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1 Securities & Investments Analysis First few Weeks: Investment Environment Markets and Instruments Weeks 3 & 4: Issuing Securities Trading Securities (market microstructure items ) Part II: Fixed Income Securities Part I: Investment Environment (continued)

2 How Securities are traded Primary market Focus: Issuing Stocks and Bonds Secondary markets Exchanges; Nasdaq & OTC; 3 rd and 4 th markets Operations Buying (with cash or on margin), Selling, Shorting Mutual Funds Issuing Securities Primary vs. secondary market 1000 s of investment banks make the primary market Types of Issues public offering vs. private placement initialpublic offering (IPO) vs. seasoned offering Underwriting red herring (preliminary prospectus) vs. prospectus firm commitment vs. best-efforts agreement» underwritten (most common) vs. best-efforts» underwriting spread = sale price to public cost to IB hiring underwriters: negotiations vs. bidding

3 Issuing Securities 2 Key IPO Facts IPO sequence: Book building > IPO > Secondary market trading IPO underpricing: Short-term underpricing / Long-term performance Under pricing is common (19%) Importance of the marginal investor (Google) hot vs. cold IPO Post -IPO trading is heavy (in 3 days, typical turnover of a year) Flipping Long-term performance Perception: IPOs underperform Reality: Comparing apples to apples, they don t Issuing Securities 3 FBN Inc. has just sold 100,000 shares in an initial public offering. The underwriter s explicit fees were $70,000. The offering price for the shares was $50, but immediately upon issue the share price jumped to $53. (a) What is your best guess as to the total cost to FBN of the equity issue? (b) Is the entire cost of the underwriting a source of profit to the underwriters? Answers: (a) In addition to the explicit fees of $70,000, FBN appears to have paid an implicit price in underpricing of the initial public offering (IPO). The underpricing is $3/share or $300,000 total, which implies total costs of $370,000. (b) No. The underwriters do not capture the part of the costs corresponding to the underpricing. The underpricing may be a rational marketing strategy.

4 Security trading Possible market types Direct search market (investor-to-investor trades; ECNs) Brokered market primary market block transactions (blocks of 10,000+ shares trade upstairs ) Dealer market (NASDAQ, OTC [ pink slips ]) Auction market (NYSE, AMEX, TSE) specialists vs. dealers Our focus: ECNs, dealer, & auction markets Bond and/or Stock Markets in the US Secondary Markets Specialist markets (aka exchange markets) NYSE(2,767 companies listed, 12-05; 3,616 companies for group, 09-07) AMEX (New York also; 881 smaller issues, 08-07) Seven others (ISE, Boston, Philadelphia, etc.) Dealer markets NASDAQ Stock Market (3,106 listings, 09-07; incl. 20% Small Caps) Electronic market in which 500+ dealers compete ( OTC?) Nasdaq InterMarket SM (aka/fkathird Market) OTC trades of NYSE-listed stocks Fourth Market Direct trades between investors on networks ECNs: ArcaEx(NYSE), Brut (Nasdaq), INET (Nasdaq), etc.

5 ArcaEx/NYSE ECNs & Stock Markets Two systems sort of in parallel Effectively, works as a three-tiered system INET/Nasdaq Small orders > Arca Bigger orders > specialist (down from 5 to 2 floors!) Large orders > upstairs INET became the backbones of Nasdaq In a sense, Nasdaq works as an ECN Order Types (specialist & dealer markets) Market Orders Limit orders limit buy» executed when price falls to target limit sell» executed when price increases to target Stop orders stop loss» executed (sell) when price falls to (below?) target stop buy» executed (buy)when price increases to (above?) target

6 Order Types 2 -- Stop Order Example The table below provides some price information on Marriott: Bid Price Asked Price Marriott 37 ¼ 38 1/ You have placed a stop-loss order to sell at $38. By placing this order, what are you in effect asking your broker to do? Given the market prices, will your order be executed? Answer: You are asking the broker to try to sell Marriott as soon as the stock is being sold at bid price of $38 or less. Here, the broker will attempt to immediately execute your order, but he may not be able to get $38 -- since the bid price is now 37 ¼. Investors Brokers > roles Dealers Participants Dealer Market

7 Participants Specialist Market Investors Brokerage firms > commission brokers Floor: Floor brokers» independent; handle some work for commission brokers Registered traders» trade directly > avoid broker commissions Specialists (NYSE, AMEX, )» Now involved in less than 1out of every 30 trades (vs. 1 out of 7, three years ago)» Floor brokers involved in another 4 out of 30 NYSE : Demutualization: from 1366 seat holders to 800 brokers paying $50k for license Trends: less trading on the floor share down to 50% vs. 80%; floor brokers and traders down to 1,700 from 3,000 Brokers (use ECNs, specialist & dealer mkts) Services order execution security safekeeping, invest spare cash in money market margin loans advice, research (full service vs. discount) full: Merrill Lynch, Goldman Sachs, UBS PaineWebber, Morgan Stanley, Smith Barney (Citigroup) commissions: $30 - $150 for 1 common stock transaction discount: Schwab, Quick & Reilly, Muriel Siebert, TDWaterhouse, Fidelity Investments, Brown&Co commissions: $10 - $40 for 1 common stock transaction Overall costs of trading Commission plus B-A spread

8 Market Making: Dealer Mkts 1 OTC Characteristics (OTC) no fixed location no membership required for trading no listing requirement for securities dealer registration with SEC; NASDAQ stock market Bid vs. Asked (offered) Prices» Bid = price at which the dealer buys from customers» Asked = price at which the dealer sells to customers Number of simultaneous prices» Walrasian auctioneer vs. OTC Market Making: Dealer Mkts 2 NASDAQ Characteristics headquartered in DC (also owns AMEX (NJ) and Brut (ECN)) no? membership required for trading no? listing requirement for securities Participants» SEC dealer registration needed Level 3 > Level 2 > Level 1 Dealers > Brokers > Investors enter B-A > know B-A s > know median B-A OTC bond market (very thin)

9 Market Making: The Specialist Broker role matches best (lowest) buy and best (highest) sell Dealer role: must maintain an orderly market quotes bid and asked prices trades on his own account used to be involved in 10-20% of all trades; now down to 3-5% MKT order > must buy at his bid / sell at his ask monopoly position Danger#1 for specialist: what if the market crashes? Market Making: Specialist 2 Which trade gets priority? best bid or best asked; crossing trades in this market» Ask = Min[specialist ask, lowest unfulfilled limit sell]» Bid = Max[specialist bid,highest unfulfilled limit buy] Danger#2 for the specialist: lack of information large traders trade with him < > quotes out of line possible solution: increase B-A spread» discourage investors» obligation to provide price continuity(example: 30-32)

10 Market Making: Specialist 3 Consider the following limit-order book of a specialist. The last trade in the stock took place at a price of $50. Limit-buy Orders Limit-sell Orders Price ($) Shares Price ($) Shares (a) If a market-buy order for a round lot (100 shares) comes in, at what price will it be filled? (b) At what price would the next market-buy order be filled? (c) You are the specialist: do you wish to increase or decrease your inventory of this stock? Block trades Market Making: Specialist 4 50% of all trades inventory problem for specialist broker matches, specialist executes Super DOT allows exchange members to send orders directly to specialist facilitates program trading (example: S&P 500)

11 Market Making: Specialist 5 Specialist s sources of income earns commissions as brokers earns B-A spread (often 1 to 2% of stock price) gets information from order book Differences with OTC OTC > brokers & search for the best B or A best price guarantee vs. trading through (OTC) price discovery vs. dealers only posting own B-A Market Making: Specialist 6 SEC-mandated changes on NASDAQ goal measures» reduce trading costs for investors public display of all limit orders > 100 shares» avoids trading through each dealer must make public his/her best quote» but quote on ECN vs. NASDAQ? display size of best limit order of customers

12 News & Numbers NASD and Amex merged in 1998» NASDAQ is a dealer market, AMEX is a specialist market Key statistics (NYSE vs. Amex vs. NASDAQ) # of companies listed NYSE(2,767 companies listed, 12-05; 3,616 corps. for group, 09-07) AMEX (881 smaller issues, 08-07) NASDAQ Stock Market (3,106 listings, Dollar volumes News & Numbers 2 Daily volumes? YTD Aug 2004 Jan 21, 2005 Nasdaq ($ billion) Nasdaq (million shares) 1,811 2,146 NYSE ($ billion) NYSE (million shares) 1,457 1,662

13 Buying on Margin & Short Sales Buying on margin idea: leverage limits: < 50% of the total value of the trade Short sales idea cash-flows: purchase vs. short sale (BKM7 Table 3.7) in practice: shares lent by broker restrictions only on upticks, proceeds cannot be reinvested, margins Buying on Margin & Short Sales 2 Numerical example: Short sale workout Question 10 Suppose that you sell short 100 shares of IBM, now selling at $70 per share. (a) What is your maximum possible loss? (b) What happens to the maximum loss if you simultaneously place a stop-buy order at $78?

14 Buying on Margin & Short Sales 3 Question 10: (a) In principle, potential losses are unbounded, growing directly with increases in the price of IBM. (b) If the stop-buy order can be filled at $78, the maximum possible loss per share is $8. If IBM shares go above $78, the stop-buy order is executed, limiting the losses from the short sale. Buying on Margin & Short Sales 4 Margin computation Purchases idea size» security deposit» at least 50% of the total value of the trade initial margin vs. maintenance margin equity in account Margin = value of stock value of stock loan = value of stock

15 Buying on Margin & Short Sales 5 Numerical example: Margin calls on purchase Question You have borrowed $20,000 on margin to buy shares in Disney, which is now selling at $80 per share. Your account starts at the initial margin requirement of 50%. The maintenance margin is 35%. Two days later, the stock price falls to $75 per share. (a) Will you receive a margin call? (b) How low can the price of Disney shares fall before you receive a margin call? Buying on Margin & Short Sales 6 Answer: (a) You will not receive a margin call. You borrowed $20,000 and with another $20,000 of your own equity, you bought 500 shares of Disney at $80 a share for a total investment of $40,000. At $75 a share, the market value of the account is $37,500, your equity is $17,500, and the percentage margin is 47%, which is above the required percentage maintenance margin of 35%. (b) A margin call will be issued when: P = (500P 20,000)/500P = 0.35, that is when P = $61.54.

16 Buying on Margin & Short Sales 7 Margin computation Short sales same idea» security deposit; initial vs. maintenance margin; etc. different implementation» shares are borrowed NOT money» cash proceeds from short sale must be left with broker» additional cash must also be deposited (at least 50% of the total value of shares owed) equity in account cash in account - value of stock owed Margin = = value of stock owed value of stock owed Timing Settlement 3 working days (cash shares, etc.) Keeping securities in street name danger Clearing house net orders every day

17 Government Regulations / Self Regulation Primary markets SEC, Fed, etc. Secondary markets dealer registrations SIPC (equivalent to FDIC; $500,000 per customer) limit breakers: trading halts, side cars, collars why? only one instance Mutual Funds Basic idea Roles record keeping (dividend reinvestment, etc.) diversification and divisibility reduced transactions costs professional management (some) NAV Mutual funds vs. management companies objectives (capital gains, growth, growth/income, income, income/security, index funds)

18 Closed-End vs. Open-End Funds Net asset value Closed-end traded through brokers (like any security) NAV puzzle why invest in a closed-end fund (dividend argument) Open-end MKT value of fund' s assets - liabilities NAV = number of shares issued redeemable from fund Costs of Trading Mutual Funds Load vs. no-load funds Costs load funds are sold through brokers (no direct sales) front load = 3 to 8.5% of NAV or 1 to 3% (low-load) why buy a load fund?!» what about exchange-traded funds (BKM6 Table 4.3) front-end load: 0 to 8.5% back-end load (redemption fee): 0 to 6%, falls with tenure (r, t) operating expenses: 0.2% to 2% 12b-1 charges (p, t) Example: Table 4.2 & Example 4.2

19 Other Investment Vehicles Commingled Funds essentially a very small open-end fund run by banks, insurance companies units vs. shares Unit investment trusts (UIT) fixed assets fixed portfolio composition Real Estate Investment Trust (REIT) similar to closed-end fund (different tax treatment) equity trusts vs. mortgage trusts Part II: Fixed Income Markets

20 Real vs. Nominal Rates and Risk Intuitively real rate = nominal rate - expected inflation Formally Rate guarantees Taxes nominal or real? expectations vs. realizations Real vs. Nominal Rates Intuitively real rate (r) = nominal rate (R) - expected inflation (i) r R - E[i] example: negative real rates vs. nominal rates? Formally (1+R) = (1+r) (1+ E[i]) Rate guarantees nominal or real? expectations vs. realizations

21 Real vs. Nominal Risk Risk volatility vs. downside Risk-free rate Risk premium for asset i E[R i ] - R f Excess return R i - R f Real vs. Nominal Rate Determinants Determinants of the real rate supply of funds by savers demand of funds by businesses government s net supply/demand of funds Determinants of the nominal rate nominal rates as predictors of inflation real rate volatility historical record

22 Problem Taxes no inflation adjustment for taxes Intuitively tax code hurts after-tax real rate of return Formally R(1-t) - i = r(1-t) - i.t Historical record

Market Microstructure

Market Microstructure (Text reference: Chapter 3) Topics Issuance of securities Types of markets Trading on exchanges Margin trading and short selling Trading costs Some regulations Nasdaq and the odd-eighths