CHAPTER 3. How Securities are Traded INVESTMENTS BODIE, KANE, MARCUS. Copyright 2011 by The McGraw-Hill Companies, Inc. All rights reserved.

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2 INVESTMENTS BODIE, KANE, MARCUS 3-2 How Securities Are Traded Primary Market Firms issue new securities through underwriter to public Investors get new securities; firm gets funding Secondary Market Investors trade previously issued securities among themselves Ownership is transferred, no new securities

3 INVESTMENTS BODIE, KANE, MARCUS 3-3 Stocks How Firms Issue Securities IPO Seasoned offering Bonds Public offering Private placement

4 INVESTMENTS BODIE, KANE, MARCUS How Firms Issue Securities Privately Held Firms Up to 499 shareholders Middlemen have formed partnerships to buy shares and get around the 499-investor restrictions Raise funds through private placement Lower liquidity of shares Have fewer obligations to release financial statements and other information

5 INVESTMENTS BODIE, KANE, MARCUS 3-5 How Firms Issue Securities Shelf Registration SEC Rule 415 (1982): Allows firms to register securities, then gradually sell them two years Private placements Firm uses underwriter to sell securities to a small group of institutional or wealthy investors. Cheaper than public offerings Suitability concerns Not traded in secondary markets

6 INVESTMENTS BODIE, KANE, MARCUS 3-6 Initial Public Offerings (IPOs) Process Road shows to publicize new offering Book-building to determine demand for new issue Degree of investor interest in the new offering valuable pricing information IPO Shares allocated based on interest Caveat: high ethics are required during IPO process. Investment Bankers go through recurring compliance training.

7 INVESTMENTS BODIE, KANE, MARCUS 3-7 IPO Some Terminology Underwriting: investment bank helps the firm to issue and market new securities Prospectus: Describes the issue and the prospects of the company. Pre-file with SEC Red herring Once registration is final and accepted by SEC - Red Herring turns into Prospectus Registration does not mean approval Firm commitment: investment bank buys securities from the issuing company, then resells to the public (price risk)

8 Figure 3.1 Relationship Among a Firm Issuing Securities, the Underwriters, and the Public INVESTMENTS BODIE, KANE, MARCUS 3-8

9 INVESTMENTS BODIE, KANE, MARCUS 3-9

10 INVESTMENTS BODIE, KANE, MARCUS 3-10 Figure 3.3 Long-term Relative Performance of Initial Public Offerings

11 How Securities are Traded Types of Markets: Direct search Buyers and sellers seek each other (Examples?) Brokered markets Brokers search out buyers and sellers Dealer markets Dealers buy for their own account Dealers have inventories of assets from which they buy and sell Example: Corporate bonds Auction markets traders converge at one place to trade INVESTMENTS BODIE, KANE, MARCUS 3-11

12 INVESTMENTS BODIE, KANE, MARCUS 3-12 Bid and Asked Prices Bid Price Bids are offers to buy In dealer markets, the bid price is the price at which the dealer is willing to buy Investors sell to the bid Bid-Ask spread is the profit for making a market in a security Ask Price Asked prices represent offers to sell In dealer markets, the asked price is the price at which the dealer is willing to sell Investors must pay the asked price to buy the security

13 INVESTMENTS BODIE, KANE, MARCUS 3-13 Types of Orders Market Order: Executed immediately You receive ~current market price Price-contingent Order: You specify buying or selling price, or price triggers A large order may be filled at multiple prices

14 Limit and Stop orders Limit order Order to buy/sell X shares at price P or better Sell X shares of Facebook at 45 (or better) Buy X shares of Apple at 475 (or better) Guarantees price but not execution Stop order Order to sell X shares once a stock hits a price trigger Sell X shares of FB at stop price of 35 Buy X shares of Apple at stop price of 600 Once price trigger is hit, it guarantees execution, as it turns into market order, but does not guarantee price INVESTMENTS BODIE, KANE, MARCUS 3-14

15 INVESTMENTS BODIE, KANE, MARCUS 3-15 Figure 3.5 Price-Contingent Orders

16 INVESTMENTS BODIE, KANE, MARCUS 3-16 Price-Contingent Orders: Sell-Stop Q. Can the stock be sold below Purchase Price? A. Yes B. No

17 INVESTMENTS BODIE, KANE, MARCUS 3-17 Price-Contingent Orders: Sell-Stop Q. Can the stock be sold above Stop Price? A. Yes B. No Q. Can the stock be sold above Purchase Price? A. Yes B. No

18 INVESTMENTS BODIE, KANE, MARCUS 3-18 Price-Contingent Orders: Buy-Stop Q. Order possible execution prices from most to least likely: A. 9, 10, 7 B. 9.1, 8.9, 11 C. 8.9, 9.1, 11 D. 8.9, 10, 7

19 INVESTMENTS BODIE, KANE, MARCUS 3-19 Price-Contingent Orders: Buy-Stop

20 Price-Contingent Combined Orders: INVESTMENTS BODIE, KANE, MARCUS 3-20 Sell-Stop-Limit Q. Can the stock be sold below the Limit Price of 10? A. Yes B. No C. Maybe Q. Will the stock be sold above the Limit Price of 10? A. Yes B. No C. Not necessarily

21 INVESTMENTS BODIE, KANE, MARCUS 3-21 Price-Contingent Combined Orders: Sell-Stop-Limit

22 Contingent Market Orders Example The market opens and stock ABC starts trading, and prints the following trade prices: 9:31 AM $ :32 AM $ :33 AM $ :34 AM $ :35 AM $ :36 AM $ :37 AM $ :38 AM $ :39 AM $ :40 AM $ :41 AM $ :42 AM $20.39 Yesterday you bought shares of ABC for $18.75 per share. The stock closed at $22.75 per share. You want to protect your profit and place a sell-stop order at $20.70 as soon as the market opens. Does your order get executed? A. Yes B. No C. Maybe INVESTMENTS BODIE, KANE, MARCUS 1-22

23 Contingent Market Orders Example The market opens and stock ABC starts trading, and prints the following trade prices: 9:31 AM $ :32 AM $ :33 AM $ :34 AM $ :35 AM $ :36 AM $ :37 AM $ :38 AM $ :39 AM $ :40 AM $ :41 AM $ :42 AM $20.39 Same scenario. You have the same position in stock ABC. You want to protect against a price decline. Before market opens, you place a sell-stop-limit order at $20.70 stop, and $20.64 limit. Does your order get executed? A. Yes B. No C. Maybe INVESTMENTS BODIE, KANE, MARCUS 1-23

24 Contingent Market Orders Example The market opens and stock ABC starts trading, and prints the following trade prices: 9:31 AM $ :32 AM $ :33 AM $ :34 AM $ :35 AM $ :36 AM $ :37 AM $ :38 AM $ :39 AM $ :40 AM $ :41 AM $ :42 AM $20.39 Different scenario. You do not own the stock. You believe the stock fair value is around $20.70 Therefore you place a buy-limit order at $20.40 Does your order get executed? A. Yes B. No C. Maybe INVESTMENTS BODIE, KANE, MARCUS 1-24

25 Contingent Market Orders Example The market opens and stock ABC starts trading, and prints the following trade prices: 9:31 AM $ :32 AM $ :33 AM $ :34 AM $ :35 AM $ :36 AM $ :37 AM $ :38 AM $ :39 AM $ :40 AM $ :41 AM $ :42 AM $20.39 Same scenario. You believe the stock fair value is around $20.70 Change to buy-limit order at $20.70 Does your order get executed? A. Yes B. No C. Maybe INVESTMENTS BODIE, KANE, MARCUS 1-25

26 INVESTMENTS BODIE, KANE, MARCUS 3-26 Trading Mechanisms Dealer markets Electronic Communication Networks (ECN) True trading systems that can automatically execute orders Exchanges Specialists markets maintain a fair and orderly market

27 INVESTMENTS BODIE, KANE, MARCUS The Rise of Electronic Trading In the US, the share of electronic trading rose from 16%, to 80% in 2000s, triggered by an interaction of new technologies/regulations 1975: Elimination of fixed commissions on the NYSE 1994: New order-handling rules on NASDAQ, leading to narrower bid-ask spreads

28 INVESTMENTS BODIE, KANE, MARCUS The Rise of Electronic Trading 1997 and 2001: Reduction of minimum tick size from one-eighth to one-sixteenth, and 1 cent, respectively 2000: Emergence of NASDAQ Stock Market 2006: NYSE is renamed to NYSE Arca after acquiring the electronic Archipelago Exchange 2007: Creation of National Market System (NMS) to link exchanges electronically

29 INVESTMENTS BODIE, KANE, MARCUS 3-29 Electronic Communication Networks ECNs: Private computer networks that directly link buyers with sellers for automated order execution. Major ECNs include NASDAQ s Market Center, ArcaEx, Direct Edge, BATS, and LavaFlow. Flash Trading : Computer programs look for even the smallest mispricing opportunity and execute trades in fractions of milli-seconds. Q. Any concerns with this? [link]

INVESTMENTS BODIE, KANE, MARCUS 3-30 Lists about 3,000 firms (2,901 here on 23-Aug-2104) Originally, NASDAQ was primarily a dealer market with a price quotation system Today, NASDAQ s Market Center

30 INVESTMENTS BODIE, KANE, MARCUS 3-30 Lists about 3,000 firms (2,901 here on 23-Aug-2104) Originally, NASDAQ was primarily a dealer market with a price quotation system Today, NASDAQ s Market Center offers a sophisticated electronic trading platform with automatic trade execution 3 levels of subscribers Limit order book open to all Lower bid/ask spreads Large orders may still be negotiated through brokers and dealers

31 INVESTMENTS BODIE, KANE, MARCUS 3-31 New York Stock Exchange (NYSE) Lists ~1,900 firms. Overall mkt cap $16.6tn Automatic electronic trading runs side-by-side with traditional broker/specialist system SuperDot: electronic order-routing system DirectPlus: fully automated execution for small orders Specialists: Match orders, handle large orders and maintain orderly trading. May need to step in and provide liquidity by using own inventory for tight market making. Q. What s the incentive for the specialist?

32 INVESTMENTS BODIE, KANE, MARCUS 3-32 Compare Requirements NASDAQ vs NYSE NYSE Requirements

33 INVESTMENTS BODIE, KANE, MARCUS 3-33 Bond Trading Most bond trading takes place in the OTC market among bond dealers. Tight trade reporting required by regulators for transparency. Market for many bond issues is thin. NYSE is expanding its bond-trading system. NYSE Bonds is the largest centralized bond market of any U.S. exchange MarketAxess.com is a growing multi-dealer bond and CDS trading platform.

34 INVESTMENTS BODIE, KANE, MARCUS 3-34 Market Structure in Other Countries London - predominately electronic trading Euronext market formed by combination of the Paris, Amsterdam and Brussels exchanges, then merged with NYSE Tokyo Stock Exchange

35 INVESTMENTS BODIE, KANE, MARCUS 3-35 Globalization and Consolidation of Stock Markets NYSE mergers and acquisitions: Archipelago (ECN) American Stock Exchange Euronext NASDAQ mergers and acquisitions: Instinet/INET (ECN) Boston Stock Exchange Chicago Mercantile Exchange acquired: Chicago Board of Trade New York Mercantile Exchange

36 HAND SIGNALS THEORY and more at INVESTMENTS BODIE, KANE, MARCUS 3-36

37 INVESTMENTS BODIE, KANE, MARCUS 1-37 Open Outcry vs Electronic Trading Open outcry NYMEX pit traders against electronic trading The executives at NYMEX pursued electronic trading to keep the exchange competitive 2006: NYMEX teamed up with the CME to use Globex Traders quit and trading pits emptied out Banks, hedge funds, and huge oil companies stopped making telephone calls to the pits and started trading directly for themselves over screens

38 $ Billion INVESTMENTS BODIE, KANE, MARCUS Figure 3.8 The Biggest Stock Markets in the World by Domestic Market Capitalization 12,000 10,000 8,000 6,000 4,000 2,000 0

39 INVESTMENTS BODIE, KANE, MARCUS 3-39 Trading Costs Brokerage Commission: fee paid to broker for making the transaction Explicit cost of trading Full Service vs. Discount brokerage Spread: Difference between the bid and asked prices Implicit cost of trading

40 INVESTMENTS BODIE, KANE, MARCUS 3-40 Buying on Margin You borrow part of the total purchase price of a position from a broker You contribute the remaining portion Margin refers to the percentage or amount contributed by you You profit when the stock appreciates Q. What (if anything) secures this loan?

41 INVESTMENTS BODIE, KANE, MARCUS 3-41 Buying on Margin (Ctd.) Initial margin set by the Fed currently 50% Margin gives you leverage: you can buy with less money Maintenance margin Minimum equity that must be kept in the margin account. Below this level you must put in more money. Margin call if value of securities falls too much

42 INVESTMENTS BODIE, KANE, MARCUS 3-42 Margin Trading: Initial Conditions (example 3.10) Share price $100 60% Initial Margin 30% Maintenance Margin 100 Shares Purchased Initial Position Stock: $10,000 Borrowed $4,000 Equity $6,000 Q. How much money did you inject?

43 INVESTMENTS BODIE, KANE, MARCUS 3-43 Maintenance Margin Example 3.1 Stock price falls to $70 per share. The position is now worth 100*$70 = $7,000 New Position Stock: $7,000 Borrowed $4,000 Equity $3,000 Margin% = $3,000 / $7,000 = 43%

44 INVESTMENTS BODIE, KANE, MARCUS 3-44 Margin Call Example 3.2 How far can the stock price fall before a margin call? Let maintenance margin = 30% Equity = 100*P - $4,000 Maintenance margin = Equity / StockValue i.e = (100*P - $4,000) / 100*P Solve for P to find the price at which you get a margin call: P = $57.14

45 INVESTMENTS BODIE, KANE, MARCUS 3-45 Table 3.4 Buying Stock on Margin Assume: You buy $20k worth of stock You borrow $5k Interest rate = 9% Your stock investment needs to beat the interest paid

46 INVESTMENTS BODIE, KANE, MARCUS 3-46 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 it was borrowed

47 INVESTMENTS BODIE, KANE, MARCUS 3-47 Short Sale: Initial Conditions (example 3.3) Dot Bomb 50% 30% $ Shares Initial Margin Maintenance Margin Initial Price Sale Proceeds $100,000 Margin & Equity $50,000 Stock Owed 1000 shares

48 INVESTMENTS BODIE, KANE, MARCUS 3-48 Example 3.3 (cont.) Dot Bomb falls to $70 per share Assets $100,000 (sale proceeds) $50,000 (initial margin) Liabilities $70,000 (borrowed shares) Equity = A L $80,000 Profit = ending equity beginning equity = (decline in share price) x (number of shares sold short) = $80,000 - $50,000 = $30,000

49 INVESTMENTS BODIE, KANE, MARCUS 3-49 Short Sale - Margin Call How much can the stock price rise before a margin call? E / L = 30% E = A L Assets = Sales Proceeds + Initial Margin L depends on price P = 1000*P so ($150,000 (1) 1000*P) / (1000*P) = 30% Solve for P: P = $115.38

50 INVESTMENTS BODIE, KANE, MARCUS 3-50 Regulation of Securities Markets Major regulations: Securities Act of 1933 Securities Act of 1934 Securities Investor Protection Act of 1970 Self-Regulation Financial Industry Regulatory Authority CFA Institute standards of professional conduct

51 INVESTMENTS BODIE, KANE, MARCUS 3-51 Regulation of Securities Markets (cont) 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 - personal certifications throughout the organization Boards must have independent directors

52 INVESTMENTS BODIE, KANE, MARCUS 3-52 Insider Trading Officers, directors, major stockholders must report all transactions in firm s stock Insiders do exploit their knowledge. Jaffe study: Inside buyers>inside sellers = stock does well Inside sellers>inside buyers = stock does poorly

Chapter 3. Securities Markets. Copyright 2010 by The McGraw-Hill Companies, Inc. All rights reserved.

Chapter 3. Securities Markets. Copyright 2010 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 3 Securities Markets McGraw-Hill/Irwin Copyright 2010 by The McGraw-Hill Companies, Inc. All rights reserved. 3.1 How Firms Issue Securities 3-2 Primary vs. Secondary Market Security Sales Primary