Chapter 3

How Securities How Securities are Tradedare Traded

Chapter Summary

Objective: To explain the institutional details and mechanics of investing in securities.

How firms issue securities Organization of secondary markets Trading and execution Margin trading Costs and regulation

Primary vs. Secondary Security Sales

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

Investment Banking Arrangements

Underwritten vs. “Best Efforts” Underwritten: firm commitment on proceeds

to the issuing firm Best Efforts: no firm commitment

Negotiated vs. Competitive Bid Negotiated: issuing firm negotiates terms

with investment banker Competitive bid: issuer structures the

offering and secures bids

Public Offerings

Public offerings: registered with the OSC (Ontario - SEC in USA) and sale is made to the investing public Red herring Prompt offering prospectus

Initial Public Offerings (IPOs) Evidence of underpricing Performance

Private Placements

Private placement: sale to a limited number of sophisticated investors not requiring the protection of registration

Dominated by institutions Very active market for debt securities Not active for stock offerings

Types of Markets

Direct search markets Brokered markets

Block transactions

Dealer marketsOTC market

Auction marketsMajor exchanges

Organization of Secondary Markets

Organized exchanges OTC market Third market Fourth market

Organized Exchanges

Auction markets with centralized order flow

Dealership function: can be competitive or assigned by the exchange (specialists or registered traders)

Securities: stock, futures contracts, options, and to a lesser extent, bonds

Examples: TSE, ME, NYSE, AMEX

OTC Market

Dealer market without centralized order flow

NASDAQ: largest organized stock market for OTC trading; information system for individuals, brokers and dealers

Levels of interaction: users, market-makers Securities: stocks, bonds and derivatives

Most secondary bonds transactions

Third Market

Trading of listed securities away from the exchange

Institutional market: to facilitate trades of larger blocks of securities

Involves services of dealers and brokers

Fourth Market

Institutions trading directly with institutions

No middleman involved in the transaction

Organized information and trading systems INSTINET POSIT

ECN development

The execution of trades

Registered trader (market-maker) functions

Maintaining a “book” Maintain a “fair and orderly market” Execute “stabilizing” trades

Registered traders possess valuable inside information about the future direction of the market

Types of Orders

Instructions to the brokers on how to complete the order

Market Limit Stop loss

Summary Reminder

Objective: To explain the institutional details and mechanics of investing in securities.

How firms issue securities Organization of secondary markets Trading and execution Margin trading Costs and regulation

Using only a portion of the proceeds for an investment

Borrow remaining component Margin arrangements differ for stocks

and futures

Margin Trading

Greatest margin Currently 30% Set by the securities commissions

Minimum margin Minimum level the equity margin can be(called “maintenance” in USA)

Margin call Call for more equity funds

Stock Margin Trading

X Corp $7050% Initial Margin30% Minimum Margin1000 Shares PurchasedInitial PositionStock $70,000 Borrowed $35,000 Equity $35,000

Margin Trading - Initial Conditions

Margin Trading - Minimum Margin

Stock price falls to $60 per share

New PositionStock $60,000 Borrowed $35,000 Equity $25,000

Margin% = $25,000/$60,000 = 41.67%

Margin Trading - Margin Call

How far can the stock price fall before a margin call?

Therefore, P = $50

Note: 1,000xP – Amount Borrowed = Equity

%30P000,1

000,35$P000,1

Leveraging effect of margin purchases

You buy 200 shares of XYZ at $100, expecting a 30% appreciation of the stock in one year:

Initial margin: 50% Financed by a 9% loan for one year Expected net return: 51%

A 30% drop in the price, though, brings a negative rate of return of -69%.

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 Close out the position: buy the stock and

return it to the owner

Short Sale - Initial Conditions

Z Corp 100 Shares50% Initial Margin30% Minimum Margin$100 Initial Price

Sale Proceeds $10,000Margin & Equity $ 5,000Stock Owed $10,000

Short Sale - Minimum Margin

Stock Price Rises to $110

Sale Proceeds $10,000Initial Margin $ 5,000Stock Owed $11,000Net Equity $ 4,000Margin % (4,000/11,000) = 36%

Short Sale - Margin Call

How much can the stock price rise before a margin call?

So, P = $115.38

Note: $15,000 = Initial margin + sale proceeds

%30P100

P100000,15$

Summary Reminder

Objective: To explain the institutional details and mechanics of investing in securities.

How firms issue securities Organization of secondary markets Trading and execution Margin trading Costs and regulation

Costs of Trading

Commission: fee paid to broker for making the transaction Full service broker Discount broker

Spread: cost of trading with dealer Bid: price dealer will buy from you Ask: price dealer will sell to you Spread: ask - bid

Execution: better price obtained

Internet Trading

On-line brokers (discount or full-service) ECNs – electronic communication

networks Pre- and post-market trading (lack of

integration, thin trading)

Regulation of Securities Markets

Government Regulation Self-Regulation in the Industry Circuit Breakers Insider Trading