primary and secondary markets

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Chapter 7:

Primary and Secondary Markets

Members:Malonzo, Minette

Manalastas, ZorenManalo, Kevin

Manddal, HonedeanMendoza, Vanessa Joy

Primary Markets:-dealing with newly issued financial

claims

Regulation of the Issuance of Securities

•Underwriting activities- are regulated by the Securities and Exchange Commission•Securities Act of 1933-governs the issuance of securities. The act requires that a registration statement be filed with the SEC by the issuer of the security

-the act provides for penalties in the form of fines and/or imprisonments if the information provided is inaccurate or material information is omitted.

Two parts of a registration.

2Chapter 7 Primary and Secondary Markets

Chapter 7 Primary and Secondary Markets

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(1) Part 1 is the prospectus- this part is typically distributed to the public as an offering of the securities(2) Part II contains supplemental information, which is not distributed to the public as part of the offering but is available from the SEC upon request

Due diligence- one of the most important duties of an underwriter to perform

The filing of a registration statement with the SEC doesn’t mean that the security can be offered to the public. The registration statement must be reviewed and approved by the SEC’s Division of Corporate Finance before the security can be offered to the public. The staff sends a “letter of comments” or “deficiency letter” to the issuer explaining the problem it encountered. The issuer must then remedy any problem by filing an amendment to the registration statement.


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Waiting period- the time interval between the initial filing of the registration statement and the time the registration statement becomes effectiveRed herring- because the prospectus is not effective, the cover page of the prospectus states this status in red ink and as a result, the preliminary prospectus is commonly referred to as red herring.

Rule 415: Shelf Registration Rule-In 1982 the SEC approved Rule 415 ,

which permits certain issuers to file a single registration document indicating that it intends to sell a certain amount of a certain class of securities at one or more times within the next 2 years. Rule 415 is popularly referred to as the shelf registration rule because the securities can be viewed as sitting on a “shelf” and can be taken off that shelf and sold to the public w/o obtaining addditional SEC approval


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Continued Reporting-any company that publicly offers a

security in the United States becomes a reporting company.

Private Placement of Securities

Securities Act of 1933 & The Securities Exchange Act of 1934- require that all securities offered to the general public must be registered with the SEC, unless given specific exemption

Three exemptions allowed by the securities act from federal registrations.•First, intrastate offerings –that is securities sold only within a state –are exempt.


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•Second, a small –offering exemption (Regulation A) specifically applies if the offerings is for $1million or less, then the securities need not be registered .•Finally , Section 4(2) of the 1933 Act exempts from registration “transactions by an issuer not involving any public offering”

In 1982 the SEC adopted Regulation D, which sets forth the specific guidelines that must be satisfied to qualify for exemption from registration under Section 4(2).

“accredited” investors- with the capability to evaluate the risk and return characteristics of the securities

-with the resources to bear the economic risks.


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Rule 144A-In April 1990, however , SEC Rule

144A became effective. This rule eliminate the 2-year holding period by permitting large institutions to trade securities acquired in a private placement among themselves w/o having to register these securities with the SEC.

-Private Placements are now classifieds as Rule 144A offerings or non-Rule 144A offerings. The latter are commonly referred to as traditional private placements. Rule144A offerings are underwritten by the investment bankers.

-Rule 144A also improves liquidity, reducing the cost of raising funds.


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Variations in Underwriting of Securities

Variations –include the “bought deal” for the underwriting of bonds, the auction process for both stocks and bonds and a right offerings for common stock

Bought Deal

Bought deal –was introduced in the Eurobond Market in 1981 when Credit Suisse First Boston purchased from General Motors Acceptance Corporation a $100million issue w/o lining up an underwriting syndicate prior to the purchase.


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Mechanics of a bought deal:

Lead manager/group manager –offers a potential issuer of debt securities a firm bid to purchase a specified amount of the securities with a certain interest rate and maturityIssuer –is given a day or so to accept or reject the bid. If the bid is accepted, the underwriting firm has “bought the deal”

Auction Process-another variation for the issuance of

securities. In this method the issuer announces the terms of the issue, and interested parties submit bids for the entire issue.


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auction form –is mandated for certain securities of regulated public utilities and many municipal debt obligations. It is commonly referred to as a competitive bidding under writing

Single-price auction or a Dutch auction -One way in which a competitive bidding can occur is all bidders pay the highest winning yield bid (or, equivalently, the lowest winning price).

Multiple-price auction -Another way is for each bidder to pay whatever they bid

Preemptive Rights Offerings


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-A corporation can issue new common stock directly to existing shareholders via a preemptive rights offering. A preemptive right grants existing shareholders the right to buy some proportion of the new share issued at a price below market value.

-A rights offering insures that current shareholders may maintain their proportionate equity interest in the corporation.

subscription price- The price at which new shares can be purchased

Standby underwriting arrangement -This arrangement calls for underwriter to buy the unsubscribed shares. The issuing corporation pays a standby fee to the investment banking firm.


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Word Capital Markets Integration and Fund-Raising Implications

-An entity may seek funds outside its local capital market with the expectation of doing so at a lower cost than if its funds are raised in its local capital markets. At the two extremes, the world capital markets can be classified as either completely segmented or completely integrated.

completely segmented market -investors in one country are not permitted to invest in the securities issued by an entity in another country

completely integrated market -contains no restriction to prevent investors from investing in securities issued in any capital market throughout the world


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Real-world capital markets are neither completely segmented nor completely integrated, but fall somewhere in between. A mildly segmented market or mildly integrated market implies that world capital markets offer opportunities to raise funds at a lower cost outside the local capital market.

Motivation for raising funds outside of the domestic marketIn the case of debt the cost will reflect two factors:(1)the risk free rate, which is accepted as the

interest rate on a US Treasury security with the same maturity or some other low-risk security (called the base rate)

(2)a spread to reflect the greater risks that investors perceive as being associated with the issue or issuer


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market frictions-occur because of differences in security regulations in various countries, tax structures, restrictions imposed on regulated institutional investors, and the credit risk perception of the issuer

Secondary markets-Already –issued financial assets trade;

market for seasoned securities.-the issuer of the asset does not receive

funds from the buyer. Rather, the existing issue changes hands in the secondary market, and funds flow from the buyer of the asset to the seller.

Functions of secondary MarketsThe secondary market provides to an issuer of securities, whether the issuer is a corporation or a governmental unit, regular information about the value of the security.


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It provides the opportunity for the original buyers of the asset to reverse their investments by selling it for cash.It brings together many interested parties and so can reduce the cost of searching for likely buyers and sellers of assets

Architectural Structure of Secondary Markets

Two general architectural structures that can be used in establishing a secondary market for a financial asset:

Order-drivenQuote –driven Markets


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Potential Parties to TradeNatural BuyersNatural SellersBrokers Dealers

Natural buyers and natural sellers-want to take position for their own portfolio. They can be retail investors or institutional investors.Broker –is a third party in a trade that acts on behalf of a buyer or seller who wishes to execute an order. -it is said to be an “agent” of the one of the parties to the tradeDealer –is an entity that acts as an intermediary in a trade by buying and selling for its own account; a dealer will buy a financial asset to place in its inventory or will sell a financial asset from its own inventory -it is said to; “take a position in an asset”


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-a dealer is acting as a principal in a tradeThe ask price –the potential income earned from this intermediary activity is the difference between the price at which a dealer is willing to offer a financial asset to investorsThe bid price –the price at which the dealer is willing to buy a financial asset from investorsBid-ask spread –the difference between ask price and bid priceMarket maker –special type of dealer; it describe a dealer who has a special obligation in the secondary market.

Open-driven Market and Quote-Driven Market

Open-driven market –is where all participants in the trade are natural buyers and natural sellers and there is no dealer acting as an intermediary; also describe as auction market.


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Quote-driven market –in here rather than having the interaction of natural buyers and natural sellers determine the price, the price is determined by the dealer based on prevailing information; it is also referred as dealer market or dealership market

Types of Order-Driven MarketContinuous order-driven market-prices are determined continuously through-out the trading days buyers and sellers submit orders.Periodic call auction- orders are batched or grouped together for simultaneous execution at preannounced times

Price scan auction –an auctioneer announces tentative prices and the participants physically present respond indicating how much they would be willing to buy and sell at each tentative price


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sealed bid/ ask auction- bid price/ask price and quantities at which a participants is willing to transact are submitted

Trading Location

Classification of organized Secondary Markets:Exchanges –secondary markets that are legally established as national securities exchanges. The products traded are approved by the director of the exchange and referred to as “listed products”Over-the-counter Market (OTC Market) –is simply the market where non-exchange traded products are traded. Trading is done by the geographically dispersed traders who are linked to one another via telecommunications system. In the case of common stock, unlisted stock are traded in the OTC market also the non-exchange traded derivatives and foreign exchange.


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Perfect Markets-a perfect market results when the number

of buyers and sellers is sufficiently large, and all participants are small enough relative to the market so that no individual market agent can influence the commodity’s price. More is involved in a perfect market than market agents being price takers. No transaction costs or impediments must interfere with the supply and demand of the commodity. Economists refer to these various costs and impediments as “friction.” In the case of financial markets, frictions would include the following:Commissions charged by brokersBid-ask spreads charged by dealersOrder handling and clearance chargesTaxes (notably on capital gains) and government-imposed transfer fees


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Costs of acquiring information about the financial assetTrading restrictions, such as exchange-imposed restrictions on the size of a position in the financial asset that a buyer or seller may takeRestrictions on market makersHalts to trading that may be imposed by regulators where the financial asset is traded

Types of Orders Investors must provide information to the broker about the conditions under which the will transact. The types of order include market orders, limit orders, stop orders, time-specific orders: market orders and limit orders. The simplest type of order is the market order, an order executed at the best price available in the market


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To avoid the danger of adverse unexpected price changes, an investor can place a limit order that designates a price threshold for the execution of the trade. The limit order is a conditional order- it is executed only if the limit price or a better price can be obtainedA buy limit order indicates that the security may be purchased only at the designated price or lower. A sell limit order indicates that the security may be sold at the designated price or higher.On an exchange, a limit order that is not executable at the time it reaches the market is recorded in a limit order book. The orders recorded in this book are treated equally with other orders in term of priority.


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This practice of selling securities that are not owned at the time of sale is referred to as selling short. The security is purchased subsequently by the investor and returned to the party that lent it. When the security is returned, the investor is said to have “covered the short position.” A profit will be realized if the purchase price is less than the price that the investor sold shortly the security.

A transaction in which an investor borrows to buy additional securities using the securities themselves as collateral is called buying on margin.

The interest rate that banks charge brokers for the transactions is known as the call money rate (also called the broken loan rate).


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Initial margin requirement- is the proportion of the total market value of the securities that the investor must pay for in cash. The initial margin requirement varies for stocks and bonds and is current 50%, although it has been below 40%.The 1934 act- gives the board of Governors of the Federal Reserve’s the responsibility to set initial margin requirement, under regulation T and U.

For the market to accommodate these types of transactions mechanism must be available in the market place where the financing of positions in securities can be done quickly and at reasonable cost and where securities can be borrowed so that short selling can take replace. The financing in securities and borrowing of securities fall into a little known, but obviously important, area of finance called security finance


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Securities finance involves two activities: securities lending and repurchase agreements.

Securities lending -The short seller borrows the security from the broker. That’s short answer, however, masks the role of a major activity in financial markets called securities lending and the motivation of the parties in a securities lending transaction. Securities lending involves the temporary transferring of a security by one party to another party.security lender -The party that transfers the securitysecurity borrower -The party needs the securityThe security lending agreement calls for the borrower to return the borrowed security to the security lender either on demand or by specified date.


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When there is cash collateral that is posted by the security borrower, the security lender now has cash available to invest. The agreement will call for the security lender to pay to the security borrower a fee referred to as the rebate. The amount of the rebate is equal to the amount of the cash collateral multiplied by the rebate rate.

The securities lending groups assist customers in negotiating the rebate rate, identifying acceptable counterparties in transactions, and investing the cash collateral to generate a spread over the rebate rate.

Repurchase agreements -being able to finance positions in securities is critical in financial market. This can be done by using the securities purchase as collateral for loan.


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A repurchase agreement, more popularly referred to as repo, is the sale of a security with a commitment by the seller to buy the same security back from the purchaser at a specified price at a designated future date. repurchase price-The price at which the seller must subsequently repurchase the securityrepurchase date- the date that the security must be repurchaseda repo is a collateralized loan, where the collateral is the security sold and subsequently repurchased.repo rate- The term of the loan and the interest rate that the entity seeking financing agrees to payWhen the term of the loan is one day, it is called an overnight repo; a loan for more than one day is called a term repo.


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The transaction is referred to as a repurchase agreement because it calls for the sale of the security and its repurchase at a future date. Both the sale price and purchase price are specified in the agreement: The difference between the purchase (repurchase) price and the sale price is the dollar interest cost of the loan.

One party is lending money and accepting a security as collateral for the loan: the other party is borrowing money and providing collateral to borrow the money. When someone lends securities in order to receive cash (i.e., borrow money), the party is said to be “reversing out” securities. A party that lends money with the security as collateral is said to be “reversing in” securities.


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The amount by which the market value of the security used as collateral exceeds the value of the loan is called repo margin. Repo margin is also referred to as the “haircut”. Repo margin is generally between 1% and 3%. For borrowers of lower creditworthiness and/or when less liquid securities are used as collateral, the repo margin can be 10% or more.

There is not one repo rate in the market. The rate varies from transaction to transaction depending on a variety of factors: quality of collateral, term of the repo, delivery requirement, availability of collateral, and the prevailing federal funds rate. The higher the credit quality and liquidity of the collateral, the lower the repo rate. The more difficult it is to obtain the collateral, the lower the repo rate.


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Role of brokers and dealers in real marketsCommon occurrences in real markets keep them from being theoretically perfect. Because of these occurrences, brokers and dealers are necessary to the smooth functioning of a secondary market.

Brokers Most investors in even smoothly

functioning markets need professional assistance. Investors need someone to receive and keep track of their orders for buying or selling, to find other parties wishing to sell or buy, to negotiate for good prices, to serve as a focal point for trading, and to execute the orders. The broker performs all of these functions.


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Dealers as market makersThe dealer acts as an auctioneer in some market structures, thereby providing order and fairness in the operations of the market.The role of a market maker in a call market structure is that of an auctioneer. The market maker does not take a position in the traded security, as a dealer does in a continuous market.Dealers also have to be compensated for bearing risk. A dealers position may involved carrying inventory of a security (a long position) or selling a security that is not in inventory (a short position).

Three types of risks are associated with maintaining a long or short position in a given security:


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First, the uncertainty about the future price of the security presents a substantial risk. A dealer who takes a long position in the security is concerned that the prices will decline in the future; a dealer who is in a short position I concerned that the price will rise.The second type of risk concerns the expected time it will take the dealer to unwind a position and its position and its uncertainty, which, in turn, depends primarily on the rate at which buy and sell orders for the security reach the market.Finally, although a dealer may be able to access better information about order flows than the general public, in some trades the dealer takes the risk of trading with someone in possession of better information.


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Market efficiencyThe term efficient, used in several context, describe the operating characteristics of a capital market. A distinction, however, can be made between an operationally (or internally) efficient market and a pricing (or externally) efficient capital market.

Operational efficiencyIn an operationally efficient market, inventors can obtain transaction services as cheaply as possible, given the costs associated with furnishing those services

Pricing efficiencyRefers to a market where prices at all times fully reflect all available information that is relevant to the valuation of securities.


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Price formation process defined the “relevant” information set that prices should reflect. Fama classified the pricing efficiency of a market into three forms: weak, semi-strong, and strong.

Weak efficiency- means that the price of the security reflects the past price and trading history of the security. Semi-strong efficiency- means that the price of the security fully reflects all public information, which includes but is not limited to historical price and trading patterns.Strong efficiency- exist in a market when the price of a security reflects all information, whether or not it is publicly available.A price efficient market carries certain implications for the investment strategy investors may wish the purpose.


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Transaction costsIn an investment era where one half of one

percentage point can make a difference when a money manager is compared against a performance benchmark, an important aspect of the investment process is the cost of implementing an investment strategy. Transaction costs are more than merely brokerage commissions-they consist of commissions, fees, execution cost, and opportunity costs.

Commissions- are the fees paid to brokers to trade securities. In may 1975 commissions became fully negotiable and have declined dramatically since then. Included in the category of fees are custodial fees and transfer fees. Custodial fees are the fees charged by an institution that holds securities in safe keeping for an investors.


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Execution costs represent the difference between the execution price of a security and the price that would have existed in the absence of trade. Execution costs can be further decomposed into market (or prices) impact and market timing costs.

Market impact costs- is the result of the bid-ask spread and a price concession extracted by dealers to mitigate their risk that an investors demand for liquidity is information motivated.Market timing costs- arises when an adverse price movement of the security during the time of the transaction can be attributed in part to other activity in the security and is not the result of a particular transaction.


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Information-motivated trading occurs when the investors believe they possess pertinent information not currently reflected in the security’s prices.Informationless trades results from either a reallocation of wealth or implementation of an investing strategy that utilizes only existing information.Opportunity costs may arise when a desired trade fails to be executed. This components of costs represents the difference in performance between an investors desired investment and the same investors actual investment after adjusting for execution costs, commissions, and fees.


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…END…

God Bless!

primary and secondary markets

Economy & Finance

local capital market

world capital markets

market timing costs

rule 144a offerings

shelf registration rule

completely segmented

capital market

secondary markets