Textbook Questions

Securities Markets

1. LG 1

2. LG 2

3. LG 3

Securities markets  are markets that allow buyers and sellers of securities to make financial transactions. Their goal is to permit such transactions to be made quickly and at a fair price. In this section we will look at the various types of securities markets and their general characteristics.

Types of Securities Markets

In general, securities markets are broadly classified as either  money markets  or  capital markets . The money market is the market where short-term debt securities (with maturities less than one year) are bought and sold. Investors use the money market for short-term borrowing and lending. Investors turn to the capital market to buy and sell long-term securities (with maturities of more than one year), such as stocks and bonds. In this text we will devote most of our attention to the capital market. There investors can make transactions in a wide variety of financial securities, including stocks, bonds, mutual funds, exchange-traded funds, options, and futures. Capital markets are classified as either primary or secondary, depending on whether securities are being sold initially to investors by the issuer (primary market) or resold among investors (secondary market).

Before offering its securities for public sale, the issuer must register them with and obtain approval from the  Securities and Exchange Commission (SEC) . This federal regulatory agency must confirm both the adequacy and the accuracy of the information provided to potential investors. In addition, the SEC regulates the securities markets.

The Primary Market

The market in which new issues of securities are sold to investors is the  primary market . In the primary market, the issuer of the equity or debt securities receives the proceeds of sales. The most significant transaction in the primary market is the  initial public offering (IPO) , which marks the first public sale of a company’s stock and results in the company’s taking on a public status. The primary markets also provide a forum for the sale of additional stock, called seasoned equity issues, by already public companies.

Table 2.1  shows that only 21 operating companies sold stock to the public for the first time in the primary market in the United States during 2008, the first full year of the Great Recession, a period considered by many economists to be the worst economic downturn since the Great Depression of the 1930s. That number is less than one-twentieth the number of IPOs in 1999, the end of the technology-stock-driven bull market. When recovery from the Great Recession began in 2009, the number of IPOs per year also began to rebound, producing nearly twice as many IPOs relative to the previous year. Over the next five years, as the economy continued to rebound, so did IPO volume, reaching 206 IPOs in 2014. Seasoned equity offerings (SEOs) follow a similar pattern. The low point for SEO volume also occurred in 2008, though SEO deals have picked up since then.

Hear about Shake Shack’s IPO

To sell its securities in the primary market, a firm has three choices. It may make (1) a  public offering , in which the firm offers its securities for sale to public investors; (2) a  rights offering , in which the firm offers shares to existing stockholders on a pro rata basis (each outstanding share gets an equal proportion of new shares); or (3) a  private placement , in which the firm sells securities directly without SEC registration to select groups of private investors such as insurance companies, investment management funds, and pension funds.

Going Public: The IPO Process

Most companies that go public are small, fast-growing companies that require additional capital to continue expanding. For example, Shake Shack, a company that originated from a hot dog cart setup in 2001 to support the rejuvenation of New York City’s Madison Square Park, raised about $98 million when it went public on January 30, 2015, at $21 per share. But not every IPO fits the typical start-up profile. Large companies may decide to spin off a unit into a separate public corporation. The media and entertainment company Time Warner did this when it spun off its magazine business, Time, Inc., in June 2014.

When a company decides to go public, it first must obtain the approval of its current shareholders, the investors who own its privately issued stock. Next, the company’s auditors and lawyers must certify that all financial disclosure documents for the company are legitimate. The company then finds an investment bank willing to underwrite the offering. This bank is the lead underwriter and is responsible for promoting the company’s stock and facilitating the sale of the company’s IPO shares. The lead underwriter often brings in other investment banking firms to help underwrite and market the company’s stock. We’ll discuss the role of the investment banker in more detail in the next section.

The underwriter also assists the company in filing a registration statement with the SEC. One portion of this statement is the  prospectus . It describes the key aspects of the securities to be issued, the issuer’s management, and the issuer’s financial position. Once a firm files a prospectus with the SEC, a quiet period begins, during which the firm faces a variety of restrictions on what it can communicate to investors. While waiting for the registration statement’s SEC approval, prospective investors may receive a preliminary prospectus. This preliminary version is called a  red herring  because a notice printed in red on the front cover indicates the tentative nature of the offer. The purpose of the quiet period is to make sure that all potential investors have access to the same information about the company—that which is presented in the preliminary prospectus—but not to any unpublished data that might provide an unfair advantage. The quiet period ends when the SEC declares the firm’s prospectus to be effective. The cover of the preliminary prospectus describing the 2015 stock issue of Shake Shack, Inc., appears in  Figure 2.1 . Notice that the preliminary prospectus has a blank where the offering price of the stock should be, just under the header that has the company name. Note also the warning, often referred to as the red herring, printed across the top of the front page.

During the registration period and before the IPO date, the investment bankers and company executives promote the company’s stock offering through a road show, which consists of a series of presentations to potential investors—typically institutional investors—around the country and sometimes overseas. In addition to providing investors with information about the new issue, road shows help the investment bankers gauge the demand for the offering and set an expected price range. Once all of the issue terms have been set, including the price, the SEC must approve the offering before the IPO can take place.

Table 2.1  highlights several interesting features of the IPO market over the last 16 years. First, the table shows the number of IPOs each year. As mentioned earlier, the number of IPOs per year moves dramatically as economic conditions change and as the stock market moves up and down. Generally speaking, more companies go public when the economy is strong and stock prices are rising. Second, the table shows the average first-day return for IPOs each year. An IPO’s first-day return is simply the percentage change from the price of the IPO in the prospectus to the closing price of the stock on its first day of trading. For example, when the details of Shake Shack’s IPO were finalized, shares were offered to investors in the final prospectus at $21 per share.

Figure 2.1 Cover of a Preliminary Prospectus for a Stock Issue

Some of the key factors related to the 2015 common stock issue by Shake Shack Inc., are summarized on the cover of the prospectus. The disclaimer statement across the top of the page is normally printed in red, which explains its name, “red herring.”

(Source: Shake Shack Inc., “Form S-1 Registration Statement,” December 29, 2014, p. 2.)

At the end of the stock’s first trading day, its price had risen to $45.90, a one-day return of 118%! You can see in  Table 2.1  that the average first-day return for all IPOs is positive in every year from 1999 to 2014, ranging from 6.4% in 2008 to 71.1% in 1999. Because IPO shares typically go up in value as soon as they start trading, we say that IPOs are underpriced on average. IPO shares are underpriced if they are sold to investors at a price that is lower than what the market will bear. In the Shake Shack offering, investors were apparently willing to pay $45.90 per share (based on the value of the shares once trading began), but shares were initially offered at just $21. We could say then that Shake Shack shares (say that three times fast) were underpriced by $24.90.  Table 2.1  indicates that the average first-day return is closely connected to the number of IPOs. Average first-day returns are higher in years when many firms choose to go public (as in 1999), and first-day returns are lower in years when few firms conduct IPOs (as in 2008).

Shake Shack sold 5.75 million shares in its IPO for $21 per share, so the gross proceeds from the offer were $120.7 million, which equals 5.75 million shares times $21 per share. This is the third feature of the IPO market highlighted in  Table 2.1 . Total gross proceeds from IPOs ranged from $9.5 billion in 2003 to $65 billion in 1999. The last column in  Table 2.1  lists total “money left on the table.” Money left on the table represents a cost that companies bear when they go public if their shares are underpriced (as most IPOs are). For example, Shake Shack underpriced its offering by $143.2 million, which comes from multiplying 5.75 million shares sold times $24.90 underpricing per share. It shouldn’t be a surprise that in the IPO market, aggregate money left on the table peaked at the same time that underpricing did. In 1999 the 477 companies that went public left $37.1 billion on the table by underpricing their shares. Given that the gross proceeds of IPOs that year (i.e., the total money paid by investors in the primary market to acquire IPO shares) were $65 billion, it seems that companies left more than half as much money on the table as they raised by going public in the first place. Put differently, if shares had not been underpriced at all in 1999, companies would have raised $102.1 billion rather than $65.0 billion, a difference of 57%.

Investing in IPOs is risky business, particularly for individual investors who can’t easily acquire shares at the offering price. Most of those shares go to institutional investors and brokerage firms’ best clients. Although news stories may chronicle huge first-day gains, IPO stocks are not necessarily good long-term investments.

The Investment Banker’s Role

Most public offerings are made with the assistance of an investment banker. The  investment banker  is a financial intermediary that specializes in assisting companies issuing new securities and advising firms with regard to major financial transactions. In the context of IPOs, the main activity of the investment banker is  underwriting . This process involves purchasing the securities from the issuing firm at an agreed-on price and bearing the risk of reselling them to the public. The investment banker also provides the issuer with advice about pricing and other important aspects of the issue.

In the case of large security issues, the lead or originating investment banker brings in other bankers as partners to form an  underwriting syndicate . The syndicate shares the financial risk associated with buying the entire issue from the issuer and reselling the new securities to the public. The lead investment banker and the syndicate members put together a  selling group , normally made up of themselves and a large number of brokerage firms. Each member of the selling group is responsible for selling a certain portion of the issue and is paid a commission on the securities it sells. The selling process for a large security issue is depicted in  Figure 2.2 .

Table 2.1 U.S. Annual IPO Data, 1999–2014

(Source: “Initial Public Offerings: Updated Statistics,”  http://bear.warrington.ufl.edu/ritter/IPOs2014Statistics.pdf , Table 1, accessed February 26, 2015.)

Year	Number of IPOs	Average First-Day Return	Aggregate Gross Proceeds (billions)	Aggregate Money Left on the Table (billions)
1999	477	71.1%	$65.0	$37.1
2000	381	56.3%	$64.9	$29.8
2001	79	14.2%	$34.2	$ 3.0
2002	66	9.1%	$22.0	$ 1.1
2003	63	11.7%	$ 9.5	$ 1.0
2004	173	12.3%	$ 31.2	$ 3.9
2005	159	10.3%	$28.2	$ 2.6
2006	157	12.1%	$30.5	$ 4.0
2007	159	14.0%	$35.7	$ 5.0
2008	21	6.4%	$22.8	$ 5.7
2009	41	9.8%	$13.2	$ 1.5
2010	91	9.4%	$29.8	$ 1.8
2011	81	13.3%	$ 27.0	$ 3.2
2012	93	17.9%	$ 31.1	$ 2.8
2013	157	21.1%	$38.8	$ 8.6
2014	206	15.5%	$42.2	$ 5.4

The relationships among the participants in this process can also be seen on the cover of the December 29, 2014, preliminary prospectus for the common stock offering for Shake Shack, Inc., in  Figure 2.1 . The layout of the prospectus cover indicates the roles of the various participating firms. Placement and larger typefaces differentiate the originating underwriters (J.P. Morgan and Morgan Stanley) from the underwriting syndicate members (Goldman, Sachs & Co., Barclays, Jefferies, William Blair, and Stifel), whose names appear in a smaller font below. J.P. Morgan and Morgan Stanley are acting as joint-lead investment banks for Shake Shack’s IPO.

Compensation for underwriting and selling services typically comes in the form of a discount on the sale price of the securities. For example, in the Shake Shack IPO, the investment bank, acting as a lead underwriter (say J.P. Morgan), might pay Shake Shack $19.50 for stock that investors will ultimately purchase for $21. Having guaranteed the issuer $19.50 per share, the lead underwriter may then sell the shares to the underwriting syndicate members for $19.75 per share. The additional 25 cents per share represents the lead underwriter’s management fee. Next the underwriting syndicate members sell the shares to members of the selling group for 85 cents more, or $20.60 per share. That 85 cent difference represents the underwriters’ discount, which is their profit per share. Finally, members of the selling group earn a selling concession of 40 cents per share when they sell shares to investors at $21 per share. The $1.50 difference between the price per share paid to Shake Shack ($19.50) and that paid by the investor ($21) is the gross spread, which comprises the lead underwriter’s management fee ($0.25), the syndicate underwriters’ discounts ($0.85), and the selling group’s selling concession ($0.40). Although the issuer places (or sells) some primary security offerings directly, the majority of new issues are sold through public offering via the process just described.

Figure 2.2 The Selling Process for a Large Security Issue

The lead investment banker hired by the issuing firm may form an underwriting syndicate. The underwriting syndicate buys the entire security issue from the issuing corporation at an agreed-on discount to the public offering price. The investment banks in the underwriting syndicate then bear the risk of reselling the issue to the public at a public offering price. The investment banks’ profit is the difference between the price they guaranteed the issuer and the public offering price. Both the lead investment bank and the other syndicate members put together a selling group to sell the issue on a commission basis to investors.

The Secondary Market

The  secondary market , or the aftermarket, is the market in which securities are traded after they have been issued. Unlike the primary market, secondary-market transactions do not involve the corporation that issued the securities. Instead, the secondary market permits an investor to sell his or her holdings to another investor. The secondary market provides an environment for continuous pricing of securities that helps to ensure that security prices reflect the securities’ true values on the basis of the best available information at any time. The ability to make securities transactions quickly and at a fair price in the secondary market provides securities traders with liquidity.

One major segment of the secondary market consists of various national securities exchanges, which are markets, registered with the SEC, in which the buyers and sellers of listed securities come together to execute trades. There are 18 national securities exchanges registered with the SEC under Section 6(a) of the Exchange Act. The  over-the-counter (OTC) market , which involves trading in smaller, unlisted securities, represents the other major segment of the secondary market. The Financial Industry Regulatory Authority (FINRA) regulates securities transactions in the OTC market. FINRA is the largest independent regulator of securities firms doing business in the United States. FINRA’s mission is to protect investors by making sure that the thousands of brokerage firms, tens of thousands of branch offices, and hundreds of thousands of registered securities representatives it oversees operate fairly and honestly.

Figure 2.3 Broker and Dealer Markets

On a typical trading day, the secondary market is a beehive of activity, where literally billions of shares change hands. The market consists of two distinct parts—the broker market and the dealer market. As shown, each of these markets is made up of various exchanges and trading venues.

Broker Markets and Dealer Markets

Historically, the secondary market has been divided into two segments on the basis of how securities are traded: broker markets and dealer markets.  Figure 2.3  depicts the makeup of the secondary market in terms of broker or dealer markets. As you can see, the  broker market  consists of national and regional securities exchanges, whereas the  dealer market  is made up of the Nasdaq OMX and OTC trading venues.

Before we look at these markets in more detail, it’s important to understand that probably the biggest difference in the two markets is a technical point dealing with the way trades are executed. That is, when a trade occurs in a broker market, the two sides to the transaction, the buyer and the seller, are brought together—the seller sells his or her securities directly to the buyer. With the help of a broker, the securities effectively change hands on the floor of the exchange.

In contrast, when trades are made in a dealer market, buyers’ orders and sellers’ orders are never brought together directly. Instead, their buy/sell orders are executed by  market makers , who are securities dealers that “make markets” by offering to buy or sell a certain amount of securities at stated prices. Essentially, two separate trades are made: The seller sells his or her securities (for example, in Intel Corp.) to a dealer, and the buyer buys his or her securities (in Intel Corp.) from another, or possibly even the same, dealer. Thus, there is always a dealer (market maker) on one side of a dealer-market transaction.

As the secondary market continues to evolve, the distinction between broker and dealer markets continues to fade. In fact, since the 21st century began there has been unprecedented consolidation of trading venues and their respective trading technologies to the point where most exchanges in existence today function as broker-dealer markets. Broker-dealer markets seamlessly facilitate both broker and dealer functions as necessary to provide liquidity for investors in the secondary market.

Broker Markets

If you’re like most people, when you think of the stock market, the first thing that comes to mind is the New York Stock Exchange (NYSE), which is a national securities exchange. Known as “the Big Board,” the NYSE is, in fact, the largest stock exchange in the world. In 2015 more than 2,400 firms with an aggregate market value of greater than $19 trillion listed on the NYSE. Actually, the NYSE has historically been the dominant broker market. Also included in broker markets are the NYSE Amex (formally the American Stock Exchange), another national securities exchange, and several so-called regional exchanges. Regional exchanges are actually national securities exchanges, but they reside outside New York City. The number of securities listed on each of these exchanges is typically in the range of 100 to 500 companies. As a group, they handle a very small fraction (and a declining fraction) of the shares traded on organized exchanges. The best known of these are the Chicago Stock Exchange, NYSE Arca (formally the Pacific Stock Exchange), Nasdaq OMX PHLX (formally the Philadelphia Stock Exchange), Nasdaq OMX BX (formally the Boston Stock Exchange), and National Stock Exchange. These exchanges deal primarily in securities with local and regional appeal. Most are modeled after the NYSE, but their membership and listing requirements are considerably more lenient. To enhance their trading activity, regional exchanges often list securities that are also listed on the NYSE.

Other broker markets include foreign stock exchanges that list and trade shares of firms in their own foreign markets (we’ll say more about these exchanges later in this chapter). Also, separate domestic exchanges exist for trading in options and in futures. Next we consider the basic structure, rules, and operations of each of the major exchanges in the broker markets.

The New York Stock Exchange

Most organized securities exchanges were originally modeled after the New York Stock Exchange. Before the NYSE became a for-profit, publicly traded company in 2006, an individual or firm had to own or lease 1 of the 1,366 “seats” on the exchange to become a member of the exchange. The word seat comes from the fact that until the 1870s, members sat in chairs while trading. On December 30, 2005, in anticipation of becoming a publicly held company, the NYSE ceased having member seats. Now part of the NYSE Euronext group of exchanges, the NYSE sells one-year trading licenses to trade directly on the exchange. As of January 1, 2015, a one-year trading license cost $40,000 per license for the first two licenses and $25,000 per additional license held by a member organization. Investment banks and brokerage firms comprise the majority of trading license holders, and each typically holds more than one trading license.

See the NYSE’s iPad App

Firms such as Merrill Lynch designate officers to hold trading licenses. Only such designated individuals can make transactions on the floor of the exchange. The two main types of floor broker are the commission broker and the independent broker. Commission brokers execute orders for their firm’s customers. An independent broker works for herself and handles orders on a fee basis, typically for smaller brokerage firms or large firms that are too busy to handle their own orders.

Trading Activity

The floor of the NYSE is an area about the size of a football field. It was once a hub of trading activity, and in some respects it looks the same today as it did years ago. The NYSE floor has trading posts, and certain stocks trade at each post. Electronic gear around the perimeter transmits buy and sell orders from brokers’ offices to the exchange floor and back again after members execute the orders. Transactions on the floor of the exchange occur through an auction process that takes place at the post where the particular security trades. Members interested in purchasing a given security publicly negotiate a transaction with members interested in selling that security. The job of the  designated market maker (DMM) —an exchange member who specializes in making transactions in one or more stocks—is to manage the auction process. The DMM buys or sells (at specified prices) to provide a continuous, fair, and orderly market in those securities assigned to her. Despite the activity that still occurs on the NYSE trading floor, the trades that happen there account for a tiny fraction of trading volume. Most trading now occurs through electronic networks off the floor.

Listing Policies

To list its shares on a stock exchange, a domestic firm must file an application and meet minimum listing requirements. Some firms have  dual listings , or listings on more than one exchange. Listing requirements have evolved over time, and as the NYSE has come under competitive pressure, it has relaxed many of its listing standards. Companies that sought a listing on the NYSE were once required to have millions in pretax earnings. Today, the NYSE will list companies with $750,000 in pretax earnings, or in some cases, with no pretax earnings at all. The NYSE does require that a listed firm have a minimum stock price of $2 to $3, and usually the market value of a company’s public float (the value of shares available for trading on the exchange) must be $15 million or more. Still, an NYSE listing does not have the prestige that it once did.

Regional Stock Exchanges

Most regional exchanges are modeled after the NYSE, but their membership and listing requirements are more lenient. Trading costs are also lower. The majority of securities listed on regional exchanges are also listed on the NYSE. About 100 million NYSE shares pass through one of the regional exchanges on a typical trading day. This dual listing may enhance a security’s trading activity.

Options Exchanges

Options allow their holders to sell or to buy another security at a specified price over a given period of time. The dominant options exchange is the Chicago Board Options Exchange (CBOE). Options are also traded on the NYSE, on Nasdaq OMX BX, NYSE Arca, and Nasdaq OMX PHLX exchanges, and on the International Securities Exchange (ISE). Usually an option to sell or buy a given security is listed on many of the exchanges.

Futures Exchanges

Futures are contracts that guarantee the delivery of a specified commodity or financial instrument at a specific future date at an agreed-on price. The dominant player in the futures trading business is the CME Group, a company comprised of four exchanges (CME, CBOT, NYMEX, and COMEX) known as designated contract markets. Some futures exchanges specialize in certain commodities and financial instruments rather than handling the broad spectrum of products.

Dealer Markets

One of the key features of the dealer market is that it has no centralized trading floors. Instead it is made up of a large number of market makers who are linked via a mass electronic network. Each market maker is actually a securities dealer who makes a market in one or more securities by offering to buy or sell them at stated bid/ask prices. The  bid price  and  ask price  represent, respectively, the highest price offered to purchase a given security and the lowest price offered to sell a given security. An investor pays the ask price when buying securities and receives the bid price when selling them. The dealer market is made up of both the Nasdaq OMX and the OTC markets. As an aside, the primary market is also a dealer market because all new issues—IPOs and  secondary distributions , which involve the public sale of large blocks of previously issued securities held by large investors—are sold to the investing public by securities dealers acting on behalf of the investment banker.

Nasdaq

The largest dealer market is made up of a large list of stocks that are listed and traded on the National Association of Securities Dealers Automated Quotation System, typically referred to as Nasdaq. Founded in 1971, Nasdaq had its origins in the OTC market but is today considered a totally separate entity that’s no longer a part of the OTC market. In fact, in 2006 Nasdaq was formally recognized by the SEC as a national securities exchange, giving it pretty much the same stature and prestige as the NYSE.

To be traded on Nasdaq, all stocks must have at least two market makers, although the bigger, more actively traded stocks, like Cisco Systems, have many more than that. These dealers electronically post all their bid/ask prices so that when investors place market orders, they are immediately filled at the best available price.

The Nasdaq listing standards vary depending on the Nasdaq listing market. The 1,200 or so stocks traded on the Nasdaq Global Select Market meet the world’s highest listing standards. Created in 2006, the Global Select Market is reserved for the biggest and the “bluest”—highest quality—of the Nasdaq stocks. In 2012 Facebook elected to list on Nasdaq Global Select rather than on the NYSE, further cementing Nasdaq’s position as the preferred listing exchange for leading technology companies.

The listing requirements are also fairly comprehensive for the roughly 1,450 stocks traded on the Nasdaq Global Market. Stocks included on these two markets are all widely quoted, actively traded, and, in general, have a national following. The big-name stocks traded on the Nasdaq Global Select Market, and to some extent, on the Nasdaq Global Market, receive as much national visibility and are as liquid as those traded on the NYSE. As a result, just as the NYSE has its list of big-name players (e.g., ExxonMobil, GE, Citigroup, Walmart, Pfizer, IBM, Procter & Gamble, Coca-Cola, Home Depot, and UPS), so too does Nasdaq. Its list includes companies like Microsoft, Intel, Cisco Systems, eBay, Google, Yahoo!, Apple, Starbucks, and Staples. Make no mistake: Nasdaq competes head-to-head with the NYSE for listings. In 2015, 13 companies with a combined market capitalization of $82 billion moved their listings from the NYSE to Nasdaq. Some well-known companies that moved to Nasdaq include Viacom, Kraft Foods, and Texas Instruments. The Nasdaq Capital Market is still another Nasdaq market; it makes a market in about 600 or 700 stocks that, for one reason or another, are not eligible for the Nasdaq Global Market. In total, 48 countries are represented by approximately 3,000 securities listed on Nasdaq as of 2015.

The Over-the-Counter Market

The other part of the dealer market is made up of securities that trade in the over-the-counter (OTC) market. These non-Nasdaq issues include mostly small companies that either cannot or do not wish to comply with Nasdaq’s listing requirements. They trade on either the OTC Bulletin Board (OTCBB) or OTC Markets Group. The OTCBB is an electronic quotation system that links the market makers who trade the shares of small companies. The OTCBB provides access to more than 3,300 securities, includes more than 230 participating market makers, and electronically transmits real-time quote, price, and volume information in traded securities. The Bulletin Board is regulated by the FINRA, which, among other things, requires all companies traded on this market to file audited financial statements and comply with federal securities law.

The OTC Markets is an unregulated segment of the market, where the companies are not even required to file with the SEC. This market is broken into three tiers. The biggest is OTC Pink, which is populated by many small and often questionable companies that provide little or no information about their operations. Securities in the OTC QB tier must provide SEC, bank, or insurance reporting and be current in their disclosures. The top tier, OTC QX, albeit the smallest, is reserved for companies that choose to provide audited financial statements and other required information. If a security has been the subject of promotional activities and adequate current information concerning the issuer is not publicly available, OTC Markets will label the security “Caveat Emptor” (buyers beware). Promotional activities, whether they are published by the issuer or a third party, may include spam e-mail or unsolicited faxes or news releases.

Alternative Trading Systems

Some individual and institutional traders now make direct transactions outside of the broker and dealer markets in the third and fourth markets. The  third market  consists of over-the-counter transactions made in securities listed on the NYSE, the NYSE Amex, or one of the other exchanges. These transactions are typically handled by market makers that are not members of a securities exchange. They charge lower commissions than the exchanges and bring together large buyers and sellers. Institutional investors, such as mutual funds, pension funds, and life insurance companies, are thus often able to realize sizable savings in brokerage commissions and to have minimal impact on the price of the transaction.

The  fourth market  consists of transactions made through a computer network, rather than on an exchange, directly between large institutional buyers and sellers of securities. Unlike third-market transactions, fourth-market transactions bypass the market maker.  Electronic communications networks (ECNs)  are at the heart of the fourth market. Archipelago (part of the NYSE Arca), Bloomberg Tradebook, Island, Instinet, and MarketXT are some of the many ECNs that handle these trades. As with the exchanges, ECNs have undergone much consolidation. For example, in 2002 Island was merged with Instinet, and then in 2005 Instinet was acquired by Nasdaq.

ECNs are most effective for high-volume, actively traded securities, and they play a key role in after-hours trading, discussed later in this chapter. They automatically match buy and sell orders that customers place electronically. If there is no immediate match, the ECN, acting like a broker, posts its request under its own name on an exchange or with a market maker. The trade will be executed if another trader is willing to make the transaction at the posted price.

ECNs can save customers money because they charge only a transaction fee, either per share or based on order size. For this reason, money managers and institutions such as pension funds and mutual funds with large amounts of money to invest favor ECNs. Many also use ECNs or trade directly with each other to find the best prices for their clients.

General Market Conditions: Bull or Bear

Conditions in the securities markets are commonly classified as “bull” or “bear,” depending on whether securities prices are rising or falling over time. Changing market conditions generally stem from changes in investor attitudes, changes in economic activity, and government actions aimed at stimulating or slowing down economic activity.  Bull markets  are normally associated with rising prices, investor optimism, economic recovery, and government stimulus.  Bear markets  are normally associated with falling prices, investor pessimism, economic slowdown, and government restraint. The beginning of 2003 marked the start of a generally bullish market cycle that peaked before turning sharply bearish in October 2007. The bearish market bottomed out in March 2009 and was generally bullish for the next several years. Since posting a return of almost −37% in 2008, the Standard and Poor’s 500 Stock Index earned a positive return in each year from 2009 to 2014.

In general, investors experience higher (or positive) returns on common stock investments during a bull market. However, some securities perform well in a bear market and fare poorly in a bull market. Market conditions are notoriously difficult to predict, and it is nearly impossible to identify the bottom of a bear market or the top of a bull market until months after the fact.

Concepts in Review

Answers available at  http://www.pearsonhighered.com/smart

1. 2.1 Differentiate between each of the following pairs of terms.

a. Money market and capital market

b. Primary market and secondary market

c. Broker market and dealer market

2. 2.2 Briefly describe the IPO process and the role of the investment banker in underwriting a public offering. Differentiate among the terms public offering, rights offering, and private placement.

3. 2.3 For each of the items in the left-hand column, select the most appropriate item in the right-hand column.

a. Prospectus	1. Trades unlisted securities
b. Underwriting	2. Buying securities from firms and reselling them to investors
c. NYSE	3. Conditions a firm must meet before its stock can be traded on an exchange
d. Nasdaq OMX BX	4. A regional stock exchange
e. Listing requirements	5. Describes the key aspects of a security offering
f. OTC	6. The largest stock exchange in the world

4. 2.4 Explain how the dealer market works. Be sure to mention market makers, bid and ask prices, the Nasdaq market, and the OTC market. What role does the dealer market play in initial public offerings (IPOs) and secondary distributions?

5. 2.5 What are the third and fourth markets?

6. 2.6 Differentiate between a bull market and a bear market.

Globalization of Securities Markets

1. LG 4

Today investors, issuers of securities, and securities firms look beyond the markets of their home countries to find the best returns, lowest costs, and best international business opportunities. The basic goal of most investors is to earn the highest return with the lowest risk. This outcome is achieved through  diversification —the inclusion of a number of different securities in a portfolio to increase returns and reduce risk. An investor can greatly increase the potential for diversification by holding (1) a wider range of industries and securities, (2) securities traded in a larger number of markets, and (3) securities denominated in different currencies, and the diversification is even greater if the investor does these things for a mix of domestic and foreign securities. The smaller and less diversified an investor’s home market is, the greater the potential benefit from prudent international diversification. However, even investors in the United States and other highly developed markets can benefit from global diversification.

In short, globalization of the securities markets enables investors to seek out opportunities to profit from rapidly expanding economies throughout the world. Here we consider the growing importance of international markets, international investment performance, ways to invest in foreign securities, and the risks of investing internationally.

Growing Importance of International Markets

Securities exchanges now operate in over 100 countries worldwide. Both large (Tokyo Stock Exchange) and small (South Pacific Stock Exchange), they are located not only in the major industrialized nations such as Japan, Great Britain, Canada, and Germany but also in emerging economies such as Brazil, Chile, India, South Korea, Malaysia, Mexico, Poland, Russia, and Thailand. The top four securities markets worldwide (based on dollar volume) are the NYSE, Nasdaq, London Stock Exchange, and Tokyo Stock Exchange. Other important foreign exchanges include the Shanghai Stock Exchange, Osaka Securities Exchange, Toronto Stock Exchange, Montreal Exchange, Australian Securities Exchange, Hong Kong Exchanges and Clearing Ltd., Swiss Exchange, and Taiwan Stock Exchange Corp.

The economic integration of the European Monetary Union (EMU), along with pressure from financial institutions that want an efficient process for trading shares across borders, is changing the European securities market environment. Instead of many small national exchanges, countries are banding together to create cross-border markets and to compete more effectively in the pan-European equity-trading markets. The Paris, Amsterdam, Brussels, and Lisbon exchanges, plus a derivatives exchange in London, merged to form Euronext, and the Scandinavian markets formed Norex. In mid-2006 Euronext and the NYSE Group—the NYSE parent—signed an agreement to combine their businesses in a merger of equals. Some stock exchanges—for example, Tokyo and Australian—are forming cooperative agreements. Others are discussing forming a 24-hour global market alliance, trading the stocks of selected large international companies via an electronic order-matching system. Nasdaq, with joint ventures in Japan, Hong Kong, Canada, and Australia, plans to expand into Latin America and the Middle East. The increasing number of mergers and cooperative arrangements represent steps toward a worldwide stock exchange.

Bond markets, too, have become global, and more investors than ever before regularly purchase government and corporate fixed-income securities in foreign markets. The United States dominates the international government bond market, followed by Japan, Germany, and Great Britain.

International Investment Performance

A motive for investing overseas is the lure of high returns. In fact, only once since 1980 did the United States stock market post the world’s highest rate of return. For example, in 2014, a good year for U.S stocks, investors would have earned higher returns in many foreign markets. During that year the Standard and Poor’s Global Index reported returns (translated into U.S. dollars) of 32% in India, 26% in Egypt, 20% in Indonesia, and 14% in Turkey. By comparison, the U.S. stock price index increased about 11%. Of course, foreign securities markets tend to be riskier than U.S. markets. A market with high returns in one year may not do so well in the next. However, even in 2008, one of the worst years on record for stock market investors, more than a dozen foreign exchanges earned returns higher than the NYSE Euronext.

Investor Facts

U.S. Market Share Even though the U.S. securities markets lead the world in terms of market share, the United States accounts for only 30% of the market value of companies in the worldwide equity markets.

(Source: World Federation of Stock Exchanges, http://www.world-exchanges.org/statistics/annual.)

Investors can compare activity on U.S. and foreign exchanges by following market indexes that track the performance of those exchanges. For instance, the Dow Jones averages and the Standard & Poor’s indexes are popular measures of the U.S. markets, and indexes for dozens of different stock markets are available.

Ways to Invest in Foreign Securities

Investors can make foreign security transactions either indirectly or directly. One form of indirect investment is to purchase shares of a U.S.-based multinational corporation with substantial foreign operations. Many U.S.-based multinational firms, such as Accenture, Facebook, Google, IBM, Intel, McDonald’s, Dow Chemical, Coca-Cola, and Nike, receive more than 50% of their revenues from overseas operations. By investing in the securities of such firms, an investor can achieve a degree of international diversification. Purchasing shares in a mutual fund or exchange-traded fund that invests primarily in foreign securities is another way to invest indirectly. Investors can make both of these indirect foreign securities investment transactions through a stockbroker.

To make direct investments in foreign companies, investors have three options. They can purchase securities on foreign exchanges, buy securities of foreign companies that trade on U.S. exchanges, or buy American Depositary Shares (ADSs).

The first way—purchasing securities on foreign exchanges—involves additional risks because foreign securities do not trade in U.S. dollars and, thus, investors must cope with currency fluctuations. This approach is not for the timid or inexperienced investor. Investors also encounter different securities exchange rules, transaction procedures, accounting standards, and tax laws in different countries. Direct transactions are best handled either through brokers at major Wall Street firms with large international operations or through major banks, such as JPMorgan Chase and Citibank, that have special units to handle foreign securities transactions. Alternatively, investors can deal with foreign broker-dealers, but such an approach is more complicated and riskier.

The second form of direct investment is to buy the securities of foreign companies that trade on both organized and over-the-counter U.S. exchanges. Transactions in foreign securities that trade on U.S. exchanges are handled in the same way as exchange-traded domestic securities. These securities are issued by large, well-known foreign companies. Stocks of companies such as Barrick Gold Corporation (Canada), General Steel Holdings (China), Cosan Ltd. (Brazil), Paragon Shipping (Greece), Manchester United (United Kingdom), and Tyco International (Switzerland) trade directly on U.S. exchanges. In addition,  Yankee bonds , U.S. dollar–denominated debt securities issued by foreign governments or corporations and traded in U.S. securities markets, trade in both broker and dealer markets.

Finally, foreign stocks also trade on U.S. exchanges in the form of  American depositary shares (ADSs) . These securities have been created to permit U.S. investors to hold shares of non-U.S. companies and trade them on U.S. stock exchanges. They are backed by  American depositary receipts (ADRs) , which are U.S dollar–denominated receipts for the stocks of foreign companies that are held in the vaults of banks in the companies’ home countries. Today more than 3,700 ADRs representing more than 100 home countries are traded on U.S. exchanges. About one-fourth of them are actively traded. Included are well-known companies such as Daimler, Fujitsu, LG Electronics, Mitsubishi, Nestle, and Royal Dutch Shell.

Risks of Investing Internationally

Investing abroad is not without pitfalls. In addition to the usual risks involved in any security transaction, investors must consider the risks of doing business in a particular foreign country. Changes in trade policies, labor laws, and taxation may affect operating conditions for the country’s firms. The government itself may not be stable. You must track similar environmental factors in each foreign market in which you invest. This is clearly more difficult than following your home market.

U.S. securities markets are generally viewed as highly regulated and reliable. Foreign markets, on the other hand, may lag substantially behind the United States in both operations and regulation. Additionally, some countries place various restrictions on foreign investment. Saudi Arabia and China only recently opened their stock markets to foreign investors, and even then only to a limited extent. Mexico has a two-tier market, with certain securities restricted from foreigners. Some countries make it difficult for foreigners to get their funds out, and many impose taxes on dividends. For example, Swiss taxes are about 35% on dividends paid to foreigners. Other difficulties include illiquid markets and an inability to obtain reliable investment information because of a lack of reporting requirements.

Furthermore, accounting standards vary from country to country. Differences in accounting practices can affect a company’s apparent profitability, conceal assets (such as the hidden reserves and undervalued assets that are permitted in many countries), and facilitate failure to disclose other risks. As a result, it is difficult to compare the financial performance of firms operating in different countries. Although the accounting profession has agreed on a set of international accounting standards, it will be years until all countries have adopted them and even longer until all companies apply them.

Another concern stems from the fact that international investing involves securities denominated in foreign currencies. Trading profits and losses are affected not only by a security’s price changes but also by fluctuations in currency values. The price of one currency in terms of another is called the  currency exchange rate . The values of the world’s major currencies fluctuate with respect to each other daily, and these price movements can have a significant positive or negative impact on the return that you earn on an investment in foreign securities.

For example, on January 2, 2015, the exchange rate for the European Monetary Union euro (€) and the U.S. dollar (US$) was expressed as follows:

US$=€0.8324€=US$1.2013US$=€0.8324€=US$1.2013

This means that 1 U.S. dollar was worth 0.8324 euros, or equivalently, 1 euro was worth 1.2013 U.S. dollars. On that day, if you had purchased 100 shares of Heineken, which was trading for €57.72 per share on Euronext Amsterdam, it would have cost you $6,933.90 (i.e., 100×57.72×1.2013100×57.72×1.2013).

Four months later, the value of the euro had fallen relative to the dollar. On April 14, 2015, the euro/US$ exchange rate was 0.9386, which meant that during the first four months of 2015, the euro depreciated relative to the dollar (and therefore the dollar appreciated relative to the euro). On April 14 it took more euros to buy $1 (€0.9386 in April versus €0.8324 in January), so each euro was worth less in dollar terms (one euro was worth $1.0654 in April versus $1.2013 in January). Had the European Monetary Union euro instead appreciated (and the dollar depreciated relative to the euro), each euro would have been worth more in dollar terms.

Currency exchange risk  is the risk caused by the varying exchange rates between the currencies of two countries. For example, assume that on April 14, 2015, you sold your 100 shares of Heineken, which was trading for €75.82 per share on Euronext Amsterdam; sale proceeds would have been $8,077.86 (i.e., 75.82×100×1.065475.82×100×1.0654).

In this example you had a win-lose outcome. The price of Heineken stock rose 31.4% (from €57.72 to €75.82), but the value of the euro declined 11.3% (falling from 1.2013 to 1.0654). You made money on the investment in Heineken, but to purchase Heineken shares, you also had to purchase euros. Because the euro depreciated from January to April, you lost money on that part of the transaction. On net you realized a gain of 16.5% because you invested $6,933.90 in January and you received $8,077.86 in April. Put another way, the increase in the value of Heineken shares more than offset the currency loss that you experienced, so your overall return was positive. If the depreciation in the euro had been greater, it could have swamped the increase in Heineken shares, resulting in an overall negative rate of return. Similarly, if the euro had appreciated, that would have magnified the return on Heineken stock. Investors in foreign securities must be aware that the value of the foreign currency in relation to the dollar can have a profound effect on returns from foreign security transactions.

Concepts in Review

Answers available at  http://www.pearsonhighered.com/smart

1. 2.7 Why is globalization of securities markets an important issue today? How have international investments performed in recent years?

2. 2.8 Describe how foreign security investments can be made, both indirectly and directly.

3. 2.9 Describe the risks of investing internationally, particularly currency exchange risk.

Trading Hours and Regulation of Securities Markets

1. LG 5

Understanding the structure of domestic and international securities markets is an important foundation for developing a sound investment program. We’ll begin with an overview of the trading hours and regulations that apply to U.S. securities markets.

Trading Hours of Securities Markets

Traditionally, the regular trading session for organized U.S. exchanges ran from 9:30 a.m. to 4:00 p.m. eastern time. However, trading is no longer limited to these hours. Most securities exchanges and ECNs offer extended trading sessions before and after regular hours. Most of the after-hours markets are  crossing markets , in which orders are filled only if they can be matched. That is, buy and sell orders are filled only if they can be matched with identical opposing sell and buy orders at the desired price. If an investor submits an order to buy shares but no matching sell order is posted, then the buy order is not filled. As you might expect, the liquidity of the market during extended hours is less than it is during the day. On the other hand, extended hours allow traders to respond to information that they receive after the official 4:00 p.m. market close. Extended hours allow U.S. securities markets to compete more effectively with foreign securities markets, in which investors can execute trades when U.S. markets are closed. ECNs were off limits to individual investors until 2003, but now both individuals and institutions can trade shares outside the traditional 9:30 to 4:00 trading day. For example, Nasdaq has its own extended-hours electronic-trading sessions from 4:00 a.m. to 9:30 a.m. and from 4:00 p.m. to 8:00 p.m.

Watch Your Behavior

 Overreacting to News A recent study found that when the prices of exchange-traded funds (ETFs) moved sharply during normal trading hours, those movements were often quickly reversed, suggesting that the initial move might have been caused by investors overreacting to news. During after-hours trading, the same pattern was not evident, suggesting that the traders who buy and sell after regular trading hours are less prone to overreaction.

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Regulation of Securities Markets

U.S. securities laws protect investors and participants in the financial marketplace. A number of state and federal laws require that investors receive adequate and accurate disclosure of information. Such laws also regulate the activities of participants in the securities markets. State laws that control the sale of securities within state borders are

Table 2.2 Important Federal Securities Laws

Act	Brief Description
Securities Act of 1933	Passed to ensure full disclosure of information about new security issues. Requires the issuer of a new security to file a registration statement with the Securities and Exchange Commission (SEC) containing information about the new issue. The firm cannot sell the security until the SEC approves the registration statement, which usually takes about 20 days. Approval of the registration statement by the SEC merely indicates that the facts presented in the statement appear to reflect the firm’s true position.
Securities Exchange Act of 1934	Formally established the SEC as the agency in charge of administering federal securities laws. The act gave the SEC the power to regulate the organized exchanges and the OTC market; their members, brokers, and dealers; and the securities traded in these markets.
Maloney Act of 1938	An amendment to the Securities Exchange Act of 1934, it provided for the establishment of trade associations to self-regulate the securities industry and led to the creation of the National Association of Securities Dealers (NASD). Today the Financial Industry Regulatory Authority (FINRA) has replaced the NASD as the industry’s only self-regulatory body.
Investment Company Act of 1940	Established rules and regulations for investment companies (e.g., mutual funds) and authorized the SEC to regulate their practices. It required investment companies to register with the SEC and to fulfill certain disclosure requirements.
Investment Advisors Act of 1940	Requires investment advisors, persons hired by investors to advise them about security investments, to disclose all relevant information about their backgrounds, conflicts of interest, and any investments they recommend. Advisors must register and file periodic reports with the SEC.
Securities Acts Amendments of 1975	Requires the SEC and the securities industry to develop a competitive national system for trading securities. First, the SEC abolished fixed-commission schedules, thereby providing for negotiated commissions. Second, it established the Intermarket Trading System (ITS), an electronic communications network linking 9 markets and trading over 4,000 eligible issues, which allowed trades to be made across these markets wherever the network shows a better price for a given issue.
Insider Trading and Act of 1988	Established penalties for insider trading. Insiders include anyone who obtains nonpublic information, typically a company’s directors, officers, major shareholders, bankers, investment bankers, accountants, and attorneys. The SEC requires corporate insiders to file monthly reports detailing all transactions made in the company’s stock. Recent legislation substantially increased the penalties for insider trading and gave the SEC greater power to investigate and prosecute claims of illegal insider-trading activity.
Regulation Fair Disclosure (2000)	Reg FD required companies to disclosure material information to all investors at the same time.
Sarbanes-Oxley Act of 2002	Passed to protect investors against corporate fraud, particularly accounting fraud. It created an oversight board to monitor the accounting industry, tightened audit regulations and controls, toughened penalties against executives who commit corporate fraud, strengthened accounting disclosure requirements and ethical guidelines for financial officers, established corporate board structure and membership guidelines, established guidelines for analyst conflicts of interest, and increased the SEC’s authority and budgets for auditors and investigators. The act also mandated instant disclosure of stock sales by corporate executives.
Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010	Passed in the wake of the 2007–2008 financial crisis. Its stated aim was to promote the financial stability of the United States by improving accountability and transparency. It created the Bureau of Consumer Financial Protection and other new agencies.

commonly called blue sky laws because they are intended to prevent investors from being sold nothing but “blue sky.” These laws typically establish procedures for regulating both security issues and sellers of securities doing business within the state. Most states have a regulatory body, such as a state securities commission, that is charged with enforcing the related state statutes.  Table 2.2  summarizes the most important securities laws enacted by the federal government (listed in chronological order).

The intent of these federal securities laws is to protect investors. Most of these laws were passed in response to some type of crisis or scandal in the financial markets. In recent decades, Congress passed two major laws in response to public concern over corporate financial scandals: The Sarbanes-Oxley Act of 2002 focuses on eliminating corporate fraud related to accounting and other information releases. The Dodd-Frank Wall Street Reform and Consumer Protection Act was passed in the wake of the 2007–2008 financial crisis. It sought to improve the financial stability of the U.S. economy through improved accountability and transparency in the financial system. The act created new financial regulatory agencies and merged or eliminated some existing agencies. Both of these acts heightened the public’s awareness of  ethics —standards of conduct or moral judgment—in business. The government and the financial community are continuing to develop and enforce ethical standards that will motivate market participants to adhere to laws and regulations. Ensuring that market participants adhere to ethical standards, whether through law enforcement or incentives, remains an ongoing challenge.

Concepts in Review

Answers available at  http://www.pearsonhighered.com/smart

1. 2.10 How are after-hours trades typically handled? What is the outlook for after-hours trading?

2. 2.11 Briefly describe the key requirements of the following federal securities laws:

a. Securities Act of 1933

b. Investment Company Act of 1940

c. Investment Advisors Act of 1940

d. Insider Trading and Fraud Act of 1988

e. Regulation Fair Disclosure (2000)

f. Sarbanes-Oxley Act of 2002

g. Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010

Basic Types of Securities Transactions

1. LG 6

An investor can make a number of basic types of security transactions. Each type is available to those who meet the requirements established by government agencies as well as by brokerage firms. Although investors can use the various types of transactions in a number of ways to meet investment objectives, we describe only the most popular use of each transaction here, as we consider the long purchase, margin trading, and short selling.

Long Purchase

The  long purchase  is a transaction in which investors buy securities, usually in the hope that they will increase in value and can be sold at a later date for profit. The object, then, is to buy low and sell high. A long purchase is the most common type of transaction. Because investors generally expect the price of a security to rise over the period of time they plan to hold it, their return comes from any dividends or interest received during the ownership period, plus the difference (capital gain or loss) between the purchase and selling prices. Transaction costs, of course, reduce this return.

Ignoring dividends and transaction costs, we can illustrate the long purchase by a simple example. After studying Varner Industries, you are convinced that its common stock, which currently sells for $20 per share, will increase in value over the next few years. You expect the stock price to rise to $30 per share within two years. You place an order and buy 100 shares of Varner for $20 per share. If the stock price rises to, say, $40 per share, you will profit from your long purchase. If it drops below $20 per share, you will experience a loss on the transaction. Obviously, one of the major motivating factors in making a long purchase is an expected rise in the price of the security.

Margin Trading

Security purchases do not have to be made on a cash basis; investors can use funds borrowed from brokerage firms instead. This activity is referred to as  margin trading . It is used for one basic reason: to magnify returns. As peculiar as it may sound, the term margin refers to the amount of equity (stated as a percentage) in an investment, or the amount that is not borrowed. If an investor uses 75% margin, for example, it means that 75% of the investment position is being financed with the person’s own funds and the balance (25%) with borrowed money.

The Federal Reserve Board (the “Fed”) sets the  margin requirement , specifying the minimum amount of equity that must be the margin investor’s own funds. The margin requirement for stocks has been at 50% for some time. By raising and lowering the margin requirement, the Fed can depress or stimulate activity in the securities markets. Brokers must approve margin purchases. The brokerage firm then lends the purchaser the needed funds and retains the purchased securities as collateral. It is important to recognize that margin purchasers must pay interest on the amount they borrow.

With the use of margin, you can purchase more securities than you could afford on a strictly cash basis and, thus, magnify your returns. However, the use of margin also presents substantial risks. Margin trading can only magnify returns, not produce them. One of the biggest risks is that the security may not perform as expected. If the security’s return is negative, margin trading magnifies the loss. Because the security being margined is always the ultimate source of return, choosing the right securities is critical to this trading strategy. In the next section, we will look at how margin trading can magnify returns and losses.

An Advisor’s Perspective

Ryan McKeown Senior VP—Financial Advisor, Wealth Enhancement Group

“Margin trading allows an investor to leverage up their investments.”

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Essentials of Margin Trading

Investors can use margin trading with most kinds of securities. They regularly use it, for example, to buy common and preferred stocks, most types of bonds, options, warrants, and futures. It is not normally used with tax-exempt municipal bonds because the interest paid on such margin loans is not deductible for income tax purposes. It is also possible to use margin on certain foreign stocks and bonds that meet prescribed criteria. Foreign stocks eligible for margin trading must trade on an exchange located in a FTSE Global Index recognized country (there are roughly 50 such countries), and the companies issuing the shares must have a market capitalization of at least $500 million. These stocks must have daily price quotations that are made available to a U.S. broker continuously via an electronic quote system, and they must have median daily trading volume of 100,000 shares or $500,000.

Magnified Profits and Losses

The idea of margin trading is to employ  financial leverage —the use of debt financing to magnify investment returns. Here is how it works: Suppose you have $5,000 to invest and are considering the purchase of 100 shares of stock at $50 per share. If you do not margin, you can buy exactly 100 shares of the

Excel@Investing

Table 2.3 The Effect of Margin Trading on Security Returns

	Without Margin (100% Equity)	With Margins of
		80%	65%	50%
*  Both the capital loss and the return on investor’s equity are negative, as noted by the parentheses.
Number of $50 shares purchased	100	100	100	100
Cost of investment	$5,000	$5,000	$5,000	$5,000
Less: Borrowed money	−$    0	−$1,000	−$1,750	−$2,500
Equity in investment	$5,000	$4,000	$3,250	$2,500
A. Investor’s position if price rises by $30 to $80/share
Value of stock	$8,000	$8,000	$8,000	$8,000
Less: Cost of investment	−$5,000	−$5,000	−$5,000	−$5,000
Capital gain	$3,000	$3,000	$3,000	$3,000
Return on investor’s equity (capital gain/equity in investment)	60%	75%	92.3%	120%
B. Investor’s position if price falls by $30 to $20/share
Value of stock	$2,000	$2,000	$2,000	$2,000
Less: Cost of investment	−$5,000	−$5,000	−$5,000	−$5,000
Capital loss *	−$3,000	−$3,000	−$3,000	−$3,000
Return on investor’s equity (capital loss/equity in investment) *	(60%)	(75%)	(92.3%)	(120%)

stock (ignoring brokerage commissions). If you margin the transaction—for example, at 50%—you can acquire the same $5,000 position with only $2,500 of your own money. This leaves you with $2,500 to use for other investments or to buy on margin another 100 shares of the same stock. Either way, by margining you will reap greater benefits from the stock’s price appreciation.

Table 2.3  illustrates the concept of margin trading. It shows a nonmargined (100% equity) transaction, along with the same transaction using various margins. For simplicity, we assume here that the investor pays no interest on borrowed funds, but in reality investors do pay interest, and that would lower returns throughout Table 2.3. Remember that the margin rates indicate the investor’s equity in the investment. When the investment is not margined and the price of the stock goes up by $30 per share (see  Table 2.3 , part A), the investor enjoys a very respectable 60% rate of return. However, observe how the rate of return goes up when margin is used. For example, consider an investor who buys 100 shares using 80% margin. This means that to pay for the $5,000 cost of the shares, the investor uses 80% of her own money ($4,000) and borrows 20% ($1,000) to pay for the rest. Now suppose that the stock price rises from $50 to $80 per share. The shares are worth $8,000, so the investor earns a $3,000 capital gain. The gain, relative to the investor’s initial investment of $4,000, represents a 75% rate of return. In other words, margin allowed the investor to earn 75% when the underlying stock only increased by 60%. It is in this sense that margin magnifies an investor’s rate of return. In part A of  Table 2.3 , the rate of return ranges from 75% to 120%, depending on the amount of equity in the investment. The more the investor borrows, the greater her rate of return. This occurs because the dollar gain is the same ($3,000) regardless of how the investor finances the transaction. Clearly, as the investor’s equity in the investment declines (with lower margins), the rate of return increases accordingly. Given this example, you might ask why an investor would ever buy a stock without borrowing money. The answer is that trading on margin also magnifies losses. Look at part B of  Table 2.3 . Suppose the investor uses 80% margin to buy 100 shares of the stock at $50 per share, but then the price of the stock falls to $20. In that case, the investor experiences a $3,000 capital loss. Relative to the initial $4,000 investment, the investor earns a −75% rate of return, whereas the decline in the stock price was just 60%.

Three important lessons about margin trading emerge from the table:

· Movements in the stock’s price are not influenced by the method used to purchase the stock.

· The lower the amount of the investor’s equity in the position, the greater the rate of return the investor will enjoy when the price of the security rises.

· The loss is also magnified when the price of the security falls (see  Table 2.3 , part B).

Note that  Table 2.3  has an Excel@Investing icon. Throughout the text, tables with this icon indicate that the spreadsheet is available on  http://www.myfinancelab.com . The use of electronic spreadsheets in finance and investments, as well as in all functional areas of business, is pervasive. We use spreadsheets from time to time throughout the text to demonstrate how the content has been constructed or calculated. As you know, we include Excel spreadsheet exercises at the end of most chapters to give you practice with spreadsheets and help you develop the ability to clearly set out the logic needed to solve investment problems.

Advantages and Disadvantages of Margin Trading

A magnified return is the major advantage of margin trading. The size of the magnified return depends on both the price behavior of the security and the amount of margin used. Another, more modest benefit of margin trading is that it allows for greater diversification of security holdings because investors can spread their limited capital over a larger number of investments.

The major disadvantage of margin trading, of course, is the potential for magnified losses if the price of the security falls. Another disadvantage is the cost of the margin loans themselves. A  margin loan  is the official vehicle through which the borrowed funds are made available in a margin transaction. All margin loans are made at a stated interest rate, which depends on prevailing market rates and the amount of money being borrowed. This rate is usually 1% to 3% above the  prime rate —the interest rate charged to creditworthy business borrowers. For large accounts, the margin loan rate may be at the prime rate. The loan cost, which investors pay, will increase daily, reducing the level of profits (or increasing losses) accordingly.

Making Margin Transactions

To execute a margin transaction, an investor must establish a  margin account  with a minimum of $2,000 in equity or 100% of the purchase price, whichever is less, in the form of either cash or securities. The broker will retain any securities purchased on margin as collateral for the loan.

The margin requirement established by the Federal Reserve Board sets the minimum amount of equity for margin transactions. Investors need not execute all margin transactions by using exactly the minimum amount of margin; they can use more than the minimum if they wish. Moreover, it is not unusual for brokerage firms and the major exchanges to establish their own margin requirements, which are more restrictive than those of the Federal Reserve. Brokerage firms also may have their own lists of especially volatile stocks for which the margin requirements are higher. There are basically two types of margin requirement: initial margin and maintenance margin.

Table 2.4 Initial Margin Requirements for Various Types of Securities

Security	Minimum Initial Margin (Equity) Required
Listed common and preferred stock	50%
Nasdaq OMX stocks	50%
Convertible bonds	50%
Corporate bonds	30%
U.S. government bills, notes, and bonds	10% of principal
U.S. government agencies	24% of principal
Options	Option premium plus 20% of market value of underlying stock
Futures	2% to 10% of the value of the contract

Initial Margin

The minimum amount of equity that must be provided by the investor at the time of purchase is the  initial margin . Because margin refers to the amount of equity in a trade, establishing a minimum margin requirement is equivalent to establishing a maximum borrowing limit. Initial margin requirements therefore place some restraint on how much risk investors can take through margin trading. All securities that can be margined have specific initial requirements, which the governing authorities can change at their discretion.  Table 2.4  shows initial margin requirements for various types of securities. The more stable investments, such as U.S. government issues, generally have substantially lower margin requirements and thus offer greater opportunities to magnify returns. Stocks traded on the Nasdaq OMX markets can be margined like listed securities.

As long as the margin in an account remains at a level equal to or higher than prevailing initial requirements, the investor may use the account in any way he or she wants. However, if the value of the investor’s holdings declines, the margin in his or her account will also drop. In this case, the investor will have what is known as a  restricted account , one whose equity is less than the initial margin requirement. It does not mean that the investor must put up additional cash or equity. However, as long as the account is restricted, the investor may not make further margin purchases and must bring the margin back to the initial level when securities are sold.

Maintenance Margin

The absolute minimum amount of margin (equity) that an investor must maintain in the margin account at all times is the  maintenance margin . When an insufficient amount of maintenance margin exists, an investor will receive a  margin call . This call gives the investor a short period of time, ranging from a few hours to a few days, to bring the equity up above the maintenance margin. If this doesn’t happen, the broker is authorized to sell enough of the investor’s margined holdings to bring the equity in the account up to this standard.

Margin investors can be in for a surprise if markets are volatile. When the Nasdaq stock market fell 14% in one day in early April 2000, brokerages made many more margin calls than usual. Investors rushed to sell shares, often at a loss, to cover their margin calls—only to watch the market bounce back a few days later.

The maintenance margin protects both the brokerage house and investors. Brokers avoid having to absorb excessive investor losses, and investors avoid being wiped out. The maintenance margin on equity securities is currently 25%. It rarely changes, although it is often set slightly higher by brokerage firms for the added protection of brokers and customers. For straight debt securities such as government bonds, there is no official maintenance margin except that set by the brokerage firms themselves.

The Basic Margin Formula

The amount of margin is always measured in terms of its relative amount of equity, which is considered the investor’s collateral. A simple formula can be used with all types of long purchases to determine the amount of margin in the transaction at any given time. Basically, only two pieces of information are required: (1) the prevailing market value of the securities being margined and (2) the  debit balance , which is the amount of money being borrowed in the margin loan. Given this information, we can compute margin according to  Equation 2.1 .

Margin=Value of securities −Debit balanceValueofsecuritiesMargin = Value of securities − Debit balanceValue of securitiesEquation2.1

=V−DV=V−DVEquation2.1a

To illustrate, consider the following example. Assume you want to purchase 100 shares of stock at $40 per share at a time when the initial margin requirement is 70%. Because 70% of the transaction must be financed with equity, you can finance the (30%) balance with a margin loan. Therefore, you will borrow 0.30×$4,0000.30×$4,000, or $1,200. This amount, of course, is the debit balance. The remaining $2,800 needed to buy the securities represents your equity in the transaction. In other words, equity is represented by the numerator (V − D) in the margin formula.

What happens to the margin as the value of the security changes? If over time the price of the stock moves to $65, the margin is then

Margin=V−DV=$6,500−$1,200$6,500=0.815=81.5%––––––––––––––Margin = V−DV=$6,500−$1,200$6,500=0.815=81.5%__

Note that the margin (equity) in this investment position has risen from 70% to 81.5%. When the price of the security goes up, your margin also increases.

On the other hand, when the price of the security goes down, so does the amount of margin. For instance, if the price of the stock in our illustration drops to $30 per share, the new margin is only 60% [i.e., ($3,000−$1,200)÷$3,000($3,000−$1,200)÷$3,000]. In that case, we would be dealing with a restricted account because the margin level would have dropped below the prevailing initial margin of 70%.

Finally, note that although our discussion has been couched largely in terms of individual transactions, the same margin formula applies to margin accounts. The only difference is that we would be dealing with input that applies to the account as a whole—the value of all securities held in the account and the total amount of margin loans.

Return on Invested Capital

When assessing the return on margin transactions, you must take into account the fact that you put up only part of the funds. Therefore, you are concerned with the rate of return earned on only the portion of the funds that you provided. Using both current income received from dividends or interest and total interest paid on the margin loan, we can apply  Equation 2.2  to determine the return on invested capital from a margin transaction.

Return on invested capital from a margin transaction = Total current income received − Total interest paid on margin loan + Market value of securities at sale − Market value of securities at purchaseAmount of equity at purchaseReturn on invested capital from a margin transaction = Total current income received − Total interest paid on margin loan + Market value of securities at sale − Market value of securities at purchaseAmount of equity at purchaseEquation2.2

We can use this equation to compute either the expected or the actual return from a margin transaction. To illustrate: Assume you want to buy 100 shares of stock at $50 per share because you feel it will rise to $75 within six months. The stock pays $2 per share in annual dividends, and during your 6-month holding period, you will receive half of that amount, or $1 per share. You are going to buy the stock with 50% margin and will pay 10% interest on the margin loan. Therefore, you are going to put up $2,500 equity to buy $5,000 worth of stock that you hope will increase to $7,500 in six months. Because you will have a $2,500 margin loan outstanding at 10% for six months, the interest cost that you will pay is calculated as $2,500×0.10×6÷12$2,500×0.10×6÷12 which is $125. We can substitute this information into  Equation 2.2  to find the expected return on invested capital from this margin transaction:

Return on invested capital from a margin transaction = $100−$125+$7,500−$5,000$2,500=$2,475$2,500=0.99=99%––––––––––Return on invested capital from a margin transaction = $100−$125+$7,500−$5,000$2,500=$2,475$2,500=0.99=99%__

Keep in mind that the 99% figure represents the rate of return earned over a 6-month holding period. If you wanted to compare this rate of return to other investment opportunities, you could determine the transaction’s annualized rate of return by multiplying by 2 (the number of six-month periods in a year). This would amount to an annual rate of return of 198% (i.e.,99×2=198)(i.e., 99 × 2 = 198).

Uses of Margin Trading

Investors most often use margin trading in one of two ways. As we have seen, one of its uses is to magnify transaction returns. The other major margin tactic is called pyramiding, which takes the concept of magnified returns to its limits.  Pyramiding  uses the paper profits in margin accounts to partly or fully finance the acquisition of additional securities. This allows investors to make such transactions at margins below prevailing initial margin levels, sometimes substantially so. In fact, with this technique it is even possible to buy securities with no new cash at all. Rather, they can all be financed entirely with margin loans. The reason is that the paper profits in the account lead to  excess margin —more equity in the account than required. For instance, if a margin account holds $60,000 worth of securities and has a debit balance of $20,000, it is at a margin level of 66.6% [i.e.,($60,000−$20,000)÷$60,000][i.e., ($60,000 − $20,000) ÷ $60,000]. This account would hold a substantial amount of excess margin if the prevailing initial margin requirement were only 50%.

The principle of pyramiding is to use the excess margin in the account to purchase additional securities. The only constraint—and the key to pyramiding—is that when the additional securities are purchased, your margin account must be at or above the prevailing required initial margin level. Remember that it is the account, not the individual transactions, that must meet the minimum standards. If the account has excess margin, you can use it to build up security holdings. Pyramiding can continue as long as there are additional paper profits in the margin account and as long as the margin level exceeds the initial requirement that prevailed when purchases were made. The tactic is somewhat complex but is also profitable, especially because it minimizes the amount of new capital required in the investor’s account.

In general, margin trading is simple, but it is also risky. Risk is primarily associated with possible price declines in the margined securities. A decline in prices can result in a restricted account. If prices fall enough to cause the actual margin to drop below the maintenance margin, the resulting margin call will force you to deposit additional equity into the account almost immediately. In addition, losses (resulting from the price decline) are magnified in a fashion similar to that demonstrated in  Table 2.3 , part B. Clearly, the chance of a margin call and the magnification of losses make margin trading riskier than nonmargined transactions. Only investors who fully understand its operation and appreciate its pitfalls should use margin.

Short Selling

In most cases, investors buy stock hoping that the price will rise. What if you expect the price of a particular security to fall? By using short selling, you may be able to profit from falling security prices. Almost any type of security can be “shorted,” including common and preferred stocks, all types of bonds, convertible securities, listed mutual funds, options, and warrants. In practice, though, the short-selling activities of most investors are limited almost exclusively to common stocks and to options. (However, investors are prohibited from using short-selling securities that they already own to defer taxes, a strategy called shorting-against-the-box.)

The Basics of Short Selling Explained

Essentials of Short Selling

Short selling  is generally defined as the practice of selling borrowed securities. Unusual as it may sound, selling borrowed securities is (in most cases) legal and quite common. Short sales start when an investor borrows securities from a broker and sells these securities in the marketplace. Later, when the price of the issue has declined, the short seller buys back the securities and then returns them to the lender. A short seller must make an initial equity deposit with the broker, subject to rules similar to those for margin trading. The deposit plus the proceeds from sale of the borrowed shares assure the broker that sufficient funds are available to buy back the shorted securities at a later date, even if their price increases. Short sales, like margin transactions, require investors to work through a broker.

Making Money When Prices Fall

Making money when security prices fall is what short selling is all about. Like their colleagues in the rest of the investment world, short sellers are trying to make money by buying low and selling high. The only difference is that they reverse the investment process: They start the transaction with a sale and end it with a purchase.

Table 2.5  shows how a short sale works and how investors can profit from such transactions. (For simplicity, we ignore transaction costs.) The transaction results in a net profit of $2,000 as a result of an initial sale of 100 shares of stock at $50 per share (step 1) and subsequent covering (purchase) of the 100 shares for $30 per share (step 2). The amount of profit or loss generated in a short sale depends on the price at which the short seller can buy back the stock. Short sellers earn profits when the proceeds from the sale of the stock are higher than the cost of buying it back.

Who Lends the Securities?

Acting through their brokers, short sellers obtain securities from the brokerage firm or from other investors. (Brokers are the principal source of

Excel@Investing

Table 2.5 The Mechanics of a Short Sale

Step 1. Short sale initiated
100 shares of borrowed stock are sold at $50/share:
Proceeds from sale to investor	$5,000
Step 2. Short sale covered
Later, 100 shares of the stock are purchased at $30/share and returned to broker from whom stock was borrowed:
Cost to investor	−$3,000
Net profit	$2,000

borrowed securities.) As a service to their customers, brokers lend securities held in their portfolios or in street-name accounts. It is important to recognize that when the brokerage firm lends street-name securities, it is lending the short seller the securities of other investors. Individual investors typically do not pay fees to the broker for the privilege of borrowing the shares; in exchange, investors do not earn interest on the funds they leave on deposit with the broker.

Margin Requirements and Short Selling

To make a short sale, the investor must make a deposit with the broker that is equal to the initial margin requirement (currently 50%) applied to the short-sale proceeds. In addition, the broker retains the proceeds from the short sale.

To demonstrate, assume that you sell short 100 shares of Smart, Inc., at $50 per share at a time when the initial margin requirement is 50% and the maintenance margin on short sales is 30%. The values in lines 1 through 4 in column A in  Table 2.6  indicate that your broker would hold a total deposit of $7,500 on this transaction. Note in columns B and C that regardless of subsequent changes in Smart’s stock price, your deposit with the broker would remain at $7,500 (line 4).

By subtracting the cost of buying back the shorted stock at the given share price (line 5), you can find your equity in the account (line 6) for the current (column A) and two subsequent share prices (columns B and C). We see that at the initial short sale price of $50 per share, your equity would equal $2,500 (column A). If the share price subsequently drops to $30, your equity would rise to $4,500 (column B). If the share price subsequently rises to $70, your equity would fall to $500 (column C). Dividing these account equity values (line 6) by the then-current cost of buying back the stock

Famous Failures in Finance Short Sellers Tip 60 Minutes

On March 1, 2015, the television news program, 60 Minutes, ran a story alleging that Lumber Liquidators, a retail purveyor of home flooring products, was selling Chinese-made flooring that contained formaldehyde in concentrations that were up to 20 times greater than the legal limit in California. The day after the story was aired, Lumber Liquidators stock fell by 25%. Where did the producers at 60 Minutes get the idea to investigate Lumber Liquidators? Apparently Whitney Tilson, manager of the hedge fund Kase Capital, approached 60 Minutes after he had conducted his own investigation and concluded that Lumber Liquidators was indeed selling flooring products that did not meet regulatory standards. Prior to giving 60 Minutes the idea for the story, Tilson shorted 44,676 shares of Lumber Liquidators. Within days of the 60 Minutes program being aired, Tilson had earned a profit on his short sale of $1.4 million.

Table 2.6 Margin Positions on Short Sales

		A	B	C
Line	Item	Initial Short Sale Price	Subsequent Share Prices
*  Investor must either (a) deposit at least an additional $1,600 with the broker to bring the total deposit to $9,100 (i.e.,$7,500+$1,600)(i.e., $7,500+$1,600), which would equal the current value of the 100 shares of $7,000 plus a 30% maintenance margin deposit of $2,100 (i.e.,0.30×$7,000)(i.e., 0.30×$7,000) or (b) buy back the 100 shares of stock and return them to the broker.
1	Price per share	$ 50	$ 30	$ 70
2	Proceeds from initial short sale [(1)×100shares][(1)×100 shares]	$5,000
3	Initial margin deposit [0.50×(2)][0.50×(2)]	$2,500
4	Total deposit with broker [(2)+(3)][(2)+(3)]	$7,500	$ 7,500	$ 7,500
5	Current cost of buying back stock [(1)×100shares][(1)×100 shares]	$5,000	$3,000	$7,000
6	Account equity [(4)−(5)][(4)−(5)]	$2,500	$ 4,500	$ 500
7	Actual margin [(6)÷(5)][(6)÷(5)]	50%	150%	7.14%
8	Maintenance margin position [(7)>30%?][(7)>30%?]	OK	OK	Margin call *

(line 5), we can calculate the actual margins at each share price (line 7). We see that at the current $50 price the actual margin is 50%, whereas at the $30 share price it is 150%, and at the $70 share price it is 7.14%.

As indicated in line 8, given the 30% maintenance margin requirement, your margin would be okay at the current price of $50 (column A) or lower (column B). But at the $70 share price, the 7.14% actual margin would be below the 30% maintenance margin, thereby resulting in a margin call. In that case (or whenever the actual margin on a short sale falls below the maintenance margin), you must respond to the margin call either by depositing additional funds with the broker or by buying the stock and covering (i.e., closing out) the short position.

If you wished to maintain the short position when the share price has risen to $70, you would have to deposit an additional $1,600 with the broker. Those funds would increase your total deposit to $9,100 (i.e.,$7,500+$1,600)(i.e., $7,500+$1,600)—an amount equal to the $7,000 value of the shorted stock plus the 30% maintenance margin, or $2,100. Buying back the stock to cover the short position would cost $7,000, thereby resulting in the return of the $500 of equity in your account from your broker. Clearly, margin requirements tend to complicate the short-sale transaction and the impact of an increase in the shorted stock’s share price on required deposits with the broker.

Advantages and Disadvantages

The major advantage of selling short is, of course, the chance to profit from a price decline. The key disadvantage of many short-sale transactions is that the investor faces limited return opportunities along with high-risk exposure. The price of a security can fall only so far (to zero or near zero), yet there is really no limit to how far such securities can rise in price. (Remember, a short seller is hoping for a price decline; when a security goes up in price, a short seller loses.) For example, note in  Table 2.5  that the stock in question cannot possibly fall by more than $50, yet who is to say how high its price can go?

A less serious disadvantage is that short sellers never earn dividend (or interest) income. In fact, short sellers owe the lender of the shorted security any dividends (or interest) paid while the transaction is outstanding. That is, if a dividend is paid during the course of a short-sale transaction, the short seller must pay an equal amount to the lender of the stock. (The mechanics of these payments are taken care of automatically by the short seller’s broker.)

Uses of Short Selling

Investors sell short primarily to seek speculative profits when they expect the price of a security to drop. Because the short seller is betting against the market, this approach is subject to a considerable amount of risk. The actual procedure works as demonstrated in  Table 2.5 . Note that had you been able to sell the stock at $50 per share and later repurchase it at $30 per share, you would have generated a profit of $2,000 (ignoring dividends and brokerage commissions). However, if the market had instead moved against you, all or most of your $5,000 investment could have been lost.

Concepts in Review

Answers available at  http://www.pearsonhighered.com/smart

1. 2.12 What is a long purchase? What expectation underlies such a purchase? What is margin trading, and what is the key reason why investors sometimes use it as part of a long purchase?

2. 2.13 How does margin trading magnify profits and losses? What are the key advantages and disadvantages of margin trading?

3. 2.14 Describe the procedures and regulations associated with margin trading. Be sure to explain restricted accounts, the maintenance margin, and the margin call. Define the term debit balance, and describe the common uses of margin trading.

4. 2.15 What is the primary motive for short selling? Describe the basic short-sale procedure. Why must the short seller make an initial equity deposit?

5. 2.16 What relevance do margin requirements have in the short-selling process? What would have to happen to experience a margin call on a short-sale transaction? What two actions could be used to remedy such a call?

6. 2.17 Describe the key advantages and disadvantages of short selling. How are short sales used to earn speculative profits?

MyFinanceLab

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What You Should Know	Key Terms	Where to Practice
LG 1 Identify the basic types of securities markets and describe their characteristics. Short-term investments trade in the money market; longer-term securities, such as stocks and bonds, trade in the capital market. New security issues are sold in the primary market. Investors buy and sell existing securities in the secondary markets.	1. ask price  , p.  46 2. bear markets  , p.  48 3. bid price,  p.  46 4. broker market,  p.  44 5. bull markets,  p.  48 6. capital market,  p.  38 7. dealer market,  p.  44 8. designated market maker (DMM),  p.  46 9. dual listing,  p. 46 10. electronic communications network (ECN),  p.  48 11. fourth market,  p.  48 12. initial public offering (IPO),  p.  38 13. investment banker,  p.  41 14. market makers,  p.  44 15. money market,  p.  38	MyFinanceLab Study Plan 2.1
LG 2 Explain the initial public offering process. The first public issue of a company’s common stock is an IPO. The company selects an investment banker to sell the IPO. The lead investment banker may form a syndicate with other investment bankers and then create a selling group to sell the issue. The IPO process includes filing a registration statement with the Securities and Exchange Commission, getting SEC approval, promoting the offering to investors, pricing the issue, and selling the shares.		MyFinanceLab Study Plan 2.2
LG 3 Describe broker markets and dealer markets, and discuss how they differ from alternative trading systems. In dealer markets, buy/sell orders are executed by market makers. The market makers are securities dealers who “make markets” by offering to buy or sell certain securities at stated bid/ask prices. Dealer markets also serve as primary markets for both IPOs and secondary distributions. Over-the-counter transactions in listed securities take place in the third market. Direct transactions between buyers and sellers are made in the fourth market. Market conditions are commonly classified as “bull” or “bear,” depending on whether securities prices are generally rising or falling. Broker markets bring together buyers and sellers to make trades. Included are the New York Stock Exchange, the NYSE Amex, regional stock exchanges, foreign stock exchanges, options exchanges, and futures exchanges. In these markets the forces of supply and demand drive transactions and determine prices. These securities exchanges are secondary markets where existing securities trade.	1. over-the-counter (OTC) market,  p.  43 2. primary market,  p.  38 3. private placement,  p.  38 4. prospectus,  p.  39 5. public offering,  p.  38 6. red herring,  p.  39 7. rights offering,  p.  38 8. secondary distributions,  p.  47 9. secondary market,  p.  43 10. Securities and Exchange Commission (SEC),  p.  38 11. securities markets,  p.  38 12. selling group,  p.  41 13. third market,  p.  48 14. underwriting,  p.  41 15. underwriting syndicate,  p.  41	MyFinanceLab Study Plan 2.3
LG 4 Review the key aspects of the globalization of securities markets, and discuss the importance of international markets. Securities exchanges operate in over 100 countries—both large and small. Foreign security investments can be made indirectly by buying shares of a U.S.-based multinational with substantial foreign operations or by purchasing shares of a mutual fund that invests primarily in foreign securities. Direct foreign investment can be achieved by purchasing securities on foreign exchanges, by buying securities of foreign companies that are traded on U.S. exchanges, or by buying American depositary shares. International investments can enhance returns, but they entail added risk, particularly currency exchange risk.	1. American depositary receipts (ADRs),  p.  51 2. American depositary shares (ADSs),  p.  51 3. currency exchange rate,  p.  52 4. currency exchange risk,  p.  52 5. diversification,  p. 49 6. Yankee bonds,  p. 51	MyFinanceLab Study Plan 2.4 Video Learning Aid for Problem P2.3
LG 5 Discuss trading hours and the regulation of securities markets. Investors now can trade securities outside regular market hours (9:30 a.m. to 4:00 p.m., eastern time). Most after-hours markets are crossing markets, in which orders are filled only if they can be matched. Trading activity during these sessions can be quite risky. The securities markets are regulated by the federal Securities and Exchange Commission and by state commissions. The key federal laws regulating the securities industry are the Securities Act of 1933, the Securities Exchange Act of 1934, the Maloney Act of 1938, the Investment Company Act of 1940, the Investment Advisors Act of 1940, the Securities Acts Amendments of 1975, the  Insider Trading  and Fraud Act of 1988, the Sarbanes-Oxley Act of 2002, and the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010.	1. crossing markets,  p.  53 2. ethics,  p.  55 3. insider trading,  p.  54	MyFinanceLab Study Plan 2.5
LG 6 Explain long purchases, margin transactions, and short sales. Most investors make long purchases—that is, they buy securities—in expectation of price increases. Many investors establish margin accounts to use borrowed funds to enhance their buying power. The Federal Reserve Board establishes the margin requirement—the minimum investor equity in a margin transaction. The return on capital in a margin transaction is magnified for both positive returns and negative returns. Paper profits can be used to pyramid a margin account by investing its excess margin. The risks of margin trading are the chance of a restricted account or margin call and the consequences of magnified losses due to price declines. Short selling is used when a decline in security prices is anticipated. It involves selling securities, typically borrowed from the broker, to earn a profit by repurchasing them at a lower price in the future. The short seller makes an initial equity deposit with the broker. If the price of a shorted stock rises, the investor may receive a margin call and must then either increase the deposit with the broker or buy back the stock to cover the short position. The major advantage of selling short is the chance to profit from a price decline. The disadvantages of selling short are the unlimited potential for loss and the fact that short sellers never earn dividend (or interest) income. Short selling is used primarily to seek speculative profits.	1. debit balance,  p.  60 2. excess margin,  p.  61 3. financial leverage,  p.  56 4. initial margin,  p.  59 5. maintenance margin,  p.  59 6. long purchase,  p.  55 7. margin account,  p.  58 8. margin call,  p.  59 9. margin loan,  p.  58 10. margin requirement,  p.  56 11. margin trading,  p.  56 12. prime rate,  p.  58 13. pyramiding,  p.  61 14. restricted account,  p.  59 15. short selling,  p.  62	MyFinanceLab Study Plan 2.6 Excel  Tables 2.3 ,  2.5 Video Learning Aid for Problem P2.19
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