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Chapter Three

How Securities

are Traded

No reproduction or further distribution permitted without the prior written consent of McGraw-Hill Education.

INVESTMENTS | BODIE, KANE, MARCUS

Broad introduction to the many venues and procedures available for trading securities in the U.S. and international markets

Trading securities

Mechanics of trade execution

Essentials of some specific types of transactions

E.g., buying on margin and short-selling

Chapter Overview

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Firms requiring new capital can raise funds by borrowing money or selling shares in the firm

Primary market is the market in which new issues of securities are offered to the public

Secondary market involves already existing securities being bought and sold on the exchanges or in the OTC market

Shares of publicly listed firms trade continually in markets such as the NYSE or NASDAQ, but the shares of private corporations are held by small numbers of managers and investors

How Firms Issue Securities

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Investment bankers are usually hired to manage the sale of securities in the primary market.

Owned by a relatively small number of shareholders

Fewer obligations to release information to the public

Jumpstart Our Business Startups (JOBS) of 2012 allows up to 2,000 shareholders

Raise funds through private placement

How Firms Issue Securities Privately Held Firms

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Initial public offering, or IPO

A firm’s first issue of shares to the public

Seasoned equity offering

The sale of additional shares in firms that already are publicly traded

Public offerings of both stocks and bonds typically are marketed by underwriters

Advises the firm regarding the terms on which it should attempt to sell the securities

How Firms Issue Securities Publicly Traded Companies

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Relationships Among a Firm Issuing Securities, the Underwriters, and the Public

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Shelf registration

Rule 415 was introduced in 1982

Allows firms to register securities and gradually sell them to the public for three years following the initial registration

Shares can be sold on short notice and in small amounts without incurring high floatation costs

These securities are referred to as “on the shelf”

How Firms Issue Securities Shelf Registration

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Initial public offerings

Road shows to publicize new offering

Bookbuilding to determine demand

Degree of investor interest provides valuable pricing information

Shares of IPOs are allocated across investors in part based on the strength of each investor’s expressed interest

How Firms Issue Securities Initial Public Offerings

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Underwriter bears price risk

IPOs are commonly underpriced compared to the price they could be marketed

Example: Dropbox

Some IPOs are overpriced

Example: Facebook

Others cannot be fully sold

How Firms Issue Securities Initial Public Offerings (Continued)

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Direct search market

Least organized

Buyers and sellers seek each other out directly

Brokered markets

Brokers offer search services to buyers and sellers

Dealer markets

Traders specializing in particular assets buy and sell assets for their own accounts

Auction markets

All traders in an asset meet (physically or electronically) at one place to buy and sell

Types of Markets

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Bid Price

Bids are offers to buy

In dealer markets, the bid price is the price at which the dealer is willing to buy

Investors “sell to the bid”

Ask Price

Ask prices are sell offers

In dealer markets, the ask price is the price at which the dealer is willing to sell

Investors must pay the ask price to buy the security

Bid and Ask Prices

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Bid-asked spread is the difference between a dealer’s bid and ask price

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Market orders

Buy or sell orders that are to be executed immediately

Trader receives current market price

Price-contingent orders

Traders specify buying or selling price

Limit buy (sell) order instructs the broker to buy (sell) shares if and when those shares are at or below (above) a specified price

Types of Orders

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Price-Contingent Order: Example

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Dealer markets

Over-the-counter (OTC) market is an informal network of brokers and dealers where securities can be traded (not a formal exchange)

Electronic communication networks (ECNs)

Computer-operated trading network

Specialist/DMM markets

Designated market maker (DMM) accepts the obligation to commit its own capital to provide quotes and help maintain a “fair and orderly market”

Trading Mechanisms

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Note individual investors must hire a broker who is a participant in the ECN to execute a trade on their behalf.

Also, DMMs have some advantages in trade execution in exchange for assuming their obligations. They replaced what formerly were called specialist firms at the NYSE.

1975: Elimination of fixed commissions on the NYSE

1994: New order-handling rules on NASDAQ, leading to narrower bid-ask spreads

1997: Reduction of minimum tick size from one-eighth to one-sixteenth

2000s: In the US, the share of electronic trading rose from 16% to 80% in 2000s

The Rise of Electronic Trading (1 of 2)

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2000: Emergence of NASDAQ Stock Market

2001: Decimalization allowed the tick size to fall to 1 cent

2005: SEC adopted Regulation NMS

2006: NYSE acquired electronic Archipelago Exchange and renamed it NYSE Arca

2007: NMS fully implemented

The Rise of Electronic Trading (2 of 2)

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The Effective Spread Fell Dramatically as the Minimum Tick Size Fell

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NASDAQ

Lists about 3,000 firms

NASDAQ’s Market Center consolidates NASDAQ’s previous electronic markets into one integrated system

Three levels of subscribers

U.S. Markets: NASDAQ

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Largest U.S. stock exchange, as measure by market value of listed stocks

Automatic electronic trading runs side-by-side with broker/specialist system

1976 (and later) – DOT and SuperDot

2000 - Direct+

2006 – NYSE Hybrid

Allowed NYSE to qualify as a fast market for the purposes of Regulation NMS, but still offered advantages of human interaction for complex trades

U.S. Markets: NYSE

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Electronic communication networks (ECNs) are computer-operated trading network for trading securities

Some registered as formal stock exchanges, while others are considered part of the OTC market

Compete in terms of the speed they can offer

Latency refers to the time it takes to accept, process, and deliver a trading order

Example: CBOE Global Markets advertises average latency times of around 100 microseconds

U.S. Markets: ECNs

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Algorithmic trading is the use of computer programs to make trading decisions

High-frequency trading is a subset of algorithmic trading that relies on computer programs to make extremely rapid decisions

Dark pools are private trading systems in which participants can buy or sell large blocks of securities without showing their hand

New Trading Strategies (1 of 2)

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Bond trading

Vast majority of bond trading takes place in the OTC market among bond dealers

Market for many bond issues is “thin” and is subject to liquidity risk

One impediment to heavy electronic trading is lack of standardization in the bond market

A single company may have dozens of outstanding bond issues, differing by coupon, maturity and seniority

New Trading Strategies (2 of 2)

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Pressure in recent years to make international alliances or merges

Much of the pressure is due to the impact of electronic trading

Wave of mergers has lead to a few giant security exchanges

ICE, NASDAQ, the LSE, Deutsche Boerse, the CME Group, TSE, and HKEX

Globalization of Stock Markets

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Biggest Stock Markets in the World

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Explicit cost - brokerage commissions

Full-service versus discount brokers

Execute orders, hold securities for safe-keeping, extend margin loans, facilitate short sales, and provide information and advice about investment alternatives

Implicit costs

Dealer’s bid-ask spread

Price concession an investor may be forced to make for trading in quantities greater than those associated with the posted bid or ask price

Trading Costs

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Investors have easy access to a source of debt financing called broker’s call loans

Buying on margin means the investor borrows part of the purchase price of the stock

Margin in the account is the portion of the purchase price contributed by the investor; remainder is borrowed from the broker

Board of Governors of the Federal Reserve System limits the use of margin loans

Buying on Margin (1 of 2)

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Current initial margin requirement is 50%

Maintenance margin

Minimum equity that must be kept in the margin account

Margin call is made if value of securities falls below maintenance level

Buying on Margin (2 of 2)

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Short sales allows investors to profit from a decline in a security’s price

Mechanics

Investor borrows stock from a broker and sells it

Must then purchase a share of the same stock in order to replace the one that was borrowed

Referred to as covering the short position

Proceeds from a short sale must be kept on account with the broker, per exchange rules

Short Sales

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Short Sale Mechanics

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See Example 3.3 and 3.4 to illustrate the mechanisms of short-selling and margin calls on short positions, respectively.

Major governing legislation

Securities Act of 1933

Securities Exchange Act of 1934

Securities Investor Protection Act of 1970

Blue sky laws

Self-Regulation

Financial Industry Regulatory Authority (FINRA)

CFA Institute

Standards of professional conduct

Regulation of Securities Markets (1 of 2)

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Sarbanes-Oxley Act

2000-2002 scandals centered on three broad practices

Allocations of shares in IPOs

Tainted securities research and recommendations

Misleading financial statements and accounting practices

Key provisions

Public Company Accounting Oversight Board

Independent financial experts to serve on audit committees of a firm’s board of directors

CEOs and CFOs personally certify firms’ financial reports

Auditors may no longer provide several other services to clients

Boards must have independent directors

Regulation of Securities Markets (2 of 2)

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Regulations prohibit trading on inside information

SEC requires officers, directors, and major stockholders to report all transactions in their firm’s stock

Insiders do exploit their knowledge

Well-publicized convictions of principals in insider trading schemes

Considerable evidence of “leakage”

Documented abnormal returns on trades by insiders

Insider Trading

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