Week 1

Chapter 03 - How Securities Are Traded

Chapter Three

How SECURITIES Are Traded

CHAPTER OVERVIEW

This chapter discusses how securities are traded on both the primary and secondary markets, with detailed coverage of both organized exchange and over the counter activities. Margin trading and short selling are discussed along with detailed examples of margin arrangements. The chapter discusses elements of regulation and ethics issues associated with security transactions.

LEARNING OBJECTIVES

After studying this chapter the student should have considerable insight as to how securities are traded on both the primary and secondary markets. The student should understand the mechanics, risk, and calculations involved in both margin and short trading. The student should begin to understand some of the implications, ambiguities, and complexities of the regulation of securities markets.

Presentation of Material

3.1 How Firms Issue Securities

Key characteristics of primary and secondary sales of securities are presented here. The relationship between the primary market terms and activity in the secondary market presents a good opportunity for class discussion and relating the material in the investment class to principles of finance.

Investment banking involves the sale of new issues of securities to investors; Figure 3.1 shows the relationship between parties involved in an underwritten offering. Shelf registrations allow a firm that is regularly reporting to sell a limited amount of new stock without going through a registered public offering. This allows a firm more flexibility in selling additional shares.

Private placements allow a firm to sell securities without going through a registered public offering. While most stock offerings employ public offerings, many issues of debt are completed using private placements. It is useful to discuss differences in the markets for equity and bond when discussing this material. Bond markets are dominated by financial institutions and many of the special characteristics of bond issues lend themselves to private placements. In some years the volume of private placements exceeds public offerings of corporate bond issues.

When a company sells securities to the general investing public for the first time, the transaction is referred to as an Initial Public Offering (IPO). The underwriting firms commonly underprice IPOs leading to significant short-term performance for some investors.

3.2 How Securities Are Traded

This section presents the major types of secondary markets. The discussion of secondary markets should be focused on services rather than institutional characteristics of our markets. Discussion of different demands for services by different types of investors can help students understand the recent developments in our markets.

Orders for transactions in securities have different priorities. Market orders are to be executed immediately at current market prices. Price-Contingent Orders place price as the first priority. Once a target price is reached, a price-contingent order becomes a market order. Students should be familiar with Figure 3.5 and understand the uses of each of these price-contingent orders.

The section continues with a discussion on the organization of markets that facilitate trade. In specialists markets, a dealer is charged to make an orderly market. The specialist is granted a monopoly position and is highly regulated. A dealer market features competition among dealers to make the market efficient. Electronic Communication Networks (ECNs) allow electronic interface among traders that bypasses the traditional dealership function.

3.3 The Rise of Electronic Trading

This section discusses how the interaction of new technologies and new regulations lead to electronic trading. In 1975, the NYSE eliminated fixed commissions and National Market System was created in the attempt to centralize trading across exchange and enhance competition. The new order-handling rules in 1994 on NASDAQ lead to narrower bid-ask spreads; 1997 and 2001 introduced the drop in the minimum tick size from one-eighth to one-sixteenth, and to 1 cent, respectively. Figure 3.6 illustrated the effect of minimum tick size on the effective spread. In 2000, NASDAQ Stock Market emerged. In 2006 NYSE was renamed to NYSE Arca after acquiring the electronic Archipelago Exchange. 2007 marked the creation of National Market System (NMS) to link exchanges electronically. Overall, the share of electronic trading in the US rose from 16% to 80% in 2000s.

3.4 U.S. Markets

The domestic securities markets have undergone significant reorganization and restructuring since the mid-1970s. For example a major component of today’s market includes the Nasdaq market system that links dealers, organized exchanges and ECNs. Listing requirements on the NYSE and Nasdaq are significantly different. The NYSE requires much larger market value of shares in the hands of the public.

3.5 New Trading Strategies

This section presents new trading strategies that came into play after the development of the electronic trading. Algorithmic Trading uses computer programs to make trading decisions. High-Frequency Trading employs special class of algorithmic with very short order execution time. Dark Pools are the trading venues that preserve anonymity, mainly relevant in block trading. Special place in the OTC market takes Bond Trading among bond dealers, with NYSE Bonds being the largest centralized bond market of any U.S. exchanges.

3.6 Globalization of Stock Markets

Figure 3.8 demonstrates the biggest stock markets in the world by domestic market capitalization, with NYSE-Euronext being by far the largest equity market. The section discusses the widespread trend to form international and local alliances and mergers. Some of the examples include NYSE’s acquisition of Archipelago (ECN), American Stock Exchange, and the merger with Euronext; acquisition of Instinet/INET (ECN), Boston Stock Exchange, and merger with OMX by NASDAQ to form NASDAQ OMX Group.

3.7 Trading Costs

On some trades only a commission is paid; on others, only a portion of the spread is paid; and many trades require both a commission and a portion of the spread are paid. This point can be made by contrasting orders on both listed and OTC stocks. While the payment of a portion of the spread is not actually reported, the concept is important when considering the total cost of trading.

3.8 Buying on Margin

This section introduces margin trading. The use of actual borrowing of funds contrasts with margin arrangement in futures. While both futures and stock trading have maintenance margins and margin calls which are similar, the costs of borrowed funds must be factored into analysis of the returns of stock margin trading. The degree of leverage available in equities is set by the Federal Reserve Board and is far less than is available in futures.

A sample margin trade is used to develop the concepts of margin call and maintenance margin. The student’s understanding of the concept is helped by explicit treatment of the accounting for the problem using assets = liabilities + equity. The initial position shows a 60% initial margin on a 100 share purchase of a stock that is selling for $100 per share. If the stock drops to $70 as depicted in the example, the equity falls to $3,000. The margin call price is then developed.

3.9 Short Sales

With the background developed in margin trading, the concept of short selling is then covered. A brief description of the mechanics of a short sale is shown here. While stock is generally available for short sellers, sometimes short sellers are not able to find additional stock to borrow when stock is called back from loan. If the short seller is not able to find other stock to borrow in that situation, he may be forced to close out her position.

A sample calculation of margin, maintenance margin and margin calls is developed for a short sale. The short sale involves 1000 shares of a stock that has an initial price of $100 with the maintenance margin of 30%. The example works through calculation of the margin position when the stock price rises to $110. The amount borrowed and owed is no longer constant with a short sale. The amount owed is actually equal to number of shares shorted time the current price. The amount owed is subtracted from the original sale proceeds plus the customer’s margin to determine the equity. With a 30% maintenance margin, the short seller will receive a margin call if the stock price rises above $115.38.

3.10 Regulation of Securities Markets

Recent scandals have rocked the securities markets. This is an area that has received and continues to receive enormous amounts of coverage in the press. Numerous proposals for additional regulation have appeared even before the costs and efficiency of Sarbanes-Oxley can be assessed. The financial crisis of 2008 has launched a new round of financial regulation legislation.

Excel Applications

Two Excel models are available for margin trading and short sales. These models allow the student to examine the impact of margining combined with stock price volatility. Excel models that cover material in this chapter are available on the Online Learning Center (www.mhhe.com/bkm).

3-1

Copyright © 2014 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.