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Chapter Three

How Securities Are Traded

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How firms issue securities

Primary vs. secondary market

Privately held vs. publicly traded companies

Initial public offerings

Market transactions

Short selling and buying on margin

Rise of electronic trading and globalization of stock markets

Market regulation

Chapter Overview

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Primary Market

Market for newly-issued securities

Firms issue new securities through underwriter (investment banker) to public

Secondary Market

Investors trade previously issued securities among themselves

How Firms Issue Securities

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Privately Held Firms

Up to 499 shareholders

Middlemen have formed partnerships to buy shares and get around the 499-investor restrictions

Raise funds through private placement

Lower liquidity of shares

Have fewer obligations to release financial statements and other information

How Firms Issue Securities

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Publicly Traded Companies

Raise capital from a wider range of investors through initial public offering, IPO

Seasoned equity offering: The sale of additional shares in firms that already are publicly traded

Public offerings are marketed by investment bankers or underwriters

Registration must be filed with the SEC

How Firms Issue Securities

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Figure 3.1 Relationship Among a Firm Issuing Securities, the Underwriters, and the Public

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Shelf Registration

SEC Rule 415: Allows firms to register securities and gradually sell them to the public for two years

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

How Firms Issue Securities

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Initial Public Offerings

Road shows to publicize new offering

Bookbuilding to determine demand for the new issue

Degree of investor interest in the new offering provides valuable pricing information

How Firms Issue Securities

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Initial Public Offerings

Underwriter bears price risk associated with placement of securities:

IPOs are commonly underpriced compared to the price they could be marketed (ex.: Groupon)

Some IPOs, however, are well overpriced (ex.: Facebook); others cannot even fully be sold

How Firms Issue Securities

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Types of Markets:

Direct search

Buyers and sellers seek each other

Brokered markets

Brokers search out buyers and sellers

Dealer markets

Dealers have inventories of assets from which they buy and sell

Auction markets

Traders converge at one place to trade

How Securities are Traded

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Bid and Asked Prices

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.”

Bid-asked spread is the profit for making a market in a security.

Ask Price

Asked prices represent offers to sell.

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

Investors must pay the asked price to buy the security.

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Market Order:

Executed immediately

Trader receives current market price

Price-Contingent Order:

Traders specify buying or selling price

A large order may be filled at multiple prices

Types of Orders

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Figure 3.5 Price-Contingent Orders

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Dealer markets

Electronic communication networks (ECNs)

True trading systems that can automatically execute orders

Specialists markets

Maintain a “fair and orderly market”

Have been largely replaced by ECNs

Trading Mechanisms

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In the US, the share of electronic trading rose from 16% to 80% in 2000s and was triggered by an interaction of new technologies and new regulations

1975: Elimination of fixed commissions on the NYSE

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

The Rise of Electronic Trading

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1997 and 2001: Reduction of minimum tick size from one-eighth to one-sixteenth, and 1 cent, respectively

2000: Emergence of NASDAQ Stock Market

2006: NYSE is renamed to NYSE Arca after acquiring the electronic Archipelago Exchange

2007: Creation of National Market System (NMS) to link exchanges electronically

The Rise of Electronic Trading

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Figure 3.6 The Effective Spread Fell Dramatically as the Minimum Tick Size Fell

(Value-weighted average of NYSE-listed shares)

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NASDAQ

Lists about 3,000 firms

Originally, NASDAQ was primarily a dealer market with a price quotation system

Today, NASDAQ’s Market Center offers a sophisticated electronic trading platform with automatic trade execution

Large orders may still be negotiated through brokers and dealers

U.S. Markets

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The New York Stock Exchange

The largest U.S. stock exchange as measured by the value of the stocks listed on the exchange

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

SuperDot : Electronic order-routing system

DirectPlus: Fully automated execution for small orders

Specialists: Handle large orders and maintain orderly trading

U.S. Markets

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ECNs

Private computer networks that directly link buyers with sellers for automated order execution over multiple exchanges

Compete in terms of the speed they can offer

Latency: The time it takes to accept, process, and deliver a trading order

Major ECNs include Direct Edge, BATS, and NYSE Arca

U.S. Markets

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Algorithmic Trading

The use of computer programs to make trading decisions

High-Frequency Trading

Special class of algorithmic with very short order execution time

Dark Pools

Trading venues that preserve anonymity, mainly relevant in block trading

New Trading Strategies

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Bond Trading

Most bond trading takes place in the OTC market among bond dealers

NYSE Bonds is the largest centralized bond market of any U.S. exchange

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

New Trading Strategies

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Widespread trend to form international and local alliances and mergers

NYSE acquired Archipelago (ECN), American Stock Exchange, and merged with Euronext

NASDAQ acquired Instinet/INET (ECN), Boston Stock Exchange, and merged with OMX to form NASDAQ OMX Group

Chicago Mercantile Exchange acquired Chicago Board of Trade and New York Mercantile Exchange

Globalization of Stock Markets

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Figure 3.8 The Biggest Stock Markets in the World by Domestic Market Capitalization

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NYSE-Euronext (US) NASDAQ-OMX Tokyo London Euronext (Europe) Shanghai Hong Kong Toronto Brazil Australia Deutsche Börse BME (Spanish) India 11795.6 3845 3325 3266 2447 2357 2258 1912 1229 1198 1184 1031 1007

$ Billion

Brokerage Commission: Fee paid to broker for making the transaction

Explicit cost of trading

Full service vs. discount brokerage

Spread: Difference between the bid and asked prices

Implicit cost of trading

Trading Costs

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Borrowing part of the total purchase price of a position using a loan from a broker

Investor contributes the remaining portion

Margin refers to the percentage or amount contributed by the investor

You profit when the stock rises

Buying on Margin

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Initial margin is set by the Fed

Currently 50%

Maintenance margin

Minimum equity that must be kept in the margin account

Margin call if value of securities falls too much

Buying on Margin

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Share price $100

60% Initial Margin

40% Maintenance Margin

100 Shares Purchased

Initial Position

Stock $10,000 Borrowed $4,000

Equity $6,000

Example 3.1 Margin Trading: Initial Conditions

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Stock price falls to $70 per share

New Position

Stock $7,000 Borrowed $4,000

Equity $3,000

Margin% = $3,000/$7,000 = 43%

Example 3.1 Margin Trading: Margin Call

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How far can the stock price fall before a margin call? Let maintenance margin = 30%

Equity = 100P - $4000

Percentage margin = (100P - $4,000)/100P

(100P - $4,000)/100P = 0.30

Solve to find:

P = $57.14

Example 3.2 Margin Trading: Maintenance Margin

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Purpose

To profit from a decline in the price of a stock or security

Mechanics

Borrow stock through a dealer

Sell it and deposit proceeds and margin in an account

Closing out the position: Buy the stock and return to the party from which it was borrowed

Short Sales

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Dot Bomb 1000 Shares

50% Initial Margin

30% Maintenance Margin

$100 Initial Price

Sale Proceeds $100,000

Margin & Equity $50,000

Stock Owed 1000 shares

Example 3.3 Short Sale: Initial Conditions

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Example 3.3 Short Sale: Dot Bomb falls to $70 per share

Assets

$100,000 (sale proceeds)

$50,000 (initial margin)

Liabilities

$70,000 (buy shares)

Equity

$80,000

Profit = Ending equity – Beginning equity

= $80,000 - $50,000 = $30,000

= Decline in share price x Number of shares sold short

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

($150,000* - 1000P)/(1000P) = 30%

P = $115.38

* Initial margin plus sale proceeds

Example 3.3 Short Sale: Margin Call

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Major regulations:

Securities Act of 1933

Securities Act of 1934

Securities Investor Protection Act of 1970

Self-Regulation

Financial Industry Regulatory Authority

CFA Institute standards of professional conduct

Regulation of Securities Markets

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Sarbanes-Oxley Act

Public Company Accounting Oversight Board

Independent financial experts to serve on audit committees of boards of directors

CEOs and CFOs personally certify firms’ financial reports

Boards must have independent directors

Regulation of Securities Markets

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Officers, directors, major stockholders must report all transactions in firm’s stock

Insiders do exploit their knowledge

Jaffe study:

Inside buyers > Inside sellers = Stock does well

Inside sellers > Inside buyers = Stock does poorly

Insider Trading

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