Chapter 3 How Securities are Traded Chapter Summary

Chapter 3 How Securities are Traded

Chapter Summary w Objective: To explain the institutional details and mechanics of investing in securities. n n n How firms issue securities Organization of secondary markets Trading and execution Margin trading Costs and regulation

Primary vs. Secondary Security Sales w Primary n n New issue Key factor: issuer receives the proceeds from the sale w Secondary n n Existing owner sells to another party Issuing firm doesn’t receive proceeds and is not directly involved

Investment Banking Arrangements w Underwritten vs. “Best Efforts” n n Underwritten: firm commitment on proceeds to the issuing firm Best Efforts: no firm commitment w Negotiated vs. Competitive Bid n n Negotiated: issuing firm negotiates terms with investment banker Competitive bid: issuer structures the offering and secures bids

Public Offerings w Public offerings: registered with the OSC (Ontario - SEC in USA) and sale is made to the investing public n n Red herring Prompt offering prospectus w Initial Public Offerings (IPOs) n n Evidence of underpricing Performance

Private Placements w Private placement: sale to a limited number of sophisticated investors not requiring the protection of registration w Dominated by institutions w Very active market for debt securities w Not active for stock offerings

Types of Markets w Direct search markets w Brokered markets Block transactions w Dealer markets OTC market w Auction markets Major exchanges

Organization of Secondary Markets w w Organized exchanges OTC market Third market Fourth market

Organized Exchanges w Auction markets with centralized order flow w Dealership function: can be competitive or assigned by the exchange (specialists or registered traders) w Securities: stock, futures contracts, options, and to a lesser extent, bonds w Examples: TSE, ME, NYSE, AMEX

OTC Market w Dealer market without centralized order flow w NASDAQ: largest organized stock market for OTC trading; information system for individuals, brokers and dealers w Levels of interaction: users, marketmakers w Securities: stocks, bonds and derivatives n Most secondary bonds transactions

Third Market w Trading of listed securities away from the exchange w Institutional market: to facilitate trades of larger blocks of securities w Involves services of dealers and brokers

Fourth Market w Institutions trading directly with institutions w No middleman involved in the transaction w Organized information and trading systems n n INSTINET POSIT w ECN development

The execution of trades w Registered trader (market-maker) functions n n n Maintaining a “book” Maintain a “fair and orderly market” Execute “stabilizing” trades w Registered traders possess valuable inside information about the future direction of the market

Types of Orders w Instructions to the brokers on how to complete the order w Market w Limit w Stop loss

Summary Reminder w Objective: To explain the institutional details and mechanics of investing in securities. n n n How firms issue securities Organization of secondary markets Trading and execution Margin trading Costs and regulation

Margin Trading w Using only a portion of the proceeds for an investment w Borrow remaining component w Margin arrangements differ for stocks and futures

Stock Margin Trading w Greatest margin n n Currently 30% Set by the securities commissions w Minimum margin Minimum level the equity margin can be (called “maintenance” in USA) n w Margin call n Call for more equity funds

Margin Trading - Initial Conditions X Corp $70 50% Initial Margin 30% Minimum Margin 1000 Shares Purchased Initial Position Stock $70, 000 Borrowed $35, 000 Equity $35, 000

Margin Trading Minimum Margin Stock price falls to $60 per share New Position Stock $60, 000 Borrowed $35, 000 Equity $25, 000 Margin% = $25, 000/$60, 000 = 41. 67%

Margin Trading - Margin Call w How far can the stock price fall before a margin call? Therefore, P = $50 Note: 1, 000 x. P – Amount Borrowed = Equity

Leveraging effect of margin purchases w You buy 200 shares of XYZ at $100, expecting a 30% appreciation of the stock in one year: n n n Initial margin: 50% Financed by a 9% loan for one year Expected net return: 51% w A 30% drop in the price, though, brings a negative rate of return of -69%.

Short Sales w Purpose: to profit from a decline in the price of a stock or security Mechanics w Borrow stock through a dealer w Sell it and deposit proceeds and margin in an account w Close out the position: buy the stock and return it to the owner

Short Sale - Initial Conditions Z Corp 50% 30% $100 Shares Initial Margin Minimum Margin Initial Price Sale Proceeds Margin & Equity Stock Owed $10, 000 $ 5, 000 $10, 000

Short Sale - Minimum Margin Stock Price Rises to $110 Sale Proceeds $10, 000 Initial Margin $ 5, 000 Stock Owed $11, 000 Net Equity $ 4, 000 Margin % (4, 000/11, 000) = 36%

Short Sale - Margin Call w How much can the stock price rise before a margin call? So, P = $115. 38 Note: $15, 000 = Initial margin + sale proceeds

Summary Reminder w Objective: To explain the institutional details and mechanics of investing in securities. n n n How firms issue securities Organization of secondary markets Trading and execution Margin trading Costs and regulation

Costs of Trading w Commission: fee paid to broker for making the transaction n n Full service broker Discount broker w Spread: cost of trading with dealer n n n Bid: price dealer will buy from you Ask: price dealer will sell to you Spread: ask - bid w Execution: better price obtained

Internet Trading w On-line brokers (discount or full-service) w ECNs – electronic communication networks w Pre- and post-market trading (lack of integration, thin trading)

Regulation of Securities Markets w w Government Regulation Self-Regulation in the Industry Circuit Breakers Insider Trading