ECON S1920 HOW SECURITIES ARE TRADED CHAPTER 3

ECON S-1920: HOW SECURITIES ARE TRADED CHAPTER 3

Chapter Overview • 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 3 -2

3. 1 How Firms Issue Securities • Primary vs. Secondary Market Security Sales • Primary • New issue created/sold • Key factor: Issuer receives proceeds from sale • Public offerings: Registered with SEC; sale made to investing public • Private offerings: Not registered; sold only to limited number of investors with restrictions on resale • Secondary • Existing owner sells to another party • Issuing firm doesn’t receive proceeds, is not directly involved 3 -3

3. 1 How Firms Issue Securities 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 • 3 -4

3. 1 How Firms Issue Securities 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 3 -5

Figure 3. 1 Relationship among a Firm Issuing Securities, the Underwriters, and the Public 3 -6

3. 1 How Firms Issue Securities • Shelf Registration • SEC Rule 415 • Security is preregistered and then may be offered at any time within the next two years • 24 -hour notice: Any or all of preregistered amount may be offered • Introduced in 1982 • Allows timing of issues 3 -7

3. 1 How Firms Issue Securities Initial Public Offerings Issuer and banker put on “road show” Purpose: Bookbuilding and pricing Underpricing • Post-initial sale returns average 10% or more—“winner’s curse” problem? • Easier to market issue; costly to issuing firm 3 -8

3. 1 How Firms Issue Securities 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 3 -9

Figure 3. 2 Average First-Day Returns for European IPOs 3 -10

Figure 3. 2 Average First-Day Returns for Non-European IPOs 3 -11

3. 2 How Securities Are Traded • Functions of Financial Markets • Overall purpose: Facilitate low-cost investment • Bring together buyers and sellers at low cost • Provide adequate liquidity by minimizing time and cost to trade and promoting price continuity • Set and update prices of financial assets • Reduce information costs associated with investing 3 -12

3. 2 How Securities Are Traded • Types of Markets • Direct Search Markets • Buyers and sellers locate one another on their own • Brokered Markets • Third-party assistance in locating buyer or seller • Dealer Markets • Third party acts as intermediate buyer/seller • Auction Markets • Brokers and dealers trade in one location • Trading is more or less continuous 3 -13

3. 2 How Securities Are Traded • Types of Orders • Market order: Execute immediately at best price • Bid price: price at which dealer will buy security • Ask price: price at which dealer will security • Price-contingent order: Buy/sell at specified price or better • Limit buy/sell order: specifies price at which investor will buy/sell • Stop order: not to be executed until price point hit 3 -14

Figure 3. 5 Price-Contingent Orders 3 -15

3. 2 How Securities Are Traded • Trading Mechanisms • Dealer markets • Over-the-counter (OTC) market: Informal network of brokers/dealers who negotiate securities sales • NASDAQ stock market: Computer-linked price quotation system for OTC market • Electronic communication networks (ECNs) • Computer networks that allow direct trading without market makers • Specialist markets • Specialist: Makes market in shares of one or more firms; maintains “fair and orderly market” by dealing personally 3 -16

3. 3 The Rise of Electronic Trading • In the US, the share of electronic trading rose from 16% to 80% in 2000 s 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 3 -17

3. 4 U. S. Securities Markets NASDAQ Lists about 3, 200 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 3 -18

3. 4 U. S. Securities Markets 3 -19

New York Stock Exchange 203 -20

New York Stock Exchange 1792: 24 brokers and merchants started with five securities 1817: Formal organization: the New York Stock & Exchange Board 1835: Average daily volume: exceed 8, 000 shares 1863: Adopted the name of the New York Stock Exchange December 15, 1886: One million shares exchange hands 1961: Average trading volume exceeds 4 millions shares per day 1982: Over 100 million shares are exchanged in just one day 1992: Average daily volume exceeds 200 million shares 1997: October 27: volume tops one billion shares for the first time 2005: On June 24: volume over 3 billion shares About 3, 000 companies listed (September 2011); capitalization of $16. 613 trillion (May 2013); average daily volume of about 6 billion shares; average daily trading value was approximately US$169 billion in 2013. 213 -21

NYSE, NASDAQ, Stocks, Bonds April 4, 2007: NYSE Group, Inc. merged with Euronext N. V. to form the first global equities exchange October 1, 2008: NYSE Euronext acquired Amex (American Stock Exchange) The NYSE is now owned by Intercontinental Exchange "NASDAQ“: "National Association of Securities Dealers Automated Quotations“; second-largest stock exchange by market capitalization in the world; as of January 25, 2011, there were 2, 711 listings, with a total capitalization of over $4. 5 trillion; average daily volume now of about 7 billion shares; began trading on February 8, 1971 as the world's first electronic stock market. Nov 2013: Global equity market capitalization (58 countries): $63. 4 trillion March 2012: Global bond market: $100 trillion 223 -22

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3. 4 U. S. Securities Markets NYSE �Lists about 2, 800 firms �Automatic electronic trading runs side-by-side with traditional broker/specialist system �Super. Dot : electronic order-routing system �Direct. Plus: fully automated execution for small orders �Specialists: Handle large orders and maintain orderly trading 3 -24

3. 4 U. S. Securities Markets 3 -25

3. 4 U. S. Securities Markets Electronic Communication Networks �ECNs: Private computer networks that directly link buyers with sellers for automated order execution without market makers �Major ECNs include NASDAQ’s Market Center, Arca. Ex, Direct Edge, BATS, and Lava. Flow. �“Flash Trading”: Computer programs look for even the smallest mispricing opportunity and execute trades in tiny fractions of a second. �Latency: Time it takes to accept, process, and deliver a trading order; speed is important in ECNs; BATs latency time about . 0002 second 3 -26

3. 3 U. S. Securities Markets • Timeline of Market Changes • 1969: Instinet (first ECN) established • 1975: Fixed commissions on NYSE eliminated • Congress amends Securities and Exchange Act to create National Market System (NMS) • 1994: NASDAQ scandal • SEC institutes new order-handling rules • NASDAQ integrates ECN quotes into display • SEC adopts Regulation Alternative Trading Systems, giving ECNs ability to register as stock exchanges 3 -27

3. 3 U. S. Securities Markets Timeline of Market Changes • 1997: SEC drops minimum tick size from 1/8 to 1/16 of $1 • 2000: National Association of Securities Dealers splits from NASDAQ • 2001: Minimum tick size $. 01 • 2006: NYSE acquires Archipelago Exchanges and renames it NYSE Arca • 2007: SEC adopts Regulation NMS, requiring exchanges to honor quotes of other exchanges 3 -28

Figure 3. 6 The Effective Spread Fell Dramatically as the Minimum Tick Size Fell (Value-weighted average of NYSE-listed shares) 3 -29

Figure Market Share of Trading in NYSE-Listed Shares 3 -30

3. 5 New Trading Strategies �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 3 -31

3. 5 New Trading Strategies Bond Trading �Most bond trading takes place in the OTC market among bond dealers. �Market for many bond issues is “thin”. �NYSE is expanding its bond-trading system. �NYSE Bonds is the largest centralized bond market of any U. S. exchange 3 -32

3. 6 Globalization of Stock Markets Globalization & Consolidation of Stock Markets �NYSE mergers and acquisitions: �Archipelago (ECN) �American Stock Exchange �Euronext �NASDAQ mergers and acquisitions: �Instinet/INET (ECN) �Boston Stock Exchange �Merges with OMX to form NASDAQ OMX Group �Chicago Mercantile Exchange acquired: �Chicago Board of Trade �New York Mercantile Exchange 3 -33

xt ( ne U AQ S) -O M X To ky Eu o Lo ro ne nd xt (E on ur op Sh e) an gh H ai on g Ko n To g ro nt o Br az Au il D st eu ra ts ch lia BM e B ör E se (S pa ni sh ) In di a D AS N ro Eu E- YS N $ Billion Figure 3. 8 The Biggest Stock Markets in the World by Domestic Market Capitalization 12, 000 10, 000 8, 000 6, 000 4, 000 2, 000 0 3 -34

3. 6 Globalization of Stock Markets �London - predominately electronic trading �Euronext – market formed by combination of the Paris, Amsterdam and Brussels exchanges, then merged with NYSE �Tokyo Stock Exchange – Roughly 2, 400 listed firms; switched to electronic trading in 1999; three sections: first section for large companies, second for mid-sized companies, and third for about 200 small high-growth stocks 3 -35

3. 6 Globalization of Stock Markets • Moving to automated electronic trading • Current trends will eventually result in 24 - hour global markets • Moving toward market consolidation 3 -36

3. 7 Trading Costs 1. Brokerage Commission: fee paid to broker for making the transaction Explicit cost of trading Full Service vs. Discount brokerage 2. Spread: Difference between the bid and asked prices Implicit cost of trading • Bid: Price at which dealer will buy from you • Ask: Price at which dealer will sell to you • Spread: Ask — bid 3 -37

3. X Steps in Trading 1. Selecting a broker � Full service � Discount 2. Opening an account � Cash account � Margin account � Discretionary account 3. Initiating a position � Long � Short sales 3 -38

3. 8 Buying on Margin: Describes securities purchased with money borrowed in part from broker • Net worth of investor's account: the equity Initial Margin Requirement (IMR) • Minimum set by Federal Reserve under Regulation T, currently 50% for stocks • Minimum % initial investor equity • 1 − IMR = Maximum % amount investor can borrow 3 -39

3. 8 Buying on Margin Equity • Position value – Borrowing + Additional cash Maintenance Margin Requirement (MMR) • Minimum amount equity can be before additional funds must be put into account • Exchanges mandate minimum 25% Margin Call • Notification from broker that you must put up additional funds or have position liquidated 3 -40

3. 8 Buying on Margin If Equity/Market value MMR, then margin call occurs (Market value – Borrowed) / Market Value MMR; solve for market value A margin call will occur when: • Market value = Borrowed/(1 − MMR) Borrowed amount also known as debit balance 3 -41

3. 8 Buying on Margin Trading: Initial Conditions • Dot. com Corp: Stock price = $70 • 50%: Initial margin • 40%: Maintenance margin • 1000 shares purchased Initial Position Stock $70, 000 Borrowed $35, 000 Equity $35, 000 3 -42

3. 8 Buying on Margin Stock price falls to $60 per share: Equity (E)= Position value (V) – Borrowing (B) + Additional cash = $60 x 1000 sh. - $35, 000 = $25, 000 Margin %: (V – B)/V = E/V = $25, 000/$60, 000 = 41. 67% How far can price fall before margin call? Margin call when Market value = Borrowed/(1 − MMR) • Market value = $35, 000/(1 –. 40) = $58, 333 New Position Stock $60, 000 Borrowed $35, 000 Equity $25, 000 3 -43

3. 8 Buying on Margin With 1, 000 shares, stock price for margin call is $58, 333/1, 000 = $58. 33 • $58, 333 - $35, 000 (Borrowing) = $23, 333 (Equity) Margin % = $23, 333/$58, 333 = 40% • To restore IMR, equity needed = ½ x $58, 333 = $29, 167 Equity in account: $23, 333; cash needed: New Position Stock $60, 000 Borrowed $35, 000 Equity $23, 333 3 -44

3. 8 Buying on Margin Buy at $70 per share • Borrow at 7% APR interest cost if using margin; use full amount margin • APRs: Buy at $70 Sell at $72 in 90 days Sell at $68 in 90 days No margin 11. 59% − 11. 59% Margin 16. 17% − 30. 17% Leverage factor 1. 4 x 2. 6 x 3 -45

3. 9 Short Sales Sale of shares not owned by investor but borrowed through broker and later purchased to replace loan Mechanics • Borrow stock from broker; must post margin • Broker sells stock, and deposits proceeds/margin in margin account (you cannot withdraw proceeds until you “cover”) • Covering or closing out position: Buy stock; broker returns title to party from which it was borrowed 3 -46

3. 9 Short Sales 3 -47

3. 9 Short Sales • Required initial margin: Usually 50% • More for low-priced stocks • Liable for any cash flows • Dividend on stock 3 -48

3. 9 Short Sales Short-sale maintenance margin requirements (equity) Price MMR < $2. 50 -$5. 00 -$16. 75 > $16. 75 100% market value $5. 00 30% market value 3 -49

3. 9 Short Sales Example You sell short 100 shares of stock at $60 per share $6, 000 must be pledged to broker You must also pledge 50% margin You put up $3, 000; now you have $9, 000 in margin account Short sale equity = Total margin account – Market value = $9, 000 - $6, 000 = $3, 000 3 -50

3. 9 Short Sales Example Maintenance margin for short sale of stock with price > $16. 75 is 30% market value 30% x $6, 000 = $1, 800 You have $1, 200 excess margin: $3, 000 - $1, 800 What price for margin call? 3 -51

3. 9 Short Sales Example When equity (. 30 x Market value) Equity = Total margin account – Market value When Market value = Total margin account / (1 + MMR) Market value = $9, 000/(1 + 0. 30) = $6, 923 Price for margin call: $6, 293/100 shares = $69. 23 3 -52

3. 9 Short Sales Example If this occurs: Equity = Total margin account – Market value Equity = $9, 000 − $6, 923 = $2, 077 Equity as % market value = $2, 077/$6, 923 = 30% To restore 50% initial margin: ($6, 923 x 0. 5) − $2, 077 = $1, 384. 50 3 -53

Table 3. 5 Cash Flows from Purchasing vs. Short-Selling Purchase of Stock Time Action Cash Flow* 0 Buy share − Initial price 1 Receive dividend, sell share Ending price + Dividend Profit = (Ending price + Dividend) – Initial price Short Sale of Stock Time Action Cash Flow* 0 Borrow share; sell it + Initial price 1 Repay dividend and buy share to replace − (Ending price + Dividend) share originally borrowed Profit = Initial price – (Ending price + Dividend) *Note: A negative cash flow implies a cash outflow. 3 -54

3. X Return on Invested Capital(ROIC) Problems: You buy 100 shares of Hazelnut at $80 per share using 60% margin. Margin loan is obtained at an interest rate of 9% per year. The stock pays a dividend of $4 per year per share. Broker commission is $0. 05 per transaction per share. Find the return on invested capital if in three months the stock price: (a) Goes to $95 per share: 553 -55

ROIC or Return on Equity (ROE) (b) Goes to $65 per share: (c) Stays at $80 per share: 563 -56

ROIC or ROE Redo the above problems under the assumption there is no margin trading. (a) Price goes to $95 per share: 2. (b) Price goes to $65 per share: (c) Price stays at $80 per share: 573 -57

ROIC or ROE 3. What are the advantages and disadvantages of margin trading? 583 -58

3. 10 Regulation of Securities Markets 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 3 -59

3. 10 Regulation of Securities Markets 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 3 -60

3. 10 Regulation of Securities Markets Insider Trading �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 3 -61

CONCLUSION �Many different financial markets with different trading mechanisms 3 -62

CONCLUSION �Globalization has brought about mergers and consolidations of exchanges �Technological developments have created massive changes in the way securities are traded �More rapid inflow of news �greater use of electronic trading �much greater volume of trading and volatility 3 -63

CONCLUSION 3 -64

CONCLUSION 3 -65

CONCLUSION �Financial markets have ballooned in size over time. 3 -66

CONCLUSION 3 -67

CONCLUSION �Possibly has created opportunities for greater consolidation of wealth – rich getting richer 3 -68

CONCLUSION 3 -69

CONCLUSION �Characteristics of a well-functioning market: �Availability of past transaction information in a timely and accurate manner �Liquidity � Marketability � Price continuity � Depth �Low transaction costs �Rapid adjustment of prices to new information 3 -70

CONCLUSION 3 -71

CONCLUSION 3 -72