How Securities Are Traded Chapter 3 Mc GrawHillIrwin

How Securities Are Traded Chapter 3 Mc. Graw-Hill/Irwin Copyright © 2005 by The Mc. Graw-Hill Companies, Inc. All rights reserved.

Primary vs. Secondary Security Sales Primary New issue Key factor: issuer receives the proceeds from the sale. Secondary Existing owner sells to another party. Issuing firm doesn’t receive proceeds and is not directly involved. 3 -2

Investment Banking Arrangements Underwritten vs. Best Efforts Underwritten: firm commitment on proceeds to the issuing firm. Best Efforts: no firm commitment. Negotiated vs. Competitive Bid Negotiated: issuing firm negotiates terms with investment banker. Competitive bid: issuer structures the offering and secures bids. 3 -3

Public Offerings Public offerings: registered with the SEC and sale is made to the investing public. Shelf registration (Rule 415, since 1982) Initial Public Offerings (IPOs) Evidence of underpricing Performance 3 -4

Private Placements Private placement: sale to a limited number of sophisticated investors not requiring the protection of registration. Dominated by institutions. Very active market for debt securities. Not active for stock offerings. 3 -5

Organization of Secondary Markets Organized exchanges OTC market Third market Fourth market 3 -6

Organized Exchanges Auction markets with centralized order flow. Dealership function: can be competitive or assigned by the exchange (Specialists). Securities: stock, futures contracts, options, and to a lesser extent, bonds. Examples: NYSE, AMEX, Regionals, CBOE. 3 -7

OTC Market Dealer market without centralized order flow. NASDAQ: largest organized stock market for OTC trading; information system for individuals, brokers and dealers. Securities: stocks, bonds and some derivatives. Most secondary bonds transactions 3 -8

Third Market Trading of listed securities away from the exchange. Institutional market: to facilitate trades of larger blocks of securities. Involves services of dealers and brokers 3 -9

Fourth Market Institutions trading directly with institutions No middleman involved in the transaction Organized information and trading systems ECN Development 3 -10

International Market Structures London Stock Exchange Dealer market similar to NASDAQ Stock Exchange Automated Quotation Greater Anonymity Tokyo Stock Exchange No market making service Sartori provides bookkeeping service Feature a floor and electronic trading Global Market Alliances 3 -11

Costs of Trading Commission: fee paid to broker for making the transaction Spread: cost of trading with dealer Bid: price dealer will buy from you Ask: price dealer will sell to you Spread: ask - bid Combination: on some trades both are paid 3 -12

Types of Orders Instructions to the brokers on how to complete the order Market Limit Stop loss 3 -13

Margin Trading Using only a portion of the proceeds for an investment. Borrow remaining component. Margin arrangements differ for stocks and futures. 3 -14

Stock Margin Trading Maximum margin Currently 50% Set by the Fed Maintenance margin Minimum level the equity margin can be Margin call Call for more equity funds 3 -15

Margin Trading - Initial Conditions X Corp $70 50% Initial Margin 40% Maintenance Margin 1000 Shares Purchased Initial Position Stock $70, 000 Borrowed $35, 000 Equity $35, 000 3 -16

Margin Trading - Maintenance 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% 3 -17

Margin Trading - Margin Call How far can the stock price fall before a margin call? (1000 P - $35, 000)* / 1000 P = 40% P = $58. 33 * 1000 P - Amount Borrowed = Equity 3 -18

Short Sales 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. 3 -19

Short Sale - Initial Conditions Z Corp 50% 30% $100 Shares Initial Margin Maintenance Margin Initial Price Sale Proceeds $10, 000 Margin & Equity 5, 000 Stock Owed 10, 000 3 -20

Short Sale - Maintenance Margin Stock Price Rises to $110 Sale Proceeds $10, 000 Initial Margin 5, 000 Stock Owed 11, 000 Net Equity 4, 000 Margin % (4000/11000) 36% 3 -21

Short Sale - Margin Call How much can the stock price rise before a margin call? ($15, 000* - 100 P) / (100 P) = 30% P = $115. 38 * Initial margin plus sale proceeds 3 -22

Regulation of Securities Markets Government Regulation Self-Regulation Circuit Breakers Insider Trading ECNs and Fragmentation 3 -23