Chapter 3. How Securities are Traded

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1 Chapter 3 How Securities are Traded

2 Primary vs. Secondary Security Sales Primary: When firms need to raise capital, they may choose to sell (or float) new securities. These new issues typically are marketed to the public by investment bankers in what is called the primary market. - New issue - Key factor: issuer receives the proceeds from the sale. Secondary: Purchase and sale of already-issued securities among private investors takes place in the secondary market. - Existing owner sells to another party. - Issuing firm doesn t receive proceeds and is not directly involved.

3 Investment Banking Arrangements Public offerings of both stocks and bonds typically are marketed by investment bankers, who in this role are called underwriters. Underwriting arrangements: Firm Commitment vs. Best Efforts - Firm Commitment: The issuing firm sells the securities to the underwriting syndicate for the public offering price less a spread that serves as compensation to the underwriters. The underwriters receive the issue and assume the full risk that the shares cannot in fact be sold to the public at the stipulated offering price. - Best Efforts: In this case, the investment banker agrees to help the firm sell the issue to the public but does not actually purchase the securities. The banker simply acts as an intermediary between the public and the firm and thus does not bear the risk of being unable to resell purchased securities at the offering price. There is no firm commitment. Negotiated vs. Competitive Bid - Negotiated: issuing firm negotiates terms with investment banker. - Competitive bid: issuer structures the offering and secures bids.

4 Investment Banking Arrangements

5 Public Offerings Public offerings: Has to be registered with the Securities and Exchange Commission (SEC) and sale is made to the investing public. - Shelf registration (SEC Rule 415, since 1982) 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

6 Public Offerings Initial Public Offerings (IPOs) - Evidence of underpricing: There are clear indications that IPOs are underpriced. Underpricing of IPOs makes them appealing to all investors, yet institutional investors are allocated the bulk of a typical new issue. Some view this as unfair discrimination against small investors. However, the apparent discounts on IPOs may be no more than fair payments for a valuable service, specifically, the information contributed by the institutional investors.

7 Privately Held Firms - Up to 499 shareholders Private Placements Investors often form 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

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

9 Organization of Secondary Markets Organized exchanges (NYSE, DSE etc.): An exchange provides facility for its members to trade securities, and only members of the exchange may trade there. Therefore, memberships, or seats, on the exchange are valuable assets. Most seats are owned by the large full-service brokerage firms. The seat entitles the firm to place one of its brokers on the floor of the exchange where he or she can execute trades. The exchange member charges investors for executing trades on their behalf. A seat on the NYSE has sold over the years for as little as $4,000 in 1878 and as much as $4 million in early December 2005! The Rise of Electronic Trading: - When first established, NASDAQ was primarily a OTC dealer market and the NYSE was a specialist market. - Today, both are primarily electronic markets. - NYSE and NASDAQ remain the two largest U.S. stock market. - But Electronic Communication Networks (ECNs) have steadily increased their market share.

10 $ Billion The Biggest Stock Markets in the World by Domestic Market Capitalization 12,000 10,000 8,000 6,000 4,000 2,000 0

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

12 Short Sales We know that you can make profit when stock price is expected to rise. You buy the share and when the price goes up, you sell it and make profit. When stock price is falling, even then you can make profit. You short sell. Meaning? You borrow the stock and sell it at the current market price. When price falls, you buy back the stock and give it back to the owner from whom you borrowed it - Profit without any initial investment! However, this practice is highly regulated.

13 Short Selling in DSE Settlement of Stock Exchange Transactions Regulations, 1998: Regulation 13: Prohibition of carry forward or short selling.- No member shall be allowed to short sell any securities or carry forward any transaction. The defaulting member shall be barred from carrying out trading in DSE immediately upon detecting the default by DSE through spot verification of the member s books & records. DSE shall simultaneously furnish details of such default to the Securities and Exchange Commission.

14 Short Selling in DSE

15 Short Selling in DSE

16 Types of Orders Instructions to the brokers on how to complete the order Market order: Market orders are simply buy or sell orders that are to be executed immediately at current market prices. The broker looks for the highest bid price for market sell order or the lowest ask price for market buy order. Limit order: Investors may also place limit orders, whereby they specify prices at which they are willing to buy or sell a security. As soon as the price reaches the limit, the broker executes the trade, e.g., You have bought a share for $50. You want to make at least $5 profit. You place a limit sell order at $55 or You have sold short a share at $50 and want to make at least $5 profit. You place limit buy order at $45. So, limit buy order is placed below the current market price and limit sell order above the current market price.

17 Types of Orders Stop (loss) order: The order lets the investor to stop further losses from accumulating or helps the investor to ensure a certain amount of profit e.g. you have bought a share for $50. Price has gone up to $55. You want to keep the upward profit potential open but at the same time want to ensure a profit of $3. You place a Stop sell order at $53 or You have short sold a share for $50. The price has gone down to $45. You want to keep your downward profit potential open but want to ensure a profit of $3. You place a stop buy order at $47. So, stop buy order is placed above the current market price and stop sell order below the current market price.

18 Margin Trading Purchasing stocks on margin means the investor borrows part of the purchase price of the stock from a broker. The broker in turn borrows money from banks at the call money rate to finance these purchases and charges its clients that rate plus a service charge for the loan.

19 Percentage margin: Stock Margin Trading - The percentage margin, which is also known as equity margin, is defined as the ratio of the net worth or equity value of the account to the market value of the securities. - Equity value = the market value - the borrowed amount (Assets Liabilities) - Market value = current market price number of shares - Percentage margin changes as the market value changes Initial Margin: The percentage margin at the beginning of the share purchase.

20 Stock Margin Trading Maximum margin: The board of governors of the Federal Reserve System sets limits on the extent to which stock purchases may be financed via margin loans. Currently, the initial margin requirement is 50%, meaning that at least 50% of the purchase price must be paid for in cash, with the rest borrowed. Maintenance margin: Minimum level to which the equity margin or percentage margin can drop Margin call: Call for more equity funds once the percentage margin falls below maintenance margin

21 Stock Margin Trading Example: Do in class Share price: $100, 100 Shares Purchased Borrowed from the broker: $4,000 a) What is the initial margin? b) What happens to equity margin if share price drops to $70? c) If the maintenance margin is 30%, how far could the stock price fall before the investor would get a margin call?

22 Practice Problems Chapter 3: 6, 7, 9, 10, 15

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