CHAPTER 4 Securities Markets

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1 REVIEW QUESTIONS CHAPTER 4 Securities Markets 4-1. The third market involves OTC transactions in securities listed on the organized exchanges. The fourth market involves direct transactions among large institutions, bypassing intermediaries such as brokers and dealers The primary factors accounting for the rapid changes in securities markets are: Pressure by institutional investors who have emerged as the dominant force in the market Computerized trading of securities Globalization of securities markets 4-3. The S&P/TSX Composite Index measures changes in market values of a portfolio of Canadian stocks due to changes in the total market capitalization of these stocks The Dow-Jones Industrial Average is a price-weighted average of 30 large (blue-chip) stocks trading on the NYSE. The S&P 500 Composite Index is a market value index consisting of 500 stocks, with a base period set to 10 ( ). These measures are the two most often-used indicators of what U.S. stocks in general are doing. The Dow-Jones Averages are carried by The Wall Street Journal, while the S&P 500 Index is the indicator most often used by institutional investors Blue chip stocks are large, well-established and well-known companies with long records of earnings and dividends. They are typically traded on the TSE (in Canada), and the NYSE (in the United States). In Canada, examples include the Royal Bank of Canada, Bombardier, and BCE. In the United States, examples include Coca-Cola, General Electric, and IBM The EAFE Index, or the European, Australia, and Far East Index, is a valueweighted index of the equity performance of major foreign markets. It is, in effect, a non-north American world index Blocks are defined as transactions involving at least 10,000 shares. Largeblock activity on the TSE or NYSE is an indicator of institutional investor participation in equity trading. Solutions Manual Chapter 4 Securities Markets 4-1

2 The average size of trades on the TSE and NYSE has grown sharply over the years. Block trading currently makes up more than half of the trading volume on the TSE and NYSE Although a few bonds trade on the formal exchanges, the bond market is primarily an OTC market with a large network of dealers making markets in the various bonds BMO Nesbitt Burns acts as the lead investment dealer in bringing out a new issue or IPO. In effect, BMO Nesbitt Burns (and the syndicate, if any), would purchase the securities from the issuer and resell them to the public, hoping to profit by the spread between the two prices. BMO Nesbitt Burns assumes the risk involved in adverse price movements The Prompt Offering Prospectus (POP) System allows qualifying senior reporting issuers to issue short-form prospectuses in lieu of full ones. Companies that use this system are usually large, well-known firms that meet the regulations of the POP System Bought deals are when the issuer sells the entire issue of shares to one investment dealer (or a group of investment dealers), that attempts to resell the shares. The investment dealer accepts all of the price risk The advantages of private placements are that the issuing company does not have to prepare a formal prospectus and that the investment dealer s fees are usually substantially lower than fees of a formal underwriting. The disadvantages of private placements are higher interest costs as well as possible restrictive provisions on the issuer s activities Marketing securities on a best efforts basis usually takes place when the issuing company is small and relatively speculative The chief function of a capital market is to facilitate the flow of funds from savers to borrowers Some large Canadian firms want to be interlisted on U.S. stock exchanges in order to increase the stock s potential market and enhance its visibility Financial markets are essential for both businesses and governments in raising capital to finance their operations. Both experience demands for funds that are not in balance with their actual funds on hand. Financial markets are absolutely essential to the functioning of our capitalistic economy. Solutions Manual Chapter 4 Securities Markets 4-2

3 Technically, primary markets can exist without secondary markets, since new securities can be sold to investors. For example, bonds could be sold to institutional investors to be held until they mature. However, investors would have difficulty reselling these securities if they needed to, and many would be discouraged from buying them because of this reason Investment dealers act as intermediaries between issuers and investors. They provide several functions, including: an advisory function, wherein they offer advice to clients concerning the issuance of new securities, an underwriting function, consisting of the purchase of securities from an issuer and their subsequent sale to investors; and a marketing function, involving the sale of the securities to the investing public. Investment dealers act as principals during a formal underwriting, since they actually take ownership of the securities, albeit for a short period of time. They act as agents during a best efforts offering, since they do not take ownership of the securities In a primary offering involving investment dealers, the potential issuer of the securities meets with an investment dealer for advice on selling the new issue. In a negotiated bid arrangement, these two parties negotiate and work together on the issue. Subsequently, the investment dealer, working with other investment dealers (i.e., a syndicate), underwrites the issue; that is, the investment dealers purchase the securities from the issuer, thereby assuming the risk involved in actually selling the securities. After all legal requirements have been met, the selling group sells the securities to the public via brokers who contact their customers about the issue The equity markets in Canada consist of the organized exchanges (Toronto, Montreal, Vancouver, Alberta and Winnipeg), and the over- the-counter market. Auction markets, involving exchanges, include a bidding (auction) process in a specific physical location with brokers representing buyers and sellers. The over-the-counter (OTC) market is a negotiated market where dealers make the market in securities by standing ready to buy from and sell to investors based on bid-ask prices. Solutions Manual Chapter 4 Securities Markets 4-3

4 4-20. Instinet, a part of the fourth market, is an electronic trading network that handles a few billion shares each year. It allows institutions to trade among themselves. Instinet can be used to trade Nasdaq stocks, thus taking business from dealers in that market A prospectus is a legal document that contains financial statements about the proposed use of the funds raised by the stock issue, future growth plans, and other relevant information Some of the concerns that the issuing company takes into account when deciding on the pricing of an IPO include: Current market conditions Competitive offerings Investor interest Possibility of having the issue undersubscribed Underpricing is generally measured as the difference between the first trading day closing price minus the issue price divided by the issue price. There is substantial recent Canadian and global evidence that IPOs are generally under-priced. This is a result of the complexity and high degree of uncertainty involved in determining a fair price for companies with no previous trading history and/or new products. Since firms do not want to overprice the issue and have it undersubscribed (thus not raising the required funds), they tend to err on the low side when pricing the shares of the IPO A price-weighted index totals the prices of all the individual stocks within the index to get the index value. A market-weighted index has each individual stock in the index weighted according to its market value (market price per share multiplied by the number of shares outstanding) Both investment dealers and commission brokers operate in the secondary market and receive a commission. Along with performing activities such as helping corporations in mergers and acquisitions, investment banking firms specialize in the design and sale of securities in the primary market while operating simultaneously in the secondary markets. Investment bankers act as intermediaries between issuers and investors. The issuer sells its securities to investment bankers, who in turn sell the securities to investors. For firms seeking to raise longterm funds, the investment banker can provide important advice to their clients during the planning stage preceding the issuance of new securities. Solutions Manual Chapter 4 Securities Markets 4-4

5 This advice includes providing information about the type of security to be sold, the features to be offered with the security, the price, and the timing of the sale. Investment bankers often underwrite new issues by purchasing the securities (once the details of the issue have been negotiated) and assuming the risk of reselling them to investors. Investment bankers provide a valuable service to the issuers at this stage. The issuer receives its check and can spend the proceeds for the purposes for which the funds are being raised. The investment bankers own the securities until they are resold. Although many issues are sold out quickly, others may not be sold for days or even weeks. Investment bankers are compensated by a spread, which is the difference between what they pay the issuer for the securities and what they sell them for to the public. A broker is an intermediary who acts as an agent representing buyers and sellers in securities transactions. The broker is supposed to act in the best interest of the investor and is compensated by a fee or commission for doing so. Individual firms employ commission brokers. Darting from booth to trading post, these highly trained men and women buy and sell securities for the general public. In return, they earn salaries and commissions A specialist is a member of an organized exchange who is charged with maintaining an orderly market in one or more stocks by buying or selling for his or her own account. Specialists are critical to the auction process because they maintain a fair and orderly market in the securities assigned to them. They manage the auction process, providing a conduit of information, by electronically quoting and recording current bid and asked prices for the stocks assigned to them. This enables current price information to be transmitted worldwide, keeping all market participants informed to the total supply and demand for any particular stock. Specialists act as agents, executing orders entrusted to them by a floor broker. These orders are to be executed if and when a stock reaches a price specified by a customer. In instances when there is a temporary shortage of buyers or sellers, specialists will buy or sell for their own accounts against the trend of the market. They are not, however, required to fund all the liquidity for the market at any time. These transactions serve to manage volatility and represent a small portion of trading. Each stock listed is allocated to a specialist, a broker who trades only in specific stocks at a designated location. All buying and selling of a stock occurs at that location, called a trading post. The floor brokers, who meet openly at the trading post to find the best price for a security, represent buyers and sellers. Solutions Manual Chapter 4 Securities Markets 4-5

6 To a large degree the specialist is responsible for maintaining the market s fairness, competitiveness and efficiency. Specifically, the specialist performs five vital functions: to act as agents, act as catalysts, act as auctioneers, stabilize prices, and provide capital The over-the-counter market mainly handles unlisted securities, or securities not listed on a stock exchange, whereas specialists handle listed securities. Both the dealer and the specialist do, however, buy and sell securities at specified prices. Specialists sometimes act as dealers, buying and selling shares of their assigned stocks to maintain and orderly market and to try and profit by a favourable spread In house trading, or internal trading, is trading done by fund managers without the use of a broker or an exchange. At a large institution with several funds or accounts, traders agree to buy and sell in-house, or cross-trade, perhaps at the next closing price. For example, at a large bank with several pension fund accounts, the manager of Account A might wish to buy IBM at the same time that the manager of Account B is selling a position in IBM. Those involved in the transactions would benefit because the cost of trading this way is less expensive, in terms of commissions and spreads. CFA PRACTICE QUESTIONS 1. B Day 1 index = ( ) / 3 = Day 2 index = ( ) / 3 = Day 3 index = ( ) / = Day 4 index = ( ) / = B Day 1 = 100 by definition 3. D Day 4 value = ($8) (1000) + ($25) (350) + ($17) (750) =$29,500 Index = ($29,500 / $26,250) x 100 = C 5. B Solutions Manual Chapter 4 Securities Markets 4-6

7 Legal Notice Copyright Copyright 2005 by John Wiley & Sons Canada, Ltd. or related companies. All rights reserved. The data contained in these files are protected by copyright. This manual is furnished under licence and may be used only in accordance with the terms of such licence. The material provided herein may not be downloaded, reproduced, stored in a retrieval system, modified, made available on a network, used to create derivative works, or transmitted in any form or by any means, electronic, mechanical, photocopying, recording, scanning, or otherwise without the prior written permission of John Wiley & Sons Canada, Ltd. Solutions Manual Chapter 4 Securities Markets 4-7