McGraw-Hill/Irwin Copyright © 2010 by The McGraw-Hill Companies, Inc. All rights reserved.

3-2

Primary vs. Secondary Market Security Sales
• Primary
– New issue is created and sold
– Key factor: issuer receives the proceeds from the sale
– Public offerings: registered with the SEC and sale is made to the investing public
– Private offerings: not registered, and sold to only a limited number of investors, with restrictions on resale
• Secondary
– Existing owner sells to another party
– Issuing firm doesn’t receive proceeds and is not directly involved
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Primary vs. Secondary Security Sales
Equity
Primary Secondary
IPO Seasoned
GCO
(Underwritten)
GCO
(Underwritten)
Best
Efforts
Rights
Competitive Negotiated
Standby &
Take-up
NYSE
Auction
ASE
Dealer
Regionals
NASDAQ
OTC
Pink Sheet
3 rd market
4th
3-4

Investment Banking Arrangements
• Underwritten vs. “Best Efforts”
– Underwritten: banker makes a firm commitment on proceeds to the issuing firm
– Best Efforts: banker(s) helps sell but makes no firm commitment
• Negotiated vs. Competitive Bid
– Negotiated: issuing firm negotiates terms with investment banker
– Competitive bid: issuer structures the offering and secures bids
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• SEC Rule 415
– Security is preregistered and then may be offered at any time within the next two
years.
• 24 hour notice, any part or all of the preregistered amount may be offered
• Introduced in 1982
• Allows timing of the issues
→
3-7

• Private placement: sale to a limited number of sophisticated investors not requiring the protection of registration
– Allowed under SEC Rule 144A
– Dominated by institutions
– Very active market for debt securities
– Not active for stock offerings
3-8

• IPO Process
–
Issuer and banker put on the “Road Show”
–
Purpose: Book building and pricing
• Underpricing
–
Post initial sale returns average about 10% or more, “Winner’s curse” problem?
– Easier to market the issue, but costly to the issuing firm
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Overall purpose: facilitate low cost investment
1. Bring together buyers and sellers at low cost
2. Provide adequate liquidity by minimizing time and cost to trade and promoting price continuity.
3. Set & update prices of financial assets
• Reduces information costs associated with investing
3-13

• Direct Search Markets
– Buyers and sellers locate one another on their own
• Brokered Markets
– 3 rd party assistance in location buyer or seller
• Dealer Markets
– 3 rd party acts as intermediate buyer/seller
• Auction Markets
– Brokers & dealers trade in one location, trading is more or less continuous
3-14

Instructions to the brokers on how to complete the order
• Market order: execute immediately at the best price
• Limit order: Order to buy or sell at a specified price or better
– On the exchange the limit order is placed in a limit order book kept by an exchange official or computer
– E.G.: Stock trading at $50, could place a buy
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3-16

• Stop loss order: Becomes a market sell order when the trigger price is encountered.
– E.G.: You own stock trading at $40. You could become a market order to sell if the price of the
• Stop buy order: Becomes a market buy order when the trigger price is encountered.
– E.G.: You shorted stock trading at $40. You could become a market order to buy if the price of the
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• Discretionary order: gives the broker the power to buy and sell for your account at the broker's discretion.
Time dimension on orders (other than market orders):
– IOC: immediate or cancel
– Day: by default
– GTC: good until canceled (usually 60 days max)
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3-19

• Nasdaq
• Small stock OTC
– Pink sheets
• Organized Exchanges
– New York Stock Exchange
– American Stock Exchange
– Regionals
• Electronic Communication Networks (ECNs)
• National Market System
3-20

Dealer Markets
• Dealer market is a market without centralized order flow
• NASDAQ: largest organized stock market for OTC trading; information system for individuals, brokers and dealers
• Securities: stocks, most bonds and some derivatives
3-21

• Nasdaq National Market: Types of securities?
• Nasdaq SmallCap Market
• Levels of subscribers to Nasdaq quotation system
– Level 1: inside quotes
– Level 2: receives all quotes but they can’t enter quotes
– Level 3: dealers can see and post quotes
– SuperMontage: Centralized limit order book for
Nasdaq securities that allows automatic trade execution
• OTC Bulletin Board
• Pink Sheet Stocks www.pinksheets.com
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3-23

• Auction markets are markets with centralized order flow
• Dealership function: can be competitive
or assigned by the exchange
(Specialists)
• Securities: lesser extent bonds
• Examples: NYSE, ASE, Regionals, CBOE, CME
3-24

• NYSE
Auction Markets
• ASE and Regionals
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• Members of the exchange:
– Purchase a seat on the exchange, gives the right to trade and a say in the governance of the exchange.
• Commission broker:
– Employee of a member firm, processes orders for the firm, earns a commission.
• Floor broker:
– Independent broker who works for various member firms as needed.
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• Floor trader:
– Independent trader who buys and sells securities for his/her own account. Often called speculator or arbitrageur.
• Specialist:
–
Exchange appointed firm in charge of running the market for a given stock(s).
–
Acts as both a broker and a dealer charged with matching buy and sell orders from customers and/or filling customer's orders by adding to or selling their own inventory of stock.
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• a) Appointed by exchange to serve as
"market maker" for one or more stocks.
• b) Specialist acts as a broker:
– Facilitating trades for certain types public orders (limit orders)
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• c) Specialist acts as a dealer: Charged with maintaining a "continuous, orderly market."
•
Must at times trade against the market
•
Can petition exchange to halt trading
•
Incur inventory costs/risks of holding stock
•
Specialists monitor and limit the bid-ask spread
3-29

• Place a market order to buy 1 round lot of
AMD with your broker.
• Broker electronically submits the order to the floor of the NYSE.
• Commission broker takes/sends order to specialist post.
• May trade with another broker or with specialist.
3-30

Trade improvement from trading with another broker:
 You place a buy market order when limit inside quotes are Bid $20.00, Ask $20.10
 Your buy market order will be executed at
 A sell market order would execute at _______ against the book.
 In an auction market, if two brokers arrive at the same time both may get price improvement by
3-31

• SuperDot
• Electronic order routing system allows brokers to electronically send orders directly to specialist.
• Useful for program trading
0
• DirectPlus
• Fully automated trade execution system
• Execution time < ½ second
• Electronic order placement is growing, large orders still require human intervention.
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• Block Houses
– Specialize in large block trades
Trade for ≥ 10,000 shares
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•
•
•
ECNs allow institutional investors to post quotes and trade directly with each other. (4 th Market)
Public limit order book
Automatic execution
•
•
•
Advantages include
Lower transactions costs (usually < 1¢ per share)
Speed even on large trade sizes
Anonymity
ECNs
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• NYSE:
• Merged with Archipelago ECN in 2006
• Merged with Euronext in 2007
• Acquired the ASE in 2008
• Entering Indian and Japanese stock markets
• NASDAQ
• Acquired Instinet/Island in 2005
• Acquired Boston Stock Exchange in 2007
• Jointly acquired Swedish exchange OMX
3-35

• Euronext
• Formed from merger of Paris, Brussels,
Lisbon and Amsterdam exchanges
• Acquired the Liffe in London
• Merged with NYSE in 2007
• CME acquired CBOT in 2007
3-36

3-37

Moving to automated electronic trading
Specialist system is largely unique to U.S.
Tokyo Stock Exchange (TSE)
• No trading floor, all electronic trading
• Three sections for different size firms
• Two major indexes: Nikkei 225 and TOPIX
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• 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
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• a) Low cost transfer of funds (competition among market makers and brokers).
– Operational or internal efficiency
• b) Adequate trading activity to ensure purchases and sales occur in timely fashion without affecting price. (Trading volume)
–
Operational or internal efficiency
3-42

Characteristics of well-functioning markets
• c) Prices speedily reflect public information
–
Informational efficiency
Informational:
Are price changes predictable so that you can earn more than you should for the risk level you are taking?
–
Allocational efficiency
Allocational:
Are prices accurately reflecting the prospects of firm/issuer’s cash flows?
3-43

•
Which is better in terms of the characteristics, the NYSE or NASDAQ?
– Effective spreads for Nasdaq and NYSE:
2004 Nasdaq
Median
NYSE Median
Effective spread in $
$0.038
$0.031
Effective spread / Price
0.27% 0.19%
Order fill rate on limits
72.3% 83.4%
Adjusted for liquidity differences with matched samples. Differences are statistically significant at the 1% leve l
Source: NYSE, NYSE Execution Quality, 2003-2004 per stock per year that trades on the NYSE as opposed to Nasdaq
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3-45

• Defined: borrowing money to purchase stock.
• Initial Margin Requirement IMR (minimum set by Federal Reserve under Regulation
T), currently 50% for stocks
• The IMR is the minimum % initial investor equity.
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• From whom do you borrow? What is a hypothecation agreement? Do you pay interest on the loan?
Equity = Position Value - Borrowing + Additional Cash
• Maintenance margin requirement (MMR): minimum amount equity can be before additional funds must be put into the account
3-47

• Margin call: notification from broker you must put up additional funds or have your position liquidated.
• At what price does the investor receive a margin call?
While the position is open the investor's equity =
Market Value - Amount borrowed
Thus a declining stock price reduces the investor's equity.
3-48

• If the Equity / Market Value

MMR a
margin call occurs.
• (Market Value - Borrowed) / Market
Value

MMR ; solve for Market Value
• A margin call will occur when:
Market Value = Borrowed / (1 – MMR)
3-49

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

(MMR = 40%)
• Stock price falls to $60 per share (1000 shares)
New Position
Stock $60,000 Borrowed
Equity
$35,000
$25,000
• Margin% = $25,000 / $60,000 = 41.67%
• Margin Trading: Margin Call How far can the stock price fall before a margin call? (MMR = 40%)
Market Value = Borrowed / (1 – MMR)
Market Value = $35,000 / (1 – 0.40) =
$58,333
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With 1000 shares, the stock price at which we receive a margin call is $58,333 / 1000 = $58.33
New Position
Stock $60,000 Borrowed
Equity
$35,000
$23,333
%Margin = $23,333 / $58,333 = 40%
How much cash must you put up?
To restore the IMR you will need equity = ½ x $58,333 = $29,167 have equity = so owe
$23,333
$ 5,834
3-52

Why do people purchase on margin?
Suppose you buy at $70 per share (borrow at a 7%
APR interest cost if use margin, use full amt. margin)
APRs (365 day year)
Buy at
$70
Sell at $72 in 90 days
No Margin 11.59%
Sell at $68 in 90 days
-11.59%
Margin 16.17% -30.17%
Leverage
Factor
1.4x
2.6x
Do institutions generally purchase on margin?
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How is it done?
• Mechanics o Borrow stock from a broker/dealer, must post margin o Broker sells stock and deposits proceeds and margin in a margin account (you are not allowed to withdraw the sale proceeds until you ‘cover’) o Covering or closing out the position:
Buy the stock and broker returns the stock title to the party from which it was borrowed o Street name?
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o A “Round Trip” is a purchase and a sale o Long position
 Buy first and then sell later
 Bullish o Short position
 Sell first and then buy later
 Bearish
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• Required initial margin: usually 50% but more for low priced stocks
Liable for any cash flows: Dividend on stock
Zero tick, uptick rule
Zero tick, uptick rule was eliminated by the SEC in
July 2007
3-57

•
Short sale maintenance margin requirements (equity)
MMR
Price
< $ 2.50
$2.50 - $
5.00
$2.50
100% market value
$5.00 -
$16.75
$5.00
> $16.75
30% market value
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•
Example:
You sell short 100 shares of stock priced at $60 per share.
o The proceeds of $6000 must be pledged to broker.
o You must also pledge 50% margin.
• 3000 invested in margin account.
$9000
Short Sale Equity = Total Margin Account - Market
Value
3-59

Maintenance margin for short sale of a stock with price
• > $16.75 is 30% of market value or withdrawn at your pleasure but assume that it is not.)
At what stock price do you get a margin call?
3-60

• 
(0.30 * 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 at which get a margin call:
$6,923 / 100 shares = $69.23
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•
If this occurs:
Equity = $9,000 - $6,923 = $2,077
Equity as % market value = $2,077 / $6,923 = 30%
You get a margin call &
You may have to restore the 50% initial margin.
If so you must deposit an additional
($6,923 / 2) - $2,077 = $1,384.5
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• Naked short sales
• Should any or all short sales be prohibited?
• Should the zero tick/uptick rule be utilized?
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• Securities Acts of 1933
• Requires full disclosure of information by issuers of new securities
• Securities Acts of 1934
• Established the SEC and require periodic disclosure of relevant financial information for firms with publicly traded securities
• Gives authority to regulate exchanges and
OTC trading/traders to the SEC
• CFTC retains authority over commodity futures and Federal Reserve sets margin requirements
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• Securities Investor Protection Act of 1970
• Protects investors from losses if a brokerage firm fails (up to $500,000 per customer).
• Self Regulation
• Financial Industry Regulatory Authority
(FINRA)
• Formed in 2007 by consolidating regulatory arms of the NASD and the NYSE.
• Examines securities firms, promulgates trading practice rules and administers a dispute resolution forum for investors and firms.
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• Illegal, but what is it?
• Definition of insiders can be ambiguous
• SEC’s Official Summary of Securities
Transactions and Holdings
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• Increased regulation
• Sarbanes-Oxley
• Additional regulation will occur as a result of the financial crisis
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• Too soon to know the details of what will happen
• Likely have reform of the SEC
• Reform of the ratings agencies approval process and funding model.
• Some type of ‘systemic’ regulator
• Continued government involvement in the markets
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3-70

a.
Explicit and Implicit costs.
Explicit: Underwriter’s Fee $70,000
Implicit: Underpricing
($53 -$50) x 100,000 = $300,000
Total Costs = $370,000 b. No. The underwriters did not directly profit from the underpricing of the securities.
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a. If the price keeps going up your losses are unlimited. b. The stop-buy order at $128 limits your max loss to about $8 per share.
3-72

a. The stock is purchased for: 300

$40 = $12,000
The amount borrowed is $4,000.
Therefore, the investor put up equity, or margin, of $8,000.
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b. If the share price falls to $30, then the value of the stock falls to $30 x $300 = $9,000. By the end of the year, the amount of the loan owed to the broker grows to:
$4,000

1.08 = $4,320
Therefore, the remaining equity in the investor’s account is:
$9,000

$4,320 = $4,680
Therefore the investor will not receive a margin call.
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c. The rate of return on the investment over the year is:
Beginning Equity = $8,000
End Equity = $4,680
(Ending equity in the account

Initial equity) / Initial equity
HPR = ($4,680

$8,000) / $8,000 =

0.415 =

41.5%
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Many exchanges and the ECNs have pretty much eliminated market-making specialists.
Here the computer finds the best prices to make the trades .
3-76

a. $50.25
b. $51.50
c. You should probably increase your position.
There is plenty of buying demand at prices just below $50, so downside risk is limited. The limit sell orders are less concentrated.
3-77

a. You buy $10,000/$50= 200 shares
Shares go up 10% $50

$55 $55 X 200=$6000
You pay interest .08 X $5000 = $400
Rate of return = 6000 – 400 – 5000 = 12%
5000 b. The margin call will occur when
Market Value = Amount Borrowed / (1 - MMR)
Market Value = $5,000 / (1 – 0.30) = $7,142.86
Stock price = $7,142.86 / 200 shares = $35.71
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a. 55.50 b. 55.25
c. The trade will not be executed because the bid price is lower than the price specified in the limit sell order.
d. The trade will not be executed because the ask price is greater than the price specified in the limit buy order.
3-79

a. In an exchange market, there can be price improvement in the two market orders. Brokers for each of the market orders (i.e., the buy and the sell orders) can agree to execute a trade inside the quoted spread.
• For example, they can trade at $55.37, thus improving the price for both customers by either $0.12 or $0.13 relative to the quoted bid and asked prices.
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b.
Whereas the limit order to buy at $55.37 would not be executed in a dealer market (since the asked price is
$55.50), it could be executed in an exchange market.
• A broker for another customer with a market sell order would view the limit buy order as the best bid price; the two brokers could agree to the trade and bring it to the specialist, who would then execute the trade.
3-81

Note that your profit ($200) equals (100 shares  profit per share of $2). Your net proceeds per share was:
$14
–$ 9
–$ 2
–$ 1
$ 2 selling price of stock repurchase price of stock dividend per share
2 trades  $0.50 commission per share (Round Trip)
3-82

d. Cannot tell from the information given. The broker will attempt to sell after the first transaction at $55 or less.
3-83