CHAPTER 3
How Securities are Traded
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McGraw-Hill/Irwin
Copyright © 2011 by The McGraw-Hill Companies, Inc. All rights reserved.
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OUTLINES
• How Firms Issue Securities: Primary versus secondary market
• Types of Markets: Brokered, Auction, and Dealers markets
• Types of Orders: Market Order, Price-Contingent Order, and Stop
Order
• Trading Mechanisms: Dealer Markets, Electronic communication
networks (ECNs), and Specialists markets.
• Buying on Margin
• Short Sales
• Short covering
• Trailing Stop Orders
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How Firms Issue Securities
• Primary Market
– Firms issue new securities through
underwriter to public
– Investors get new securities; firm gets
funding
• Secondary Market
– Investors trade previously issued
securities among themselves
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Primary Market
• Stocks
– Initial Public Offerings (IPOs)
– Seasoned Equity Offering
– Private placement
• Bonds
– Public offering
– Private placement
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Primary Market
I. Public Offerings (Bonds and Stocks):
An issue of Securities to the public for the first time by a formerly privately
owned company that is going public
Underwriting: Investment bank helps the firm to issue and market
new securities
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Primary Market: Underwriting
• Process
– Road shows to publicize new offering
– Bookbuilding to determine demand for the new
issue
– Degree of investor interest in the new offering
provides valuable pricing information
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Primary Market: Underwriting
Process:
• Red herring: Preliminary registration statement filed with the
securities and Exchange Commission (SEC)
• Prospectus: Final and accepted Statement that describes the
issue and the prospects of the company
• Announcement of the price at which the security will be offered
to the public.
• A Firm Commitment: the issuing firm sells the securities to the
underwriting syndicate for the public offering price less a spread.
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Figure 3.3 Long-term Relative Performance of
Initial Public Offerings
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Primary Markets:
II. Seasoned Equity Offerings (SEO)
Xiaohui Gao and Jay Ritter, JFE (Forthcoming)
• SEO: as issue by companies that already have floated equity
• 1. Fully Marketed Offers: Similar to IPOs
• 2. Accelerated Offers:
Bought Deals:
Bought deals started in the mid-1980s. With a bought deal, the
issuing firm announces the amount of stock it wishes to sell
and investment banks bid for these shares, usually by
submitting bids shortly after the market’s close. The bank that
offers the highest net price wins the deal. The winning bank
then resells the shares, primarily to institutional investors,
usually within 24 hours. Because of this timing, bought deals
are also known as overnight deals. Bought deals are
essentially auctions to underwriters followed by open market
sales.
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Primary Markets:
Seasoned Equity Offerings (SEO)
Accelerated Bookbuilt Offers:
Banks submit proposals, usually specifying a gross spread but
not necessarily an offer price, for the right to underwrite the
sale of the shares. The winning bank then usually forms a
small underwriting syndicate and begins marketing the shares
to institutional investors. The offer price is then negotiated
between the issuing firm and the bank. The bookbuilding
procedure is “accelerated” in the sense that no road show is
conducted and the underwriting procedure is typically
completed within 48 hours.
• 3. Right Offers: Current shareholders are given short-term warrants
to purchase newly issued shares at a fixed offer price. (very rare in
U.S.)
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Primary Market
III. Private Placements
– Firm uses investment bankers to sell securities directly to a small
group of institutional or wealthy investors.
– Cheaper than public offerings
– Less suited for very large offerings.
– Private placements not traded in secondary markets
– In this process, instead of underwriters, placement agents act as
intermediaries between the issuer and investors. However, they
do not assume any underwriting risks. In recent years, some
issuers have bypassed placement agents and have done private
placements directly with ultimate investors.
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How Securities are Traded
Types of Markets:
• Direct search
– Buyers and sellers seek each other
• Brokered markets
– Brokers search out buyers and sellers
Example, Investment Bankers who market a firm’s
securities to the public act as brokers
• Dealer markets
– Dealers have inventories of assets from which they buy and sell
Example, most bonds trade in over-the-counter dealer markets.
Auction markets
– traders converge at one place to trade either physically or
electronically. Example, New York Exchange Stock (NYSE)
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Bid and Asked Prices
Bid Price
Ask Price
• Bids are offers to buy.
• In dealer markets, the
bid price is the price at
which the dealer is
willing to buy.
• Investors “sell to the
bid”.
• Bid-Asked spread is the
profit for making a
market in a security.
• Asked prices represent
offers to sell.
• In dealer markets, the
asked price is the price
at which the dealer is
willing to sell.
• Investors must pay the
asked price to buy the
security.
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Types of Orders
I.
Market Order:
They are buy or sell orders that are to be executed
immediately at the current market prices.
Complications:
1. Market order might be filled at multiple price
2. Another trader may beat our investor to the quote
3. The best price quote may change before our investor’s
order arrives
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Types of Orders
II.
Price-contingent Order:
Traders specify buying or selling price
– A limit buy order: Instruct the broker to buy some number of
shares if and when the share can be obtained at or below a
stipulated price.
– A limit sell order: Instruct the broker to sell some number of
shares if and when the share can be sold at or above a
stipulated price.
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Types of Orders
III. Stop order:
– Stop-loss orders: Specify that the stock is to be sold if its price
falls below a stipulated level.
– Stop-buy orders: Specify that a stock should be bought when its
price rises above a stipulated level.
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Figure 3.5 Price-Contingent Orders
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Trading Mechanisms
I.
Dealer Markets:
Dealers quote prices at which they are willing to buy or
sell securities. A broker then executes a trade by
contracting a dealer listing an attractive quote.
Computer network where prices are quoted is called
National Association of Securities Dealers Automatic
Quotations System (NASDAQ)
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Trading Mechanisms
• II.
Electronic communication networks (ECNs)
It allows participants to post market and limit orders that can
be automatically executed.
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Trading Mechanisms
III.
Specialists markets
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Trading Mechanisms
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Trading Mechanisms
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Trading Mechanisms
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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
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Table 3.1 Partial Requirements for Listing
on NASDAQ Markets
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New York Stock Exchange
• Lists about 2,800 firms
• Automatic electronic trading runs side-by-side
with traditional broker/specialist system
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New York Stock Exchange: Traditional broker/specialist
system
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York Stock Exchange: Automatic electronic trading
System
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Table 3.2 Some Initial Listing
Requirements for the NYSE
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Electronic Communication Networks
• ECNs: Private computer networks that directly link buyers with
sellers for automated order execution
• Major ECNs include NASDAQ’s Market Center, ArcaEx, Direct
Edge, BATS, and LavaFlow.
• “Flash Trading”: Computer programs look for even the smallest
mispricing opportunity and execute trades in tiny fractions of a
second.
• Some high-speed traders are given direct access to their
broker’s computer-trading codes and can execute trades in a
little as 250 microseconds (.00025 seconds)
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Electronic Communication Networks
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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
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Market Structure in Other Countries
• London - predominately electronic
trading
• Euronext – market formed by
combination of the Paris, Amsterdam
and Brussels exchanges, then merged
with NYSE
• Tokyo Stock Exchange
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Globalization and Consolidation of
Stock Markets
• NYSE mergers and acquisitions:
– Archipelago (ECN), (2006)
– American Stock Exchange (2008)
– Euronext (2007)
• NASDAQ mergers and acquisitions:
– Instinet/INET (ECN), (2005)
– Boston Stock Exchange, (2007)
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Globalization and Consolidation of
Stock Markets
• Chicago Mercantile Exchange acquired:
– Chicago Board of Trade, (2007)
– New York Mercantile Exchange, (2008)
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Figure 3.6 Market Capitalization of Major
World Stock Exchanges, 2007
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Trading Costs
1.
Brokerage Commission: fee paid to broker for making the
transaction
– Explicit cost of trading
– Full Service vs.
Discount brokerage (the only information they provide is the
price quotation)
2. Spread: Difference between the bid and asked prices
– Implicit cost of trading
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Buying on Margin
•
Borrowing part of the total purchase price of a position using a loan
from a broker (Broker’s Call Loans).
•
The act of taking advantage of broker’s call loans is called buying on
margin
•
Investor contributes the remaining portion.
•
Margin refers to the percentage or amount contributed by the
investor.
•
You profit when the stock appreciates.
•
The brokers borrow from banks at the call money rate and then
charge their clients that rate plus a service charge for the loan.
•
All securities purchased on margin must be determined with the
brokerage firm.
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Buying on Margin (Ctd.)
• Initial margin is set by the Fed
– Currently 50%
• Maintenance margin
– Minimum equity that must be kept in the margin account
– Margin call if value of securities falls too much
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Margin Trading:
Initial Conditions Example 3.1
Share price
$100
60%
Initial Margin
40%
Maintenance Margin
100
Shares Purchased
Initial Position
Stock $10,000 Borrowed
Equity
$4,000
$6,000
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Maintenance Margin Example 3.1
Stock price falls to $70 per share
New Position
Stock $7,000 Borrowed $4,000
Equity
$3,000
Margin% = Equity on Account / Value of Stock
= $3,000
/ $7,000
= 43%
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Margin Call Example 3.2
How far can the stock price fall before a margin call?
Let maintenance margin = 30%
Equity = 100P - $4000
Percentage margin
=
.3 = Equity on Account / Value of Stock
= (100P - $4,000) / 100P
= (100P - $4,000) / 100P
Solve to find:
P = $57.14
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Table 3.4 Illustration of Buying Stock
on Margin
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Buying On Margin
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Buying On Margin
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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
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Short-Selling Versus Purchasing
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Short Sale:
Initial Conditions Example 3.3
Dot Bomb
50%
30%
$100
1000 Shares
Initial Margin
Maintenance Margin
Initial Price
Sale Proceeds
$100,000
Margin & Equity $50,000
Stock Owed
1000 shares
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Short Sale:
Initial Conditions Example 3.3
•
•
Percentage Margin =
= Equity / Value of Stock Owed
= 50,000 / 100,000
= .5
If Price falls to $70
Profit = ending equity – beginning equity
= $80,000 - $50,000 = $30,000
= decline in share price x number of shares sold short
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Short Sale - Margin Call
How much can the stock price rise before a margin call?
Percentage margin
=
.3 = Equity on Account / Value of Stock
($150,000* - 1000P) / (1000P)
P = $115.38
If stock price rise above $115.38 per share, you will get a margin call,
and you will either have to put up additional cash or cover your short
postion by buying shares to replace the ones borrowed.
* Initial margin plus sale proceeds
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Short Sale
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Short covering
• Short covering is the act of buying back shares in order to close
out a short position. Let's assume a trader was short Citigroup at
$23.50 in early October. In order to open this position the trader
would sell short 500 shares by borrowing these from their broker
and selling them on open market. This creates a net short position
for the trader. So, the only way to close out this position is to buy
back or cover the position. In the below chart Citigroup experienced
a free fall down to $3. This leads to a massive short squeeze which
shot the stock up over $8 in a matter of days. Many investors
believe that shorting is evil. However, shorting is a normal part of the
markets and adds to its liquidity.
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Short covering
• For example, as a stock begins to fall precipitously, many traders
that are short will begin to cover their position to get out with a profit.
This short covering sends a large number of buy orders into the
market which in turn creates counter move rallies. Without short
covering, the market will just continue to float lower, as buyers are
not willing to step in front of a falling knife.
• http://www.mysmp.com/stocks/short-covering.html
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Short Covering
•
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Trailing Stop Orders
• A sell trailing stop order sets the stop price at a fixed amount below
the market price with an attached "trailing" amount. As the market
price rises, the stop price rises by the trail amount, but if the stock
price falls, the stop loss price doesn't change, and a market order is
submitted when the stop price is hit. This technique is designed to
allow an investor to specify a limit on the maximum possible loss,
without setting a limit on the maximum possible gain. "Buy" trailing
stop orders are the mirror image of sell trailing stop orders, and are
most appropriate for use in falling markets.
• http://institutions.interactivebrokers.com/en/trading/orders/trailingSto
ps.php
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Trailing Stop Orders
• You have purchased 100 shares of XYZ for $66.34 per share (your
Average Price) and want to lock in a profit and limit your loss. You
set a trailing stop order with the trailing amount 20 cents below the
current market price. To do this, first create a SELL order, then
select TRAIL in the Type field and enter 0.20 in the Trailing Amt
field. The trailing amount is the amount used to calculate the initial
Stop Price, by which you want the limit price to trail the stop price.
You submit the order.
• You transmit your order. The current market price of XYZ is $62.46
and the initial stop price is calculated as $62.26, or $62.46 – the
trailing amount of 0.20.
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Trailing Stop Orders
Avg Price
Action
Qty
Order Type
Market Price
Trailing Amount
Stop Price (Calculated as
Market Price – Trailing Amount)
66.34
SELL
100
TRAIL
62.46
0.20
62.26
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Trailing Stop Orders
• As soon as you submit your order, the price of XYZ starts to rise and
hits $62.66. The trailing stop price has adjusted accordingly and is at
$62.46, or $62.66 – the $0.20 trailing amount.
Avg Price
Action
Qty
Order Type
Market Price
Trailing Amount
Stop Price (Calculated as
Market Price – Trailing Amount)
66.34
SELL
100
TRAIL
62.66
0.20
62.46
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Trailing Stop Orders
• Suddenly the market price of XYZ drops to 62.56. Your stop price
remains at 62.46. If the market price continues to drop and touches your
stop price, the trailing stop order will be triggered, and a market order to
sell 100 shares of XYZ will be submitted.
Avg Price
Action
Qty
Order Type
Market Price
Stop Price (Calculated as
Market Price – Trailing Amount)
66.34
SELL
100
TRAIL
62.56
62.46
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Trailing Stop Orders
• The market price of XYZ continues to drop and touches your stop
price or 62.46. A market order to sell 100 shares of XYZ at 62.46 is
submitted and filled.
Avg Price
Action
Qty
Order Type
Market Price
Stop Price (Calculated as
Market Price – Trailing Amount)
Order Filled at 62.46
66.34
SELL
100
TRAIL
62.46
62.46
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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
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Regulation of Securities Markets
(Ctd.)
• 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
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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
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A Group Assignment
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