CHAPTER 3 How Securities are Traded Investments, 8th edition Bodie, Kane and Marcus Slides by Susan Hine McGraw-Hill/Irwin Copyright © 2009 by The McGraw-Hill Companies, Inc. All rights reserved. How Firms Issue Securities • 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 How Firms Issue Securities Continued • Investment Banking • Shelf Registration • Private Placements • Initial Public Offerings (IPOs) 3-3 Investment Banking • Underwritten: firm commitment on proceeds to the issuing firm -buying out all stock at lower price than announced one (spread) and sell them to public • Red herring: preliminary prospectus • Prospectus 3-4 Figure 3.1 Relationship Among a Firm Issuing Securities, the Underwriters and the Public 3-5 Shelf Registrations • SEC(securities and exchange commission) Rule 415 • Introduced in 1982 • Ready to be issued – on the shelf can gradually sell for two years 3-6 Private Placements • Sale to a limited number of sophisticated investors not requiring the protection of registration • Allowed under Rule 144A -less costly because registration statements are not required • Less liquid and lower price due to absence of general public • Very active market for debt securities • Not active for stock offerings 3-7 Initial Public Offerings • Process – Road shows: distribute and gather info – Bookbuilding: finally decide price Investors give true info? If yes, why? • Underpricing – Post sale returns – Cost to the issuing firm • Long term poor performer? 3-8 Figure 3.2 Average Initial Returns for IPOs in Various Countries 3-9 Figure 3.3 Long-term Relative Performance of Initial Public Offerings 3-10 How Securities are Traded • Types of Markets – Direct search • Least organized – Brokered • Trading in a good is active • e.g. primary market; broker=underwriter – Dealer • Trading in a particular type of asset increases; – Auction • Most integrated, e.g. NYSE • No need to compare prices bet. dealers 3-11 Types of Orders • Market orders—executed immediately – Bid Price, Ask Price • Price-contingent orders – Limit orders • Buy limit order $21 for the current market price $23 • Sell limit order $24 for the current market price $23 3-12 Types of Orders… – Stop orders • Buy stop order (stop loss order) $24 for the current market price $23 • Sell stop order $20 for the current market price $23 3-13 Figure 3.4 The Limit Order Book to be sold at $20.77; to be bought at $20.78 3-14 Figure 3.5 Price-Contingent Orders 3-15 Trading Mechanisms • Dealer markets -Dealers quote prices -Brokers contact dealers and match quotes • Electronic communication networks (ECNs) -No intermediation of brokers -Executed automatically if orders are matched • Specialists markets 3-16 Trading Mechanisms… • Specialists markets -Each security is assigned to a specialist -Brokers with clients’ orders send them to specialist -Specialist acts as broker, executing orders -Specialist maintains fair and orderly market 3-17 U.S. Security Markets • Nasdaq and NYSE have evolved in response to new information technology • Both have increased their commitment to automated electronic trading 3-18 Nasdaq • Orig. over-the-counter dealer market, now electronic communication network • NASDAQ Global Select Market, Global Market, Capital Market • Levels of subscribers – Level 1 – only receives inside quotes – Level 2 – receives all quotes but they can’t enter quotes – Level 3 – can enter all quotes; are dealers making markets 3-19 Table 3.1 Partial Requirements for Listing on NASDAQ Markets 3-20 New York Stock Exchange • How it works – Investor sends order to brokers, who contact – Floor brokers go to – Specialists try to find party to accept order license of floor broker is bought by the year. • Block houses: brokers who match big block trades. • SuperDot: electronic trading system 3-21 Table 3.2 Some Initial Listing Requirements for the NYSE 3-22 Table 3.3 Block Transactions on the New York Stock Exchange 3-23 Other Systems • Electronic Communication Networks – Private computer networks that directly link buyers with sellers • National Market System – Securities Act of Amendments of 1975 – attempt to integrate all markets • Bond Trading – Automated Bond System (ABS) – Developing but still by OTC dealer market 3-24 Market Structure in Other Countries • London - predominately electronic trading • Euronext – market formed by combination of the Paris, Amsterdam and Brussels exchanges • Tokyo Stock Exchange -First section, Second section, Mothers -Nikkei 225(price weighted), TOPIX(value weighted) of first section company • Globalization and consolidation of stock markets 3-25 Figure 3.6 Market Capitalization of Major World Stock Exchanges, 2007 3-26 Trading Costs Full service brokers, discount brokers • 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 3-27 Buying on Margin • Paying only part of price and borrowing rest from broker • Margin in the account is part payed by investor • Broker borrows that money from bank at broker's call rate and charges investor with that rate plus service charge. • Securities bought this was are kept at broker's as collateral for the loan. Margin arrangements differ for stocks and futures 3-28 Stock Margin Trading • Initial Margin is currently 50%; you can borrow up to 50% of the stock value – Set by the Fed • Maintenance margin,usually 25%: minimum amount which net worth (equity) in trading can be • Margin call: notification from broker that you must put up additional funds when net worth falls below maintenance margin 3-29 Margin Trading - Example 3.1 Buying 110 shares of X Corp at $100 60% Initial Margin 40% Maintenance Margin Initial Position Assets Stock value $10,000 Liabilities and net worth Loan $4,000 Equity $6,000 3-30 Margin Trading - Example 3.1... Suppose stock price falls to $70 per share New Position Assets Stock value $7,000 Liabilities and net worth Loan $4,000 Equity $3,000 Investor's new margin is now Margin% = $3,000/$7,000 = 43% Still, ok. It's above maintenance margin. But if maintenance margin is 45%, 3-31 Margin Trading - Example 3.1... But if maintenance margin is 50%, margin call is made to put in at least additional funds of: ($3,000+x)/$7,000=0.5→ x=$500 New position here Assets Liabilities and net worth Stock value $7,000 Loan $4,000 Deposit Equity $3,000 $500 Deposit $500 3-32 Margin Trading - Margin Call Example 3.2 How far can stock price P fall before a margin call? Suppose maintenance margin is %30. (100P - $4,000)* / 100P ≥ 30% !100P - Amount Borrowed = Net worth(Equity)! P ≥ $57.14 3-33 Table 3.4 Buying Stock on Margin $100 per share, investing $10,000 cash and buying on margin total of $20,000, 9% margin loan rate Buying on margin can bring huge gain and loss, too. 30% price rise: ((26,000-10,900)-10,000)/10,000=0.51 No price change((20,000-10,900)-10,000)/10,000=-0.09 30% price fall:((14,000-10,900)-10,000)/10,000=-0.69 3-34 Short Sales • Sell security without having it • Mechanics – Borrow stock through a broker from someone – Sell it and deposit proceeds plus margin(again!) in an account at broker – Cover the short position: buy the stock from someone and return to the party from whom you borrowed Purpose: profit from a decline in the price of security 3-35 Short Sale – Initial Conditions Example 3.3 Dot Bomb $100 50% 30% Position Assets Cash $100,000 T-bills 50,000 1,000 Shares Initial Price Initial Margin Maintenance Margin Liabilities and net worth Short position $100,000 Net worth(equity)50,000 Net worth/Value of security owed= $x/$100,000=0,5---->x=$50,000 3-36 Short Sale – Example 3.3... -Sale Proceeds -Margin & Equity -Stock Owed $100,000 $ 50,000 $100,000 Suppose Stock price falls down to $70 Cover(close out) short position now -Buy 1,000 shares at $70 on market, costing $70,000 -Your gain: 100,000-70,000=$30,000 3-37 Short Sale - Maintenance Margin Suppose stock Price Rises to $110 Position Assets Liabilities and net worth Cash $100,000 Short position $110,000 T-bills 50,000 Net worth(equity)40,000 Sale Proceeds $100,000 Initial Margin 50,000 Stock Owed 110,000 Net Equity 40,000 Margin % (40,000/110,000) 36% 3-38 Short Sale - Maintenance Margin... Suppose maintenance margin is 40% Maintenance call is made. How many more additional fund to put in: $x/$110,000=40% ---> x=$44,000 Put in additional $4,000 New Position Assets Liabilities and net worth Cash $100,000 Short position $110,000 T-bills 50,000 Net worth(equity)44,000 Cash 4,000 (or whatever) 3-39 Short Sale - Margin Call... Suppose maintenance margin is 30%. How much can stock price P rise before margin call? Debt(value of shares to pay back)1,000P Net worth(equity) in your account $150,0001000P Your margin ration is ($150,000 - 1000P) / (1000P) ≥ 30% P ≥ $115.38 3-40 Regulation of Securities Markets • Major regulations – Securities Act of 1933; registration of new securities, prospectus etc. – Securities Exchange Act of 1934 Securities Investor Protection Act of 1970; protect investors from default of brokers • Self-Regulation – Stock markets are largely self-regulating 3-41 Regulation Securities Markets Continued • Regulatory Responses to Recent Scandals --->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 and are liable to penalties – Auditors no longer provide other services – Boards must have independent directors 3-42 Circuit Breakers • Trading halts If DJIA falls 30%, market closes down. 3-43 Insider Trading • Officers, directors, major stockholders must report all transactions in firm’s stock • Insiders do exploit their knowledge; proof? -Criminal conviction -Leakage of useful information to some traders before public announcement -Study reports that insiders make abnormal gains over share trade. 3-44