Class Business
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Upcoming Homework
Investment Banking
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Main intermediary in security issuance
Terms
– Primary vs Secondary market
– Underwritten vs. “Best Efforts” offering
– Negotiated vs. Competitive Bid
– Red herring vs. Tombstone
Security Offerings
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Public offerings: registered with the SEC and sale
is made to the investing public
– Shelf registration (Rule 415, since 1982)
Initial Public Offerings (IPOs)
Two IPO pricing puzzles
– IPO stocks experience on average large returns
on the first day of trading.
– IPO stocks under-perform comparable publicly
traded companies over the next five years.
700
80
600
70
60
50
400
40
300
30
200
20
100
10
0
0
19
90
19
91
19
92
19
93
19
94
19
95
19
96
19
97
19
98
19
99
20
00
20
01
20
02
20
03
20
04
Number of IOPS
500
Source: Ritter (2004)
Average First-Day Returns
Number of IPOs (Bars)
Average First-Day Returns (Diamonds)
40
80
35
70
30
60
25
50
20
40
15
30
10
20
5
10
0
0
Average First-Day Returns
Money Left on Table (billions)
Money Left on Table (Bars)
Average First-Day Returns (Diamonds)
90 91 92 93 94 95 96 97 98 99 00 01 02 03 04
19 19 19 19 19 19 19 19 19 19 20 20 20 20 20
MLOT = (Closing Price – IPO Price)  (Number of Shares Sold at IPO Price)
Source: Ritter (2004)
Long-Term Performance of
IPOs (1970-2002)
First
Year
Second
Year
Third
Year
Fourth
Year
Fifth
Year
Mean
IPO Firms
6.8%
6.1%
9.3%
14.3%
9.9%
9.3%
SizeMatched
Firms
11.4%
14.7%
14.1%
14.5%
12.4%
13.4%
Difference
-4.6%
-8.6%
-4.8%
-0.20%
-2.5%
-4.14%
Source: Ritter (2004)
IPO Puzzles: Bookbuilding
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Bookbuilding
– Preliminary price set
– Road show
– Those who show a willingness to pay a higher price
get more shares
– Money “left on table” is compensation for revealing
price information
Trading
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Types of orders
Locations
Margin buying
Short selling
Order Types
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Market buy: buy at best going price
Market sell: sell at best going price
Price below
the limit
Price
above the
limit
Sell
Stop-loss
(Stop-sell)
Limit sell
Buy
Limit Buy
Stop Buy
Bid-Ask Prices
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The ask price is the price at which someone stands
willing to sell.
The bid price is the price at which someone stands
willing to buy.
Ask>Bid (always)
Bid-Ask and Over-the Counter
Markets
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On Over-the-Counter markets:
– Only dealers post bid-ask prices.
– All buy orders buy at ask (the higher
price)
•
•
•
–
Market buy
Limit buy
Stop buy
All sell orders sell at bid (the lower price)
•
•
•
Market sell
Limit sell
Stop Sell
Trading on OTC Market
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Investor places an order with broker.
Broker tries to locate the dealer offering the
best deal.
Trades are negotiated through dealers who
maintain an inventory of securities.
Trading on Exchanges
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Investor places an order with broker.
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Brokerage firm contacts its commission broker or
independent floor broker to execute order.
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The specialist “makes a market” in the shares of one
or more firms.
– Can act as both a broker and a dealer
– Maintains a limit order book.
– Maintains a “fair and orderly market” by dealing
personally in the stock.
Bid-Ask and Exchanges
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Any limit order is a bid-ask price
– Any broker can post a limit order
– These are arranged at specialist desk
Last Trade = $50.00
market buy & stop buy orders executed at
lowest ask
market sell & stop-loss orders executed at
highest bid
Example of Limit Order Book
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Last trade: $50
If a market buy for 100 shares
comes in, what price will it get?
At what price will the next market
buy be filled?
If you were the specialist, would
you want to increase or decrease
your inventory?
Costs of Trading
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Commission
– Fee paid to broker
Bid-Ask Spread
– Bid: Price dealer will buy from you
– Ask: Price dealer will sell to you
Market Impact
– Larger orders impact the market price
Taxes
– Government taxes realized capital gains for
taxable investors.
Exchange vs. Nasdaq
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Lower direct costs to list and trade on Nasdaq
– No physical location to maintain
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Indirect costs of Trading on Nasdaq
– Price Discovery
– Collusion (Paul Schultz, Notre Dame)
– Trading through (next slide)
Trading Through
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Dealer posts: bid $20, ask $20.15 for 1000 shares
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Customer order #1:
– limit order buy 1000 shares at $20.10
Customer order #2:
– Market sell 1000
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Dealer can
– Buy 1000 shares at $20 (at her bid price)
– Immediately sell for 20.10
– Pocket $100 – instant no risk
Margin and Short Sales
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Buying on Margin
– Use borrowed funds to invest in securities.
– Bullish strategy.
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Short Sales
– Sell securities without owning them.
– Bearish strategy.
Buying on Margin
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Suppose you have $10,000 and you are very bullish
in Microsoft.
You can borrow $10,000 from your broker at a 10%
interest rate.
Buy $20,000 worth of MSFT stock.
What are the returns of this trading strategy if
Microsoft stock increases or falls by 25% during the
next year?
Return of Buying on Margin
MSFT increases 25% MSFT decreases
25%
Value of Stock
Position
Pay Back Loan
Net Value of Account
Return
25,000
15,000
-11,000
-11,000
14,000
4,000
40%
-60%
Buying on Margin
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Federal securities law mandate limitations on borrowing.
Limit is defined in terms of “the margin”.
Equity in "Margin Account"
Margin 
Value of Asset
–
–
–
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A=L+E implies E=A-L = Price*Shares - Loan
Initial margin must exceed 50%
Maintenance margin set by broker
Value of shares in previous example initially=$20,000
Value of loan = $10,000
Initially, margin is (20,000-10,000)/20,000 = 50%
Example of Margin Calls
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Suppose now, that MSFT dropped within a year by 30%.
Broker has set maintenance margin at 25%.
The securities are then worth just $14,000.
Your margin equals:
$14,000 - $11,000
Margin 
 21.43%.
$14,000
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Your current margin is lower than the maintenance margin and you
will receive a margin call from your broker.
Three Possible Options to
Satisfy Margin Call
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Close out position
Reduce your loan
Increase your equity position
Risks of Margin Purchases
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Broker gives you a margin call if the maintenance
margin is not met.
Broker can sell your securities without asking for your
permission
The potential losses can exceed your initial
investment. For example:
MSFT:
Loan:
Equity:
Initial Position
20,000
10,000
10,000
In One Year
10,000
11,000
- 1,000
Short Selling
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Securities are sold by someone who does not own
them.
How does this work?
– Borrow the securities from somebody,
– Sell the securities at the current market price,
– Pay dividends to the original owner,
– Eventually, buy back the securities and return
them to the owner along with fee for borrowing
Short Selling
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The broker keeps the proceeds
Broker requires a margin account as collateral.
Equity
Margin 
Value of Stock Owed
A=L+E
Total assets = cash from selling stock + equity
Cash from selling stock cannot be invested elsewhere
Equity can be cash or some kind of security
The value of the stock is a liability (varies over time)
Always true E = A – L
As value of asset shorted increases, equity drops
Short Selling
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Suppose the current price of GM is $50.
You expect the price to fall.
You decide to short sell 2000 shares
If initial margin must be 50%, how much equity do you need to post
in your margin account?
Value of asset shorted = 2000*50 = 100,000
.50 
Equity
 Equity=50,000
100,000
Short Selling
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Suppose the price of GM suddenly jumps to $55.
What is your margin? What is your total gain/loss?
Assets have not changed: A = $150,000
But liabilities have: L=2000*55=110,000
E=A-L implies E=150,000-110,000=40,000
Value of asset owed = 2000*55 =110,000
40,000
Margin 
 36%
110,000
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You have lost $10,000 of equity.
Three Possible Options to Satisfy
Margin Call on Short Position
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Close out position
Reduce liabilities
– Buy back shares
Add more equity to your account
Risks of Short Sales
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Broker can force you to cover short position
– If borrowed stocks are called back from
lender and broker cannot borrow different
shares.
– If margin call is not satisfied.
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What is the limit on losses due to short
selling?
Returns and Short-sales
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You have $100 of equity
Current price of Intel = $50
Current price of Microsoft = $25
You are bearish on Intel and bullish on MSFT
Short 1 share of Intel (get $50 now)
– This money cannot be invested elsewhere
– Assume return is zero.
Buy 4 shares of MSFT
– Assume these shares satisfy margin requirement
100(1  rMSFT )  50 - 50(1  rINTEL )
GR 
100
1
1
 1(1  rMSFT )  (1  0)  (1  rINTEL )
2
2
NR  1* rMSFT
1
1
 *0  * rINTEL
2
2
Returns and Buying on Margin
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You have $100 of equity
Current price of Intel = $50
Current price of Microsoft = $25
You are very bullish on MSFT
Invest 100% of your investment equity in MSFT
Borrow $50 and also invest that in MSFT
– Rate on loan is rF
150(1  rMSFT ) - 50(1  rF )
GR 
100
1
 1.5(1  rMSFT )  (1  rF )
2
1
NR  1.5(rMSFT )  * rF
2
Example
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You have $1000.
– Short sell $500 of Nike
– Buy $600 of Oracle
– Buy $900 of Intel
Returns:
– Nike: 5%
– Oracle: -6%
– Intel: 3%
What is the return on your portfolio?
Example
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Weight in Nike: -50%
Weight in Oracle: 60%
Weight in Intel: 90%
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Return = -.5(.05) + .6(-.06) +.9(.03)= -.034%
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