Chapter 3

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FINA 2802: Investments and Portfolio Analysis
Securities Markets
Dragon Yongjun Tang
January 21 & 23, 2010
Lecture 4 & 5:
Securities Markets
Reading: Chapter 3
 Practice Problem Sets:

1,2,3,4,6,7,8,9,10,12,13,14,18,20,21
2
Learning Objectives

Role of investment bankers in primary issues

Identify the various security markets

Describe the role of brokers

Compare trading practices in exchanges vs dealer
markets

Buy Stock on Margin and Sell Stock Short
3
Life Cycle of a Company
Private
(Entrepreneur + VC)
Primary
Secondary
Commission Investment Bank
Public
(NYSE/Nasdaq)
Dealer
Market Maker
Buy on Margin
Buy
Sell Short
Bid-ask Spread
Commission
Broker
Commission
Sell
4
How Firms Issue Securities
Primary Market:
•Initial Public Offering (IPO)
•Seasoned Equity Offering (SEO)
Investment Bankers:
•Assist firms in issuing securities
•Firm Commitment (Take a risk in
underwriting)
•Best efforts (issuer bears the risk of not
placement)
5
Figure 3.1 Relationship Among a Firm
Issuing Securities, the Underwriters
and the Public
6
Figure 3.2 A Tombstone Advertisement
7
Shelf Registration
SEC Rule 415
Allows firms to register securities and
sell them gradually to the public for two
years.
8
Private Placements
 Firms
sell shares directly to a
small group of institutional or
wealthy investors
 Cheaper: No need to register to
SEC (Rule 144A)
 Smaller offerings
9
Initial Public Offering
(IPO)
Road shows, bookbuilding
Cost: commissions (7%) + underpricing
Investment bankers tend to underprice new issues
IPO prices tend to rise after IPO (“Money left on the
table”)
IPO are usually poor long-term investments
Internet Auction
10
IPO Underpricing:
A dramatic example (VA Linux)




IPO price: $30
First day closing price: $239.25
Today’s price: $1.00
Replicate this picture using
finance.yahoo.com (LNUX)
Day's Range:
1.00 - 1.04
52wk Range:
0.32 – 2.18
Volume:
Avg Vol (3m):
28,795
270,871
Market Cap:
P/E (ttm):
EPS (ttm):
Div & Yield:
64.31M
N/A
-0.055
N/A (N/A)
Last Trade:
1y Target Est:
1.0025
1.59
11
Figure 3.3 Average Initial Returns for IPOs
in Various Countries
12
Figure 3.4 Long-term Relative
Performance of Initial Public Offerings
13
Where Securities Are
Traded
Secondary Market
Organized exchanges
– NYSE (or the Big Board); AMEX; regional
exchanges
 Over the counter (OTC)
– Nasdaq: market makers; three levels
– Bond trading
 Directly between the two parties
– Electronic Communication Networks (ECN)

14
National Market System
•Established by Exchange Act of 1975
•Intent was to link firms electronically
•Resulted in Consolidated Tape
15
Bond Trading
Major concern: Liquidity
Automated
Bond System
(ABS)
OTC
market
16
Trading on Exchanges
The participants:
 Investors
 Brokerage firms (owns a “seat”
on the exchange)
 Commission brokers
 Floor brokers
17
Trading on Exchanges
The specialist (or market maker):
•Makes a market
•The brokers’ broker
•Maintains the limit order book
•Maintains a fair and orderly market
NYSE is an example
18
New York Stock
Exchange (NYSE)
19
Trading on Exchanges
Types of orders:
Market
 Limit
 Day
 Good-till-canceled
 Stop-loss orders; stop-buy orders

20
Figure 3.5 Limit Order Book for Intel
on Archipelago
21
Figure 3.6 Price-Contingent Orders
22
Trading on Exchanges
Block orders - at least 10,000 shares
DOT & SuperDOT - direct to specialist
Settlement – three business days
Shares “In Street Name”. Shares kept
by the broker after a transaction
23
Trading on OTC Markets
•Negotiated market
•No specialist
•NASDAQ computer system
24
Nasdaq
25
Market Structures in Other
Countries





London - predominately electronic trading
Euronext – market formed by combination
of the Paris, Amsterdam and Brussels
exchanges
Tokyo Stock Exchange
Hong Kong Stock Exchange
Shanghai Stock Exchange
26
Cost of Trading
Broker’s commissions:
Explicit
“Hidden” costs:
Bid-Ask Spread
Price Concession
27
Cost of Trading
Impact of trading costs on returns
Return =
capital gains + current income - all broker ' s fees
initial investment + initial broker ' s fees
Cost of Trading
Example: You bought a stock for $70 and later sold it for $80
You received $8 in dividends, paid an initial broker’s fee of $1%
of purchase price, and paid another $1% of selling price when
you sold the stock. What is your return on this investment
(ignoring taxes)?
29
Placing an Order
• Should you use a full-service or a
discount broker?
• What is the value of the full-service
broker’s advice?
30
Student Loan



You think your value will go up
You want to make the most out of it
So you borrow money to finance education
31
Buying on Margin
Borrow
to buy securities (make
use of the Broker call’s loan)
Securities
stay with the broker
as collateral
32
Buying on Margin
Investor’s account:
Assets
Liabilities
Value of stocks purchased
Loan from Broker
Equity
Cost of setting up a margin strategy
33
Buying on Margin
 At
time 0:
Initial investor' s equity 0
Initial Margin 0 
Market val ue of securities
 At
0
any future time
Actual investor' s equity t
Actual Margin t 
Market val ue of securities
t
Buying on Margin
• The Federal Reserve System sets
minimum initial margin
requirements currently 50%
• All exchanges set a minimum
maintenance margin requirement
currently around 30%
35
Buying on Margin
Example: What is the initial margin if the investor purchases
100 shares of stock at $100 per share using $6,000 of her own
money and borrows the rest?
36
Buying on Margin
Example (continued): If the value of the above stock fell to $70
per share, what is now the actual margin?
37
Buying on Margin
Example (continued): If the value of the above stock fell to $50
per share, what is now the actual margin?
38
Buying on Margin
Margin Call
Pmin= the lowest price a share can fall to without a call
L = the loan value
M = the margin requirement
N = the number of shares
Buying on Margin
Margin Call Example: An investor purchases 100 shares of
stock at $100 per share using $6,000 of her own money and
borrows the rest. If the maintenance margin is 30%, what is the
lowest price a share can fall without a call?
40
Margin Trading - Initial Conditions
X Corp
50%
40%
1000
Initial Position
Stock $70,000
$70
Initial Margin
Maintenance Margin
Shares Purchased
Borrowed $35,000
Equity
35,000
41
Margin Trading - Maintenance Margin
Stock price falls to $60 per share
New Position
Stock $60,000 Borrowed $35,000
Equity
25,000
Margin% = $25,000/$60,000 = 41.67%
42
Margin Trading - Margin Call
How far can the stock price fall before a
margin call?
(1000P - $35,000)* / 1000P = 40%
P = $58.33
* 1000P - Amt Borrowed = Equity
43
Problem 3, Chapter 3 (p. 93)
Dee Trader opens a brokerage account, and purchases 300 shares of Internet
Dreams at $40 per share. She borrows $4,000 from her broker to help pay
for the purchase. The interest rate on the loan is 8%.
a. What is the margin in Dee’s account when she first purchases the stock?
b. If the share price falls to $30 per share by the end of the year, what is the
remaining margin in her account? If the maintenance margin requirement is
30%, will she receive a margin call?
c. What is the rate of return on her investment
44
Problem 7, Chapter 3 (p. 94)
You are bullish on Telecom stock. The current market price is $50 per share,
and you have $5,000 of your own to invest. You borrow an additional
$5,000 from your broker at an interest rate of 8% per year and invest
$10,000 in the stock.
a. What will be your rate of return if the price of Telecom stock goes up by
10% during the next year? (Ignore the expected dividend.)
b. How far does the price of Telecom stock have to fall for you to get a
margin call if the maintenance margin is 30% of the value of the short
position? Assume the price all happens immediately.
45
Why buy on margin?
Borrowing magnifies ROE (risky strategy)
Return
on Equity ( ROE
income
) 
equity
income
Return on Total Investment ( ROA ) 
total investment
Leverage and ROE
ROE
RS  RL
RS
L
E
RS  RL
47
Short Sales
Borrow Securities to sell them
Sell first -- then buy!
Margin is required (cost of short
selling)
Short position must be covered
Investor expects price to decline
48
Short Selling
Original Stock Holder
100 Shares
Broker
100 Shares
Short Seller
100 Shares
New Stock Holder
49
Short Sales
Return on
Short Sale Price  Buy Back Price

Per Share Investment
( margin )
Short Sale
Short Sales
Example: An investor sells short 100 shares of stock at $100
per share. The margin requirement is 50% of the short sale.
a. If the investor covers her short sale when the stock price
declines to $70 per share, what is the return on the short
sale?
b. What is the return if there is no margin requirement?
51
Short Sales
Example: An investor sells short 100 shares of stock at $100
per share. The margin requirement is 50% of the short sale.
c. If the investor covers her short sale when the stock price
increases to $130 per share, what is the return on the
short sale?
52
Short Sales-Initial Margin
Investor’s account at time 0:
Assets
Value of stocks sold ( P0  N )
Initial Margin (E0)
Liabilities
Value of Stocks owed ( P0  N )
Equity (Current Margin)
Equity
Percentage Initial Margin=
Value of Stocks owed
As time elapses, the value of stocks owed changes, affecting
the %Margin!
Short Sales-Margin
Investor’s account at time t:
Assets
Liabilities
Value of stocks sold( P0  N ) Value of Stocks owed ( Pt  N )
Initial Margin (E0)
DIVIDENDS DUE
Equity (Et=Current Margin)
Percentage Margin=
Equity ( current margin)
Value of Stocks owed
As time elapses, the value of stocks owed changes,
affecting the %Margin!
Short Sales -Margin
How high can the price of stock go before a
margin call is issued?
Actual margin=
Equity t
P N  E0  Pt N
 0
Value of stock owed t
Pt N
We want actual margin > required margin.
Solve for
Pt
Short Sales
Margin call price:
Pmax 
NP0  E0
N M  1
Pmax maximumprice per share without margin call
P0  price per share at time of short sale
E0  initial margin
N  number of shares sold short
M  margin requiremen t
Short Sales
Example: An investor sells short 100 shares of stock at $100 per
share. The initial margin requirement is 50% of the short sale. If
the maintenance margin is 30%, what is the maximum stock price
without a margin call on the short sale?
57
Short Sale - Initial Conditions
Z Corp
50%
30%
$100
100 Shares
Initial Margin
Maintenance Margin
Initial Price
Sale Proceeds
$10,000
Margin & Equity
5,000
Stock Owed 10,000
58
Short Sale - Maintenance Margin
Stock Price Rises to $110
Sale Proceeds
$10,000
Initial Margin
5,000
Stock Owed
11,000
Net Equity
4,000
Margin % (4000/11000)
36%
59
Short Sale - Margin Call
How much can the stock price rise before a
margin call?
($15,000* - 100P) / (100P) = 30%
P = $115.38
* Initial margin plus sale proceeds
60
Problem 4, Chapter 3 (p. 93)
Old Economy Traders opened an account to short sell 1,000 shares of
Internet Dreams from Question 3. The initial margin requirement was 50%.
(The margin account pays no interest.) A year later, the price of Internet
Dreams has risen from $40 to $50, and the stock has paid a dividend of $2
per share.
a. What is the remaining margin in the account?
b. If the maintenance margin requirement is 30%, will Old Economy receive
a margin call?
c. What is the rate of return on the investment?
61
Problem 8, Chapter 3 (p. 94)
You are bearish on Telecom and decide to sell short 100 shares at the
current market price of $50 per share.
a. How much in cash or securities must you put into your brokerage
account if the broker’s initial margin requirement is 50% of the value of
the short position?
b. How high can the price of the stock go before you get a margin call if
the maintenance margin is 30% of the value of the short position?
62
Regulations of Securities
Markets
Securities Act of 1933
Securities Exchange Act of 1934
Securities Investor Protection Act of 1970
Blue Sky Laws
Circuit Breakers
Main Concern: Insider Trading
Trading scandals and reactions: Sarbanes-Oxley Act
63
Summary




Issuing securities
Trading
Buying on margin and short sales
Next class: Mutual Funds
64
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