How securities are traded
BKM Ch 3
Zvi Wiener
tel: 02-588-3049
Spring-03
mswiener@mscc.huji.ac.il
http://pluto.mscc.huji.ac.il/~mswiener/zvi.html
Investments
How Securities Are Traded
How Firms Issue Securities
Where Securities are Traded
Trading on the Exchanges
Buying on Margin
Short Sales
Regulation of Securities Markets
Mutual Funds
Zvi Wiener
BKM Ch 3
slide 2
Primary market - when issued
Secondary market - any time later
Primary market
public offering
private placement
IPO (initial public offering)
Seasoned new issue
Zvi Wiener
BKM Ch 3
slide 3
Public offerings of stocks and bonds are usually
underwritten by investment bankers. A lead investment
banker forms an underwriting syndicate to share the
commitment.
The syndicate provides market advice and handle the
SEC registration process.
(red herring=preliminary prospectus)
1. Firm Commitment
2. Best-Efforts Basis
Zvi Wiener
BKM Ch 3
slide 4
Shelf Registration
Since 1982 the SEC allows (rule 415) shelf
registration. One can register now but
actually trade during two years.
Rule 144A of SEC
Trading of private placements among some
institutions.
Zvi Wiener
BKM Ch 3
slide 5
IPO
Road show
Book – indication of interest
IPO underpricing effect in the first days and
bad performance later.
Internet IPO
Zvi Wiener
BKM Ch 3
slide 6
Private Placements
Private placement: sale to a limited number
of sophisticated investors not requiring the
protection of registration.
Dominated by institutions.
Very active market for debt securities.
Not active for stock offerings.
Zvi Wiener
BKM Ch 3
slide 7
Secondary Market
national (NYSE, AMEX)
regional - firms located in its area
exchanges for derivatives
Trading conducted by members (seat owners)
Commission brokers seats - full-service brokers
Zvi Wiener
BKM Ch 3
slide 8
Seat price on the NYSE in $K
year
1875
1905
1935
1965
1975
1980
Zvi Wiener
high
6.8
140
250
138
275
480
low
4.3
72
65
190
55
175
year high low
1985 600 310
1990 430 250
1995 1,050 785
1999 2,650 2,000
BKM Ch 3
slide 9
NYSE Listing Requirements
Pretax Income last year
$2,5M
Average annual pretax in 2 years
$2M
Market value of publicly held stock
$60M
Shares publicly held
1.1M
Holders of 100 shares or more
2,000
Zvi Wiener
BKM Ch 3
slide 10
The Over-the-Counter Market
More than 35,000 issues are traded
Since 1972 the NASDAQ gives quotes
(National Association of Security Dealers)
network of dealers linked by a computer
system.
Zvi Wiener
BKM Ch 3
slide 11
OTC levels
Level 3: Market makers
Maintain inventories of securities
May enter bid-ask prices and update them
Level 2: Receive all bid-ask quotes
Can not enter quotes
Are brokers who act for clients
Do not actively deal on their own account
Level 1: Receive median bid-ask quotes
Investors looking for information.
Zvi Wiener
BKM Ch 3
slide 12
Third and Fourth Markets
The third market - exchange-listed securities
traded on the OTC
Fourth marked - investors trading directly
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BKM Ch 3
slide 13
The National Market System
Securities Act Amendments of 1975 directed
SEC (Securities and Exchange Commission)
to implement a national competitive system.
Requirements to companies
Insider trading is prohibited
Public Information control
Zvi Wiener
BKM Ch 3
slide 14
Other Countries
LSE - London Stock Exchange
TSE - Tokyo Stock Exchange
German
Zurich
Paris
Toronto
Israel
Zvi Wiener
BKM Ch 3
slide 15
Participants
Commission Brokers - serve clients
Floor Broker - independent broker
Registered Traders - act on their own account
Specialists
Zvi Wiener
BKM Ch 3
slide 16
Types of Orders
Market Order
Limit Order (price, time)
Stop-Loss Order
(sell if the price falls below some level)
Stop-Buy Order
(buy if the price rises above some level)
Block sales (10,000 shares), block houses, standard
price taking assumption isn’t valid.
Zvi Wiener
BKM Ch 3
slide 17
Limit Orders
Condition Price below
Action
the limit
Buy
Limit buy
order
Sell
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Stop loss
order
BKM Ch 3
Price above
the limit
Stop buy
order
Limit sell
order
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Roles of a Specialist
Specialist “makes a market” in a share.
He can act either as a broker or as a dealer.
Specialist maintains a “book”- list of
outstanding orders.
Provides liquidity.
Is obligated to provide price continuity.
Zvi Wiener
BKM Ch 3
slide 19
Trading on the OTC Market
Dealer Market
Investor contacts broker
The broker tries to find a dealer
Computerized system
Zvi Wiener
BKM Ch 3
slide 20
Trading Costs
Full-Service - advice, research, execution
Discount Brokerage - only execute
Brokerage fees + the bid-ask spread
Paying for order flow
Odd versus even quotes
Internet innovation
Zvi Wiener
BKM Ch 3
slide 21
Buying on Margin
Initial Margin is defined by the FRS (Federal
Reserve System) about 50% by investor’s funds,
the rest is borrowed from the broker. Margined
stock is left with the broker.
Maintenance Margin are set by the NYSE and
the brokerage firm. If the balance falls below, the
investor is subject to a margin call.
Margin is equity in the account as a percent of
the value of the account, a leveraged position.
Zvi Wiener
BKM Ch 3
slide 22
Below Maintenance Margin
Value of securities no longer support loan
Investor must do something!
1. Sell some shares
2. Send cash
Above Initial Margin
Investor may
1. Do nothing
2. Buy more shares with no additional cash
3. Increase loan amount
Zvi Wiener
BKM Ch 3
slide 23
Short Sales
An investor borrows a stock from the broker
The short seller expect the price to decline
Covering the position - purchasing the stock
One can short a stock only after an uptick
Required deposit (50%)
All dividends must be paid
Margin call possible
What is the difference between buying on
margin and selling short?
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BKM Ch 3
slide 24
Short position - pessimist
Long position - optimist
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BKM Ch 3
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Short Sale
You short 100 shares at $50
Dividends of $1/share are paid
You cover position at $40
Profit = $900
You short 100 shares at $50
Dividends of $1/share are paid
You cover position at $60
Loss = ($1,100)
Zvi Wiener
BKM Ch 3
slide 26
Margin Calls on Short Transactions
you go short 100 shares at $50; MM 30%
Assets
Liability & Equity
$5,000 Proceeds
$5,000 C.S.
$2,500 Cash
$2,500 Equity
$7,500
$7,500
Margin = (Assets-Liabilities)/Liabilities
0.3 = ($7,500-100 P)/(100 P)
P = $57.69
Zvi Wiener
BKM Ch 3
slide 27
Regulation on Securities Markets
Securities Act of 1933 - disclosure of new issues
Securities Act of 1934 - established SEC
The Commodities Futures Trading Commission
The Securities Investor Protection Corporation
protects investors from losses against brokerage
firm bankruptcy
Zvi Wiener
BKM Ch 3
slide 28
Other Restrictions
Circuit Breakers. Trading is stopped for 1
hour when DJIA falls 250 points from the
previous day’s close and stops trading for 2
hours if the drop is 400 points.
Insider Trading. Insiders are: major
shareholders, officers and directors. They
must disclose their trades to SEC (and SEC
discloses it to public).
Zvi Wiener
BKM Ch 3
slide 29
Home Assignment
Required:
• read chapter 3 in BKM.
• read very carefully summary at the end.
• problems 2, 7, 12, 14, 16, 17 (3rd ed).
• problems 2, 9, 18, 20, 22, 23 (5th ed).
• find names of all 30 companies in DJIA
• find names of all 25 companies in TA-25
• closely follow financial news!
Zvi Wiener
BKM Ch 3
slide 30
Mutual Funds
BKM Ch 4
Zvi Wiener
tel: 02-588-3049
Spring-03
mswiener@mscc.huji.ac.il
http://pluto.mscc.huji.ac.il/~mswiener/zvi.html
Investments
Mutual Funds
Open-End Funds, sell at net asset value + load.
NAV = (Assets - Liabilities)/Shares
Closed-End Funds. No new shares issued.
Front-end load
Back-end load
Operating expenses
12B-1 Charges - annual fees
Zvi Wiener
BKM Ch 3
slide 32
Advantages:
Diversification and divisibility
Professional management
Small investment
Reinvestment of dividends, capital gains
Disadvantages:
Commissions (loads)
Time delay or illiquidity
Zvi Wiener
BKM Ch 3
slide 33
Home Assignment
• read chapter 4 in BKM (5th ed).
• find major types of mutual funds in Israel
• find 5 largest mutual funds in Israel
• what was their performance and fees last
year?
Zvi Wiener
BKM Ch 3
slide 34
Additional Slides
Zvi Wiener
BKM Ch 3
slide 35
Costs of Trading
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
Zvi Wiener
BKM Ch 3
slide 36
Margin Trading
Using only a portion of the proceeds for an
investment.
Borrow remaining component.
Margin arrangements differ for stocks and
futures.
Zvi Wiener
BKM Ch 3
slide 37
Stock Margin Trading
Maximum margin
Currently 50%
Set by the Fed
Maintenance margin
Minimum level the equity margin can be
Margin call
Call for more equity funds
Zvi Wiener
BKM Ch 3
slide 38
Margin Trading - Initial
Conditions
X Corp
50%
40%
1000
Initial Position
Stock $70,000
Zvi Wiener
$70
Initial Margin
Maintenance Margin
Shares Purchased
Borrowed
Equity
BKM Ch 3
$35,000
$35,000
slide 39
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%
Zvi Wiener
BKM Ch 3
slide 40
Margin Trading - Margin Call
How far can the stock price fall before a
margin call?
(1000P - $35,000)* / 1000P = 40%
P = $58.33
* 1000P - Amount Borrowed = Equity
Zvi Wiener
BKM Ch 3
slide 41
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.
Zvi Wiener
BKM Ch 3
slide 42
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
Zvi Wiener
BKM Ch 3
slide 43
Short Sale - Maintenance Margin
Stock Price Rises to $110
Sale Proceeds
Initial Margin
Stock Owed
Net Equity
Margin % (4000/11000)
Zvi Wiener
BKM Ch 3
$10,000
5,000
11,000
4,000
36%
slide 44
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
Zvi Wiener
BKM Ch 3
slide 45