Lecture Presentation Software
to accompany
Investment Analysis and
Portfolio Management
Eighth Edition
by
Frank K. Reilly & Keith C. Brown
Chapter 4
Organization and Functioning of
Securities Markets
Questions to be answered:
• What is the purpose and function of a market?
• What are the characteristics that determine the quality
of a market?
• What is the difference between a primary and
secondary capital market and how do these markets
support each other?
Organization and Functioning of
Securities Markets
• What is Rule 415 and Rule 144A and how do they
affect corporate security underwriting?
• What are call markets and when are they typically
used?
• What is the third market?
• What are Electronic Communication Networks
(ECNs) and alternative trading systems (ATSs)
and how do they differ from the primary listing
markets?
• What are the major types of orders available
to investors and market makers?
What is a market?
• Brings buyers and sellers together to aid in the
exchange of goods and services
• Does not require a physical location
• Both buyers and sellers benefit
– Reduces search & screening costs
– Price discovery
Characteristics of a Good Market
• Availability of past transaction information
– must be timely and accurate
• Liquidity
– marketability
– price continuity
– depth
• Low transaction costs
• Rapid adjustment of prices to new information
Decimal Pricing
• The Canadian equity market switched to decimal
pricing in April, 1996
• The US equity market switched to decimal
pricing in early 2001
• All North American equity markets now price in
dollars & cents rather than 1/8ths and 1/16ths
• Reasons for decimal pricing:
 Easier for investors to understand prices
 Reduces the size of the bid-ask spread
 Markets more competitive on a global basis
Organization of the Securities Market
• Primary markets
– Market where new securities are sold by the
firms/entities issuing securities
– The funds raised go to the issuer
• Secondary markets
– Market where already issued securities are
bought and sold by investors. The issuer does
not receive any funds in a secondary market
transaction
Government Bond Issues
• Treasury Bills – negotiable, non-interest bearing securities
with original maturities of one year or less
• Government of Canada Bonds – original maturities of more
than 1year
• The Bank of Canada publishes detailed information on the
auction process on its website;
http://www.bankofcanada.ca/en/markets/markets_auct.html
Canadian Treasury Bills
• Prior to November 1995 Treasury bills were issued in bearer form and
were available in denominations ranging from $1,000 to $1,000,000.
• Effective November 1995 all new issues of Treasury bills are issued in
global certificate form only whereby a global certificate for the full
amount of the Treasury bill is issued in fully registered form in the name
of CDS & Co., a nominee of CDS.
• Treasury bills are sold via auction every two weeks by the Bank of
Canada on behalf of the Government of Canada
• Treasury bills must be purchased, transferred or sold, directly or
indirectly, through a participant of the Debt Clearing Service, which is
operated by CDS, and only in integral multiples of $1,000 (face value).
• The Government of Canada also periodically issues cash management
bills (CMBs).
• CMBs are Treasury bills with maturities of less than three months
(they can be as short as one day) used as a source of short-term financing
for the Government. CMB auctions can take place on any business day,
typically for next-day delivery, but on some occasions for same-day
delivery.
Government of Canada Coupon
Bonds
• Prior to December 1993 Government of Canada bonds were issued in
coupon-bearer and fully registered form, and were available in
denominations ranging from $1,000 to $1,000,000.
• Between December 1993 and September 1995 Government of Canada
bonds were issued only in fully registered form.
• Effective October 1995 Government of Canada marketable bonds are
issued in global certificate form only whereby a global certificate for
the full amount of the bonds is issued in fully registered form in the
name of CDS & Co., a nominee of the Canadian Depository for
Securities Limited (CDS).
• The bonds must be purchased, transferred or sold, directly or
indirectly, through a participant of the Debt Clearing Service, which is
operated by CDS, and only in integral multiples of $1,000 (face value).
• All Canadian-dollar marketable bonds are non-callable and pay a fixed
rate of interest semi-annually.
Canada Bills
• Canada Bills are promissory notes denominated in US dollars and
issued only in book-entry form.
– Book-entry form means that no certificate is issued
• They mature not more than 270 days from their date of issue, and are
discount obligations with a minimum order size of US$1,000,000 and
a minimum denomination of US$1,000.
• Delivery and payment for Canada Bills occur in same-day funds
through Chase Manhattan Bank in New York City.
• Primary distribution of Canada Bills occurs through five dealers: CIBC
Wood Gundy Inc., Credit Suisse First Boston Corporation, Goldman,
Sachs & Co., Lehman Brothers Inc. and RBC Dominion Securities Inc.
• Rates on Canada Bills are posted daily for terms of one to six months.
• Canada Bills are issued for foreign exchange reserve funding purposes
only.
Canada Notes
• Canada Notes are promissory notes usually denominated in US dollars
and available in book-entry form.
• They are issued in denominations of US$1,000 and integral multiples
thereof. At present the aggregate principal amount outstanding issued
under the program is limited to US$10.0 billion.
• Notes can be issued for terms of nine months or longer, and can be
issued at a fixed or a floating rate.
• The interest rate or interest rate formula, issue price, stated maturity,
redemption or repayment provisions, and any other terms are
established by the Government of Canada at the time of issuance of the
notes and will be indicated in the Pricing Supplement. Delivery and
payment for Canada Notes occur through the Bank of New York.
• The notes are offered by the Government through five dealers: Credit
Suisse First Boston Corporation, Goldman, Sachs & Co., Lehman
Brothers Inc., Nesbitt Burns Securities Inc. and Scotia Capital Markets
(USA) Inc. The Government may also sell notes to other dealers or
directly to investors.
• Canada Notes are issued for foreign exchange reserve funding
purposes only
Corporate Bond and Stock Issues
New issues are divided into two groups
1. Seasoned new issues - new shares offered
by firms that already have stock
outstanding
2. Initial public offerings (IPOs) - a firm
selling its common stock to the public for
the first time
Underwriting Relationships with
Investment Bankers
1. Negotiated
– Most common
– Full services of underwriter
2. Competitive bids
– Corporation specifies securities offered
– Lower costs
– Reduced services of underwriter
3. Best-efforts
– Investment banker acts as broker
Shelf Registration
• Allows firms to register securities and sell them
piecemeal over the next two years
• Referred to as Rule 415 in the US; as a shelf
registration in Canada
• Great flexibility
• Reduces registration fees and expenses
• Allows requesting competitive bids from several
investment banking firms
• Especially popular for bond sales
Private Placements
• The issuing firm sells to a small group of
institutional investors without the need for a
Prospectus
• Lower issuing costs than a public offering
• Referred to as Rule 144A in the US
Why Secondary Financial Markets
Are Important
• Provides liquidity to investors who acquire
securities in the primary market
• Results in lower required returns than if
issuers had to compensate for lower
liquidity
• Helps determine market pricing for new
issues
Secondary Equity Markets
1. Primary listing markets
–
New York, American, Tokyo, and London stock
exchanges
2. Regional markets
–
Toronto, Chicago, San Francisco, Boston, Osaka, Nagoya,
Dublin, Cincinnati
3. OTC markets
- Nasdaq
4. Third-market dealers/brokers
–
Madoff Investment Securities, Knight Trading Group, Jefferies
Group, ITG
5. Fourth Market – alternative trading systems
Alternative Trading Systems (ATSs),
• Electronic Communications Networks (ECNs)
– Archipelago, BRUT, Instinet, Island, REDIBook
– Are electronic trading systems that automatically match buy and
sell orders at specified prices
• Electronic Crossing Systems (ECSs)
– POSIT, Global Instinet Crossing, Arizona Stock Exchange
– provide greater anonymity for participants
Basic Trading Systems
• Pure auction market (also known as orderdriven market)
– Toronto Stock Exchange
– Market price determined by buy & sell orders
placed by investors
• Dealer market (also known as quote-driven
market)
– NASDAQ
– Bid & ask prices posted by dealers who “make
a market” in the stock
Call Versus Continuous Markets
• Call markets trade individual stocks at specified
times. All orders are gathered and then a single
price is determined which satisfies most orders.
– Used for opening prices on TSX if orders build up
overnight or after trading is suspended
• In a continuous market, trades occur at any time
the market is open
– During regular trading hours, the TSX is a continuous
market
Global Stock Exchanges
• Trend toward consolidations or affiliations that will
provide more liquidity and greater economies of scale to
support the technology required by investors
• Many of the larger companies in countries such as
Canada, the U.K., Germany, and Japan that can qualify for
listing on a U.S. exchange become dual-listed
• The existence of strong international exchanges has made
possible a global equity market wherein stocks that have a
global constituency can be traded around the world 24
hours a day
Major Types of Orders
• Market orders
– Buy or sell at the best current price
– Provides immediate liquidity
• Limit orders
– Order specifies the buy or sell price
– Time specifications for order may vary
• Instantaneous - “fill or kill”, part of a day, a full day,
several days, a week, a month, or good until
canceled (GTC)
Major Types of Orders
• Short sales
– Sell overpriced stock that you don’t own and purchase
it back later (at a lower price)
– Borrow the stock from another investor (through your
broker)
– Can only be made on an up-tick
– Short seller must pay any dividends to the lender of the
stock
– Margin requirements apply (must maintain margin of
150% of current market price)
– Subject to “close-outs” during a short squeeze
– Lender loses the right to vote the stock
Major Types of Orders
• Special Orders
– Stop loss
• Conditional order to sell stock if it drops to a given
price
• Market order is triggered once the market price
touches the stop loss price
• Does not guarantee price you will get upon sale
– Stop buy order
• Investor who sold short may want to limit loss if
stock increases in price
Margin Transactions
• Is available on any type of order but not to all investors
(depends on the nature of the account you establish)
• Borrow a portion (usually up to 50%) of the purchase
price using the stock as collateral
• Interest rate on margin credit may be below prime rate
• Regulations limit proportion borrowed
• The use of margin leverages or magnifies both gains
and losses.
Margin: Canadian Stocks
Long Positions
• Margin requirements can be found on the IDA (Investment
Dealers Association) website (www.ida.ca)
– See Section 100 of their Rule Book. Common stocks are in
Subsection (f), reproduced below.
• On securities (other than bonds and debentures) including
rights and warrants listed on any recognized stock
exchange in Canada or the United States, on the Tokyo
Stock Exchange First Section or on the stock list of the
London Stock Exchange:
– Securities selling at $2.00 or more - 50% of market value
– Securities selling at $1.75 to $1.99 - 60% of market value
– Securities selling at $1.50 to $1.74 - 80% of market value
Margin: Canadian Stocks
Short Positions
•
•
•
•
Securities selling at $2.00 or more - 150% of market value
Securities selling at $1.50 to $1.99 - $3.00 per share
Securities selling at $0.25 to $1.49 - 200% of market value
Securities selling at less than $0.25 - market value plus
$0.25 per share
Margin: Interesting facts
• The lowest margin requirement is for Treasury bills, which
is equal to 1% of market value multiplied by maturity over
365. Thus the most equity you would have to post to buy a
one year Treasury bill would be 1% of its current market
value.
• Securities selling under $1.50, securities of companies
designated as Capital Pool Companies on the TSX Venture
Exchange and securities of companies classified as Tier 3
or Inactive Tier 2 issuers on the TSX Venture Exchange
may not be carried on margin.
Margin Transactions
Buy 200 shares at $50 = $10,000 position
Borrow 50%, investment of $5,000
If price increases to $60, position
–
–
–
–
Value is $12,000
Less
- $5,000 borrowed
Leaves $7,000 equity for a
$7,000/$12,000 = 58% equity position
• If the minimum margin is 50%, then have
excess margin in your account
Margin Transactions
Buy 200 shares at $50 = $10,000 position
Borrow 50%, investment of $5,000
If price decreases to $40, position
–
–
–
–
Value is $8,000
Less
- $5,000 borrowed
Leaves $3,000 equity for a
$3,000/$8,000 = 37.5% equity position
• If the minimum margin is 50%, then are short
margin in the account (will have to add $2,000)