Chapter 3:Securities Markets
1
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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
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Buy Stock on Margin and Sell Stock Short
3.1 HOW FIRMS ISSUE SECURITIES
securities resell
and rebuy
first issue
securities
Firms
Primary market
(1)
New securities
Issuers receive fund
Secondary
market
(2)
•Existing owner sells to
another party
•Issuing firm doesn’t
receive proceeds and is not
directly involved

There are 2 types of primary issues for
stock
◦ IPO (initial public offering): first sale of stock by a
formerly private company
◦ SEO (seasoned equity offering): offered by
companies which already have stocks trading in
the market

There are 2 types of primary issues for
bond:
◦ Public offering: issue of bonds sold to public and
then can be traded on the secondary market
◦ Private placement: issue of bonds that is usually
sold to one or a few institutional investors and
held to maturity.
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Investment Banking
Shelf Registration
Private Placements
Initial Public Offerings (IPOs)

Underwritten vs. “Best Efforts”
◦ Underwritten: firm commitment on proceeds to the issuing
firm
resell
firms
sell
I.B.
securities
Public
securities
 Assume the risk of not being able to resell to public
◦ Best effort
 I.B. does not buy securities
 Agree to help to sell to public
 Less common than underwritten

Underwriting syndicate:
◦ More than one I.B. involved in the underwriting process
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SEC Rule 415 (1982): SEC allows firms to register
securities and sell to public within 2 years
Avoid flotation cost
Little paperwork, ready to be issued – on the shelf
limited in time (2 years)
Why limited in time?
Private placement: sale to a limited number of
sophisticated investors not requiring the protection
of registration
•
•
•
•
•
•
Allowed under Rule 144A
Much cheaper than public offering
Don’t trade in secondary market
Dominated by few institutions
Very active market for debt securities
Not active for stock offerings
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IPO: investment bank assists companies going from
private to public (first issuance of securities to
public)
I.B advise companies on terms of the issue (price,
volume, find buyers)
Step 1:
◦ I.B. file preliminary draft with SEC.
◦ The draft (red herring): information about issues and the
company

Step 2:
◦ Once SEC approve, I.B. organizes a road show
◦ Road show: travel around countries to publicize the
offerings
 Generate interest among investors, provide info about offerings
 provide feedback to issuers and I.B. about the price, volume of
the issues to be sold
Investors

Investment bank
show interest
“book”
book building
poll all potential
investors
Book building is important
◦ Provides feedback to the issuer and I.B. about the issue
◦ Issuers and I.B. revise the initial estimates
 New price
 New volume
 Identify potential buyers
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IPO is usually underpriced
Dec 1999, VA Linux sold IPO for $30/share, after 1 day the
price went up to $239.25/share, (698% return)
Why IPO is underpriced?
I.B. organizes road shows to provide info about the issue to
public and get feedback
I.B. mainly contact institutional investors (big buyers)
Why big buyer is important?
◦ they can buy at large volume
◦ they can provide feedback about the issue


Big buyers should get the discount for their activities, hence
IPO is underpriced
Long-term performance of IPO is poor
HOW SECURITIES ARE TRADED

Direct search:
◦ Least organized market
◦ buyers and seller meet directly

Brokered
◦ Assist buyers and sellers in finding each other
◦ get commission fees

Dealer
◦ Traders specializing in particular assets buy and sell for their own
accounts. Buyers buy from the dealer. Sellers sell to the dealer
◦ Bid-ask spread

Auction
◦ all traders meet at one place to buy or sell an asset
◦ specialist system
◦ May not need to trade with the specialists so can save the bid-ask
spread

Market—executed immediately at the current
market price
◦ Bid Price: price at which a dealer or other trader is willing to
buy
◦ Ask Price: price at which a dealer or other trader is willing
to sell

Price-contingent: investor specify prices they are
willing to buy or to sell
◦ limit orders:
 Limit-buy: buy if the price falls below a certain level
 Limit-sell: sell if the price rises above a certain level
◦ Stop orders: trades not to be executed unless stock hits a
price limit
 Stop-buy: buy when price rises above a certain level
 Stop-loss: sell when price falls below a certain level

limit orders:
◦ Limit-buy: buy if the price falls below a certain
level
 Example: current price of IBM = 90.69. Think it is too
high, only buy if the price is 85 or below. So you make a
limit buy order with the limit is $85
◦ Limit-sell: sell if the price rises above a certain
level
 Example: current price of MSFT = 22.63. Think it is too
low, only sell if the price is 30 or higher. So you make a
limit sell order with the limit is $30

Stop orders: trades not to be executed
unless stock hits a price limit
◦ Stop-buy: buy when price rises above a certain
level
 Example: the current price of Apple is 111.04. If you
believe the price will go down, you short Apple stock
 If the price actually goes down, make profit
 However, in case it may not go down, you might want to
make a stop-buy order with the price limit is 111.04 to
prevent loss
◦ Stop-loss: sell when price falls below a certain
level
 example: the current price of Dell is 12.25. You believe
stock price will go up so you buy Dell stock
 Stock price might go down, and you might have loss. To
prevent that, make a stop-loss order with the price limit
is 12.25

what type of trading order you might give to your
broker in each of the following circumstances
◦ you want to buy shares of Intel to diversify your portfolios.
You believe that the share price is at the “fair value”, you
want the trade done quickly and cheaply
◦ you want to buy shares of Intel but believe that the current
price is too high given the firm’s prospect. If shares could
be obtained at a price 5% lower than the current value, you
would like to purchase shares for your portfolio
◦ you plan to purchase a house sometime next month, and
will sell your shares of Intel to provide funds for your down
payment. While you believe that Intel share price is going to
rise over the next few weeks, if you are wrong and the
share price drops suddenly, you will not be able to afford
the purchase. Therefore, you want to hold on to the shares
for as long as possible, but still protect yourself against the
risk of a big loss
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Dealer markets (over-the-counter market)
Specialists markets (formal or organized
exchanges)
Electronic communication networks (ECNs)
investors
instructions to
buy or sell
brokers
confirmation
Bid
Dealer 1
50.20
Dealer 2
50.15
Dealer 3
50.10
Ask
contact
through a
computer
network
confirm
-ation
dealers
50.20 is the inside bid (best bid)
50.25 is the inside ask (best ask)
Dealer 1
50.25
Dealer 2
50.26
Dealer 3
50.27
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The most important market in the OTC or
dealer system
◦ Nasdaq Global Select Market
◦ Nasdaq Global Market
◦ Nasdaq Capital Market
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Small stock OTC
◦ Pink sheets
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No specialist
Dealers can be located anywhere they can
communicate effectively with buyers and sellers
3 levels of members
◦ Level 3: market makers, dealers
 maintain inventories
 stand ready to buy and sell
 set bid-ask quotes
◦ Level 2: brokers
 receive all quotes, try to get best quotes for clients
 deal with level 3 (dealers)
◦ Level 1: investors
 receive only inside quotes
 not active investors, only need current information on prices
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Largest exchange in the U.S.
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Three members
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◦ 2,800 firms, market cap is $15 trillion
◦ daily trading: 1.8 (bil) shares, valued at $75 (bil)
◦ Commission brokers
◦ Floor brokers
◦ Specialist
if the order is small, commission brokers can send
the order directly to computer network
If the order is large, commission brokers send the
order to floor brokers, and then floor brokers
either send order to specialist or negotiate directly
with other floor brokers
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Now a publicly held company
◦ Merge with Archipelago Exchange to form NYSE group in
2006
◦ Merge with Euronext to form NYSE-Euronext in 2007
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Block sales
◦ Blocks of tens of thousands of shares of stock
◦ Block houses

SuperDot
◦ Enables members to send order directly to specialists
◦ in 2006, processed about 13 mil trades per day, executed
in matter of seconds
◦ small orders
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Bond Trading
◦ 2006 NYSE obtained approval to expand bond trading
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American Stock Exchange (AMEX)
Regionals
Electronic Communication Networks (ECNs)
◦ Directly between the two parties.
◦ INET and Archipelago

National Market System
 Established by Exchange Act of 1975
 Intent was to link firms electronically
 Resulted in Consolidated Tape
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London - predominately electronic trading
Euronext – market formed by combination of
the Paris, Amsterdam and Brussels exchanges
Tokyo Stock Exchange
3.5 TRADING COSTS

Explicit cost
◦ Commission: fee paid to broker for making the
transaction

Implicit cost
◦ 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
Impact
trading
costs
on returns
capitalof
gains
+ current
income
- all broker
Return =
initial investment
' s fees
+ initial broker ' s fees
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)?
3.6 BUYING ON MARGIN



Using only a portion of the proceeds for an
investment
Borrow remaining component
Margin arrangements differ for stocks and
futures

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Maximum margin is currently 50%; you can
borrow up to 50% of the stock value
Set by the Fed
Maintenance margin: minimum amount equity
in trading can be before additional funds must
be put into the account
Margin call: notification from broker you must
put up additional funds
Investor’s account:
Assets
Liabilities
Value of stocks purchased
Loan from Broker
Equity
Cost of setting up a margin strategy

At time 0:
Initial investor' s equity 0
Initial Margin 0 
Market val ue of securities

0
At any future time
Actual investor' s equity t
Actual Margin t 
Market val ue of securities
t
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?
Example (continued): If the value of the above stock fell to $70
per share, what is now the actual margin?
Buying on Margin
Example (continued): If the value of the above stock fell to $50
per share, what is now the actual margin?
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
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?
X Corp
$70
50%
Initial Margin
40%
Maintenance Margin
1000
Shares Purchased
Initial Balance Sheet Position:
Stock $70,000 Borrowed
$35,000
Equity
35,000
Stock price falls to $60 per share
New Balance Sheet Position:
Stock $60,000
Borrowed
$35,000
Equity
25,000
Margin% = $25,000/$60,000 = 41.67%
How far can the stock price fall before a
margin call?
Since 1000P - Amt Borrowed = Equity then:
(1000P - $35,000) / 1000P = 40%
P = $58.33
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
3.7 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
Original Stock Holder
100 Shares
Broker
100 Shares
100 Shares
New Stock Holder
Short Seller
Return on
Short Sale

Short Sale Price  Buy Back Price
Per Share Investment
( margin )
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?
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?

Investor’s account at time t = 0
Assets
Liabilities + Equity
Cash (sale) = P0*N
Value of stocks = P0*N
(borrowed)
Equity or
initial
Cash (deposit)
margin
or initial margin
Percentage of initial margin =
(equity at time 0)/(value of stocks borrowed at time0)

Investor’s account at time t
Assets
Liabilities + Equity
Cash (sale) = P0*N
Value of stocks = Pt*N
(borrowed)
Equity or
Cash (deposit)
current margin
or initial margin
at time t
Percentage of margin at time t = (equity at time t)/(value of stocks
borrowed at time t)
As time elapses, the value of stock changes hence affecting the value
of percentage margin
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?
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
Stock Price Rises to $110
Sale Proceeds
Initial Margin
Stock Owed
Net Equity
Margin % (4000/11000)
$10,000
5,000
11,000
4,000
36%
How much can the stock price rise before a
margin call?
Since Initial margin plus sale proceeds =
$15,000, then:
($15,000 - 100P) / (100P) = 30%
P = $115.38
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?
CHAPTER 4: INVESTMENT
COMPANIES
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Definition: financial intermediaries that collect
funds from individual investors and invest those
funds in a potentially wide range of securities
Administration & record keeping
◦ issue periodic status reports, keeping track of capital gain
distributions, dividends, investments, and redemption
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Diversification & divisibility: diversify portfolios and
investors can buy fractional shares of many
different securities
Professional management: full-time staffs of
security analysts and portfolio managers
Reduced transaction costs: can achieve substantial
savings on brokerage fees and commissions
because of large transactions

Net Asset Value
◦ Used as a basis for valuation of investment
company shares
◦ Selling new shares
◦ Redeeming existing shares
Calculation:
Market Value of Assets - Liabilities
Shares Outstanding
4.2 TYPES OF INVESTMENT COMPANIES



Pools of money from many investors that is
invested in a portfolio fixed for the life of the
fund
Little active management
Example: invest in municipal bond, corporate
bond

Hire managers to manage portfolio
Open-End

Closed-End

◦ stand ready to redeem or issue shares at their net
asset value. If investors in open-end funds want to
cash out shares, they sell back to the fund at NAV
◦ Funds cannot issue or redeem shares. Investors
who want to cash out must sell shares to other
investors
◦ Sold at premium or discount to NAV
◦ Shares of close-end fund are traded on organized
exchanges just like other common stocks.
◦ Commingled funds
 partnership of investors that pool their funds. Similar
to open-end fund. Example: trust or retirement
account that have portfolios much larger than those
of most individual investors but still too small to
warrant managing on a separate basis
◦ REITs: similar to closed-end fund but invest in
real estate or loans secured by real estate
◦ Hedge Funds
 like mutual fund: hedge fund allows private investors
to pool assets to be invested by a fund manager
 Unlike mutual fund: hedge fund are commonly
structured as private partnerships and are not subject
to many SEC regulations
4.3 MUTUAL FUNDS
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

mutual fund is a common name for openend investment company. Account for >90%
of investment company asset.
Described in the prospectus
Management companies manage a family of
mutual funds. Some examples include:
◦
◦
◦
◦
Fidelity
Vanguard
Putnam
Dreyfus

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Money Market: invest in money market
securities.
Equity: invest in stocks
◦ Income fund and growth fund

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Specialized Sector: sector funds
Bond: invest in bond

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Balanced Funds: hold both equities and
fixed income securities in relatively
stable proportions to meet needs of
individual investors
Asset Allocation and Flexible: similar to
balance funds but the proportion can
change according to managers’ forecasts
Indexed: match performance of a broad
market index. Example: Vanguard 500
Index Fund
International
4.4 COSTS OF INVESTING IN
MUTUAL FUNDS

Fee Structure
◦ Front-end load: commission or sale charge
paid when purchasing the shares
◦ Back-end load: redemption or exit fee
incurred when you sell shares.


Operating expenses
12 b-1 charges
 distribution costs paid by the fund
 Alternative to a load

Fees and performance
NAV1  NAV0  Income and capital gain distributions
Rate of return =
NAV0
Initial NAV = $20
Income distributions of $.15
Capital gain distributions of $.05
Ending NAV = $20.10:
$20.10 - $20.00 + $.15 + $.05
Rate of Return =
 1.5%
$20.00
4.6 EXCHANGE-TRADED FUNDS



ETF allow investors to trade index
portfolios like shares of stock
Examples – SPDRs, Diamonds, and WEBS
Potential advantages
◦ Trade continuously
◦ Lower taxes
◦ Lower costs

Potential disadvantages
4.7 MUTUAL FUND INVESTMENT
PERFORMANCE: A FIRST LOOK


Evidence shows that average mutual fund
performance is generally less than broad
market performance
Evidence suggests that over certain
horizons some persistence in positive
performance
◦ Evidence is not conclusive
◦ Some inconsistencies
94
4.8 INFORMATION ON MUTUAL FUNDS
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Wiesenberger’s Investment Companies
Morningstar (www.morningstar.com)
Yahoo (finance.yahoo.com/funds)
Investment Company Institute
Popular press
Investment services