CHAPTER 3
Securities Markets
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3.1 HOW FIRMS ISSUE SECURITIES
Primary Versus Secondary Markets
• Primary
– New issue
– Key factor: issuer receives the proceeds from
the sale
• Secondary
– Existing owner sells to another party
– Issuing firm doesn’t receive proceeds and is
not directly involved
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How Securities Are Issued
• Investment Banking: The investment banker purchases the securities
from the issuing company and then resell them to the public.
– Typical underwriting makes a firm commitment about the price and
assumes the risk that the shares may not be sold to the public at the
quoted price
– In case of best-effort agreement the investment banker does not
actually purchase the securities but agrees to help the firm sell the
issue to the public
• Shelf Registration:
– Introduced in 1982, it allows firms to register securities and
gradually sell them to the public for two years following the initial
registration.
• Private Placements:
– The firm using an investment banker sells shares directly to a small
group of institutional and wealthy investors. It is not traded in
secondary market.
• Initial Public Offerings (IPOs)
– With the approval of SEC a prospectus (describing the firm and the
security it is issuing) is circulated for invitation of application for
shares to the public. Shares are subsequently traded in secondary
market.
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3.2 WHERE SECURITIES ARE TRADED
Types of Secondary Markets
• Stock exchanges or auction Market:
– An exchange provides a facility for its members to trade
securities. The membership allows the firm to place one of its
brokers on the floor of exchange where he can execute trades.
The NYSE is by far the largest single exchange. Daily trade
averaged $1.04b. in 2000. Since prices are determined by
bidding from buyers and sellers so the market is also known as
auction market.
• The Over-the-counter Market
– It is not a formal exchange. There is no membership
requirements. Thousands of brokers register with the SEC as
dealers in OTC securities. Security dealers quote prices at
which they are willing to buy and sell securities through a
computer based network. There is a considerable spread
between the bid (purchase) and ask (sell) prices. NASDAC
(National Association of Securities Dealer Automatic Quotation
System) of USA is the famous OTC market of the world where as
much as 35,000 issues are traded.
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3.3 Types of Orders (DSE)
• Based on price: Based on price:
– Market Orders
• Market orders are simply buy and sell orders that are to be executed
immediately at current market prices.
– Limit Orders
• Investors may choose to place a limit order, where they specify prices
at which they are willing to buy or sell a security. If IBM is selling at $98
bid, and $98.10 asked, for example, a limit buy order may instruct the
broker to buy the stock if and when the share price falls below $97.
Similarly, a limit order for sell may be at $99 Ss
• Based on volume:
– Partial Fill:
• executed as much as possible and rest remains otstanding for sell
– Partial fill and kill:
• Executed as much as possible and rest of the order cancelled
– Full fill and kill:
• The entire order would be executed as soon as possible or cancelled.
• Based on validity:
– Good till day
• By default all orders are valid ttill the end of the current day
– Good till date
• The order remains valid over 30 days:
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3.4 MARKET STRUCTURE IN OTHER
COUNTRIES
• London
– Until 1997, London security firms acted both dealers and
brokerage firms. In 1997, the London Stock Exchange introduced
an electronic trading system dubbed SETS (Stock Exchange
Electronic Trading Services) which automatically executes all buy
and sell orders via computer network. Thus it follows
predominantly electronic trading. However, SEAQ (Security
Exchange Automated Quotations) continues to operate for the
“Upstairs Market” in large block transactions or other less liquid
transactions. This is comparable to block market of DSE.
• Euronext was formed in 2000 by merger of the Paris, Amsterdam and
Brussels exchanges. This is an electronic trading system. Investors
can enter their orders directly without contacting their brokers.
• Tokyo Stock Exchange (TSE) is the largest stock exchange in Japan
accounting for about 80% of total trading. There is no specialist
system on the TSE. Instead, a saitori maintains a public limit order
book, matches market and limit orders, and is obliged to follow actions
to slow down market price movements beyond the prescribed limit.
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3.5 TRADING COSTS
• 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
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3.6 BUYING ON MARGIN
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Why do investors buy securities on margin?
• Suppose an investor is bullish on IBM stock, which is selling for $100
per share. He expects the price to go up by 30% in the next year. With
an investment of $10,000 his rate of return would be 30% (ignoring any
dividends).
• Now assume the investor borrows another $10,000 from the broker
and invests in IBM too. Total investment in IBM is now $20,000.
Assuming an interest rate on margin loan of 9% per year, what will be
the rate of return if IBM goes up by 30%?
– The 200 shares will be worth $26,000. Paying off $10,900 of
principal an interest on the margin loan leaves $15,100 (i.e.,
$26,000-$10,900). The rate of return is ($15,100$10,000)/$10,000=51%. This is much higher than the rate of return
without loan.
• What about the downside risk?
• Suppose, instead of going up by 30%, the price of IBM stock goes
down by 30% to $70 per share.
– The 200 share now fetches $14,000. After paying off $10,900 the
investor is left with ($14,000-$10,900)=$3,100. The result is a
disastrous return of ($3,100-$10,000)/$10,000=-69%.
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Buying on Margin
• Using only a portion of the proceeds for an investment
• Borrow remaining component
• Margin arrangements differ for stocks and futures
Balance Sheet
Assets
Value of stock
Liabilities and Owners’ Equity
$7,000 Loan from broker
Equity
$4,000
$3,000
Margin=Equity in account/Value of stock=$3,000/$7,000=43%
What happens if price goes down below $4,000?
Owner’s equity becomes negative. The value no longer is a sufficient
collateral to cover the loan. So, the broker sets a maintenance margin.
If percentage margin falls below the maintenance level, the broker
issue margin call, which requires the investor to add new cash or
securities to the margin account.
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Margin Trading - Initial Conditions
X Corp initial price
50%
40%
1000
$70
Initial Margin
Maintenance Margin
Shares Purchased
Initial Balance Sheet Position:
Stock $70,000 Borrowed $35,000
Equity
35,000
If, 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%
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Margin Trading - Margin Call
How far can the stock price fall before a margin call?
Since, 1000P - Amount Borrowed = Equity,
So:
(1000P - $35,000) / 1000P = 40%
P = $58.33
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3.7 SHORT SALES
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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 it
back to the party from whom it was borrowed
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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
Balance sheet
Liabilities & Owner’s Equity
Assets
Cash
T-bill
$10,000
5,000
Short position
Equity
$10,000
5,000
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Short Sale - Maintenance Margin
If, stock price rises to $110
Sale Proceeds
Initial Margin
Stock Owed
Net Equity
Margin % (4,000/11,000)
$10,000
$ 5,000
$11,000
$ 4,000
36%
Balance Sheet
Liabilities & Owner’s Equity
Assets
Cash
T-bill
$10,000
5,000
Short position
Equity
$11,000
4,000
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Short Sale – Margin Call
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
Balance Sheet
Liabilities & Owner’s Equity
Assets
Cash
T-bill
$10,000
5,000
Short position
Equity
$11,538
3,462
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