Salaar - Finance
Capital Markets
Winter Semester 2009
Lahore School of Economics
Salaar Farooq – Assistant Professor
Salaar - Finance
Securities Firms
&
Investment banks
Lecture
Salaar - Finance
Securities Firms &
Investment Banks
Learning Objectives
 Underwriting?
 Broker-dealer-IPO’s
 Investment Banking?
 Secondary markets?
 Mechanics of Markets?
Salaar - Finance
Primary Markets
Learning Objectives
 What are Primary Markets & IPO’s?
 What is an Investment Banker?
 How securities are issued: Process?
 What is Arbitrage?
 What are private placements?
 What are some SEC regulations?
 World Capital Mkts considerations
Salaar - Finance
Financial Markets?
Primary Markets
Primary Market
Initial Public Offering (IPO)
Salaar - Finance
Financial Markets?
Primary Markets
Primary Market
Market for new issues of securities (investment bankers)
Issuers receive funds (raise capital)
Buyers receive financial claims
Initial Public Offering (IPO)
Process of initial sale of new securities
After initial sale, securities trade in the secondary markets
Salaar - Finance
Financial Markets?
Investment Banker
Investment Banker
Firm specializing in the sale of new securities to the public
Key Role of Investment Banks
Assist in obtaining funds for Corporations, Govts, & Foreign Entities.
And for Investors, act as brokers or dealers in buying & selling securities.
Salaar - Finance
INVESTMENT BANKERS
• Specialize in design & sale of securities in the primary market
• Work with issuers to bring a new issue of securities to market—
legal, accounting, pricing, and so forth
• Involved in other matters, such as advising firms on mergers and
acquisitions, or reorganizations
Salaar - Finance
INVESTMENT BANKING
• Investment bankers form a syndicate to sell new securities-multiple investment bankers working together
• Investment bankers underwrite an issue,
purchasing securities from issuer & assuming risk of reselling
• Investment bankers profit from the spread between
price they pay & price they sell the issue
Salaar - Finance
Financial Markets?
Investment Banking
Performed by 2 groups:
Securities Firms
Firm specializing in the distribution of new securities to the public &
also in secondary mkts as brokers & dealers
Commercial Banks
Also underwrite securities.
Salaar - Finance
Investment Banking
How they make money?
Commissions
Fees
Spread Income
Also from:
Money management
Mergers & Acquisitions
Trading of securities etc.
Salaar - Finance
Financial Markets?
Investment Banker
Investment Banker
Firm specializing in the sale of new securities to the public
Underwriting – Buying of securities from issuer
Process by which investment bankers purchase an issue of securities from a firm
and resell it to the public
PROSPECTUS: Provides info about the IPO to the customers
Salaar - Finance
Financial Markets?
Under-writing Process
3 Main Areas:
1.
Advising the issuer on terms & timing of offering
2.
Buying Securities from issuer
3.
Distributing the securities to public
Salaar - Finance
Financial Markets?
Under-writing Process
Buying securities:
Firm Commitment:
Investment Bank agrees to buy from issuer at fixed price
Best efforts under-writing
When the IB does not buy the securities but provides expertise
Gross Spread – Discount (4-7%)
Difference b/w price paid to issuer & price received from public
Salaar - Finance
issuer
Originating investment banker
Underwriting Syndicate (group of invest bankers)
MARKETING MUSCLE CRITICAL
Selling group (syndicate + selected retail brokers)
INVESTORS BUYING IN PRIMARY MKT
Salaar - Finance
Privatization?
Salaar - Finance
Privatization?
 Offering securities of Govt owned companies to public…
 Thereby liquidating Govt ownership
 Also performed by Investment Banks
Salaar - Finance
Arbitrage?
Another activity of Investment Banks
Salaar - Finance
Arbitrage?
Another activity of Investment Banks
Trading discrepancies in same security at different locations…
Example…
JNJ at 51.83-.90 in NY
JNJ at 51.95-99 in LDN
Locking a profit with no risk
Salaar - Finance
Financial Markets?
Global Investment Banking &
Private Placements
Global Investment Banker
Private Placements
Salaar - Finance
Financial Markets?
Global Investment Banking &
Private Placements
Global Investment Banker
Firm specializing in the sale of new international securities to the
public
Private Placements
Securities are issued directly to financial institutions bypassing the open market.
- typically insurance, pension funds and investment companies

No SEC filing required

Investment banking fees is saved
Salaar - Finance
OTHER PRIMARY MARKET ISSUES
• Investment banking is a global operation now,
…as firms raise capital around the world in order to reduce
costs
Salaar - Finance
Financial Markets?
Regulation of Issuance of Securities
Underwriting is regulated by the SEC
Some rules:
 Registration statement of intent to issue
Part I: Prospectus
Part II: Supplemental Info
 Responsibility of Due Diligence is with underwriter
 Shelf Registration rule : can sell in the market (not allowed before)
Salaar - Finance
Continued…
Regulation of Issuance of Securities
Underwriting is regulated by the SEC
Some rules:
 Continued Reporting
 Rule 144A:
Privately placed securities CAN be sold immediately
(not allowed before)
Salaar - Finance
Raising Capital outside domestic market
4 main reasons:
Salaar - Finance
Raising Capital outside domestic market
4 main reasons:
1. Local market may not be large enough
2. Reduced cost of funding
3. To diversify source of funding
4. To manage foreign exchange risks
Salaar - Finance
Financial Markets?
Secondary Markets
Markets where existing securities are traded
For investments to be attractive…
they must have…
“LIQUIDITY” & SECONDARY markets provide that
Salaar - Finance
Financial Markets?
Secondary Markets
Function of Secondary Markets?
Salaar - Finance
Financial Markets?
Secondary Markets
Function of Secondary Markets
 Provides info on Value of Security
 Indicates Consensus price
 Shows how well the Firm is using funds
 Gives an idea of how NEW issues would be received
 Provides Liquidity to the markets
 Allows for investments to change ownership easily
Salaar - Finance
Financial Markets?
US Securities Markets for Equities
Where are these exchanges?
Equity
NYSE
AMEX
NASDAQ
ECN’S
KSE
BONDS
NYSE & AMEX Bond markets
Salaar - Finance
Financial Markets?
US Securities Markets for Equities
Equity
NYSE (New York Stock Exchange)
AMEX (American Stock Exchange)
NASDAQ (National Association of Securities Dealers)
ECN’S (Electronic Communications Network)
KSE (Karachi!)
BONDS
NYSE & AMEX Bond markets
Salaar - Finance
Financial Markets?
US Securities Markets for Equities
Equity
NYSE – 1366 seats (1.5mil$)-2800 co’s valued 13 trillion-Dvol 1.5Bil
AMEX – 807 seats – 760 companies – 2% of ttl value – 200mil vol
NASDAQ- 3843 co’s – 1bil vol – computerized mkt network
ECN’S (Electronic Communications Network)-linked to all
OTC – Not listed but registered, 3000 co’s – dealer network linked
KSE: 200 seats, 163 active, 658 co’s, 35B MCap, 350m! vol, 100 co’s =90% Mcap
BONDS
NYSE & AMEX Bond markets
Salaar - Finance
Perfect Markets?
Conditions Required?
Salaar - Finance
Perfect Markets?
Conditions Required
1.
Large no. of buyers & sellers & no one is significant. (LIQUIDITY)
2.
Everyone is a price taker
3.
Price is determined by pure Supply-Demand
4.
No frictions exist (COSTS)
Frictions
Costs & barriers to affecting Buyers/sellers payoffs
Eg.
Commisions
Bid-ask spreads
Taxes etc
Salaar - Finance
Financial Markets?
Securities Markets for Equities
Bid price
Offer Price
Block trades
Program trading
Salaar - Finance
Financial Markets?
Securities Markets for Equities
Bid price
Px some one will buy for
Offer Price
Px someone will sell for
Block trades
Trades of 10,000 or more
Program trading
Computer generated buy & sell signals for $1 mil or more
Salaar - Finance
Financial Markets?
Securities Markets for Equities
OTC (Over the counter mkts)
ECN’s
After Hours Trading
Salaar - Finance
Financial Markets?
Securities Markets for Equities
OTC (Over the counter mkts)
Stocks not listed on an exchange but traded on closed computer networks
ECN’s
Computerized trading network for large traders & brokers – computer matched orders
After Hours Trading
Normal hrs: 9.30 – 1600
AHT hrs: 1600-2000
Salaar - Finance
Financial Markets?
Securities Markets for Equities
Dow Jones Industrial Average
Standard & Poor’s (S&P 500)
Nasdaq
Salaar - Finance
Financial Markets?
Securities Markets for Equities
Dow Jones Industrial Average
30 Blue chip stocks – stock price weighted average
Standard & Poor’s (S&P 500)
500 stock composite
Nasdaq
100 Large cap companies
Salaar - Finance
KSE 30
Salaar - Finance
Brokerags vs Dealers?
 Brokers = middle-men
 Dealers = shopkeepers (MARKET MAKERS)
Salaar - Finance
Brokerage Firms
 Full Service Brokers
 Discount Brokers
 Online Discount Brokers
Salaar - Finance
Brokerage Firms
 Full Service Brokers
Offer Full Range of services including info and advice.
 Discount Brokers
offers execution services
 Online Discount Brokers
offers platforms on the net
Salaar - Finance
Types of Brokerage Accounts
 Cash Account
 Margin Account
 Asset Management Account
 Wrap Account
 Commissions
 Drip (Dividend Reinvestment Plan)
Salaar - Finance
Types of Brokerage Accounts
 Cash Account
Only cash transactions
 Margin Account
Allows cash and debt transactions
 Asset Management Account
Offers investment of cash balances and Cheque writing
 Wrap Account
all fees are wrapped into one
 Commissions
 Drip (Dividend Reinvestment Plan)
free reinvestment by companies
 DOLLAR COST AVERAGING - illustrate
Salaar - Finance
How Orders Work
 Organize Exchanges (NYSE, NASDAQ)
 Super Dot (NYSE)
 NASDAQ System of dealers
 Decimalization of stock prices
Salaar - Finance
How Orders Work
 Organize Exchanges (NYSE, NASDAQ)
 Super Dot (NYSE)
Electronic system for NYSE
 NASDAQ System of dealers
Through computer market making firms
 Decimalization of stock prices
Jan 2001 stocks were decimalized, average spread five cents (NOW 1c)
Salaar - Finance
Types of Orders
 Market Order
 Limit Order
 Stock Order
Salaar - Finance
Types of Orders
 Market Order
Best price on the floor – ENSURES EXECUTION NOT PX
 Limit Order (new position)
specified or better price – ENSURES PX – NOT EXECUTION
 Stop Order (existing position)
Automatic execution at specified price
 BUY STOP – PROTECTS PROFITS
 SELL STOPS – PROTECT LOSSES
Salaar - Finance
Investor Protection
 Government Regulation
 SEC
 Self Regulation
 NASD
Salaar - Finance
Investor Protection
 Government Regulation
 SEC
1934
 Self Regulation
stock exchanges monitor and regulate
 NASD
Also monitor
Salaar - Finance
Margin
 Margin
 Initial Margin
 Maintenance Margin
 Margin Call
Salaar - Finance
Margin (Leveraged Positions)
 Margin
part of transaction value which is customers equity
 Initial Margin
the part the customer must pay to initiate a transaction – 50%
 Maintenance Margin
%age of securities value which must be on hand as equity – 25%
 Margin Call
demand from broker for cash if actual M < maintenance M
Salaar - Finance
Margin
 Margin
part of transaction value which is customers equity
 Initial Margin
amount investor puts up / value of transaction
 Maintenance Margin
%age of securities value which must be on hand as equity
 Margin Call
MARKED TO MARKET EVERYDAY
 Actual margin =
(current value of stock – amount borrowed) / current value
Salaar - Finance
Short Sales
 Being Long
 Being Short
 Short Sale
 Short Interest Ratio
Salaar - Finance
Short Sales
 Being Long
normal position of buying stock
 Being Short
having sold stock not owned
 Short Sale
selling stock not owned but borrowed
 Short Interest Ratio
shares short to average daily volume
Salaar - Finance
Market Efficiency
Markets absorb & reflect all new information
into security prices
Salaar - Finance
Securities Firms &
Investment Banks
Learning Objectives
 Underwriting?
 Broker-dealer-IPO’s
 Investment Banking?
 Secondary markets?
 Mechanics of Markets?