Chapter 4
Securities Markets
Learning Objectives
• Distinguish between primary and secondary
markets.
• Describe how the equity markets are organized
and how they operate.
• Explain what we mean by the third and fourth
markets.
• State the major stock market indicators.
• Describe, briefly, the bond and derivatives
markets.
• Discuss the factors behind rapid change in the
securities markets
Importance of Financial Markets
• Help firms and governments raise cash by selling
securities
• Allow investors with excess funds to invest and
earn a return
• Channel funds from savers to borrowers
• Allocate resources optimally (i.e., provide funds to
those who can make the best use of them)
• Help allocate cash to where it is most productive
• Help lower the cost of exchange
• Secondary markets, where investors trade existing
securities, assures investors that they can quickly
sell their securities if the need arises
Primary Markets
• The market for new issues of securities, such as
government T-bills or a corporation’s stocks or
bonds.
• The issuers of the securities receive cash from the
buyers who, in turn, receive financial claims on the
issuing organization.
• Issue facilitated by investment dealers


Specialists in advice, design, and sales
Intermediaries between issuer and investor
Primary Markets
• New securities are issued in a primary market

Initial public offering (IPO) versus “seasoned” new
issue
• IPO – Common stock shares of a company being
sold for the first time
• Seasoned new issue – Sales of common stock of
a publicly traded company
• New securities maybe traded repeatedly in the
secondary market, but the original issuers will be
unaffected
Primary Markets
Firms issue securities when they have good uses for
the funds and the market price is high
Example:
• In response to high stock market price levels,
during 2000, the TSX set a record of $5.4 billion
raised by initial public offerings (IPOs)
• The IPO activity declined to $1.57 billion in 2001,
then to $0.96 billion in 2002, before recovering
slightly in 2003 to $1.09 billion
Primary Markets
• Pricing of IPOs is a complex and important decision
• Firms do not want to set their price too low since a
higher price means that less shares have to be
issued to raise the same amount of capital
• Firms do not want to overprice the issue and have it
“undersubscribed,” thus not raising the required
funds
• Example: During Jan. 2000, 724 Solutions Inc.,
went public at $37 a share. The shares closed their
first day of trading at three times the issue price
($111), and then skyrocketed to $345 before falling
back to the $55 range by October 2000
Primary Markets
• There is substantial Canadian, US, and global
evidence that, on average, IPOs are underpriced.
• Underpricing is measured as:
(first trading day closing price – issue price) / issue price
Example
For the 724 Solutions Inc. example the underpricing
is equal to
(111 – 37) / 37 = 200%
Investment Dealers
• An Investment Dealer is an organization
specializing in the sale of new securities, usually by
purchasing the issue and reselling it to the public.
• Known as Investment Bankers in the US.
• Investment dealers act as intermediaries between
issuers and investors.
• Provide important information to their clients:
1- the type of security to be sold
2- the features to be offered with the security
3- the timing of the sale
4- the offer price
Investment Dealers
• Investment dealers specialize in the design and sale
of securities in the primary market while operating
simultaneously in the secondary markets.
• Underwriting services: Risk of selling the new
securities to investors is assumed from issuer.
• The new securities are purchased from the issuer at
a discount
• Investment dealers are compensated by a spread,
which is the difference between what they pay the
issuer for the securities and what they sell them for
to the public.
Investment Dealers
• Coordinate marketing by helping issuer register
securities, issue prospectus, and sell securities
• All public offerings are regulated by the Canadian
Business Corporations Act (CBCA) and provincial
securities regulations. They require a prospectus to
be prepared.
• A prospectus is a legal document which contains:
1- relevant financial statements
2- proposed use of funds from the issue
3- future growth plans
4- relevant information regarding the share issue
Underwriting
• Services provided by underwriters
 Formulate method used to issue securities
 Price the securities
 Sell the securities
• Syndicate – group of underwriters that market
the securities and share the risk associated with
selling the issue
• Spread – difference between what the syndicate
pays the company and what the security sells for
in the market
Firm Commitment Underwriting
•
•
•
•
Also called a “bought deal”
Issuer sells entire issue to underwriting syndicate
The syndicate then resells the issue to the public
The underwriter makes money on the spread
between the price paid to the issuer and the price
received from investors when the stock is sold
• The syndicate bears the risk of not being able to
sell the entire issue for more than the cost
• Most common type of underwriting in Canada
Best Efforts Underwriting
• Underwriter sells as much of the issue as possible,
but can return any unsold shares to the issuer
without financial responsibility
• Underwriter must make their “best effort” to sell the
securities at an agreed-upon offering price
• The company bears the risk of the issue not being
sold
• The offer may be pulled if there is not enough
interest at the offer price. In this situation, the
company does not get the capital and they have still
incurred substantial flotation costs
Underwriting Process
•
•
•
The issuing company sell the securities to
the financing group (also known as
managing underwriters or syndicate
managers) which consists of one or two
firms
The financing group sells the securities to
the marketing group at a “draw down” price
The securities are distributed for sale to the
public
Issuance of Securities
• Prompt Offering Qualification (POP) System:
allows qualifying senior reporting issuers to sell new
securities over time via “short form” prospectuses in
lieu of full ones
• Senior reporting issuers qualify if they have made prior
public distributions and are subject to continuous
disclosure requirements
• The rationale is that there is already a great deal of
information available on the company that would
normally be included in the prospectus
• Short form prospectuses save issuers a great deal of
time and money, and generally focus on price,
distribution spread, use of proceeds, and security
attributes
Issuance of Securities
• Listing Process:
- New share issues are usually traded over-thecounter (OTC) and are considered for listing on an
exchange only after proof of satisfactory distribution
is available
Issuance of Securities
• Global Security Issues:
- The global perspective allows companies to raise
capital in amounts that would have been impossible
only a few years earlier because they were limited to
selling securities in their own domestic markets
- Many Canadian companies issue bonds in the US and
Europe.
- A number of Canadian companies are “interlisted” on
more than one stock market, primarily markets in the
US, such as Nasdaq or the NYSE.
- The motivation for Canadian firms to do so is to
increase its stock’s potential market and enhance its
visibility
Issuance of Securities
• Private Placements:
- A private placement means new security issues
are sold directly to a small group of institutional
investors, such as insurance companies and
pension funds, thus bypassing the open market
- Advantage: Registration not required (i.e., the firm
does not have to prepare a full prospectus)
- Disadvantage: higher interest costs because the
financial institutions usually require a higher
return than would be required for a public
subscription
Secondary Markets
• Markets where investors trade previously
issued securities
• Exist for the trading of common stocks,
preferred stocks, warrants, bonds, put and call
options.
Auction Markets
• Auction markets involve bidding (auction
process) in a specific physical location, such as
the TSX. The bidding determines the security
prices.

Brokers represent investors (both buyers and
sellers) for a fee
Canadian Stock Exchanges
• At the start of 1999 there were five stock exchanges in
Canada





Toronto Stock Exchange (TSX)
Montreal Exchange (ME)
Vancouver Stock Exchange (VSE)
Winnipeg Stock Exchange (WSE)
Alberta Stock Exchange
• A restructuring occurred in 1999 and 2000 and now
there are two stock exchanges in Canada TSX and
TSX Venture Exchange
• Since 2000 the Bourse de Montreal has become the
Canadian national derivatives market
Canadian Stock Exchanges
• Toronto Stock Exchange (TSX) is a secondary
auction market for equity securities


Largest Canadian stock market
Listing requirements for traded firms are more
stringent than the listing requirements on the TSX
Venture Exchange and exclude smaller companies
• TSX Venture Exchange is Canada’s “junior” stock
market


Provides the economy with a capital-raising
infrastructure for small and medium size businesses
Listed companies are active in technology, oil & gas,
mining, and financial services
New York Stock Exchange (NYSE)
• Is the largest secondary market in the world based on
trading volume and on the market capitalization of its
firms
• Regarded as the best regulated exchange in the world
and has proven its ability to function in crisis (e.g.,
Black Monday in Oct. 1987)
• A not-for-profit corporation and has about 400 members
• Members are usually partners or directors of
stockbrokerage houses and some own several seats
(e.g., Merrill Lynch owns over 20 seats)
New York Stock Exchange (NYSE)
• Due to stringent listing requirements in the NYSE
compared to TSX, only the largest Canadian
companies are able to list their shares on NYSE
(Table 4.2 pg 100)
• Exchange participants



market specialists (are exchange members who are
responsible for maintaining an orderly market in one or
more stocks by buying or selling shares from their
accounts)
floor brokers (represent public orders to buy or sell
shares and work to get their customers the best price,
either independent or house floor brokers)
registered traders
New York Stock Exchange (NYSE)
• Major roles of NYSE specialist

Dealer (an individual or a firm that makes a market in
a stock by buying from and selling to investors)
 Agent
 Catalyst
 Auctioneer
Stock Exchanges
• Formal organizations approved and regulated
by the SEC (or the provincial securities
commissions such as the OSC in Canada)
• Members


Can only trade listed stocks
Must buy a seat on the exchange in order to be
permitted to trade on the exchange
• Exchange member firms must be publicly
owned, maintain adequate capital
requirements, and key personnel must
complete required courses
Stock Exchanges
• Exchanges qualify as non-profit associations and
are not subject to corporate income tax.
• Exchanges have the power to suspend trading or
listing privileges of an individual security
temporarily or permanently
• Listing requirements
 minimum capitalization, shareholder equity,
average closing share price, etc.
General Exchange Initial Listing
Requirements (specifics may vary)
Standard
NYSE
Distribution
a) 2,000
round lot
holders
b) 1.1m
public
shares
Market Value
$100m
(public shares)
TSX
Nasdaq
(NM)
Nasdaq
(Sm. Cap)
a) 300 board
lot holders
b) 1m public
shares
a) 400 round
lot owners
b) 1.1m
a) 300 round
lot owners
b) 1m
$4m Cdn.
$75m
(or Total
Assets or
Total Sales >
$75m)
$50m
(or Stock
Equity >$5m
or Net Income
>$0.75m)
General Exchange Initial Listing
Requirements (cont’d)
Standard
NYSE
TSX
Nasdaq
(NM)
Nasdaq
(Sm. Cap)
Before-Tax
Earnings
from
Continuing
Operations
$6.5 m over
past 3
years:$2.5m
last year +
($2m/ $2m),
OR
$4.5m last
year and pos.
all 3 years
For Senior
Industrial
Companies:
$300,000 CDN
last year
$1m last
year (or in 2
of last 3
years)
$0.75m Net
Income
(or $5m Equity
or $50m Mkt.
Value)
Cash Flow
$25m
Operating
Cash Flow
over last 3
years
Pre-Tax CF
$0.7m last year
and prior 2-year
average
($0.5m)
N/A
N/A
Over-the-Counter (OTC) Markets
• OTC markets do not have a physical location but
consist of a network of dealers standing ready to either
buy or sell securities at specified prices over the phone
or over a computer network


Dealers profit from spread between buy and sell prices
Handle unlisted securities
• Canadian OTC stocks are trading on the TSX Venture
Exchange


More speculative in nature than exchanges
Low trading volume and few bids or offers (“thin” or
illiquid market)
• US OTC Market: NASDAQ
Over-the-Counter (OTC) Markets
• Trading unlisted stocks
• Nasdaq stock market: consists of a network of
market makers or dealers who compete with
each other through an electronic network of
terminals
• Nasdaq market makers conduct transactions
directly with each other and with customers
• Each Nasdaq company has a number of
competing dealers who make a market in the
stock, with a minimum of 2 and an average of 11
dealers
Over-the-Counter (OTC) Markets
• Nasdaq market tiers

Nasdaq National Market (3,600 co.’s)

Small Capitalization Market (850 co.’s)
• Other OTC markets (8,000 co.’s)

OTC Bulletin Board
 “Pink Sheets” market
 Both are markets for very “thinly” traded securities, many
of which trade infrequently
- Stocks traded on Nasdaq vary widely in size, price,
quality, and trading activity. They range from small startups to companies like Microsoft and Intel
Third and Fourth Markets
• Third Market:


An OTC market for trading in securities listed on
organized exchanges
Used in the US for extremely large transactions to
avoid minimum exchange-regulated commission
fees
• Fourth market:



Trading network among investors interested in
buying and selling large blocks of stock
Brokers, dealers bypassed so costs are low
Electronic or telephone network
Trading
After-Hours Trading:
• Electronic Communications Networks (ECNs)
allow investors to trade after exchange hours
(4 to 8 P.M. EST, and sometimes early in the
morning)
• Limitations may exist on the types of orders
that are placed and the size of orders
• In 2001, less than half of the on-line brokerage
firms allowed their customers this option
Trading
In-House Trading:
• Also called internal trading, is trading by fund
managers without the use of a broker or an
exchange
• This new trend has significant implications for the
NYSE (handles about 5% of its trading volume)
• For example, Fidelity Investments, one of the
largest mutual fund companies, operates an inhouse trading system for its own funds.
International Equity Markets
• Toronto Stock Exchange is the eighth-largest
stock exchange in the world

Many different equity markets exist
• Emerging markets


Generally less regulation and standardization of
trading activity
Risks: Illiquidity, lack of information, political
uncertainty
Equity Market Indicators
• Provide a composite report of market behavior on a
given day to answer the question “What did the
market do today?”
• An “index” is a series of numbers that represent a
combination of stock prices in such a manner that
percentage changes in this series can be calculated
over time. Used mainly for performance
comparisons
• An “average” is similar to an index but is composed
of equally-weighted items.
Equity Market Indicators (cdn)
• S&P/TSX Composite Index




Market value (capitalization) weighted index that
measures market activity of stocks listed on the
TSX
In 2004, comprised of 223 companies
representing almost 70 per cent of the market
capitalization
Stocks included on this index are reviewed on a
quarterly basis
Has a base level of 1,000
Equity Market Indicators (cdn)
• S&P/TSX 60 Index



Designed to mimic the performance of the
S&P/TSX composite Index
Index has a base value of 100
Stocks represent 60 of the largest and most
actively traded stocks comprising the S&P/TSX
Composite Index
Equity Market Indicators (US)
• Dow Jones Industrial Average (DJIA)




Most widely quoted measure of NYSE stock
performance
Composed of 30 “blue-chip” stocks that trade on the
NYSE and Nasdaq
Price weighted (i.e., is affected more by changes in
higher priced stocks)
Is calculated by adding the prices of the 30 stocks
together and dividing by a divisor (less than 1,
0.1458 in 2003)
DJIA = ∑ P/n
Equity Market Indicators (US)
• S&P 500 Composite Index




Composed of 500 “large” firm stocks
Consists primarily of NYSE stocks
Market value weighted index that measures US
stock performance
Broader measure than the DJIA
• Nikkei 225 Average (Japan)

Price weighted index of 225 actively-traded stocks
on the Tokyo Stock Exchange
Bond Markets





Investors can purchase either new bonds being issued in
the primary market or existing bonds in the secondary
market
Secondary bond market is primarily an over-the-counter
(OTC) market
Government of Canada bonds actively trade in dealer
markets
Corporate bonds are not as actively traded as
government issues since about 40% of corporate bonds
are held by institutional investors
Government bonds comprise about 73% of the Canadian
bond market with Government of Canada bonds
representing the major component
Market Developments
• Growth of institutional trading

Block trading of stocks (transactions of at least
10,000 shares or $100,000 in value)
•


Affects market structure and operation
Block trading now accounts for more than half
of all TSX and NYSE trading volume
Negotiated, not fixed, commissions
Market Developments
• Globalization of securities markets




24-hour trading
Instinet is an electronic trading mechanism that
allows institutional investors to trade with each
other electronically at any hour
Instinet provides investors privacy and low trading
costs because regular brokerage fees do not
have to be paid
Institutions are able to negotiate prices
electronically with each other
Appendix 4-A
Stock Market Indexes
• S&P/TSX Composite Index
 Pit Qit
S & P / TSX 
(k )
 PibQib
• Dow Jones Industrial Average
DJIAt   Pit / n
*
Price Weighted Indexes
•
•
 Arithmetic average of current prices
 Assumes you purchase an equal number
shares of each stock represented in the index
 e.g., DJIA, Nikkei 225
Problems:
 Must adjust denominator downward for
splits
 Stocks with higher prices have greater
influence
PWI = [  of stock prices ] / [number of stocks
in index]
Value Weighted Indexes
•
•
 Total value (mkt. cap.) of all stocks in the
index
 Assumes you make a proportionate market
value investment in each company in the index
 e.g., S&P 500/ NYSE indexes
Problem:  Market Cap.,  impact on index
MVW = [ (Price today) (number of shares) /
(Price base) (number of Shares)] (Index Value
BEG)
Equal Weighted Indexes
•
 Unweighted index (e.g. Value-Line
Composite Average, Financial Times Index –
LSE)
 Assumed the investor makes an equal dollar
investment in each stock in the index
 Geometric average or arithmetic average
Problem:
 GA leads to downward bias since GA<AA