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Chapter 3 How Securities Are Traded

Chapter 3 How Securities Are Traded. Topics Covered. How securities are first marketed to the public by investment bankers Underwriters, IPOs – Underpricing, SEOs How and where already-issued securities are traded among investors. Mechanics of trading – specialist vs. dealer markets

Gabriel
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Chapter 3 How Securities Are Traded

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  1. Chapter 3How Securities Are Traded

  2. Topics Covered • How securities are first marketed to the public by investment bankers Underwriters, IPOs – Underpricing, SEOs • How and where already-issued securities are traded among investors. Mechanics of trading – specialist vs. dealer markets Costs of trading – spreads, commissions, Nasdaq controversy on dealer collusion Buying on margin and short selling

  3. Primary vs. secondary security sales • 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.

  4. Primary markets: Public offerings • Public offerings: registered with the SEC and sale is made to the investing public. • Shelf registration (Rule 415, since 1982) • Initial Public Offerings (IPOs) • Evidence of underpricing • Performance

  5. Figure 3.3 Average Initial Returns for IPOs in Various Countries

  6. Figure 3.4 Long-term Relative Performance of Initial Public Offerings

  7. Investment Banking Arrangements • Underwritten vs. Best Efforts • Underwritten: firm commitment on proceeds to the issuing firm. • Best Efforts: no firm commitment. • Negotiated vs. Competitive Bid • Negotiated: issuing firm negotiates terms with investment banker. • Competitive bid: issuer structures the offering and secures bids.

  8. Figure 3.1 Relationship Among a Firm Issuing Securities, the Underwriters and the Public

  9. US primary listing market • New York Stock Exchange (N) • American Stock Exchange (A) • NASDAQ (Q) • Over-the-Counter (OTC) • Nasdaq small cap (S) • OTCBB (U) • Pink Sheets

  10. Primary markets: Private placements • Private placement: sale to a limited number of sophisticated investors not requiring the protection of registration. • Dominated by institutions. • Very active market for debt securities. • Not active for stock offerings.

  11. Organization of secondary markets • Organized exchanges • OTC market • Third market • Fourth market

  12. Trading Mechanisms • Specialists markets (NYSE) • Dealer markets (NASDAQ) • Electronic communication networks (ECNs)

  13. Organized Exchanges • Auction markets with centralized order flow. • Dealership function: can be competitive or assigned by the exchange (Specialists). • Securities: stock, futures contracts, options, and to a lesser extent, bonds. • Examples: NYSE, AMEX, Regionals, CBOE.

  14. NYSE • The NYSE is a hybrid market. It has: • floor traders (like a futures pit) • an electronic limit order book (like Euronext) • a designated dealer (the specialist) to maintain liquidity and otherwise coordinate trading. • This mix is the outcome of political, technological and economic forces over the last 200 years.

  15. Table 3.2 Seat Prices on the NYSE

  16. NYSE NYSE’s MarkeTrac: http://marketrac.nyse.com/mt/

  17. Nasdaq • National Market System • Nasdaq SmallCap Market • Levels of subscribers • Level 1 – inside quotes • Level 2 – receives all quotes but they can’t enter quotes • Level 3 – dealers making markets • SuperMontage • OTC Bulletin Board

  18. Table 3.1 Partial Requirements for Listing on Nasdaq Markets

  19. Table 3.3 Some Initial Listing Requirements for the NYSE

  20. Trading of Exchange-Listed Securities Investor  Broker  Commission Broker or Floor Broker on the exchange  Specialists (Market Maker or Dealer) Each stock is assigned to a specialist. The specialist usually handles several stocks Trading of Nasdaq Securities Investor  Broker  Dealers More than 400 dealer firms A stock is typically handled by 10 –20 dealer firms

  21. US regional exchanges • Pacific Exchange / Archipelago (P) • Chicago (formerly Midwestern) Stock Exchange (M) • Boston Stock Exchange (B) • Philadelphia Stock Exchange (X) • Cincinnati Stock Exchange (C)

  22. Third markets • Trading of listed securities away from the exchange. • Institutional market: to facilitate trades of larger blocks of securities. • Involves services of dealers and brokers

  23. Fourth Market • Trading in exchange-listed stocks within Alternative Trading Systems (ATS), such as ECNs (Instinet, Island, Archipelago) • Institutions trading directly with institutions • No middleman involved in the transaction

  24. Table 3.5 Electronic Computer Networks (ECNs)

  25. Major international stock markets • Europe • London Stock Exchange (LSE) • EuroNext (Paris/Netherlands/Belgium) • Deutsche Borse (DB) • Milan Stock Exchange • Swiss Stock Exchange Stockholm/Copenhagen/Helsinki/Oslo (OM) • Toronto Stock Exchange (TSX)

  26. Asia • Tokyo Stock Exchange (TSE) • Taiwan Stock Exchange • Korean Stock Exchange (KSE) • Australian Stock Exchange (ASX) • Hong Kong Stock Exchange

  27. International market structures • London Stock Exchange • Dealer market similar to NASDAQ • Stock Exchange Automated Quotation • Greater Anonymity • Tokyo Stock Exchange • No market making service • Electronic limit order book • No longer uses Sai-tori or floor trader (since 1999)

  28. Figure 3.7 Dollar Volume of Trading in Major World Markets, 2004

  29. Costs of Trading • 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

  30. Orders and Order Properties

  31. Orders • Orders are instructions to trade that traders give to brokers and exchanges that arrange their trades. • Orders always specify • The security to be traded • The quantity to be traded • The side of the order (buy or sell)

  32. Orders may specify • Price specifications • How long the order is valid • When the order can be executed • Whether they can be partially filled or not

  33. Some important terms 1 • Bid: buy order specifying a price (price is called the bid). • Offer: sell order specifying a price (price is called offer or ask). • Best Bid: standing buy order that bids the highest price bid. • Best offer: standing sell order that has the lowest price offer.

  34. Some important terms 2 • Dealers have an obligation to continuously quote bids and offers, and the associated sizes (number of shares), when they are registered market markers for the stock. • Their quotes also have to be firm during regular market hours.

  35. Some important terms 3 • Public orders with a price limit can also become the market bid or offer if they are at a better price than those currently quoted by a registered market maker. • The market’s best bid and offer constitute the inside market, the best bid/ask, or the BBO. The best bid and offer across all markets trading an instrument is called the NBBO.

  36. Some important terms 4 • The difference between the best offer and the best bid is the bid/ask spread, or the inside spread (touch). • Orders supply liquidity if they give other traders the opportunity to trade. • Orders demand liquidity (immediacy) if they take advantage of the liquidity supplied by other traders’ orders.

  37. What are agency/proprietary orders? • Orders submitted by traders for their own account are proprietary orders. • Broker-dealers and dealers. • Since most traders are unable to directly access the markets, most order are instead agency orders. • Presented by a broker to the market.

  38. Market orders Instruction to trade at the best price currently available in the market. • Immediacy • Buy at ask/sell at bid => pay the bid/ask spread • Price uncertainty • Fills quickly but sometimes at inferior prices.

  39. Used by impatient traders and traders who want to be sure that they will trade. It is usually thought that insiders use that type of order. • When submitting a market order execution is nearly certain but the execution price is uncertain. • Takes liquidity from the market in terms of immediacy. They then pay a price for immediacy which is the bid-ask spread.

  40. Market order: Example 1 Suppose that the quote is 20 bid, 24 offered. Suppose that the best estimate of the true value of the security is 22. • A market buy order would be executed at 24 for a security worth 22. • The price paid would be 24 and therefore the price of immediacy would then be 2.

  41. Market order: Example 2 • A market sell order would be executed at 20 for a security worth 22. • The price received would be 20 and therefore the price of immediacy would then be 2. • The price of immediacy is the bid-ask spread.

  42. Price improvement • Price improvement is when a trader is willing to step up and offer a better price than that of the prevailing quotes (at order arrival). • Who benefits from price improvement? • Who loses from price improvement?

  43. Market impact • Large market orders tend to move prices. • Liquidity might not be sufficient at the inside quotes for large orders to fill at the best price. • Prices might move further following the trade. • Information and liquidity reasons.

  44. Market impact: Example • For example, suppose that a 10K share market buy order arrives in IBM and the best offer is $100 for 5K shares. • Half the order will fill at $100, but the next 5K will have to fill at the next price in the book, say at $100.02 (where we assume that there is also 5K offered). • The volume-weighted average price for the order will be $100.01, which is larger than $100.00.

  45. Limit orders • A limit order is an instruction to trade at the best price available, but only if it is no worse than the limit price specified by the trader. • For a limit buy order, the limit price specifies a maximum price. • For a limit sell order, the limit price specifies a minimum price.

  46. Limit orders: Examples • If you submit a limit buy order for 100 shares (round lot) of Dell with limit price of $20. This means that you do not want to buy those 100 shares of Dell at a price above $20. • If you submit a limit sell order for 100 shares (round lot) of Dell with limit price of $24. This means that you do not want to sell those 100 shares of Dell at a price below $24.

  47. If the limit order is executable (marketable), than the broker (or an exchange) will fill the order right away. • If the order is not executable, the order will be a standing offer to trade. • Waiting for incoming order to obtain a fill. • Cancel the order. • Standing orders are placed in a file called a limit order book.

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