CHAPTER 3

1. CHAPTER 3 Securities Markets

2. 3.1 HOW FIRMS ISSUE SECURITIES

3. 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

4. How Securities Are Issued • Investment Banking • Shelf Registration • Private Placements • Initial Public Offerings (IPOs)

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

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

7. Figure 3.2 A Tombstone Advertisement

8. Shelf Registrations • SEC Rule 415 • Introduced in 1982 • Ready to be issued – on the shelf • Allows firms to register securities and gradually sell them to the public for two years following the initial registration

9. Private Placements Private placement: sale to a limited number of sophisticated investors not requiring the protection of registration • Allowed under Rule 144A • Dominated by institutions; suitable for smaller offerings; less expensive to issuer • Very active market for debt securities • Not active for stock offerings

10. Initial Public Offerings • Process • Road shows (generate interest; provide info on prices the offering might command) • Bookbuilding (indications of interest) • Underpricing • Post-sale returns (median 1-day return, NASDAQ, 1997-02, was 17.8%) • An added cost to the issuing firm (over and above the explicit cost about 7%)

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

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

13. 3.2 HOW SECURITIES ARE TRADED

14. Types of Secondary Markets • Direct search (e.g. newspaper want-ads) • Brokered (e.g. real estate brokers) • Dealer (e.g. OTC securities market) • Auction (e.g. NYSE)

15. Types of Orders • Market—executed immediately • Bid Price • Ask Price • Price-contingent • Investors specify prices • Stop orders

16. Limit Orders Name a Limit Price Limit-Buy Order: Buy if Market Price is Below Limit Price Limit-Sell Order: Sell if Market Price is Above Limit Price Stop-Loss Orders Name a Limit Price Stop-Loss Order: Sell if Market Price is Below Limit Price Stop-Buy Order: Buy if Market Price is Above Limit Price Price-Contingent Orders

17. Figure 3.5 Limit Order Book for Intel on Archipelago

18. Figure 3.6 Price-Contingent Orders

19. Trading Mechanisms • Dealer markets (e.g. OTC markets; dealers quote prices for buy/sell) • Electronic communication networks or ECNs (traders post market and limit orders over computer networks; orders matched without broker) • Specialists markets (e.g. NYSE; trade in a security managed by specialist; specialist may act as dealer and as broker)

20. 3.3 U.S. SECURITIES MARKETS

21. U.S. Security Markets • Nasdaq • Small stock OTC • Pink sheets • Organized Exchanges • New York Stock Exchange • American Stock Exchange • Regionals • Electronic Communication Networks (ECNs)

22. Nasdaq • Nasdaq Global Select Market • Nasdaq Global Market • Nasdaq Capital Market • Small stock OTC • Pink sheets

23. New York Stock Exchange • Largest exchange in the U.S. • Automated for small orders • Member functions • Commission brokers • Floor brokers; takes orders to specialist’s post • Specialists

24. New York Stock Exchange • Now a publicly held company • Block sales • SuperDot (electronic order routing system; allows firms to send market and limit orders directly to the specialist) • Bond Trading • 2006 NYSE obtained approval to expand bond trading • May provide OTH dealer market in bonds

25. Other Exchanges and Trading Systems • American Stock Exchange (AMEX) • Regionals • Electronic Communication Networks (ECNs) • National Market System

26. 3.4 MARKET STRUCTURE IN OTHER COUNTRIES

27. Other Countries • London - predominately electronic trading • Euronext – market formed by combination of the Paris, Amsterdam and Brussels exchanges • Tokyo Stock Exchange (saitori maintains public limit order book; tries to slow down large price changes; does not trade from own account)

28. Figure 3.7 Market Capitalization of Listed Firms, 2005

29. 3.5 TRADING COSTS

30. 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

31. 3.6 BUYING ON MARGIN

32. Buying on Margin • Using only a portion of the proceeds for an investment • Borrow remaining component • Margin arrangements differ for stocks and futures

33. Buying on Margin • 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

34. Margin Trading - Initial Conditions 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

35. Margin Trading - Maintenance Margin 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%

36. Margin Trading - Margin Call How far can the stock price fall before amargin call? Since 1000P - Amt Borrowed = Equity then: (1000P - $35,000) / 1000P = 40% P = $58.33

37. 3.7 SHORT SALES

38. 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 to the party from which is was borrowed

39. Short Sale - Initial Conditions Z Corp 100 Shares  First borrow 100 shares, then sell them. 50% Initial Margin 30% Maintenance Margin $100 Initial Price Sale Proceeds: $10,000 Margin & Equity: 5,000 Initial Margin: $5,000/$10,000 = 50% Value of Stock Owed $10,000

40. Short Sale - Maintenance Margin Stock Price Rises to $110 Sale Proceeds $10,000 Initial Margin (T-Bills?) 5,000 Value of Stock Owed $11,000 Margin (5,000 – 1,000) 4,000 Margin % (4,000/11,000) 36%

41. 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

42. 3.8 REGULATION OF SECURITIES MARKETS

43. Major Regulations • Securities Acts of 1933 • Securities Acts of 1934 • Securities Investor Protection Act of 1970

44. Self-Regulation • National Association of Securities Dealers (NASD) • Oversees participants in the Nasdaq market • NYSE has its own regulatory arm

45. Regulation Response to Recent Scandals • Sarbanes-Oxley Act

46. Circuit Breakers • Trading halts: If DJIA falls by 10%, trading halted fro 1 hour (prior to 2:00 pm.) or ½ hour (between 2 and 2:30 pm) or not at all (after 2:30 pm.) If DJIA falls 20%, trading halted for 2 hours (before 1:00), 1 hour (between 1:00 and 2:00), rest of day (after 2:00). If DJIA falls by 30%, market closed rest of day. • Collars: When Dow moves -2% from prior day’s close, Rule 80A of NYSE requires that index arbitrage orders pass a “tick test”. In a falling market, sell orders executed only on a plus tick or, if last price was an uptick, at the last price.

47. Insider Trading • Illegal • Definition of insiders can be ambiguous • SEC’s Official Summary of Securities Transactions and Holdings