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CHAPTER 3

CHAPTER 3. Securities Markets. The Goals of Chapter 3. How to issue securities Describe the role of investment bankers in the underwriting process How to trade securities Introduce various types of security markets, e.g., dealer, specialist, or electronic network markets

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CHAPTER 3

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  1. CHAPTER 3 Securities Markets

  2. The Goals of Chapter 3 • How to issue securities • Describe the role of investment bankers in the underwriting process • How to trade securities • Introduce various types of security markets, e.g., dealer, specialist, or electronic network markets • Introduce different types of orders • Introduce stock exchanges in the U.S. and in other countries • Analyze the structure of trading costs • Introduce the margin account and margin trade • Regulations of securities markets in the U.S. are skipped

  3. 3.1 HOW FIRMS ISSUE SECURITIES

  4. Primary Versus Secondary Markets • Primary market • For new issues of securities • Key function: issuer receives the proceeds from the sale of newly issued stocks or bonds • Two types of issues of common stock: initial public offerings (IPOs) and seasoned equity offerings (SEOs) • IPOs are stocks issued by a formerly privately owned company that is going public, i.e., selling stock to the public for the first time • Privately held firms: up to 499 shareholders and fewer obligations to release financial statements to the public • SEOs are offered by companies that already have sold equity to the public before • In a word, firms issue new securities and receive the proceeds from the sale in the primary market

  5. Primary Versus Secondary Markets • Secondary market • Market for already existing securities • Trading of already-issued securities among investors • Issuing firm does not receive proceeds and is not directly involved • Ownership is simply transferred from one investor to another, so trading in secondary markets does not affect the outstanding amount of securities • The stock exchanges we are familiar with all belongs to secondary markets, e.g., NYSE, Tokyo Stock Exchange, Taiwan Stock Exchange, etc.

  6. How Securities Are Issued • Public Offering vs. Private Placement • Private placement (私下募集) • Firms (using investment bankers) sell newly issued securities to a limited number of sophisticated institutional or wealthy investors without the registration process (hence is cheaper than public offering) • Due to the lack of the registration process, private placements cannot be traded in the secondary market, so their liquidity is restricted, and maybe the prices of them are reduced due to the illiquidity • Private placements are less suited for raising a large amount of funds • Very active for debt securities (sold to banks or insurance companies and held until maturity), but not active for stock offerings

  7. How Securities Are Issued • Public offering (公開發行) • Investment bankers (投資銀行) • Shelf registration (上架登記) • Initial public offerings (IPOs) (初次公開發行)

  8. Investment Banking Arrangements • Public offerings are typically marketed by investment bankers who in this role are called underwriters (承銷商) • A preliminary registration statement must be filed to the Securities and Exchange Commission (SEC), describing the issue information and the prospects of the company • SEC is the authority in the U.S. responsible for the affairs of securities issuance and trading • The final form of the statement, approved by the SEC, is called the prospectus (公開說明書) • One function of the investment bankers is to help the issuing firm to prepare this statement

  9. Investment Banking Arrangements • Underwriting process: • Investment bankers purchase the securities from the issuing company at the public offering price less a spread, which serves as compensation to underwriters, and then resell them to the public or other financial institutions or intermediaries • The above procedure is called a firm commitment (包銷)because the investment banker commits (guarantees) to buy and sell an entire issue of securities and takes all financial responsibility for any unsold shares • Firm commitment (包銷) vs. Best efforts (代銷) • Best efforts: underwriters help for selling but make no firm commitment

  10. Relationship Among the Issuing Firm, the Underwriters and the Private Investors in the Underwriting Syndicate (聯合承銷) ※ Usually, an investment banker does not underwrite the securities alone. Instead, the arrangement of underwriting syndicate is often adopted ※ The term “syndicate” means that several investment bankers are united to conduct the underwriting business for an issuing firm ※ In most cases, a leading investment banker organizes an underwriting syndicate of several investment bankers to market the new issues of securities and share the responsibility for selling these securities

  11. Shelf Registrations • SEC (Securities and Exchange Commission) Rule 415 introduced in 1982 • Allowing firms to register (or said preregister) a large amount of securities and gradually sell them to the public for the next two years following the initial registration • After a notice for 24 hours, part or all of the preregistered amount may be offered • The registered securities are “on the shelf,” ready to be issued, and hence with the name shelf registration • Advantages for shelf registrations • Firms can issue and sell securities in small amounts without incurring substantial registration costs • Allows timing of the issues

  12. Initial Public Offerings • The most complicated public offering because the issuing firm is usually new and not well-known to investors • After the preparation of the prospectus, • Road shows to promote the new securities • To provide information about the offering and generate interest among potential investors • To collect information for the issuing firm about the price and amount at which they can market the securities • Bookbuilding process to record potential investors ※ It is common for investment bankers to revise both their initial estimates of the public offering price and the number of shares offered based on the feedback from the road shows

  13. Initial Public Offerings • Underpricing for IPOs • The reason is possible to attract potential institutional investors to participate in bookbuilding process and share their information • Also due to the large-scale trading, institutional investors have the bargaining power to purchase securities at a undervalued price • For IPOs, in addition to the explicit cost of around 7% of the fund raised, underpricing should be viewed as another cost of the issuing firm • Such underpricing is reflected in price jumps that occur on the date when the IPO shares are first traded in public security markets (see the next slide) • The long term performance of IPOs and non-IPOs (see Slide 3-15)

  14. Average First Day Returns for European and Non-European IPOs 164% 26% 16% 11% 36% 18% ※ This figure shows average first-day returns on IPOs of stocks in different countries across the world(Diagram A is for European countries, and Diagram B is for non-European countries) ※ The results indicate that the underpricing for IPOs is a universal phenomenon

  15. Long-term Relative Performance of Initial Public Offerings, 1970-2006 ※ This figures compares the performance of IPOs with shares of other firms of the same size in the same industry for the following 5 years after the issue of IPOs ※ The underperformance of the IPOs suggests that, on average, the investing public may be too optimistic about the prospects of these firms

  16. 3.2 HOW SECURITIES ARE TRADED

  17. Types of Markets • Financial markets exist to facilitate low cost investment process • Bring together buyers and sellers at low cost • Provide adequate liquidity to minimize time and cost to trade and promote price continuity • Update and quote prices of financial assets (reduces information costs associated with investment) • Different types of financial markets introduced here: • Direct search markets, brokered markets, dealer markets, and auction markets

  18. Types of Markets • Direct search markets • Buyers and sellers must seek each other out directly • For example, to sell your used furniture by advertising on the newspaper or internet • The liquidity in this market is poor, so this market is not suited for securities trading • Brokered market (經紀商市場) • In active markets, brokers find it profitable to offer search services to buyers and sellers, e.g., the real estate market • Brokers earn commissions for matching buyers and sellers rather than buy and sell assets for themselves • In primary markets, investment bankers marketing a firm’s securities to the public act as brokers

  19. Types of Markets • Dealer markets (自營商市場) • Dealers specialize in trading several assets, and make profits by purchasing these assets for their own accounts and sell them later • Dealers act as intermediate buyers/sellers • Bid (asked) price is the price at which a dealer is willing to buy (sell) the asset • The bid-ask spreads between dealers’ purchasing and selling prices are the source of profit • Dealer markets save traders the search costs because traders can easily look up the quoted prices at which they can buy from or sell to dealers • The market of foreign currency exchange is a typical example of a dealer market

  20. Types of Markets • Auction market (集中競價市場) • The most integrated market is an auction market, in which all tradersmeet at one place to buy or sell an asset • The buyer who offers the highest price or the seller who would like to sell the asset at the lowest price can buy or sell the asset with the highest priority • The New York Stock Exchange (NYSE) and Taiwan Stock Exchange are examples of auction markets • An advantage of auction markets over dealer markets is that traders need not search across dealers to find the best prices and thus save the bid-ask spread

  21. Types of Orders • Instructions to the brokers on how to complete the trade: market and price-contingent orders • Market orders (市價委託單) • Market orders are buy or sell orders that are to be executed immediately at current market prices, i.e., they are with the highest priority to be executed • Limit orders (限價委託單) • A limit buy (sell) order instructs the broker to buy (sell) shares once the share price is obtained at or below (above) a specified limit • For limit buy (sell) orders, it is impossible to buy (sell) shares higher (lower) than the specified price • A collection of limit orders waiting to be executed is called a limit order book (The rule to match limit and market orders is discussed on Slide 3-27)

  22. Types of Orders • Stop orders (停損委託單) • Stop-loss (buy) orders specify that a stock share should be sold (bought) immediately when its price falls below (rises above) a limit • In other words, investors who send stop-loss (stop-buy) orders will sell (buy) shares equal to or lower (higher) than the specified limit • Once the limit is hit, the stop orders become market orders, which will be executed immediately • Stop-buy orders are often coupled with short sales to limit potential losses from the short position • Short sales mean that investors sell borrowed securities in anticipation of a price decline and are required to return an equal number of shares to the lenders at some time point in the future

  23. Summary of Price-Contingent Orders

  24. Trading Mechanisms • Three trading systems in the U.S.: OTC dealer markets, ECNs, and specialists on exchanges • Dealer markets • In the over-the-counter (OTC) (櫃檯買賣市場) market, dealers quote prices at which they are willing to buy or sell securities, and a broker executes a trade by contacting a dealer listing the most attractive quotes • OTC market: A decentralized market where market participants trade over the telephone, fax, or electronic network instead of a physical trading floor • In the U.S., the National Association of Securities Dealers Automatic Quotation System (NASDAQ) was developed in 1971 to link brokers and dealers to negotiate sales of securities on a computer network

  25. Trading Mechanisms • Electronic communication networks (ECNs) • ECNs allow participants to post market and price-contingent orders over computer networks, so limit order books are public and governed by computers • Computer-network trading system allowing direct trading without the need for brokers and dealers • Thus, you can treat ECNs as auction markets operated by computers and you can access this market through the computer network directly • The attraction is due to its speed, cheaper transaction costs (no brokerage fee and bid-asked spread but it is necessary to pay for the system), and anonymity

  26. Trading Mechanisms • Specialist markets (特種經紀商市場) • Adopted by NYSE • A specialist is a trader who makes a market (造市) for several stocks (but for each security, it is assigned to one single specialist) • Make a market: be always ready, willing, and able to trade a particular security at the quoted bid and asked prices • The task of dealers is to make a market, but in dealer markets, there could be many dealers for one security • There are fewer than 10 specialist firms on the NYSE now • Two main tasks for specialists (act as either a broker or a dealer): • The specialist’s role as a broker is simply to execute the orders from other brokers (earn commission fees for managing orders)

  27. Trading Mechanisms • The specialist maintains a limit order book of all unexecuted limit orders entered by brokers on behalf of their clients (see the limit order book for INTEL on the next slide) • The rule to match limit and market orders • The specialist matches market buy (sell) orders with unexecuted limit sell (buy) orders which specify the lowest (highest) limit sell (buy) price • Since all orders for one security come to the post of a specialist on the trading floor, this specialist system results in an auction market, and the best orders “win” the trades • To act as a dealer, specialists are also required and permitted by the stock exchange to maintain an orderly market by buying and selling shares for their own account and thus earn the bid-asked spread

  28. Trading Mechanisms Constructed with limit sell orders ※In limit order books, limit buy prices cannot be higher than limit sell prices. Once it happens, those limit buy and sell orders can be matched and executed immediately ※ Amarket buy (sell) order is matched with the limit sell (buy) order with the lowest (highest) limit sell (buy) price  Trade the asset at the price specified in the limit sell (buy) order  The final settlement price (結算價格)for a market order is uncertain Constructed with limit buy orders

  29. Trading Mechanisms • In a word, specialists can execute market orders either with the limit orders or with their own account at the bid and asked prices • Thus, the effective asked (bid) price is the lower (higher) of the specialist’s asked (bid) price and the lowest (highest) price of unexecuted limit-sell (limit-buy) orders • The reasons to maintain a narrow bid-asked spread • A too wide spread would cause the specialist to lose the ability to profit from the bid-asked spread if other traders use limit orders to form a narrower effective bid-asked spread • Maintaining price continuity is one of the criteria to evaluate the performance of specialists by the exchange (The past performance is the key factor to compete for becoming the specialist for newly listed stocks)

  30. 3.3 U.S. SECURITIES MARKETS

  31. NASDAQ • National Association of Security Dealers Automated Quotation System (NASDAQ): • An quotation and information system for individuals, brokers, and dealers and largest organized stock market for OTC trading (lists around 3000 firms) • Three listing options: • Select market (largest firms), Global market (the next tier of firms), and Capital market (the third tier of firms) • Because NASDAQ does not use specialists, and OTC trades do not require a centralized trading floor as do exchanged-listed stocks, dealers can be located anywhere as long as they can communicate effectively with other traders

  32. NASDAQ • Three levels of subscribers for quotations • Level 3 (for dealers): receive all bid and asked quotes and can input the bid and asked prices for their own • Level 2 (for brokers): receive all bid and asked quotes • Level 1 (for investors who is not actively trading securities but interested in current prices): receive the highest bid and lowest asked prices (also called inside quotes) on each stock • NASDAQ was originally more a price quotation system than a trading system • NASDAQ introduced the electronically trading platforms, called the NASDAQ Market Center, to handle the majority of its trade since 2004

  33. New York Stock Exchange • The largest stock exchange in the world • Founded in 1817 • Merged with Euronext in 2007 • Lists over 8,000 firms globally (until 2013) • With a combined market capitalization of its listed companies to be $13.61 trillion in May 2013 • Average daily trading is $45 billion (1.6 billion shares) in 2010 • NYSE is a continuous auction market operated with specialists • It requires very heavy trading to cover the expense of maintaining the market • Thus, listing requirements of NYSE limit the stocks traded on the exchange to those with sufficient trading interests from the public

  34. New York Stock Exchange • The flow chart of orders sent to NYSE

  35. New York Stock Exchange ※Members of the exchangepurchase a seat on the floor of NYSE, giving them the right to trade and a say in the governance of NYSE ※ The membership or the seat can be traded like any other assets ※ The value of a seat, varied year by year and worth $3.25 million in 2005, is determined to reflect the commissions that members might earn by trading on behalf of clients ※ In 2005, there were 1,366 seat-holding members of NYSE ※ Floor broker: a member of an exchange who can act as a broker for other members or other non-member brokerage firms ※ Floor trader: a member of an exchange who trades on the floor of that exchange for his own account

  36. New York Stock Exchange • Block trading • Large transactions in which over 10,000 shares of stock are traded (too large for specialists to handle) • “Block houses,” which are brokerage firms specializing in matching block buyers and sellers, are involved to aid in the placement for block trades • Block houses discreetly arrange large trades out of the public eye to avoid moving prices against their clients • Dark pools: electronic trading networks where participants can anonymously trade large blocks of securities • Most block trading today has been replaced by dark pools • Another approach: split large trades into many smaller ones, each of which is executed electronically

  37. New York Stock Exchange • Computer network in NYSE • SuperDOT (DOT: Designated OrderTurnaround) is an electronic order-routing system that enables NYSE member firms to send market and limit orders directly to the specialist over computer lines • Direct+, launched in 2000, can automatically cross trades without human intervention • NYSE Hybrid market: allow brokers to send orders either for immediate electronic execution or to the specialist, who could seek price improvement form another trader • Computer network is especially useful for algorithmic trading (演算法交易), which uses computer programs to send orders to simultaneously buy or sell different securities

  38. Other Exchanges • American Stock Exchange (AMEX) • Founded in 1908 • Merged by NYSE in 2008, and has been renamed NYSE AMEX • List smaller and younger firms than NYSE • It is a leader in the development of exchange-traded funds (ETF), which are securities that represent claims to entire portfolios of stock markets (ETF will be introduced in detail in Ch 4)

  39. Other Exchanges • Electronic Communication Networks (ECNs) • The first ECN, Instinet, was established in 1969 • Some ECNs today: Direct Edge, BATS, and NYSE Arca (NYSE merged with Archipelago exchange in 2006 and renamed it NYSE Arca) • Latency time (等待時間): The time it takes to accept, process, and deliver a trading order • BATS advertises the latency time of around 0.002 second in 2012 • Financial markets are moving to automated electronic trading • Result in 24-hour global markets • Moving toward market integration

  40. Other Exchanges • Rise of electronic trading (timeline of market changes) • 1969: Instinet (the first ECN) is established • 1975: Fixed commissions on NYSE are eliminated • At the same year, U.S. Congress amends Securities and Exchange Act to create National Market System (NMS), which intends to propose a centralized quotation system among exchanges such that traders can route orders to the market makers displaying the best price nationwide • 1994: NASDAQ scandal • NASDAQ dealers collude to maintain wide bid-asked spreads • SEC institutes new order-handling rules: Published dealer quotes had to reflect limit orders of customers, allowing them to effectively compete with dealers to capture trades

  41. Other Exchanges • NASDAQ integrates ECN quotes into display, enabling the electronic exchanges to compete for trades • SEC adopts Regulation Alternative Trading Systems, giving ECNs the right to register as stock exchanges • 1997: SEC drops minimum tick size from 1/8 to 1/16 of $1 and further reduce it to $0.01 in 2001, which effectively narrows bid-asked spreads • 2000: National Association of Securities Dealers splits from NASDAQ, which essentially becomes a large ECN • 2005: SEC adopts Regulation NMS • Link exchanges electronically • Require exchanges to obtain the best price (among all exchanges) for investors when such price is represented by automated quotations that can be immediately executed • 2006: NYSE acquires Archipelago Exchanges and renames it as NYSE Arca

  42. 3.4 STOCK MARKETS IN OTHER COUNTRIES

  43. Other Countries • London Stock Exchange (LSE) • Similar to NASDAQ, it starts from a quotation system and introduces electronic executing system later • London security firms act as both dealers and brokers, i.e., both making a market in securities and executing trades for their clients • They are not specialists because for one security, any security firm can be the dealer of that security • Euronext Exchange • It was formed in 2000 by a merger of the Paris, Amsterdam, and Brussels exchanges • In 2002, it acquired LIFFE, the London International Financial Futures and Options Exchange • In 2007, Euronext merged with the NYSE group to become NYSE-Euronext

  44. Other Countries • Tokyo Stock Exchange (TSE) • The largest stock exchange in Japan, accounting for about 80% total trading in Japan • In addition to TSE, there are also Osaka Securities Exchange (大阪證券交易所)and Nagoya Securities Exchange (名古屋証券交易所) • There is no specialist on TSE • Before 1999, a saitori maintains the limit order book and matches market and limit orders. However, saitoris do not trade for their own accounts • In 1999, TSE closed its trading floor and switched to all-electronic trading • Three sections for different size firms, including the First (large), Second (midsized), and “Mothers” (emerging and high-growth) sections

  45. Market Capitalization of Listed Firms, 2011 ※ In 2007, NASDAQ merged with OMX, which operated seven Nordic and Baltic stock exchanges, to form NASDAQ OMX Group

  46. 3.5 TRADING COSTS

  47. Trading Costs • Commission: fee paid to brokers for making the transaction • Except for trading in ECN markets, traders need to pay the brokerage fee • However, in ECN markets, traders need to pay for the system, which is much cheaper than the brokerage fee • Spread: cost of trading with dealers • Asked: price at which dealer will sell to you • Bid: price at which dealer will buy from you • Spread: asked minus bid • Combination: on some trades both are paid • In a well-functioning market, the trading cost is lower due to the competition in the market

  48. 3.6 BUYING ON MARGIN

  49. Buying on Margin • When purchasing securities, investors can access to a source of debt financing provided by brokers (called broker’s call loans), and then can buy on margin(保證金) in the U.S. • Buying on margin means using only a portion of the proceeds for an investment, and the remainder is borrowed from the broker • Investors need to pay the interest for the borrowing amount • The Board of Governors of the Federal Reserve System set the limit of using margin loans

  50. Buying on Margin • Initial margin (初始保證金)is currently set to be 50%, which means at least 50% of the purchase price must be paid from the investor, with the rest borrowed • Maintenance margin (維持保證金): minimum percentage for equity in trading (the part belongs to the investor) can be before additional funds must be put into the account • If the percentage margin falls below this level, the broker will issue a margin call • Margin call: notification from the broker you must put up additional funds

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