CHAPTER 3 Securities Markets

1. CHAPTER 3 Securities Markets

2. 3.1 HOW FIRMS ISSUE SECURITIESPrimary 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

3. How Securities Are Issued • Investment Banking: The investment banker purchases the securities from the issuing company and then resell them to the public. • Typical underwriting makes a firm commitment about the price and assumes the risk that the shares may not be sold to the public at the quoted price • In case of best-effort agreement the investment banker does not actually purchase the securities but agrees to help the firm sell the issue to the public • Shelf Registration: • Introduced in 1982, it allows firms to register securities and gradually sell them to the public for two years following the initial registration. • Private Placements: • The firm using an investment banker sells shares directly to a small group of institutional and wealthy investors. It is not traded in secondary market. • Initial Public Offerings (IPOs) • With the approval of SEC a prospectus (describing the firm and the security it is issuing) is circulated for invitation of application for shares to the public. Shares are subsequently traded in secondary market.

4. 3.2 WHERE SECURITIES ARE TRADED Types of Secondary Markets • Stock exchanges or auction Market: • An exchange provides a facility for its members to trade securities. The membership allows the firm to place one of its brokers on the floor of exchange where he can execute trades. The NYSE is by far the largest single exchange. Daily trade averaged $1.04b. in 2000. Since prices are determined by bidding from buyers and sellers so the market is also known as auction market. • The Over-the-counter Market • It is not a formal exchange. There is no membership requirements. Thousands of brokers register with the SEC as dealers in OTC securities. Security dealers quote prices at which they are willing to buy and sell securities through a computer based network. There is a considerable spread between the bid (purchase) and ask (sell) prices. NASDAC (National Association of Securities Dealer Automatic Quotation System) of USA is the famous OTC market of the world where as much as 35,000 issues are traded.

5. 3.3 Types of Orders (DSE) • Based on price: Based on price: • Market Orders • Market orders are simply buy and sell orders that are to be executed immediately at current market prices. • Limit Orders • Investors may choose to place a limit order, where they specify prices at which they are willing to buy or sell a security. If IBM is selling at $98 bid, and $98.10 asked, for example, a limit buy order may instruct the broker to buy the stock if and when the share price falls below $97. Similarly, a limit order for sell may be at $99 Ss • Based on volume: • Partial Fill: • executed as much as possible and rest remains otstanding for sell • Partial fill and kill: • Executed as much as possible and rest of the order cancelled • Full fill and kill: • The entire order would be executed as soon as possible or cancelled. • Based on validity: • Good till day • By default all orders are valid ttill the end of the current day • Good till date • The order remains valid over 30 days:

6. 3.4 MARKET STRUCTURE IN OTHER COUNTRIES • London • Until 1997, London security firms acted both dealers and brokerage firms. In 1997, the London Stock Exchange introduced an electronic trading system dubbed SETS (Stock Exchange Electronic Trading Services) which automatically executes all buy and sell orders via computer network. Thus it follows predominantly electronic trading. However, SEAQ (Security Exchange Automated Quotations) continues to operate for the “Upstairs Market” in large block transactions or other less liquid transactions. This is comparable to block market of DSE. • Euronext was formed in 2000 by merger of the Paris, Amsterdam and Brussels exchanges. This is an electronic trading system. Investors can enter their orders directly without contacting their brokers. • Tokyo Stock Exchange (TSE) is the largest stock exchange in Japan accounting for about 80% of total trading. There is no specialist system on the TSE. Instead, a saitori maintains a public limit order book, matches market and limit orders, and is obliged to follow actions to slow down market price movements beyond the prescribed limit.

7. 3.5 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

8. 3.6 BUYING ON MARGIN

9. Why do investors buy securities on margin? • Suppose an investor is bullish on IBM stock, which is selling for $100 per share. He expects the price to go up by 30% in the next year. With an investment of $10,000 his rate of return would be 30% (ignoring any dividends). • Now assume the investor borrows another $10,000 from the broker and invests in IBM too. Total investment in IBM is now $20,000. Assuming an interest rate on margin loan of 9% per year, what will be the rate of return if IBM goes up by 30%? • The 200 shares will be worth $26,000. Paying off $10,900 of principal an interest on the margin loan leaves $15,100 (i.e., $26,000-$10,900). The rate of return is ($15,100-$10,000)/$10,000=51%. This is much higher than the rate of return without loan. • What about the downside risk? • Suppose, instead of going up by 30%, the price of IBM stock goes down by 30% to $70 per share. • The 200 share now fetches $14,000. After paying off $10,900 the investor is left with ($14,000-$10,900)=$3,100. The result is a disastrous return of ($3,100-$10,000)/$10,000=-69%.

10. Buying on Margin • Using only a portion of the proceeds for an investment • Borrow remaining component • Margin arrangements differ for stocks and futures Balance Sheet Margin=Equity in account/Value of stock=$3,000/$7,000=43% What happens if price goes down below $4,000? Owner’s equity becomes negative. The value no longer is a sufficient collateral to cover the loan. So, the broker sets a maintenance margin. If percentage margin falls below the maintenance level, the broker issue margin call, which requires the investor to add new cash or securities to the margin account.

11. Margin Trading - Initial Conditions X Corp initial price $70 50% Initial Margin 40% Maintenance Margin 1000 Shares Purchased Initial Balance Sheet Position: Stock $70,000 Borrowed $35,000 Equity 35,000 If, 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%

12. Margin Trading - Margin Call How far can the stock price fall before a margin call? Since, 1000P - Amount Borrowed = Equity, So: (1000P - $35,000) / 1000P = 40% P = $58.33

13. 3.7 SHORT SALES

14. 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 it back to the party from whom it was borrowed

15. Short Sale - Initial Conditions Z Corp 100 Shares 50% Initial Margin 30% Maintenance Margin $100 Initial Price Sale Proceeds $10,000 Margin & Equity 5,000 Stock Owed 10,000 Balance sheet

16. Short Sale - Maintenance Margin If, stock price rises to $110 Sale Proceeds $10,000 Initial Margin $ 5,000 Stock Owed $11,000 Net Equity $ 4,000 Margin % (4,000/11,000) 36% Balance Sheet

17. 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 Balance Sheet