Chapter 3: How Securities are Traded

1. 1 Chapter 3: How Securities are Traded Objective: To explain the institutional details and mechanics of investing in securities. How firms issue securities Where securities are traded Trading on exchanges and OTC market Trading with margin Trading costs

2. 2 1. How firms issue securities Primary market Market for new issues, e.g., initial public offerings (IPO) and seasoned equity offerings (SEO). The issuer receives the proceeds from the sale Secondary market Trading of already issued securities among investors occur in this market

3. 3 Investment Bankers IPO process Registration, preliminary prospectus, road shows, final approval, issuance, aftermarket stabilization Typically, investment dealers make a firm commitment on proceeds to the issuing firm Best Efforts: no firm commitment Issuing firm typically negotiates terms with investment bankers rather than using competitive bids.

4. 4 Short form prospectus (or shelf registration in U.S.) Initial Public Offerings (IPOs) Bookbuilding process Underpricing of IPO stocks Underpricing adds to usual 7% spread. IPOs have poor long-term performance Internet IPO in 1995 and a �Dutch auction� by W.R. Hambrecht on a limited number of IPOs.

5. 5 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 Private placement

6. 6 2. Where securities are traded Types of Markets Direct search markets Brokered markets (e.g., real estate, block trades in upstairs market) Dealer markets: dealers trade on their own accounts. (e.g., over-the-counter (OTC) market such as NASDAQ) Auction markets: all transactors converge at one place for trading (e.g., NYSE)

7. 7 Types of market Stock markets Organized exchanges OTC market Third market Fourth market Foreign markets Derivative markets

8. 8 Organized Exchanges Auction markets with centralized order flow A dealer (specialists or registered traders) is assigned to make a market for a stock by the exchange Securities: stocks, futures contracts, options, and to a lesser extent, bonds Examples: TSX, ME, NYSE, AMEX, Regional exchanges, CBOE Toronto Stock Exchange (TSX) About 1,200 stocks are listed The 7th largest exchange in the world

9. 9 OTC Market Dealer market without centralized order flow �NASDAQ is the largest electronic screen-based equity securities market in the U.S.�, both in terms of number of listed companies (approximately 3,200) and traded share volume. Securities: stocks, bonds and derivatives Most secondary bonds transactions

10. 10 Third Market Trading of exchange-listed securities on the OTC market. Institutional market: to facilitate trades of larger blocks of securities Involves services of dealers and brokers

11. 11 Fourth Market Investors trading directly with other investors (without using a broker) The advent of ECNs (electronic communication network) fuels the growth of the fourth market ECNs captured about 40% of Nasdaq trading volume. Nasdaq acquired in Dec. 2005 Inet, the largest ECN.

12. 12 Foreign markets London Stock Exchange Dealer market similar to NASDAQ From 1997, a new electronic trading system similar to ECNs handles most of trading with SEAQ system serving as �upstairs market� Euronext: electronic trading system Tokyo Stock Exchange (TSE) Limit-order book market similar to ECN Saitori provides bookkeeping service Feature a floor and electronic trading

13. 13 3. Trading on exchanges: Types of orders Market orders: orders to be executed immediately at current market prices. Current market prices are for a specified number of shares (size). Limit orders: orders which specify maximum buying price or minimum selling price. Example: $21 bid, $21.25 ask. Limit buy order at $21: investor instructs the broker to buy the share if and when the share price falls below $21.

14. 14 Limit sell order at $22: investor instructs the broker to sell the share if and when the share price rises above $22. Inside quotes: highest bid and lowest ask (See a limit-order book). Limit orders supply liquidity to the market. Market orders consume the liquidity. Stop-loss orders a stop-loss sell order at $19 will be executed if the price falls below $19 and stops further losses.

15. 15 Expiration of a limit order Day orders, open or good-till-cancelled orders, fill or kill orders Block sales Trades over 100,000 shares. �Block houses� broker block trades in upstairs market.

16. 16 Execution of trades Registered trader (specialist) Market-making Maintaining a �book� Maintain a �fair and orderly market� � price continuity Execute �stabilizing� trades: purchase at uptick and sale at downtick. Valuable inside information about market direction Faces adverse selection risk

17. 17 4. Trading costs Brokerage commission: fee paid to broker for making the transaction Full service broker Discount broker Bid-ask spread Price impact

18. 18 Investments with borrowing. Borrowing cash: buying on margin Borrowing shares of stock: short sales Initial margin: initial �equity� portion Minimum margin Minimum level of the equity margin Currently 30%, set by the securities commissions Margin call Call from the broker for more equity (investor�s own money) 5. Trading with margin

19. 19 You bought on margin one share of ABC at $70, paying $35 of your own money. The minimum margin is set at 30%. A. Initial position Stock $70 Borrowing $35 Equity $35 B. New Position: Stock price=$40 Stock $40 Borrowing $35 Equity $5 Margin= $5/$40 = 12.5% Example: margin trading

20. 20 Margin call Investor is required to put up $7 to bring up the margin to $12 ($5+7), or 30% ($12/40) of current value of stock. How far can the stock price fall before a margin call? (1*P - $1*35)/1*P = 30% ? P=$50

21. 21 Leveraging effect of margin trade You buy 200 shares of XYZ at $100, expecting a 30% appreciation of the stock in one year: Initial margin: 50% Financed by a 9% loan for one year Expected net return: 51% (30%*2-9%) A 30% drop in the price, though, results in -69% return.

22. 22 Short Sales Purpose: to profit from a decline in the price of a stock or security Mechanics Borrow a share of stock through a dealer Sell the share. Deposit proceeds and margin in an account Buy the share and return it to the initial owner through a dealer (close out the position).

23. 23 Example: Short Sale You short sell one share of XYZ at $100. The minimum margin is set at 50%. A. Initial position cash $100 Borrowing $100 T-bill $50 Equity $50 B. New Position: Stock price=$140 cash $100 Borrowing $140 T-bill $50 Equity $10 Margin= $150/$140 = 107%

24. 24 Margin call Investor is required to put up $60. T-Bill is now $50+60 = $110. Market value of asset is $100+$110=$210, or $210/140=150% of value of stock owed. How far can the stock price rise before a margin call? ($100 + $50)/1*P = 1.5 ? P=$100 $100+$50: sale proceeds + initial margin, which equals market value of assets. Stop-buy orders often accompany short sales.

25. 25 5. Regulation of securities markets Government Regulation Self-Regulation in the industry Self-regulatory organization (SRO) such as Exchanges and Investment Dealers Association (IDA) Circuit Breakers (e.g. trading halts) Insider Trading