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Chapter 3

How Securities Are Traded. Chapter 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.

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Chapter 3

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  1. How Securities Are Traded Chapter 3

  2. 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.

  3. 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.

  4. 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. 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.

  6. Organization of Secondary Markets • Organized exchanges • OTC market • Third market • Fourth market

  7. 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.

  8. OTC Market • Dealer market without centralized order flow. • NASDAQ: largest organized stock market for OTC trading; information system for individuals, brokers and dealers. • Securities: stocks, bonds and some derivatives. • Most secondary bonds transactions

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

  10. Fourth Market • Institutions trading directly with institutions • No middleman involved in the transaction • Organized information and trading systems • ECN Development

  11. International Market Structures • London Stock Exchange • Dealer market similar to NASDAQ • Stock Exchange Automated Quotation • Greater Anonymity • Tokyo Stock Exchange • No market making service • Sartori provides bookkeeping service • Feature a floor and electronic trading • Global Market Alliances

  12. 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

  13. Types of Orders • Instructions to the brokers on how to complete the order • Market • Limit • Stop loss

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

  15. Stock Margin Trading • Maximum margin • Currently 50% • Set by the Fed • Maintenance margin • Minimum level the equity margin can be • Margin call • Call for more equity funds

  16. Margin Trading - Initial Conditions X Corp $70 50% Initial Margin 40% Maintenance Margin 1000 Shares Purchased Initial Position Stock $70,000 Borrowed $35,000 Equity $35,000

  17. Margin Trading - Maintenance Margin Stock price falls to $60 per share New Position Stock $60,000 Borrowed $35,000 Equity $25,000 Margin% = $25,000/$60,000 = 41.67%

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

  19. 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 it was borrowed.

  20. 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

  21. Short Sale - Maintenance Margin Stock Price Rises to $110 Sale Proceeds $10,000 Initial Margin 5,000 Stock Owed 11,000 Net Equity 4,000 Margin % (4000/11000) 36%

  22. Short Sale - Margin Call How much can the stock price rise before a margin call? ($15,000* - 100P) / (100P) = 30% P = $115.38 * Initial margin plus sale proceeds

  23. Regulation of Securities Markets • Government Regulation • Self-Regulation • Circuit Breakers • Insider Trading • ECNs and Fragmentation

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