Securities Markets: Primary vs Secondary, IPOs, and Trading

1. CHAPTER 3 Securities Markets

2. 3.1 HOW FIRMS ISSUE SECURITIES

3. Primary Versus Secondary Markets

4. IPOs • Initial Public Offerings (IPOs): Selling stock to the public for the first time. Stocks are issued by a formerly privately owned company (Investment Banking)

5. IPOs • 1. Go to the brokerage firm • 2. Investigation • 3. Visit the company • 4. Prepare proposal and suggest a price band. • 5. Issue prospectus on financial times or other newspapers.

6. How Securities Are Issued • Investment Banking: Public offerings of both stocks and bonds are marketed by investment bankers. • Primary market activities can be divided into two as best effort selling and underwriting activities. • Best Effort Selling: Investment banking firm does not buy the entire issue from the issuer but agrees to use its expertise to sell the securities.

7. IPOs • Underwriting: Underwriters purchase the securities from the issuer and promises to sell them at a specified price during the determined period. • Stand-by Underwriting • Firm Commitment (Bought Deal) • Underwriting discount (fee) • Underwriting Syndicate

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

9. Figure 3.2 A Tombstone Advertisement

10. Private Placements • Private placement: Primary offerings in which shares are sold directly to a small group of institutional or wealthy investors. • Dominated by institutions • Very active market for debt securities • Not active for stock offerings

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: The least orginized market. Buyers and sellers must seek each other out directly. • Brokered: In markets where trading in a good is active, brokers find it profitable to effer search services to buyers and sellers (real estate market) • Dealer: Markets in which traders specializing in particukar assets buy and sell for their own accounts (Over the Counter-OTC Market). • Auction: Market where all traders meet at one place to buy and sell an asset (NYSE)

15. Types of Orders • Marke orders: buy and sell orders that are to be executed immediately at current market prices. • Bid Price • Ask Price • Bid-Ask Spread • Price-contingent orders • Limit buy (sell) order: An order specifiying a price at which they are willing to buy or sell. • Stop orders: Trade is not to be executed unless stock hits a price limit. • For stop-loss orders, the stock is to be sold if its price falls below a specified level. • For stop-buy orders, a stock should be bought when its price rises above a limit.

16. Figure 3.5 Limit Order Book for Intel on Archipelago

17. Figure 3.6 Price-Contingent Orders

18. Trading Mechanisms • Dealer markets (OTC market): An informal network of brokers and dealers who negotiate sales of scurities. • Electronic communication networks (ECNs): Computer networks that allow direct trading without the need for market makers. • Specialists markets: A trader who makes a market in the shares of one or more firms and who maintains a fair and orderly market” by dealing personaly in the market.

19. 3.3 U.S. SECURITIES MARKETS

20. Nasdaq • Nasdaq stock market: The computer-linked priced quotation system for the OTC market.

21. New York Stock Exchange • Stock exchanges: Secondary markets where already-issued securities are bought and sold by members. • NYSE: • Largest exchange in the U.S. • Automated for small orders • Floor brokers for large orders • Specialists

22. New York Stock Exchange • Now a publicly held company • Block sales: Large transactions in which at least 10,000 shares of stock are bought and sold. • SuperDot: Electronic ordering system • Bond Trading • 2006 NYSE obtained approval to expand bond trading • However, the vast majority of bond trading occurs in the OTC market among bond dealers.

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

24. 3.4 MARKET STRUCTURE IN OTHER COUNTRIES

25. Other Countries • London - predominately electronic trading • Euronext – market formed by combination of the Paris, Amsterdam and Brussels exchanges • Tokyo Stock Exchange

26. Figure 3.7 Market Capitalization of Listed Firms, 2005

27. 3.5 TRADING COSTS

28. 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

29. 3.6 BUYING ON MARGIN

30. Buying on Margin • is the use of credit to purchase securities • You can borrow up to 50% of the stock value. marginable securities by using your own assets as collateral. (Initial Margin) • Benefits; • Increase the purchaing power of the investors. • Risks associated with margin borrowing; • The value of the securities you deposited or purchased on margin may decrease. • If the equity in your account falls below the min maintenance level (maintanence margin), a margin call will exist. • If the margin call occurs, you will be required to increase the equity up to the min. maintenance levels by immediately deposited additional funds or marginable securities.

31. 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

32. 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%

33. 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

34. 3.7 SHORT SALES

35. Short Sales Sale of the borrowed securities that are not owned . • It is required from the customers to deposit at least 50% of the deal for short-selling in cash or in securities. • 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

36. 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

37. 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%

38. 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

39. 3.8 REGULATION OF SECURITIES MARKETS

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