FINA 2802: Investments and Portfolio Analysis Securities Markets Dragon Yongjun Tang January 21 & 23, 2010

1. FINA 2802: Investments and Portfolio AnalysisSecurities MarketsDragon Yongjun TangJanuary 21 & 23, 2010

2. Lecture 4 & 5: Securities Markets • Reading: Chapter 3 • Practice Problem Sets: 1,2,3,4,6,7,8,9,10,12,13,14,18,20,21

3. Learning Objectives • Role of investment bankers in primary issues • Identify the various security markets • Describe the role of brokers • Compare trading practices in exchanges vs dealer markets • Buy Stock on Margin and Sell Stock Short

4. Life Cycle of a Company Private (Entrepreneur + VC) Primary Commission Investment Bank Public (NYSE/Nasdaq) Secondary Dealer Market Maker Buy on Margin Sell Short Broker Bid-ask Spread Buy Commission Commission Sell

5. How Firms Issue Securities • Primary Market: • Initial Public Offering (IPO) • Seasoned Equity Offering (SEO) • Investment Bankers: • Assist firms in issuing securities • Firm Commitment (Take a risk in underwriting) • Best efforts (issuer bears the risk of not placement)

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

7. Figure 3.2 A Tombstone Advertisement

8. Shelf Registration SEC Rule 415 Allows firms to register securities and sell them gradually to the public for two years.

9. Private Placements • Firms sell shares directly to a small group of institutional or wealthy investors • Cheaper: No need to register to SEC (Rule 144A) • Smaller offerings

10. Initial Public Offering (IPO) • Road shows, bookbuilding • Cost: commissions (7%) + underpricing • Investment bankers tend to underprice new issues • IPO prices tend to rise after IPO (“Money left on the table”) • IPO are usually poor long-term investments • Internet Auction

11. IPO Underpricing:A dramatic example (VA Linux) • IPO price: $30 • First day closing price: $239.25 • Today’s price: $1.00 • Replicate this picture using finance.yahoo.com (LNUX)

12. Figure 3.3 Average Initial Returns for IPOs in Various Countries

13. Figure 3.4 Long-term Relative Performance of Initial Public Offerings

14. Where Securities Are Traded Secondary Market • Organized exchanges • NYSE (or the Big Board); AMEX; regional exchanges • Over the counter (OTC) • Nasdaq: market makers; three levels • Bond trading • Directly between the two parties • Electronic Communication Networks (ECN)

15. National Market System • Established by Exchange Act of 1975 • Intent was to link firms electronically • Resulted in Consolidated Tape

16. Bond Trading Major concern: Liquidity • Automated Bond System (ABS) • OTC market

17. Trading on Exchanges The participants: • Investors • Brokerage firms (owns a “seat” on the exchange) • Commission brokers • Floor brokers

18. Trading on Exchanges The specialist (or market maker): • Makes a market • The brokers’ broker • Maintains the limit order book • Maintains a fair and orderly market • NYSE is an example

19. New York Stock Exchange (NYSE)

20. Trading on Exchanges Types of orders: • Market • Limit • Day • Good-till-canceled • Stop-loss orders; stop-buy orders

21. Figure 3.5 Limit Order Book for Intel on Archipelago

22. Figure 3.6 Price-Contingent Orders

23. Trading on Exchanges Block orders - at least 10,000 shares DOT & SuperDOT - direct to specialist Settlement – three business days Shares “In Street Name”. Shares kept by the broker after a transaction

24. Trading on OTC Markets • Negotiated market • No specialist • NASDAQ computer system

25. Nasdaq

26. Market Structures in Other Countries • London - predominately electronic trading • Euronext – market formed by combination of the Paris, Amsterdam and Brussels exchanges • Tokyo Stock Exchange • Hong Kong Stock Exchange • Shanghai Stock Exchange

27. Cost of Trading • Broker’s commissions: • Explicit • “Hidden” costs: • Bid-Ask Spread • Price Concession

28. Cost of Trading Impact of trading costs on returns

29. Cost of Trading Example: You bought a stock for $70 and later sold it for $80 You received $8 in dividends, paid an initial broker’s fee of $1% of purchase price, and paid another $1% of selling price when you sold the stock. What is your return on this investment (ignoring taxes)?

30. Placing an Order • Should you use a full-service or a discount broker? • What is the value of the full-service broker’s advice?

31. Student Loan • You think your value will go up • You want to make the most out of it • So you borrow money to finance education

32. Buying on Margin • Borrow to buy securities (make use of the Broker call’s loan) • Securities stay with the broker as collateral

33. Buying on Margin Investor’s account: AssetsLiabilities Value of stocks purchased Loan from Broker Equity Cost of setting up a margin strategy

34. Buying on Margin • At time 0: • At any future time

35. Buying on Margin • The Federal Reserve System sets minimum initial margin requirements currently 50% • All exchanges set a minimum maintenance margin requirement currently around 30%

36. Buying on Margin Example: What is the initial margin if the investor purchases 100 shares of stock at $100 per share using $6,000 of her own money and borrows the rest?

37. Buying on Margin Example (continued): If the value of the above stock fell to $70 per share, what is now the actual margin?

38. Buying on Margin Example (continued): If the value of the above stock fell to $50 per share, what is now the actual margin?

39. Buying on Margin Margin Call Pmin= the lowest price a share can fall to without a call L = the loan value M = the margin requirement N = the number of shares

40. Buying on Margin Margin Call Example: An investor purchases 100 shares of stock at $100 per share using $6,000 of her own money and borrows the rest. If the maintenance margin is 30%, what is the lowest price a share can fall without a call?

41. 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

42. 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%

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

44. Problem 3, Chapter 3 (p. 93) Dee Trader opens a brokerage account, and purchases 300 shares of Internet Dreams at $40 per share. She borrows $4,000 from her broker to help pay for the purchase. The interest rate on the loan is 8%. a. What is the margin in Dee’s account when she first purchases the stock? b. If the share price falls to $30 per share by the end of the year, what is the remaining margin in her account? If the maintenance margin requirement is 30%, will she receive a margin call? c. What is the rate of return on her investment

45. Problem 7, Chapter 3 (p. 94) You are bullish on Telecom stock. The current market price is $50 per share, and you have $5,000 of your own to invest. You borrow an additional $5,000 from your broker at an interest rate of 8% per year and invest $10,000 in the stock. a. What will be your rate of return if the price of Telecom stock goes up by 10% during the next year? (Ignore the expected dividend.) b. How far does the price of Telecom stock have to fall for you to get a margin call if the maintenance margin is 30% of the value of the short position? Assume the price all happens immediately.

46. Why buy on margin? Borrowing magnifies ROE (risky strategy)

47. Leverage and ROE ROE

48. Short Sales Borrow Securities to sell them Sell first -- then buy! Margin is required (cost of short selling) Short position must be covered Investor expects price to decline

49. Short Selling Original Stock Holder Short Seller 100 Shares 100 Shares Broker 100 Shares New Stock Holder

50. Short Sales