Securities Trading Mechanics & Institutional Details

1. Chapter 3 How Securities are Traded

2. Chapter Summary • Objective: To explain the institutional details and mechanics of investing in securities. • How firms issue securities • Organization of secondary markets • Trading and execution • Margin trading • Costs and regulation

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

4. 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

5. Public Offerings • Public offerings: registered with the OSC (Ontario - SEC in USA) and sale is made to the investing public • Red herring • Prompt offering prospectus • Initial Public Offerings (IPOs) • Evidence of underpricing • Performance

6. 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

7. Types of Markets • Direct search markets • Brokered markets Block transactions • Dealer markets OTC market • Auction markets Major exchanges

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

9. Organized Exchanges • Auction markets with centralized order flow • Dealership function: can be competitive or assigned by the exchange (specialists or registered traders) • Securities: stock, futures contracts, options, and to a lesser extent, bonds • Examples: TSE, ME, NYSE, AMEX

10. OTC Market • Dealer market without centralized order flow • NASDAQ: largest organized stock market for OTC trading; information system for individuals, brokers and dealers • Levels of interaction: users, market-makers • Securities: stocks, bonds and derivatives • Most secondary bonds transactions

11. 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

12. Fourth Market • Institutions trading directly with institutions • No middleman involved in the transaction • Organized information and trading systems • INSTINET • POSIT • ECN development

13. The execution of trades • Registered trader (market-maker) functions • Maintaining a “book” • Maintain a “fair and orderly market” • Execute “stabilizing” trades • Registered traders possess valuable inside information about the future direction of the market

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

15. Summary Reminder • Objective: To explain the institutional details and mechanics of investing in securities. • How firms issue securities • Organization of secondary markets • Trading and execution • Margin trading • Costs and regulation

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

17. Stock Margin Trading • Greatest margin • Currently 30% • Set by the securities commissions • Minimum margin • Minimum level the equity margin can be (called “maintenance” in USA) • Margin call • Call for more equity funds

18. Margin Trading - Initial Conditions X Corp $70 50% Initial Margin 30% Minimum Margin 1000 Shares Purchased Initial Position Stock $70,000 Borrowed $35,000 Equity $35,000

19. Margin Trading - Minimum 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%

20. Margin Trading - Margin Call • How far can the stock price fall before a margin call? Therefore, P = $50 Note: 1,000xP – Amount Borrowed = Equity

21. Leveraging effect of margin purchases • 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% • A 30% drop in the price, though, brings a negative rate of return of -69%.

22. 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 • Close out the position: buy the stock and return it to the owner

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

24. Short Sale - Minimum Margin 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%

25. Short Sale - Margin Call • How much can the stock price rise before a margin call? So, P = $115.38 Note: $15,000 = Initial margin + sale proceeds

26. Summary Reminder • Objective: To explain the institutional details and mechanics of investing in securities. • How firms issue securities • Organization of secondary markets • Trading and execution • Margin trading • Costs and regulation

27. Costs of Trading • Commission: fee paid to broker for making the transaction • Full service broker • Discount broker • Spread: cost of trading with dealer • Bid: price dealer will buy from you • Ask: price dealer will sell to you • Spread: ask - bid • Execution: better price obtained

28. Internet Trading • On-line brokers (discount or full-service) • ECNs – electronic communication networks • Pre- and post-market trading (lack of integration, thin trading)

29. Regulation of Securities Markets • Government Regulation • Self-Regulation in the Industry • Circuit Breakers • Insider Trading