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Security Markets

Security Markets. Objectives Primary market Secondary Market Summary. Objectives. U.S. Treasury Bonds Stock Issue in the Primary Market Why do companies issue stock? How are stocks placed? Where are the opportunities? Stock Trading in the Secondary Market Where are stocks traded?

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Security Markets

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  1. Security Markets Objectives Primary market Secondary Market Summary

  2. Objectives • U.S. Treasury Bonds • Stock Issue in the Primary Market • Why do companies issue stock? • How are stocks placed? • Where are the opportunities? • Stock Trading in the Secondary Market • Where are stocks traded? • How are stocks traded?

  3. U.S. Treasury Bonds • Initially sold in an auction by the NY Fed • Auction participants: • Primary dealers • Competitive vs. Non-competitive bids • On-the-run vs. off-the-run treasuries • On-the-run - most recently issued bonds or notes of a particular maturity • Off-the-run – treasuries issued before on-the-run treasuries • On-the-run treasuries are more liquid and expensive compared to off-the-run treasuries

  4. Primary Market • Why do Companies Issue Stock? • To finance business expansion • A new factory costs $100MM • To retire existing debt • Payoff $10MM high interest loan from the bank • To buy-out venture capital • Venture capitalist exits in 1-3 years after IPO *usually 7% of the issue

  5. Primary Market • How are Stocks Placed? • IPO (initial public offering) market for new issues • SEO (seasoned equity offering) for secondary • Private placement (not traded in secondary markets) • Underwriting Process Issuing Firms Underwriting Syndicate Lead Underwriter Investment Banker A Investment Banker B Investment Banker C Investors

  6. Underwriters Filing a preliminary registration with the SEC (red herring) Road Shows Potential Investors Potential Investors Approval of the final statement by the SEC (prospectus) Book Building Underwriters The issuing firm The issuing firm Issue Underwriters Underwriters Potential Investors Potential Investors Investors Investors Best-Efforts Agreement Firm Commitment Primary Market • IPO Process Choosing investment bankers

  7. IPO Performance – Short-Term • Opportunities • First day underpricing • >10% appreciation from IPO price to first day closing • E.g. $10 IPO closes at more than $11 on the first day of trading

  8. IPO Performance – Long-Term • Subsequent underperformance * Data for 1970-2006 IPOs

  9. Primary Market • Money on the Table • Q: FBN, Inc sold 100,000 shares at offer price of $50/share in an IPO, underwriter charges a fee of $70,000 and the share price jumps immediately to $53 after trading • What is the cost of equity issue to FBN? • What is the profit for the underwriter? • A: The stock is under priced at $50. The company could have got $53, so … • Total cost to the company • Money on the table = 100,000×3 = 300,000, • Fee = 70,000, • Total cost = 370,000 • Underwriter’s profit • Fee = 70,000 • Where did the $300,000 go?

  10. Primary Market • Exploiting the Opportunities • Buy at IPO price and flip after IPO date • Benefit: • 18.8% return on average for one day • Concern: • Smaller chance of getting into good IPOs • Greater chance of getting into bad IPOs • Sell short IPO stocks on the first day of trading • Benefit: • Profit from the long-run underperformance • Problem: • Cost of shorting IPO shares

  11. Secondary Market • Definition • Markets for investors to buy and sell stocks • How are stocks traded? • Q: How do I buy 100 shares of Microsoft? • A: Depending on the type of order • Market order: buy immediately at current market price • Quick execution with unknown price • E.g., last transaction for MSFT is $26.12, so you will be able to buy at a price around $26.12 immediately. • Limit order: buy with a price specified • Slow execution with known price • E.g., you submit an order to buy MSFT at $26 (limit price), and wait until the price drops to $26.

  12. Secondary Market • How are stocks traded? • Sell order • Market (23.723?) • Limit (above 23.74?) • Stop-loss (below 23.723?) • Buy order • Market (23.74?) • Limit (below 23.723?) • Stop-buy (above 23.74?) • Limit Order • Limit the gain • Stop Order • Stop the loss • Where is the price going?

  13. Secondary Market • Market Buy of 4,100 shares • 100 at 23.74 • 3,000 at 23.74 • 1,000 at 23.749 • Market Sell of 2,000 shares • 1,720 at 23.723 • 280 at 23.722 • Limit Buy 100 share at 23.715 • 100 share appears on the book between 23.71 and 23.72 1,720 100 23.715

  14. Commission Broker Commission Broker Brokerage Firm Brokerage Firm Buyers Specialist Sellers Floor Broker Floor Broker Secondary Market • Where are stocks traded? • Exchanges • NYSE, AMEX, … • Specialist (Designated Market Maker) system

  15. Dealer Brokerage Firm Brokerage Firm Buyers Dealer Sellers Dealer Secondary Market • Where are stocks traded? • Over-the-Counter Market • NASDAQ • Multiple dealer system

  16. Brokerage Firm Brokerage Firm Buyers Sellers Secondary Market • Where are stocks traded? • Electronic Communication Network (ECN) • The fourth market • Island, ArcaEx, Instinet, … • Direct trading among investors on a electronic limit order book Electronic Limit Order Book

  17. To Think About… • NYSE, Amex, NASDAQ, ECNs – are they all linked together? • Price Discovery • What is it? • Where does it take place?

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