Chapter 3

CHAPTER 3

Securities Markets

McGraw-Hill/Irwin

© 2008 The McGraw-Hill Companies, Inc., All Rights Reserved.

3.1 HOW FIRMS ISSUE SECURITIES

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Primary Versus Secondary Markets 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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How Securities Are Issued Investment Banking Shelf Registration Private Placements Initial Public Offerings (IPOs)

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Investment Banking Arrangements Underwritten vs. “Best Efforts” – Underwritten: firm commitment on proceeds to the issuing firm – Best Efforts: no commitment on proceeds…

Negotiated vs. Competitive Bid – Negotiated: issuing firm negotiates terms with investment banker – Competitive bid: issuer structures the offering and secures bids

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

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Figure 3.2 A Tombstone Advertisement

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Shelf Registrations SEC Rule 415 Introduced in 1982 Ready to be issued – on the shelf Allows firms to register securities and gradually sell them to the public for two years following the initial registration

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Private Placements Private placement: sale to a limited number of sophisticated investors not requiring the protection of registration Allowed under Rule 144A Dominated by institutions; suitable for smaller offerings; less expensive to issuer Very active market for debt securities Not active for stock offerings

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Initial Public Offerings Process – Road shows (generate interest; provide info on prices the offering might command) – Bookbuilding (indications of interest)

Underpricing – Post-sale returns (median 1-day return, NASDAQ, 1997-02, was 17.8%) – An added cost to the issuing firm (over and above the explicit cost about 7%) 3-10

Figure 3.3 Average Initial Returns for IPOs in Various Countries

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Figure 3.4 Long-term Relative Performance of Initial Public Offerings

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3.2 HOW SECURITIES ARE TRADED

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Types of Secondary Markets Direct search (e.g. newspaper want-ads) Brokered (e.g. real estate brokers) Dealer (e.g. OTC securities market) Auction (e.g. NYSE)

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Types of Orders Market—executed immediately – Bid Price – Ask Price

Price-contingent – Investors specify prices – Stop orders

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Price-Contingent Orders Limit Orders Name a Limit Price Limit-Buy Order: Buy if Market Price is Below Limit Price Limit-Sell Order: Sell if Market Price is Above Limit Price

Stop-Loss Orders Name a Limit Price Stop-Loss Order: Sell if Market Price is Below Limit Price Stop-Buy Order: Buy if Market Price is Above Limit Price

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Figure 3.5 Limit Order Book for Intel on Archipelago

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Figure 3.6 Price-Contingent Orders

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Trading Mechanisms Dealer markets (e.g. OTC markets; dealers quote prices for buy/sell) Electronic communication networks or ECNs (traders post market and limit orders over computer networks; orders matched without broker) Specialists markets (e.g. NYSE; trade in a security managed by specialist; specialist may act as dealer and as broker) 3-19

3.3 U.S. SECURITIES MARKETS

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U.S. Security Markets Nasdaq Small stock OTC – Pink sheets

Organized Exchanges – New York Stock Exchange – American Stock Exchange – Regionals

Electronic Communication Networks (ECNs) 3-21

Nasdaq Nasdaq Global Select Market Nasdaq Global Market Nasdaq Capital Market Small stock OTC – Pink sheets

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New York Stock Exchange Largest exchange in the U.S. Automated for small orders Member functions – Commission brokers – Floor brokers; takes orders to specialist’s post – Specialists

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New York Stock Exchange Now a publicly held company Block sales SuperDot (electronic order routing system; allows firms to send market and limit orders directly to the specialist) Bond Trading – 2006 NYSE obtained approval to expand bond trading – May provide OTH dealer market in bonds 3-24

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

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3.4 MARKET STRUCTURE IN OTHER COUNTRIES

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Other Countries London - predominately electronic trading Euronext – market formed by combination of the Paris, Amsterdam and Brussels exchanges Tokyo Stock Exchange (saitori maintains public limit order book; tries to slow down large price changes; does not trade from own account) 3-27

Figure 3.7 Market Capitalization of Listed Firms, 2005

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3.5 TRADING COSTS

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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 3-30

3.6 BUYING ON MARGIN

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Buying on Margin Using only a portion of the proceeds for an investment Borrow remaining component Margin arrangements differ for stocks and futures

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Buying on Margin Maximum margin is currently 50%; you can borrow up to 50% of the stock value Set by the Fed Maintenance margin: minimum amount equity in trading can be before additional funds must be put into the account Margin call: notification from broker you must put up additional funds 3-33

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 3-34

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%

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Margin Trading - Margin Call How far can the stock price fall before a margin call? Since 1000P - Amt Borrowed = Equity then: (1000P - $35,000) / 1000P = 40%

P = $58.33

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3.7 SHORT SALES

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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 is was borrowed 3-38

Short Sale - Initial Conditions Z Corp 100 Shares  First borrow 100 shares, then sell them. 50% Initial Margin 30% Maintenance Margin $100 Initial Price Sale Proceeds: $10,000 Margin & Equity: 5,000 Initial Margin: $5,000/$10,000 = 50% Value of Stock Owed $10,000

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Short Sale - Maintenance Margin Stock Price Rises to $110 Sale Proceeds $10,000 Initial Margin (T-Bills?) 5,000 Value of Stock Owed $11,000 Margin (5,000 – 1,000) 4,000 Margin % (4,000/11,000) 36% 3-40

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

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3.8 REGULATION OF SECURITIES MARKETS

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Major Regulations Securities Acts of 1933 Securities Acts of 1934 Securities Investor Protection Act of 1970

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Self-Regulation National Association of Securities Dealers (NASD) – Oversees participants in the Nasdaq market

NYSE has its own regulatory arm

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Regulation Response to Recent Scandals Sarbanes-Oxley Act

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Circuit Breakers Trading halts: If DJIA falls by 10%, trading halted fro 1 hour (prior to 2:00 pm.) or ½ hour (between 2 and 2:30 pm) or not at all (after 2:30 pm.) If DJIA falls 20%, trading halted for 2 hours (before 1:00), 1 hour (between 1:00 and 2:00), rest of day (after 2:00). If DJIA falls by 30%, market closed rest of day. Collars: When Dow moves -2% from prior day’s close, Rule 80A of NYSE requires that index arbitrage orders pass a “tick test”. In a falling market, sell orders executed only on a plus tick or, if last price was an uptick, at the last price. 3-46

Insider Trading Illegal Definition of insiders can be ambiguous SEC’s Official Summary of Securities Transactions and Holdings

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