Ch3. Security markets

3.1. How firms issue securities

• When firms need to raise capital they may choose to sell or float securities.

• - primary market• - secondary market

• Public firms can use the secondary market to raise capitals whereas privately held firms can not.

• Private firms use a private placement (next slide) to raise capitals.

• Procedure:• (1) Preliminary registration (red herring) to SEC for

approval. Information about the issue and prospects of the issuing firm. After it is approved, it is called “prospectus.” The issuing price is announced.

• - Firm commitment: an issuing firm sell securities at a discount (spread between an announced offer price and a purchased price) to underwriters (e.g. investment banks) or syndicates who will sell to the public.

• - Self registration: Under Rule 415, firms can register securities and then sell them gradually to the public for two years.

• -Private placement: primary offering in which shares are sold directly to a small group of institutional or wealthy investors

• (2) Initial Public Offering (IPO)• After SEC approval and distribution of prospectus to

interested investors, investment bankers organize “road show” to publicize imminent offerings (Book and bookbuilding – process of polling potential investors).

• IPO cost tends to be around 7%.• IPO is generally under-priced. It is another cost to

issuing firms and payment for investment services and information distribution.

• Wall Street scandal -“Spinning”: investment bankers used IPO allocation to insider of the issuing firms as kickback in order to curry favors.

• Interestingly, IPOs have been poor long-term investments.

3.2 how securities are traded• 1) Types of markets• (1) Direct search market – least organized market:

buyers and sellers must seek each other directly. E.g) buying refrigerator.

• (2) Brokered market: brokers provide search service and charge to buyers. E.g) Real estate market.

• (3) Dealer market: Dealers specialize in various assets, purchase these assets for their own accounts, and later sell them for a profit from their inventory. Spread between buying and selling prices is their potential profit.

• (4) Auction market: all traders meet at one place to buy and sell an asset. Buyers do not search for sellers in different places. E.g) NYSE

• 2) Types of orders• (1) Market order: buy and sell orders that are to

be executed immediately at current market price. E.g) “buy or sell at market”

• - bid price: the price at which a dealer or trader is willing to purchase securities.

• - asked price: the price at which a dealer or trader is willing to sell securities.

• - bid and ask spread: the difference between a dealer’s bid and asked price.

(2) price-contingent orders

Price falls below the limit

Price rises above the limit

Buy Limit buy order Stop buy order

Sell Stop loss order Limit sell order

• Inside quotes: the highest buy and lowest sell quotes.• Decimal pricing.

• 3) Trading Mechanisms• An investor who wishes to buy and sell shares will place an order

with a brokerage firm. The broker charges a commission for arranging the trade on the client’s behalf. Three major trading systems in U.S.

• (1) Over-the-counter (OTC) dealer markets: an informal network of brokers and dealers who negotiate sales of securities. Dealers quote prices and brokers execute a trade by contacting the dealers. NASDAQ allows for electronic execution of trades at quoted price without the need of direct negotiation.

• (2) Electronic Communication Networks (ECNs) allowing participants to post market and limit orders over computer networks. E.g) Archipelago

• (3) Specialist markets. • Specialist is a trader who makes a market in the shares of one or

more firms and who maintains a fair and orderly market by dealing personally in the market. E.g) NYSE

• Both NASDAQ and NYSE are primarily electronic markets.

• (4) Another issues: Price increments (Tick size) and electronical integration.

• Dealers’ profits from big bid and ask spreads, using varying quotes in markets.

• Decimalization (1 cent tick size) dramatically reduces the cost of trading (effective bid-ask spread).

• Regulation NMS (national market system) in 2007: to link exchanges electronically, creating in effect one integrated electronic market.

3.3. U.S. markets• NASDAQ is the most important dealers’ market and NYSE is the

most important former exchange market. • 1) NASDAQ lists about 3000 firms and offers three listing options.

Originally it was price quotation system but started to include electronic trading system.

• -Three market quotation: NASDAQ global select market is for the largest, most actively traded firms. NASDAQ Global market is for the next tier of firms. NASDAQ capital market is the third tier of listed firms. Table 3.1 shows the listing requirements, depending on market classification.

• - Three levels of subscribers: level 3 subscribers are market makers in OTC. They maintain inventories and buy and sell securities at the quoted bid and ask prices. They are able to enter bid and ask price. Level 2 subscribers receive only bid and ask price but can not enter. They are typically brokers. Level 3 subscribers receive only inside quotes.

• - NASDAQ Market Center: integrated electronic market system.

• NASDAQ purchased Instinet which operates the major electronic communications network INET.

• 2) New York Stock Exchange (NYSE) listing about 2800.• Specialist markets and seats• An investor places an order with a brokerage firm which either

sends the order to the floor of the exchange via computer network or contacts its brokers on the floor of the exchange to work the order. Small orders are almost sent electronically for automatic execution while larger orders are prone to be sent a floor broker for negotiation.

• Merged with Archipelago to form a publicly held company called NYSE Group in 2006. Merged with Euronext to form NYSE-Euronext in 2007.

• Each seat on the exchange is replaced by an annual license permitting traders to conduct business on the floor.

• SuperDot: electronic order-routing system that enables brokerage firms to send market and limit orders directly to the specialist over the line.

• Direct +: fully automated trade-execution system, no limit in sizes.• NYSE Hybrid: system allowing brokers immediately send orders to

dealers or specialists.

• 3) Electronic communication networks (ECN).• Markets gaining advantage over less automated markets.• ECN market: Direct Edge, BATS and NYSE Arca• Brokers affiliating ECN can access and enter orders in limit order

book.• Reduced Latency (time it takes to accept, process, and deliver the

order)

• 3.4. new trading strategies• The marriage of electronic trading with computer tech has significant

impacts on trading.

1) Algorithmic trading is the use of computer program to make rapid trading decisions. This system exploits very small discrepancies in security prices, cross-market price comparison, very short term trend caused by new information, etc. e.g) Pair trading in which normal price relations between pairs of stocks seems temporarily disrupted and traders can receive small profits. But it caused Flash Crash of 2010.

2) High-frequency Trading: a subset of Algorithmic trading that relies on computer programs to make very rapid trading decisions, exploiting bid-ask spreads or tiny cross market price discrepancy. The success relies on the speed (millisecond or microsecond) to identify and execute this profit opportunity. Thus colocation of trading center next to electronic exchange trading became an issue.

• 3) Dark Pools• Blocks: a trade of more than 10,000 shares.• Block traders worry their impacts on pricing. Thus tend to seek

anonymity.• Dark Pools: electronic trading system where participants can

anonymously buy or sell large blocks of securities. Even trades are not reported.

• 4) Bond trading• Most of bond trades happens in OTC market with dealers using a

computer quotation system.• In 2006, the NYSE obtained regulatory approval to expand its bond

trading system (NYSE Bonds)to include the debt issues of any NYSE-listed firm.

3.5 Market structure in other countries

1) London: • - Electronic trading system, SETS (stock exchange electronic trading

system)• - FTSE (footsie) 100 Index2) Euronext- a merger of Paris, Amsterdam and Brussels exchanges.- Merged with NYSE- Electronic trading system, NSC.- Cross trading agreement with several other European exchanges3) Tokyo - Converting to electronic trading- First section is for larger size firms. Second section is for mid size firms.

Mothers section is for emerging and high-growth stocks.- Nikkei 225 (price weighted) and TOPIX (value weighted)

4) Globalization and consolidation

3.6 Trading costs

• 1) Broker’s commission• - full service: executing order, holding securities,

extending margin loans, facilitating short sales, advice relating to investment alternatives.

• - discount service: same services of full service except for advice. Just providing price information.

• 2) Dealer’s bid and ask spread.• 3) Buyers’ price concession.

3.6. Buying on Margin• Borrow part of purchasing price of the stock from a

broker. The broker borrows money from a bank at the call rate. It is called broker’s call loans.

• Margin: portion of purchasing price contributed by an investor. The remainder is borrowed from the broker. If securities are purchased on margin, they are maintained with a brokerage firm in street name (collateral). The percentage margin decreases below the maintenance margin set by the broker, the broker issues margin call which requires an investor to add more cash or securities to the margin account.

• Board of Governors of Federal Reserve System limits

margin loans. Current initial margin requirement is 50%.

• E.g) Buy 100 stocks at $100, borrowing $4000 from a broker.

• Assets Liabilities and equities• Stock $10,000 Loan $4,000

Equity $6,000

Margin=Equity / Stock = 6000/10000

• e.g) If the stock price reduces by 30%, • Asset Liabilities & equities• $7,000 Loan $4,000

Equity $3000

Margin = 3000/7000 = 0.43

e.g) what is the price to meet the maintenance margin of 0.3?

(100P-4000)/100P = 0.3 here P is a stock price. P= $57.14. If the price falls below $57.14, the broker issues a margin call.

• E.g) margin amplifies the risk (ignoring dividend payments)

• 1) invest $10000 at $100 per share. If price goes up by 30%, then return is 30%.

• [130*(10000/100)-10000]/10000=30%

• 2) invest $20000 including margin of $10000 at $100 per share. A rate of margin loan is 9% per year. If price goes up by 30%, then

[(130*(20000/100)-10000-10000*0.09) -10000] / 10000 = 51%

• 3) if price goes down by 30%, • [70*(10000/100)-10000]/10000 = -30%

• 4) if price goes down by 30%, the investment on margin generates

• [(70*(20000/100)-10000 -0.9*10000)-10000]/10000 = - 69%.

3.4 Short sales• (Covering) short sales: The sale of shares not owned by

the investors but borrowed through a broker and later purchased to replace the loan.

• (Naked) short sales: The sale of share owned but later purchased when the short sale is closed.

• Short sellers profit from a decline in a security’s price but pay the lender of the security any dividend paid during the short sale. They are required to post margin (cash or collateral) with the broker to cover loss.

• The proceeds from short sale is required to be kept on account with the broker and can not be invested to generate incomes.

• Due to loss from rising stock price, short sale tends to come with stop buy order.

• Securities for short sale is typically provided by a brokerage firm.

• E.g) an investor short sells 1000 shares (market price per share is $100). 50% margin requirement from the broker is set up. The investor use T-bill of 50000 as margin requirement.

• Cash 100000 Short position 100000• T-bill 50000 Equity 50000

• Margin = equity / value of stock = 50000 / 100000 = 0.5

3.8 Regulation• 1) Federal and state laws• Security Act of 1933: full disclosure of relevant

information relating to the issue of new securities.• Securities Exchange Act of 1934: • - Established and empowered SEC to register and

regulate securities exchanges, OTC trading, brokers and dealers.

• Commodity Futures Trading Commission (CFTC) regulates trading in futures market

• Security Investor Protection Act (1970) established the Security Investor Protection Corporation (SIPC) to protect investors from failure of brokerage firms.

• Blue sky laws: state laws to regulate security trading.• Self-regulation: Financial Industry Regulatory Authority

(FINRA) and CFA Institute

• 2) Scandals and regulation• Three types of scandals: allocation of shares in IPO, tainted

securities research and recommendations, and misleading financial statements/accounting practices.

• Sarbanes-Oxley Act (2002): page 76-77.

• 3) Inside trading: illegal trading with inside information. Inside information means that non-public information/knowledge about a corporation possessed by corporate officers, major owners, or other individuals with privileged access to information about the firm.

• SEC requires officers, directors, and major stockholders to report all transactions in their firm’s stock.