Chapter 3

How Securities are Traded

Primary vs. Secondary Security Sales

Primary: When firms need to raise capital, they may

choose to sell (or float) new securities. These new issues

typically are marketed to the public by investment bankers

in what is called the primary market.

- New issue

- Key factor: issuer receives the proceeds from the sale.

Secondary: Purchase and sale of already-issued

securities among private investors takes place in the

secondary market.

- Existing owner sells to another party.

- Issuing firm doesn’t receive proceeds and is not directly involved.

Investment Banking Arrangements

Public offerings of both stocks and bonds typically are marketed byinvestment bankers, who in this role are called underwriters.

Underwriting arrangements: “Firm Commitment” vs. “Best Efforts”

- Firm Commitment: The issuing firm sells the securities to theunderwriting syndicate for the public offering price less a spreadthat serves as compensation to the underwriters. The underwritersreceive the issue and assume the full risk that the shares cannot infact be sold to the public at the stipulated offering price.

- Best Efforts: In this case, the investment banker agrees to helpthe firm sell the issue to the public but does not actually purchasethe securities. The banker simply acts as an intermediary betweenthe public and the firm and thus does not bear the risk of beingunable to resell purchased securities at the offering price. There isno firm commitment.

Negotiated vs. Competitive Bid

- Negotiated: issuing firm negotiates terms with investment banker.

- Competitive bid: issuer structures the offering and secures bids.

Investment Banking Arrangements

Public Offerings

Public offerings: Has to be registered with theSecurities and Exchange Commission (SEC) andsale is made to the investing public.

- Shelf registration (SEC Rule 415, since 1982)

Allows firms to register securities and gradually sell

them to the public for two years

Shares can be sold on short notice and in small

amounts without incurring high floatation costs

Public Offerings

Initial Public Offerings (IPOs)

- Evidence of underpricing:

There are clear indications that IPOs are underpriced.

Underpricing of IPOs makes them appealing to allinvestors, yet institutional investors are allocated thebulk of a typical new issue.

Some view this as unfair discrimination against smallinvestors.

However, the apparent discounts on IPOs may be nomore than fair payments for a valuable service,specifically, the information contributed by theinstitutional investors.

Private Placements

Privately Held Firms

- Up to 499 shareholders

Investors often form partnerships to buy shares and

get around the 499-investor restrictions

- Raise funds through private placement

- Lower liquidity of shares

- Have fewer obligations to release financial

statements and other information

Private Placements

Private placement: sale to a limited number of

sophisticated investors not requiring the protection

of registration.

Dominated by wealthy institutions.

Very active market for debt securities.

Not active for stock offerings.

Organization of Secondary Markets

Organized exchanges (NYSE, DSE etc.): An exchangeprovides facility for its members to trade securities, and only membersof the exchange may trade there. Therefore, memberships, or seats, onthe exchange are valuable assets. Most seats are owned by the largefull-service brokerage firms. The seat entitles the firm to place one ofits brokers on the floor of the exchange where he or she can executetrades. The exchange member charges investors for executing trades ontheir behalf. A seat on the NYSE has sold over the years for as little as$4,000 in 1878 and as much as $4 million in early December 2005!

The Rise of Electronic Trading:

- When first established, NASDAQ was primarily a OTC dealermarket and the NYSE was a specialist market.

- Today, both are primarily electronic markets.

- NYSE and NASDAQ remain the two largest U.S. stock market.

- But Electronic Communication Networks (ECNs) have steadilyincreased their market share.

The Biggest Stock Markets in the World by Domestic Market Capitalization

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Costs of Trading

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

Short Sales

We know that you can make profit when stockprice is expected to rise. You buy the share andwhen the price goes up, you sell it and makeprofit.

When stock price is falling, even then you canmake profit. You short sell. Meaning? You borrowthe stock and sell it at the current market price.When price falls, you buy back the stock and giveit back to the owner from whom you borrowed it -Profit without any initial investment!

However, this practice is highly regulated.

Short Selling in DSE

Settlement of Stock Exchange Transactions Regulations, 1998:

Regulation 13: “Prohibition of carry forward or short selling.- No

member shall be allowed to short sell any securities or carry forward

any transaction. The defaulting member shall be barred from carrying

out trading in DSE immediately upon detecting the default by DSE

through spot verification of the member’s books & records. DSE shall

simultaneously furnish details of such default to the Securities and

Exchange Commission.”

Short Selling in DSE

Short Selling in DSE

Types of Orders

Instructions to the brokers on how to complete the order

Market order: Market orders are simply buy or sell orders thatare to be executed immediately at current market prices. Thebroker looks for the highest bid price for market sell order or thelowest ask price for market buy order.

Limit order: Investors may also place limit orders, wherebythey specify prices at which they are willing to buy or sell asecurity. As soon as the price reaches the limit, the brokerexecutes the trade, e.g., You have bought a share for $50. Youwant to make at least $5 profit. You place a limit sell order at$55 or You have sold short a share at $50 and want to make atleast $5 profit. You place limit buy order at $45. So, limit buyorder is placed below the current market price and limit sellorder above the current market price.

Types of Orders

Stop (loss) order: The order lets the investor to stopfurther losses from accumulating or helps the investor toensure a certain amount of profit e.g. you have bought ashare for $50. Price has gone up to $55. You want to keepthe upward profit potential open but at the same time wantto ensure a profit of $3. You place a Stop sell order at $53or You have short sold a share for $50. The price has gonedown to $45. You want to keep your downward profitpotential open but want to ensure a profit of $3. You placea stop buy order at $47. So, stop buy order is placed abovethe current market price and stop sell order below thecurrent market price.

Margin Trading

Purchasing stocks on margin means the

investor borrows part of the purchase price

of the stock from a broker.

The broker in turn borrows money from

banks at the call money rate to finance these

purchases and charges its clients that rate

plus a service charge for the loan.

Stock Margin Trading

Percentage margin:

- The percentage margin, which is also known as equity margin, isdefined as the ratio of the net worth or ‘equity value’ of theaccount to the market value of the securities.

- Equity value = the market value - the borrowed amount (Assets –Liabilities)

- Market value = current market price × number of shares

- Percentage margin changes as the market value changes

Initial Margin: The percentage margin at the beginning of theshare purchase.

Stock Margin Trading

Maximum margin: The board of governors of the FederalReserve System sets limits on the extent to which stockpurchases may be financed via margin loans. Currently, theinitial margin requirement is 50%, meaning that at least50% of the purchase price must be paid for in cash, withthe rest borrowed.

Maintenance margin: Minimum level to which the equitymargin or percentage margin can drop

Margin call: Call for more equity funds once thepercentage margin falls below maintenance margin

Stock Margin Trading

Example: Do in class

Share price: $100, 100 Shares Purchased

Borrowed from the broker: $4,000

a) What is the initial margin?

b) What happens to equity margin if share price drops to

$70?

c) If the maintenance margin is 30%, how far could the

stock price fall before the investor would get a margin

call?

Practice Problems

Chapter 3: 6, 7, 9, 10, 15