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Chapter 3 How Securities are Traded

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Page 1: Chapter 3 How Securities are Traded. McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. Primary vs. Secondary Security Sales

Chapter 3

How Securities are Traded

Page 2: Chapter 3 How Securities are Traded. McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. Primary vs. Secondary Security Sales

McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved.

Primary vs. Secondary Security Sales

• Primary•

• Secondary•

Page 3: Chapter 3 How Securities are Traded. McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. Primary vs. Secondary Security Sales

McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved.

Investment Banking Arrangements

• Underwritten vs. “Best Efforts”• Underwritten: • Best Efforts:

• Negotiated vs. Competitive Bid• Negotiated: • Competitive bid:

Page 4: Chapter 3 How Securities are Traded. McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. Primary vs. Secondary Security Sales

McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved.

• Public offerings: registered with the SEC and sale is made to the investing public• Shelf registration (Rule 415, since 1982)

• Initial Public Offerings (IPOs)•

Public Offerings

Page 5: Chapter 3 How Securities are Traded. McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. Primary vs. Secondary Security Sales

McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved.

Private placement: sale to a limitednumber of sophisticated investors notrequiring the protection of registration• Allowed under Rule 144A• Dominated by institutions• Very active market for debt securities• Not active for stock offerings

Private Placements

Page 6: Chapter 3 How Securities are Traded. McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. Primary vs. Secondary Security Sales

McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved.

Organization of Secondary Markets

• Organized exchanges• OTC market• Third market• Fourth market

Page 7: Chapter 3 How Securities are Traded. McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. Primary vs. Secondary Security Sales

McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved.

Organized Exchanges

• Auction markets with centralized order flow

• Dealership function: can be competitive or assigned by the exchange (Specialists)

• Securities: stock, futures contracts, options, and to a lesser extent, bonds

• Examples: NYSE, AMEX, Regionals, CBOE

Page 8: Chapter 3 How Securities are Traded. McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. Primary vs. Secondary Security Sales

McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved.

OTC Market• Dealer market without centralized order flow• NASDAQ: largest organized stock market for

OTC trading; information system for individuals, brokers and dealers• National Market System• Nasdaq SmallCap Market

• Lower volume securities• OTC Bulletin Board• Pink Sheets from NASD

• Securities: stocks, bonds and some derivatives• Most secondary bond transactions

Page 9: Chapter 3 How Securities are Traded. McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. Primary vs. Secondary Security Sales

McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved.

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

Page 10: Chapter 3 How Securities are Traded. McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. Primary vs. Secondary Security Sales

McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved.

Fourth Market

• Investors trading directly with other investors

• Originally developed for institutional trading

• Trading now on ECNs• Technological developments leading to

individual investors trading directly

Page 11: Chapter 3 How Securities are Traded. McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. Primary vs. Secondary Security Sales

McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved.

Electronic Computer Networks (ECNs)

• Major ECNs• Island ECN• Instinet• REDIBook• Archipeligo

• Competing with Nasdaq and NYSE for volume

• Leads to some fragmentation of markets

Page 12: Chapter 3 How Securities are Traded. McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. Primary vs. Secondary Security Sales

McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved.

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

Page 13: Chapter 3 How Securities are Traded. McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. Primary vs. Secondary Security Sales

McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved.

Types of Orders

Instructions to the brokers on how tocomplete the order• Market• Limit• Stop loss

Page 14: Chapter 3 How Securities are Traded. McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. Primary vs. Secondary Security Sales

McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved.

Margin Trading

• Using only a portion of the proceeds for an investment

• Borrow remaining component• Margin arrangements differ for stocks

and futures

Page 15: Chapter 3 How Securities are Traded. McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. Primary vs. Secondary Security Sales

McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved.

Stock Margin Trading• Maximum margin is currently 50%;

• • Maintenance margin:

• Margin call:

Page 16: Chapter 3 How Securities are Traded. McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. Primary vs. Secondary Security Sales

McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved.

Margin Trading - Initial Conditions

X Corp $70

50% Initial Margin

40% Maintenance Margin

1000 Shares Purchased

Initial Position

Stock $70,000 Borrowed $35,000

Equity 35,000

Page 17: Chapter 3 How Securities are Traded. McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. Primary vs. Secondary Security Sales

McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved.

Margin Trading - Maintenance Margin

Stock price falls to $60 per share

New Position

Stock $60,000 Borrowed $35,000

Equity 25,000

Margin% =

Page 18: Chapter 3 How Securities are Traded. McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. Primary vs. Secondary Security Sales

McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved.

Margin Trading - Margin Call

How far can the stock price fall before amargin call?

(1000P - $35,000)* / 1000P = 40%

P =

* 1000P - Amt Borrowed = Equity

Page 19: Chapter 3 How Securities are Traded. McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. Primary vs. Secondary Security Sales

McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved.

Short SalesPurpose: to profit from a decline in the

price of a stock or securityMechanics•

Page 20: Chapter 3 How Securities are Traded. McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. Primary vs. Secondary Security Sales

McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved.

Short Sale - Initial Conditions

Z Corp 100 Shares

50% Initial Margin

30% Maintenance Margin

$100 Initial Price

Sale Proceeds $10,000

Margin & Equity 5,000

Stock Owed

Page 21: Chapter 3 How Securities are Traded. McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. Primary vs. Secondary Security Sales

McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved.

Short Sale - Maintenance Margin

Stock Price Rises to $110

Sale Proceeds $10,000

Initial Margin 5,000

Stock Owed 11,000

Net Equity 4,000

Margin %

Page 22: Chapter 3 How Securities are Traded. McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. Primary vs. Secondary Security Sales

McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved.

Short Sale - Margin Call

How much can the stock price rise before a margin call?

($15,000* - 100P) / (100P) = 30%P =

* Initial margin plus sale proceeds

Page 23: Chapter 3 How Securities are Traded. McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved. Primary vs. Secondary Security Sales

McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved.

Regulation and Trends in Markets

• ECNs present new challenges in regulation

• Global markets with alliances are developing

• Current Issues with• Agency problems associated with

investment banking and research• Insider trading violations


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