Lecture Presentation Software to accompany

Investment Analysis and Portfolio Management

Eighth Editionby

Frank K. Reilly & Keith C. Brown

Chapter 4

Organization and Functioning of Securities Markets

Questions to be answered:• What is the purpose and function of a market?

• What are the characteristics that determine the quality of a market?

• What is the difference between a primary and secondary capital market and how do these markets support each other?

Organization and Functioning of Securities Markets

• What is Rule 415 and Rule 144A and how do they affect corporate security underwriting?

• What are call markets and when are they typically used?

• What is the third market?• What are Electronic Communication Networks

(ECNs) and alternative trading systems (ATSs) and how do they differ from the primary listing markets?

• What are the major types of orders available to investors and market makers?

What is a market?

• Brings buyers and sellers together to aid in the exchange of goods and services

• Does not require a physical location

• Both buyers and sellers benefit– Reduces search & screening costs

– Price discovery

Characteristics of a Good Market• Availability of past transaction information

– must be timely and accurate

• Liquidity– marketability– price continuity– depth

• Low transaction costs• Rapid adjustment of prices to new information

Decimal Pricing• The Canadian equity market switched to decimal

pricing in April, 1996• The US equity market switched to decimal

pricing in early 2001• All North American equity markets now price in

dollars & cents rather than 1/8ths and 1/16ths• Reasons for decimal pricing:

Easier for investors to understand prices Reduces the size of the bid-ask spread Markets more competitive on a global basis

Organization of the Securities Market

• Primary markets– Market where new securities are sold by the

firms/entities issuing securities – The funds raised go to the issuer

• Secondary markets– Market where already issued securities are

bought and sold by investors. The issuer does not receive any funds in a secondary market transaction

Government Bond Issues

• Treasury Bills – negotiable, non-interest bearing securities

with original maturities of one year or less

• Government of Canada Bonds – original maturities of more

than 1year

• The Bank of Canada publishes detailed information on the

auction process on its website;

http://www.bankofcanada.ca/en/markets/markets_auct.html

Canadian Treasury Bills

• Prior to November 1995 Treasury bills were issued in bearer form and were available in denominations ranging from $1,000 to $1,000,000.

• Effective November 1995 all new issues of Treasury bills are issued in global certificate form only whereby a global certificate for the full amount of the Treasury bill is issued in fully registered form in the name of CDS & Co., a nominee of CDS.

• Treasury bills are sold via auction every two weeks by the Bank of Canada on behalf of the Government of Canada

• Treasury bills must be purchased, transferred or sold, directly or indirectly, through a participant of the Debt Clearing Service, which is operated by CDS, and only in integral multiples of $1,000 (face value).

• The Government of Canada also periodically issues cash management bills (CMBs).

• CMBs are Treasury bills with maturities of less than three months (they can be as short as one day) used as a source of short-term financing for the Government. CMB auctions can take place on any business day, typically for next-day delivery, but on some occasions for same-day delivery.

Government of Canada Coupon Bonds

• Prior to December 1993 Government of Canada bonds were issued in coupon-bearer and fully registered form, and were available in denominations ranging from $1,000 to $1,000,000.

• Between December 1993 and September 1995 Government of Canada bonds were issued only in fully registered form.

• Effective October 1995 Government of Canada marketable bonds are issued in global certificate form only whereby a global certificate for the full amount of the bonds is issued in fully registered form in the name of CDS & Co., a nominee of the Canadian Depository for Securities Limited (CDS).

• The bonds must be purchased, transferred or sold, directly or indirectly, through a participant of the Debt Clearing Service, which is operated by CDS, and only in integral multiples of $1,000 (face value).

• All Canadian-dollar marketable bonds are non-callable and pay a fixed rate of interest semi-annually.

Canada Bills• Canada Bills are promissory notes denominated in US dollars and

issued only in book-entry form. – Book-entry form means that no certificate is issued

• They mature not more than 270 days from their date of issue, and are discount obligations with a minimum order size of US$1,000,000 and a minimum denomination of US$1,000.

• Delivery and payment for Canada Bills occur in same-day funds through Chase Manhattan Bank in New York City.

• Primary distribution of Canada Bills occurs through five dealers: CIBC Wood Gundy Inc., Credit Suisse First Boston Corporation, Goldman, Sachs & Co., Lehman Brothers Inc. and RBC Dominion Securities Inc.

• Rates on Canada Bills are posted daily for terms of one to six months.• Canada Bills are issued for foreign exchange reserve funding purposes

only.

Canada Notes• Canada Notes are promissory notes usually denominated in US dollars

and available in book-entry form. • They are issued in denominations of US$1,000 and integral multiples

thereof. At present the aggregate principal amount outstanding issued under the program is limited to US$10.0 billion.

• Notes can be issued for terms of nine months or longer, and can be issued at a fixed or a floating rate.

• The interest rate or interest rate formula, issue price, stated maturity, redemption or repayment provisions, and any other terms are established by the Government of Canada at the time of issuance of the notes and will be indicated in the Pricing Supplement. Delivery and payment for Canada Notes occur through the Bank of New York.

• The notes are offered by the Government through five dealers: Credit Suisse First Boston Corporation, Goldman, Sachs & Co., Lehman Brothers Inc., Nesbitt Burns Securities Inc. and Scotia Capital Markets (USA) Inc. The Government may also sell notes to other dealers or directly to investors.

• Canada Notes are issued for foreign exchange reserve funding purposes only

Corporate Bond and Stock Issues

New issues are divided into two groups

1. Seasoned new issues - new shares offered by firms that already have stock outstanding

2. Initial public offerings (IPOs) - a firm selling its common stock to the public for the first time

Underwriting Relationships with Investment Bankers

1. Negotiated– Most common– Full services of underwriter

2. Competitive bids– Corporation specifies securities offered– Lower costs– Reduced services of underwriter

3. Best-efforts– Investment banker acts as broker

Shelf Registration

• Allows firms to register securities and sell them piecemeal over the next two years

• Referred to as Rule 415 in the US; as a shelf registration in Canada

• Great flexibility• Reduces registration fees and expenses• Allows requesting competitive bids from several

investment banking firms• Especially popular for bond sales

Private Placements

• The issuing firm sells to a small group of institutional investors without the need for a Prospectus

• Lower issuing costs than a public offering• Referred to as Rule 144A in the US

Why Secondary Financial Markets Are Important

• Provides liquidity to investors who acquire securities in the primary market

• Results in lower required returns than if issuers had to compensate for lower liquidity

• Helps determine market pricing for new issues

Secondary Equity Markets

1. Primary listing markets– New York, American, Tokyo, and London stock

exchanges

2. Regional markets– Toronto, Chicago, San Francisco, Boston, Osaka, Nagoya,

Dublin, Cincinnati

3. OTC markets- Nasdaq

4. Third-market dealers/brokers– Madoff Investment Securities, Knight Trading Group, Jefferies

Group, ITG

5. Fourth Market – alternative trading systems

Alternative Trading Systems (ATSs),

• Electronic Communications Networks (ECNs)– Archipelago, BRUT, Instinet, Island, REDIBook

– Are electronic trading systems that automatically match buy and sell orders at specified prices

• Electronic Crossing Systems (ECSs)– POSIT, Global Instinet Crossing, Arizona Stock Exchange

– provide greater anonymity for participants

Basic Trading Systems• Pure auction market (also known as order-

driven market)– Toronto Stock Exchange– Market price determined by buy & sell orders

placed by investors

• Dealer market (also known as quote-driven market)– NASDAQ– Bid & ask prices posted by dealers who “make

a market” in the stock

Call Versus Continuous Markets

• Call markets trade individual stocks at specified times. All orders are gathered and then a single price is determined which satisfies most orders.– Used for opening prices on TSX if orders build up

overnight or after trading is suspended

• In a continuous market, trades occur at any time the market is open– During regular trading hours, the TSX is a continuous

market

Global Stock Exchanges

• Trend toward consolidations or affiliations that will provide more liquidity and greater economies of scale to support the technology required by investors

• Many of the larger companies in countries such as Canada, the U.K., Germany, and Japan that can qualify for listing on a U.S. exchange become dual-listed

• The existence of strong international exchanges has made possible a global equity market wherein stocks that have a global constituency can be traded around the world 24 hours a day

Major Types of Orders

• Market orders– Buy or sell at the best current price

– Provides immediate liquidity

• Limit orders– Order specifies the buy or sell price

– Time specifications for order may vary

• Instantaneous - “fill or kill”, part of a day, a full day, several days, a week, a month, or good until canceled (GTC)

Major Types of Orders• Short sales

– Sell overpriced stock that you don’t own and purchase it back later (at a lower price)

– Borrow the stock from another investor (through your broker)

– Can only be made on an up-tick– Short seller must pay any dividends to the lender of the

stock– Margin requirements apply (must maintain margin of

150% of current market price)– Subject to “close-outs” during a short squeeze– Lender loses the right to vote the stock

Major Types of Orders

• Special Orders– Stop loss

• Conditional order to sell stock if it drops to a given price

• Market order is triggered once the market price touches the stop loss price

• Does not guarantee price you will get upon sale

– Stop buy order• Investor who sold short may want to limit loss if

stock increases in price

Margin Transactions

• Is available on any type of order but not to all investors (depends on the nature of the account you establish)

• Borrow a portion (usually up to 50%) of the purchase price using the stock as collateral

• Interest rate on margin credit may be below prime rate

• Regulations limit proportion borrowed

• The use of margin leverages or magnifies both gains and losses.

Margin: Canadian Stocks Long Positions

• Margin requirements can be found on the IDA (Investment Dealers Association) website (www.ida.ca) – See Section 100 of their Rule Book. Common stocks are in

Subsection (f), reproduced below.

• On securities (other than bonds and debentures) including rights and warrants listed on any recognized stock exchange in Canada or the United States, on the Tokyo Stock Exchange First Section or on the stock list of the London Stock Exchange:– Securities selling at $2.00 or more - 50% of market value – Securities selling at $1.75 to $1.99 - 60% of market value – Securities selling at $1.50 to $1.74 - 80% of market value

Margin: Canadian Stocks Short Positions

• Securities selling at $2.00 or more - 150% of market value

• Securities selling at $1.50 to $1.99 - $3.00 per share

• Securities selling at $0.25 to $1.49 - 200% of market value

• Securities selling at less than $0.25 - market value plus $0.25 per share

Margin: Interesting facts• The lowest margin requirement is for Treasury bills, which

is equal to 1% of market value multiplied by maturity over 365. Thus the most equity you would have to post to buy a one year Treasury bill would be 1% of its current market value.

• Securities selling under $1.50, securities of companies designated as Capital Pool Companies on the TSX Venture Exchange and securities of companies classified as Tier 3 or Inactive Tier 2 issuers on the TSX Venture Exchange may not be carried on margin.

Margin Transactions

Buy 200 shares at $50 = $10,000 position

Borrow 50%, investment of $5,000

If price increases to $60, position– Value is $12,000

– Less - $5,000 borrowed

– Leaves $7,000 equity for a

– $7,000/$12,000 = 58% equity position

• If the minimum margin is 50%, then have excess margin in your account

Margin Transactions

Buy 200 shares at $50 = $10,000 position

Borrow 50%, investment of $5,000

If price decreases to $40, position– Value is $8,000

– Less - $5,000 borrowed

– Leaves $3,000 equity for a

– $3,000/$8,000 = 37.5% equity position

• If the minimum margin is 50%, then are short margin in the account (will have to add $2,000)