Chapter 1

Securities Markets and Market Mechanics

Primary Market vs. Secondary Market

• Primary– Sale of new securities to raise money for issuer

• Secondary– Resale of securities – Issuing company not involved

Go public• process in which start-up or heretofore private

firm sells its shares in public offering

Initial Public Offering (IPO)• offering to public of securities in firm

previously privately held

Red Herring• Registration statement that initiates a public

offering; front page contains a paragraph in red ink

Investment banker• firm that advises on and/or brings new issues to

the market

Underwrite• to agree to buy a new security issue, with

intention to sell securities to public at higher price

Prospectus

• Official document that all companies offering new securities to the public must file with SEC

• Spells out in detail – financial position of offering company– what new funds will be used for– qualifications of corporate officers– risk factors– nature of competition– other material information

Best-effort basis• a securities offering in which underwriter

acts as agent for issuer but is not obligated to purchase securities

Firm-commitment basis• underwriter purchases securities from

issuer and commits to selling them to public

Shelf Registration

• SEC provision allowing pre-registration of amount of security to be sold over a 2-year period without specific registration of each sale

• permitted by SEC Rule 415

Private Placement

• Direct sale of securities to one or small number of large buyers without registration requirements of public offering

• Legal restrictions on – who may purchase – resale of securities purchased in a private

placement

Lettered Stock

• Newly issued • Sold at discount to large investors in private

placement prior to a public offering of same issue• Restricted• Buyers agree not to sell their shares for specified

period (SEC Rule 144)

Secondary Offering or Distribution

• Large public securities offering • Made outside the usual exchange or OTC

market• Allows more time for absorption of large

quantity than usual channels

Secondary Market: The Players

• Brokerage firms

• Registered representatives (brokers)

• Dealers

• Floor Brokers

• Specialists

• Registered competitive market makers

Brokerage firm• Offers various financial services including

– access to the securities markets– account management– margin loans– investment advice– underwriting

Registered Representative• Employee of registered brokerage firm qualified to serve as

account executive for customers, a.k.a. broker – must be licensed to sell securities and pass series 7 exam – individuals who have passed the series 6 exam are licensed to

sell products such as mutual funds and initial offerings of closed-end investment companies

Dealer• Security trader • Acts as principal rather than as agent • Considered a specialist or a market maker• NOT a broker

Floor Broker• Employees of firms who execute trades on an

exchange floor on behalf of their firm’s clients

Specialist• Exchange member who makes a market in listed

securities

Registered Competitive Market Maker (RCMM)• Holds a seat on exchange • Trades for his or her own account• Also called floor traders

Gramm-Leach-Bliley Act• Accelerated the erosion of the lines between

brokerage firms and other financial services firms

Roles of the Specialist

• Auctioneer: establishes the opening price for a security and maintains a fair and orderly market

• Agent: executes orders for floor brokers• Catalyst: conduit of order flow• Provider of capital: uses firm’s capital to minimize any

imbalance between public demand and supply for a security

• Stabilizes prices: buy and sell stock to cushion temporary imbalances and avoid unreasonable price variations

The Secondary Market:The Institutions

• Stock exchanges– National– Regionals

• Over-the-counter

• Third and fourth markets

• Consolidated tape

NYSE (New York Stock Exchange)• Largest based on Wall Street• Lists large- to mid-capitalization stocks• Toughest for listing standards• A membership is referred to as a Seat

AMEX (American Stock Exchange)• Deals in small- to mid-capitalization stocks• Merged with NASDAQ

Regional Exchanges

• Chicago Stock Exchange

• Pacific Exchange

• Boston Stock Exchange

• Philadelphia Stock Exchange

• Cincinnati Stock Exchange

Dual Listing• Security listed for trading on more than

one organization, usually the NYSE and in over-the-counter market

OTC (Over-the-Counter)• Market in unlisted securities and off-

board trading in listed securities

NASDAQ

• Automated information system that provides brokers and dealers with price quotations on securities traded over-the-counter

• Formerly National Association of Securities Dealers Automated Quotations

Three Categories of NASDAQ OTC Quotations

• National Market Issues (NMI): largest and most actively traded stocks

• SmallCap List: smaller firms• Bulletin Board: much smaller issues

NASDAQ Quotations

• Level 1: subscribers receive only the highest bid and lowest ask prices on a security

• Level 2: subscribers can receive all prices but can not enter quotes

• Level 3: subscription entitles users to enter their own bid and ask prices

Pink Sheets• Quotation source for most publicly traded OTC

issues

Third Market• Over-the-counter trading of exchange-listed

securities

Fourth Market• Direct trading of listed securities between

institutions

The Secondary Market:The Transactions

• Costs of trading

• Types of Orders

• SuperDot and PERS

• Selling Short

• Large Secondary Market Trades

Cost of Trading

• Commissions (explicit): fees charged by brokers for handling investment transactions

– May Day: SEC abolished fixed-commission schedule on May 1, 1975• Bid-ask spread (implicit): price difference

between bid price and ask price for an asset• Price concession (implicit): only on large orders

Market Order• Order to buy or sell at market price that

requires immediate executionLimit Order• Order to buy or sell at prespecified priceStop-Loss Order • Order to sell or buy at market when certain

price is reachedStop-Limit Order• Order to implement limit order when market

price reaches certain level(continued)

Types of Orders

MIT Order• Becomes a market order if a specified price or

better is reachedDay Order • Executable only during day order placedFill-or-Kill Order• Canceled if not immediately executedGTC Order• Remains in effect until executed or canceledVersus Purchase• sale that specifies purchase date of securities to

be delivered for sale

Types of Orders (continued)

SuperDot (Super Designated Order Turnaround System)

• Used at NYSE• Transmits member firms’ market and day limit

orders through common message switch to proper trading floor workstation

• Largest market order that can be handled is 30,099 shares

• Used particularly for program trading

PERS (Post Execution Routing System)• Used on the AMEX• Same as the SuperDot

Selling Short

• Selling asset not owned with commitment to purchase asset in future

• Can now be done on uptick or downtick

• Must be able to borrow necessary securities

Bear Raid

• Attempt to drive prices down by selling short

Block Trade• trade involving 10,000 shares or more• usually handled by block house

Special Offerings• Large block of stock offered for sale on

exchange with special incentive fees paid to purchasing brokers

• Also called spot secondary

Tender Offer

• Offer to purchase a large block of securities

• Made outside the general market (exchanges, OTC)

• Tender offer may be part of an effort to take over company

Security Markets: Regulation

• Securities Act of 1933• Securities Exchange Act of 1934• Investment Company Act of 1940• Investment Advisor Act of 1940• SIPC Act of 1970• Securities Act Amendments of 1975• Sarbanes-Oxley Act of 2002• Banking Act of 1933

Securities Act of 1933• Deals with issuance of securities• Addresses the registration process, disclosure

requirements, and related matters

Securities Exchange Act of 1934• Deals with existing securities• Addresses filing of periodic reports, regulation of

exchanges and brokerage firms, ongoing disclosure requirements

• Prohibits certain unethical practices, such as market manipulation and insider trading

Investment Company Act of 1940• Requires that investment companies disclose their financial condition and investment policies to investors when stock is initially sold and, subsequently, on a regular basis

Investment Advisors Act of 1940 • Requires that firms or sole practitioners compensated for advising others about securities investments must register with SEC and conform to regulations designed to protect investors

Securities Investor Protection Act of 1970• Created the federal agency Securities Investor Protection Corporation • Guarantees the safety of brokerage accounts up to $500,000, no more than $100,000 of which may be in cash

Securities Act Amendments of 1975• Calls for national competitive system for securities trading • Ended fixed brokerage commission rates

Sarbanes-Oxley Act of 2002• Mandates reforms to

– Enhance corporate responsibility– Enhance financial disclosures– Combat corporate and accounting fraud

• Creates the “Public Company Accounting Oversight Board,” also known as the PCAOB

• Oversees the activities of the auditing profession.

Banking Act of 1933• Created the FDIC, provider of deposit insurance

Practical Issues

• Street Name

• Stock Certificates

• Types of Accounts– Cash– Margin– Option– Wrap

Street Name• securities held in customer accounts at

brokerage houses but registered in firm’s name

Advantages of Street-Name Registration

• Offers secure storage• Lets securities be traded without new certificates being

issued or certificates delivered in a timely manner• Allows customers who move frequently to file only one

change of address with brokerage firm instead of notifying all companies separately

• Only single Form 1099 needs to be filed

Disadvantages of Street-Name Registration

• Assets may be tied up during the reorganization of bankrupt brokerage firm

• Dividends and interest may be credited to an improper account

• Properly credited dividends may be retained by broker in a non-interest-bearing account for a few days before being sent to shareholder

• Discount coupons and sample products not sent to street-name accounts

Stock Certificates• Document showing ownership of

specified number of shares of company’s stock

Types of Accounts

• Cash Account– Type 1 account– Must have sufficient cash at time of purchase

• Margin Account– Type 2 account– Can borrow up to margin limit– Short sales in this account only

• Option Account– Special paperwork required

Discretionary Account• Account over which broker is authorized to

exercise FULL discretion with regard to purchases and sales

Limited Discretionary Account• Gives broker authority to make only certain

types of trades without prior consent

Wrap Accounts

• Advantages:

– Customization: Tailored to individual’s specific needs. Clients may choose not to hold a particular company or industry for personal, ethical, or economic reasons.

– Tax efficiency: Optimal tax treatment can be achieved.

– Simple fee structure: wrap fee makes cost of account clear and explicit

• Disadvantage:

– Total fee may be higher than that paid by most accounts

Portfolio Turnover Rate

• Measures trading activity in an account by showing the percentage of the portfolio that has been replaced during a given time period